CHAPTER 1

Accounting: Information for Decision Making

Solutions

REVIEW QUESTIONS

1.1 Step 1: Specify the decision problem, including the decision maker’s goals.
Step 2: Identify options.
Step 3: Measure benefits (advantages) and costs (disadvantages) to determine the value
(benefits reaped less costs incurred) of each option.
Step 4: Make the decision, choosing the option with the highest value.

1.2 Because people place different emphasis on factors such as money, risk, and leisure.

1.3 The benefits of an option less its costs. Because value is the contribution of an option to the
decision maker’s goals, we measure value relative to the status quo, which is not doing
anything at all.

1.4 The value of the next best option.

1.5 An organization is a group of individuals engaged in a collectively beneficial mission. The

key difference between individual and organizational decision making relates to goals –
organizational goals rarely coincide with the goals of all individual participants.

1.6 (1) Policies and procedures; (2) Monitoring; (3) Incentive schemes and performance
evaluation.

1.7 Planning decisions relate to choices about acquiring and using resources to deliver products
and services to customers. Control decisions relate to motivating, monitoring, and
evaluating performance.

1.8 Plan, Implement, Evaluate, Revise (PIER Cycle).

1.9 To help measure the costs and benefits of decision options.

1.10 Persons outside the firm. These individuals make decisions about buying and selling stock,
lending money, dividends, and taxes.

1.11 Persons inside the firm. These individuals make decisions about which products and
services to offer, the prices of products and services, what equipment to purchase, who to
hire and how to pay them.

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1.12 The primary users (external vs. internal), governing principles, the unit of analysis,
emphasis, periodicity, and types of data considered.

1.13 Ethics relate to every step of the decision framework. Ethics can shape our goals, the
options we consider, how we measure costs and benefits, and the ultimate decision we
make.

1.14 The Foreign Corrupt Practices Act of 1977.

1.15 The key financial players include the CEO, CFO, controller, treasurer, and chief internal
auditor. The roles of each player are described in detail in the appendix.

1.16 (1) Competence, (2) Confidentiality, (3) Integrity, and (4) Objectivity.

DISCUSSION QUESTIONS

1.17 Your ultimate goal could be to earn as much as you can before you retire, say, 40 years
after you graduate. With this goal in mind, you have to plan a career path and evaluate the
three job offers to see which of these jobs will take you on that path. Besides pay, factors
such as the reputation of the organization, the quality of on-the-job training you will get,
opportunities to climb the organizational ladder are very important from a career
perspective. If all three job offers are equally attractive in terms of the career you have
chosen for yourself, then short-term goals and desires will dictate which job offer you
should accept. All else equal, you will naturally want to accept the job offer that pays you
the most, or you may be willing to accept slightly lower pay to live in a city that you like,
or work for an organization with better reputation, and so on.

1.18 Yes, this statement is true. Opportunity cost is the value of the next best option. As more
options become available, it is possible that a new option may be more attractive than the
current best option, in which case the new option becomes the best option, and the current
best option becomes the next best option. In this case, the opportunity cost increases but it
can never decrease as long as all the current options are also available to choose from.

1.19 Let us assume that you are not fully prepared for your exam tomorrow (if you are fully
prepared, then you might as well watch TV because you stand to lose nothing i.e., your
opportunity cost is zero). By watching TV, you risk being unable to answer some questions
and making a poorer grade in the exam. Thus, the opportunity cost is the lost benefit from
not receiving a better grade that the preparation would have helped you secure.

1.20 Let us say that the full-time MBA program takes two years to complete. The opportunity
cost of pursuing the program is the income she will be losing over this period by quitting
her existing job, the experience she will lose from not being on the job for two years, and
any promotions she may be foregoing.

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1.21 Differences in individual goals can arise from:

 Differences in preferences: Some individuals place a greater weight on maximizing

wealth, others place a greater weight on being the best in what they do (the two are not
always perfectly correlated)
 Attitudes toward risk: Some have a greater tolerance for risk than others
 Differences in ethical thresholds: What is perfectly acceptable ethical behavior for some
may not be acceptable to others.

A Casino is a good example of a business that exploits variations in individual tastes for risk.
Casinos tailor their offerings to accommodate individuals with different risk tolerance levels
– some involve high stakes where risks and returns are higher, and others involve low stakes.

1.22 This problem is an exercise in conditional probability. You have no choice but to pick a
door at random in the first stage. Once the door has been opened you have only two
options: Stay with your initial pick or switch. Let us evaluate the chance of winning with
both options.
(1) Suppose you stay with your initial pick. Then, the following outcomes are possible
a. You initially picked the door that had the prize. Since you are staying with your
choice, you win for sure.
b. You initially picked a door that did not have the prize. Then, because you are
staying with your choice, you lose for sure.
Because the initial choice is random, the probability that you are in situation (a) is 1/3
and the probability that you are in situation (b) is 2/3. In situation (a) staying with your
choice leads to 100% chance of winning and in situation (b) staying leads to 0% chance
of winning. Thus, the probability of winning by following this strategy is 1/3*1 + 2/3*0 =
1/3.

(2) The key to computing the probability of winning in this case is to realize that the host
will only open the door that does NOT have the prize. Then the following outcomes are
possible:
a. You initially picked the door that had the prize. Then, if you switch, you lose for
sure.
b. You initially picked a door that did not have the prize. Then, one of the two
remaining doors has the prize. But, the host will not pick this door. He will only
open the door without the prize, meaning that the closed door (which you did not
pick) has the prize for sure.
The probability that you are in situation (a) is 1/3 and the probability that you are in
situation (b) is 2/3. In situation (a) switching leads to 0% chance of winning and in
situation (b) switching leads to 100% chance of winning. Thus, the probability of
winning by following this strategy is 1/3*0 + 2/3*1 = 2/3! A random pick followed by
switching doors is the smart choice.

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This problem has vexed many people (do a Google search on “Monty Hall Problem”)
because the solution is counter intuitive.

1.23 The goal of a nonprofit hospital is to provide adequate healthcare to the community it
serves at low cost, without a profit motive. The goal of a university is to meet the
educational needs of the community/country and to promote knowledge and discovery.
Many universities also attract students from other states/countries as part of an outreach
effort to promote diversity and learning. State universities are mostly government funded
and do not have an explicit profit motive, but most private universities do. The goal of an
honor society in a university is to promote academic excellence, cultural diversity, and
leadership.

1.24 The goal of a class is typically articulated in the syllabus – to effectively communicate the
subject matter and its importance to the students, and to ensure that students leave the class
with a good understanding of the concepts, principles and methods relating to the subject
matter. Your individual goals might include learning the subject thoroughly and/or earning
an “A” in the class. Goals can diverge. You may not be as interested in the subject matter
as you are in getting an “A.” You would prefer easier exams, and less homework. But your
instructor may be more interested in your learning the subject matter and may assign you a
lot of homework, and may administer tough exams. The instructor can motivate you by
making you work hard, giving challenging tests, presenting the subject matter in a way that
gets you interested, and offering a lot of help and guidance outside the classroom.

1.25 Sales commissions are a way to motivate sales personnel to strive hard to sell more. The
more they are able to sell, the more money they get. The advantage of course is that
revenues and profits increase for the organization. The disadvantage is that commissions
often make the sales people follow aggressive tactics with potential buyers (you may have
experienced this behavior in auto dealerships, department stores, furniture stores, and
consumer electronics stores). Such behavior may turn away customers in the long run.
Commissions also promote cut-throat competition among sales personnel in vying for
customers, which can prove counter-productive.

1.26 In wars and in combat situations, individuals have to depend on each other for survival.
Working well in groups becomes a matter of life and death. So there is a natural alignment
between team and individual goals. In a typical profit-making organization, the “free-rider”
problem is more difficult to eliminate, because there is a natural incentive for each
individual to contribute minimally to team goals and yet try to reap the full benefit. You
may see this behavior when you work on group assignments for your class. Some
individuals take responsibility and put in the effort needed, while others – realizing that the
work is going to get done – do not contribute as much, and devote their time to other
“productive” activities. The incentives are similar in profit-making organizations as well.

1.27 When we say “that wasn’t too bad,” we are essentially comparing what happened with
what we expected would happen. That is, our expectations were not met. Most of us plan
ahead, and sometimes things don’t quite go the way we plan, for reasons beyond our

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control. In such instances, we adjust our expectations and then evaluate what actually
happened. For example, let us say you set out on a drive to Chicago from Bloomington,
Indiana and you plan to cover the distance in 4 hours. But along the way, you run into
unexpected rough weather, and it takes you 6 hours to reach Chicago. Given the driving
conditions that you had to endure, you say to yourself “that wasn’t too bad.”

1.28 Yes, it does. There is a control problem in both scenarios. But in the first scenario the
control problem is not related to divergence in goals, which is the case when you have to
evaluate another individual’s performance. A process can go out of control for reasons
beyond your control, and all you can do is to fine tune the process. Feedback on how the
process is going helps in this respect. In the second case, you have to control another
individual’s actions through monitoring or by providing appropriate incentives.

1.29 Financial statements of companies are in general very aggregate. They provide an
assessment of performance over a period, say, a quarter or a year. They reflect the
combined outcome of scores of actions taken by thousands of individuals within the
organization over that period. They also report past performance and are not forward
looking, which is what we need for decision making. Therefore, financial statements are
not particularly useful for day-to-day decision making.

1.30 Yes, in general, this is true. Most accounting systems are designed to measure historical
performance. However, the purpose of a management accounting system is to help decision
making by providing reasonable estimates of opportunity costs. To the extent that trends in
historical cost patterns can help in estimating future costs (or opportunity costs), even
traditional financial accounting systems do help.

1.31 One could argue effectively that firms, interested in surviving in a competitive
marketplace, would want to do so. By engaging auditors even if not required to do so, firms
are signaling to investors that they have nothing to hide and that they are good firms to
invest in. As another example, in this increasing global product markets, many companies
seek third-party quality assurance (such as ISO 9000) to convey to all the markets around
the world that their products are of high quality. Note that such third-party certifications are
not required by governments.

1.32 This is a tough question. You face a difficult trade-off involving a troubling ethical
dilemma. Many TV channels, especially family-oriented channels, would opt to not show
the tape because it might hurt their viewership in the long-run, let alone cause emotional
harm in the short run. Such channels do not face much of a trade-off. On the other hand,
other TV stations, in particular cable channels, might well allow their profit motive to
dictate their decision.

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EXERCISES

1.33.
a. Microsoft corporation lists “[T]o enable people and businesses throughout the world to
realize their full potential” as its overarching mission. The firm also lists a variety of related
goals and strategies, such as trustworthy computing and broad customer connection, designed
to accomplish this mission.

Microsoft’s goals and objectives are particularly noteworthy because they do not make
explicit reference to the shareholders’ ultimate goal of maximizing the return on their
investment. There are at least two ways to view this.

Some argue that, as a modern organization, Microsoft recognizes the claims of multiple
stakeholders in the corporation arising because of the firm’s size and impact on the economy.
That is, the organization recognizes its obligations to parties such as its customers,
employees, and society. A modern firm’s mission statement reflects this broader view of the
organization in which profit maximization is not the firm’s only goal.

Others argue that even the broader statements are a means to an end. For example, the goal of
“trustworthy computing” or “excellence in everything we do” surely increases the market for
Microsoft’s products. Similarly, a firm may stress environment-friendly operations because
doing so is good business. The focus helps the firm reduce costs (by reducing the risk of
future litigation and payouts), increase revenues (by potentially enlarging the customer base),
and comply with governmental regulations (thereby avoiding fines). Similar arguments apply
for firms’ attention to worker health and safety. Thus, one might view all of Microsoft’s
goals and strategies as being consistent with profit maximization.

Both views are reasonable. The strength of your belief in the for-profit orientation of
corporations determines your choice between the two extremes listed above.

b. The mission statement for the Metropolitan Museum of Art (popularly known as the Met)
states:

The mission of The Metropolitan Museum of Art is to collect, preserve, study, exhibit,
and stimulate appreciation for and advance knowledge of works of art that
collectively represent the broadest spectrum of human achievement at the highest
level of quality, all in the service of the public and in accordance with the highest
professional standards.

This statement underscores the museum’s not-for-profit motive and emphasizes the
museum’s mission on all aspects of the study of art. Notice that, similar to the mission
statement of the Corporation for Public Broadcasting, the Met’s mission statement is very
inclusive regarding the definition of art and the museum’s beneficiaries.

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Both Microsoft’s and the Metropolitan Museum of Art’s mission statements take a broad
view of the organization’s mission. Microsoft’s mission statement is very customer focused,
whereas the Met’s mission statement focuses on the art itself. The differing foci are
indicative of Microsoft’s for-profit orientation (quality, innovative products, and customer
satisfaction are all stepping-stones to profit) and the Met’s orientation of increasing the
appreciation for art (regardless of profit).

1.34. The credo for Johnson and Johnson states:

We believe our first responsibility is to the doctors, nurses and patients,

to mothers and fathers and all others who use our products and services.
In meeting their needs everything we do must be of high quality We must constantly
strive to reduce our costs in order to maintain reasonable prices. Customers' orders
must be serviced promptly and accurately. Our suppliers and distributors must have
an opportunity to make a fair profit.

We are responsible to our employees, the men and women who work with us
throughout the world. Everyone must be considered as an individual.
We must respect their dignity and recognize their merit. They must have a sense of
security in their jobs. Compensation must be fair and adequate,
and working conditions clean, orderly and safe. We must be mindful of ways to help
our employees fulfill their family responsibilities. Employees must feel free to make
suggestions and complaints. There must be equal opportunity for employment,
development and advancement for those qualified. We must provide competent
management, and their actions must be just and ethical.

We are responsible to the communities in which we live and work and to the world
community as well. We must be good citizens – support good works and charities and
bear our fair share of taxes. We must encourage civic improvements and better
health and education. We must maintain in good order the property we are privileged
to use, protecting the environment and natural resources.

Our final responsibility is to our stockholders. Business must make a sound profit.
We must experiment with new ideas. Research must be carried on, innovative
programs developed and mistakes paid for. New equipment must be purchased, new
facilities provided and new products launched. Reserves must be created to provide
for adverse times. When we operate according to these principles, the stockholders
should realize a fair return.

The above statement underscores J&J’s multi-faceted objectives. It recognizes obligations to

customers, suppliers, employees, the community and shareholders. Interestingly, the
statement places shareholders last, implicitly asserting that if we take care of the others,
shareholders will automatically earn a fair return. The importance of the credo to the firm
also is evident by its placement on the firm’s home page.

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1.35.
a. For this decision, your goal is to minimize the amount that you pay over the semester for
fitness – cost is your primary consideration.

b. Based on the information provided, you have two options:

1. Join the fitness center for the semester at a cost of $80.

2. Pay for the fitness center on a per use basis at a cost of $4 per visit.

We also could include a third option – not using the fitness center at all (the status quo).
However, it appears that you have rejected this option and are committed to using the fitness
center in some fashion.

c. The cash outflow associated with option is:

1. $80, or the amount it costs to join the fitness center.

2. 16 × $4 = $64. (Since you plan on using the fitness center 16 times and each visit costs
$4).

d. Given the available options, you are better off (to the tune of $16, or $80-$64) by paying for
the fitness center on a per-use basis rather than joining the fitness center.

Notice how the four step framework is applicable to “everyday” decisions, in addition to
business decisions. Indeed, we could use the four-steps to frame every decision we make.

Additionally, the timing of cash flow may be important – if a student has to pay the $80 all at
once, then this reduces the attractiveness of joining as some students may not have the $80 to
spare, especially at the beginning of the semester.

Note: Uncertainty and beliefs might affect students’ choices – for example, if students
believe that there is a significant chance they will really get into an exercise routine and use
the fitness center more often than once a week, then joining may be the best way to go. If
students believe that they will use the center more than 20 times, then joining is the low-cost
alternative (since 20 × $4 = $80). Further, some may pay the fee to motivate themselves...“I
paid $80 and I need to get some return for it.” However, as we will learn later, such thinking
is a classic “sunk cost fallacy.”

1.36.
a. Angela’s goal in this decision problem is to make the most money or maximize profit.
b. Angela has three options:
(i) Raise the price of the Jelly donuts from $1.20 to $1.50 each.
(ii) Keep the price at $1.20 per jelly donut but make 100 more jelly donuts and 100 less
chocolate donuts.
(iii) Not do anything.

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c. Cash flow associated with option (i): Net cash inflow per glazed donut: $0.40 (= price of
$0.80 – cost of $0.40). Net cash inflow per jelly donut: $0.90 (= 1.50 – 0.60). Net cash
inflow per chocolate donut: $0.50 (= 1.00 – 0.50). Total expected cash flows to Angela from
this option: 300 * $0.40 + 250 * $0.90 + 200 * $0.50 = $445.
Cash flow associated with option (ii): Net cash inflow per glazed donut: $0.40 (= price of
$0.80 – cost of $0.40). Net cash inflow per jelly donut: $0.60 (= 1.20 – 0.60). Net cash
inflow per chocolate donut: $0.90 (= 1.00 – 0.50). Total expected cash flows to Angela from
this option: 300 * $0.40 + 350 * $0.60 + 100 * $0.50 = $380.
Cash flow associated with option (iii) = 300 * $0.40 + 250 * $0.60 + 200 * $0.50 = $370.
d. Based on the calculations in part c. above, Angela should raise the price of her Jelly donuts to
$1.50.

1.37.
a. The cash outflow associated with scrapping the action figures is $1,000; as such, the value of
this option is ($1,000).

b. Reworking the action figures will cost Toys Ahoy! $1,200, but selling them to the toy store
will bring in $750 in revenues. Thus, the cash flow associated reworking the action figures
and selling them to the toy store is $750 – $1,200 = ($450).

Unfortunately, the value of both options is negative. However, relative to scrapping the toys,
reworking them increase’s Toys Ahoy!’s profit by ($450) – ($1,000) = $550. Thus,
reworking the action figures is the preferred option.

c. Intuitively, the fact that Toys Ahoy! spent $6.25 to produce each action figure is not
relevant to the decision at hand because Toys Ahoy! has already incurred the expenditure –
it is a sunk cost.

1.38.
a. Rachel’s cash outflow associated with Option 1 is $1,050 (airfare of $750 + one night hotel
stay for $175 + other expenses of $125). With Option 2, Rachel’s cash outflow would be
$725 (car rental of $150 + two nights’ hotel stay for $350 + other expenses of $225).
b. The opportunity cost of Option 1 is the value of Option 2, which is ($725). The opportunity
cost of Option 2 is the value of Option 1, which is ($1,050).
c. The value of Option 2 is greater than its opportunity cost (i.e., $725 is lower in cost than
$1,050). Yes, Option 2 is better for her based on the expenses given.
d. Well, drives can be long and exhausting, and Rachel may not feel alert at the conference.
This is a “cost” that Rachel has to bear with the second option. She might well feel that the
extra $325 she has to spend is well worth avoiding strenuous driving. On the other hand,
often fights get canceled due to factors beyond one’s control. With driving, there is a little
more control. This is an intangible benefit associated with Option 2.

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1.39.
a. The following table provides the value of each of the four options that Usman faces:

Option 1 Option 2 Option 3 Option 4

Revenue $2,500 $5,000 $1,700 $0
Cost 700 3,800 250 400
Value (net cash flow) $1,800 $1,200 $1,450 ($400)

b. The opportunity cost of Option 1 is $1,450. The opportunity cost of each of options 2, 3 and
4 is $1,800.
c. Based on the data given, value exceeds opportunity cost only for Option 1 (the value of
Option 1 is $1,800, its opportunity cost is $1,450).
d. Doing charity work may give Usman a tremendous amount of satisfaction that is
immeasurable. The question is whether this satisfaction is worth more than $1,800 he stands
to make by choosing Option 1.

1.40.
a. The three options available to Nick are: (i) Status quo: Continue doing what he does and
reject the job offer; (ii) accept the job offer, but don’t work on computer repairs in the
evening; (ii) accept the job offer, and continue repairing computers for his clients for two
hours in the evening.
b. (i) Status quo option: Nick’s monthly income under this option will be $11,250 (=$75 per
hour * 6 hours a day * 25 days a week).
(ii) Accept the job, and not work in the evenings: Nick’s monthly income will be $7,500.
(iii) Accept the job, and work in the evenings: Nick’s monthly income will be $10,000
($7,500 + ($50 per hour * 2 hours a day * 25 days)).
c. The opportunity cost of the status quo option is $10,000. The opportunity cost of each of the
other two options is $11,250.
d. Nick should choose the status quo. The opportunity cost of this option is $10,000 (accepting
the job, and continuing to work in the evenings.) which is less than its value of $11,250.

1.41.
a. The opportunity cost of any option is the value of the next-best option. Assume Jon could use
the same color paint for another job. What’s Jon’s next-best option? The problem makes it
clear that the paint is “unique” and has few, if any, alternative uses. Given this, Jon’s
opportunity cost of using the paint for another job is $0. This estimate assumes that there is
no cost to storing the paint.

b. Jon’s next-best option is to dispose of the paint at a cost of $40. Jon can avoid this cost by
using the paint for another job. Thus, the opportunity cost of using the paint for another job is
($40). Jon should therefore be willing to pay someone up to $40 to let him use the paint in
their job.

c. The fact that Jon received a non-refundable advance of $350 does not change the opportunity
cost in any way. The revenue and the cash costs are past events and are sunk. Both value and

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opportunity cost are forward looking – because this amount does not change relative to
the status quo, the $350 is not relevant to the decision at hand.

1.42.
a. The incremental cost of carrying one additional passenger for Greyhound is very minimal. So
the cash flow to Greyhound from issuing the ticket is close to $40.
b. The opportunity cost allowing the individual to travel is to leave with another empty seat.
Therefore, the opportunity cost is zero as they are many available seats in the bus. The cash
flow associated with denying the individual’s request to travel is the opportunity cost of $40.
c. Yes. If Greyhound allows people to get on for a fraction of the ticket price just because there
are still some empty seats, human tendency would be to wait till the last minute to get a
cheap ticket. If everybody engages in this behavior, think of what would happen ahead of a
bus leaving. Therefore, setting a firm ticketing policy and sticking to the policy pays off in
the long run. In the short run, it may well be the case some seats will be unfilled, but the
ticket price would be set appropriately in anticipation of such eventualities.

1.43.
a. Zap’s decision problem centers on what to do with the 25,000 unsold “ZAP” kits. Zap’s goal
is to maximize profits. For the unsold 25,000 units, this means maximizing the revenue, or
net cash inflow, received (number of units sold multiplied by the selling price per unit) from
the sales of this product.

It is important to note that the amount Zap paid to produce the 25,000 units, or 25,000 ×
$7.50 = $187,500 is sunk and is not at all relevant to their decision. From a financial
accounting standpoint, this amount will be expensed on the income statement regardless of
the option chosen.

b. Based on the information provided, Zap has two options:

1. Sell the 25,000 units to the national home-improvement store for $7 per unit.
2. Sell the product via the company’s website. Under this option, the company expects to
sell 60% of the remaining 25,000 units at a selling price of $9.95 per unit.

We could, of course, conceive of other options, such as discarding all of the “ZAP” kits or
donating them to a municipality (for parks, etc.). However, it appears that Zap does not wish
to explore these options.

c. The increase in Zap’s cash flow under each option is:

Option
1. Sell to store 2. Sell via website
Expected sales in units 25,000 15,000
(= 25,000 × .60)
Selling price per unit $7.00 $9.95
Net increase in cash flow $175,000 $149,250

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Again, we note that the cost of producing the 25,000 units, or 25,000 × $7.50 = $187,500 is a
sunk cost and is not relevant to measuring the net cash flow associated with each option.
Moreover, we are interested in measuring the future sacrifices and future benefits associated
with each option. The fact that Zap spent $187,500 to produce the 25,000 units is not relevant
because the expenditure (and associated cash outflow) occurred in the past – it is a sunk cost.

d. Given the available options, Zap’s preferred option is to sell the remaining 25,000 units to
the home-improvement store for $7 a unit. Even though it appears that Zap will lose $7.00 –
$7.50 = ($0.50) per unit, the company maximizes its cash flow and profit by selling the
unsold units “at a loss.”

Note: This exercise illustrates the classic price-quantity tradeoff – in this instance, the
company is better off selling more units at a lower price than selling fewer units at a higher
price. In other instances, the relation flips.

1.44.
a. The owners likely have multiple goals. Making a profit is important, as is winning games and
championships. Some owners also probably enjoy the prestige and glamour associated with
owning a professional sports team. Yet other owners wish to give back to the city and
community by funding appropriate recreational outlets.

Each person in the coaching staff ultimately worries about his or her own career. Surely, the
coaching staff enjoys what they do and being associating with “winners.” However, some
part of their concern about the team’s success stems from its effect on their personal career
prospects. Coaches are not as worried as owners about the team’s overall profitability or
other monetary issues.

Players have potentially conflicting goals. On the one hand, they wish to do what is best for
the team. However, they also recognize that they have only a few years in their careers and
that their earnings during this period must sustain them through their lives. Thus, players
bargain aggressively with owners, sometimes putting team profitability in jeopardy. Such
actions may also create animosity among players and affect the team’s effectiveness. For
instance, a player may “hold out” (i.e., not report to training camps) for more compensation.

b. Teams can and do use a number of systems to align players’ incentives with team incentives.
Clauses giving incentive pay for reaching different levels of the playoffs and reaching
milestones in performance (e.g., batting averages, rushing yards) are common. Contracts also
usually specify parameters for physical fitness, as well as norms for expected behavior.
Contracts often allow teams to ‘fire’ players if they engage in behavior that damages a team’s
reputation.

Designing and implementing contract-based and formal control measures is difficult in this
setting as team performance depends on many factors. It is often difficult to specify what
players should do or to measure their contribution to the team’s success. Teams therefore rely

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a great deal on intangibles such as “leadership” and “culture” when motivating players to do
the right thing. Coaches sometimes discipline players by benching them for games or
denying players time on the field/court. They also rely on the players’ ego and the value
players attach to their reputation to keep players in check.

1.45. Yes. This is a classic example of how a conflict of interests can come about. With respect
his own evening work, Nick is solely responsible for the quality of what he does. However, when
part of a larger organization, there is some room for sharing and shirking one’s responsibility.
Naturally, we would expect Nick to think about his own evening even as he is going through the
motions of the day. So, the employer should be concerned. This is why employments contracts
typically have clauses that prevent full time employees from taking on other jobs that would
interfere with their work.

1.46.
Organizations invest in monitoring programs because the organization’s goals may not
always coincide with the goals of individual employees. When owners and other stakeholders
delegate decision making, they run the risk that employees will make decisions that may not
be in the organization’s best interests. For example, employees may pad expense accounts,
take excessive breaks or time off, or even steal from the company.

Monitoring can help by either penalizing undesired behavior or rewarding desired behavior.
For example, mystery shopper programs help assess the quality of store operations and make
sure that employees are following company policies. For example, a fast food franchisee may
not keep the facilities up to the standards consistent with the franchisor’s corporate image.
Audit visits and other mechanisms serve to deter such behavior – in extreme instances, the
franchisee could lose its license.

Just telling someone to follow the rules often is not enough. Enforcement or follow-up is
necessary. Without enforcement, employees might simply agree to the rules but then ignore
them and do whatever they want. Incentive schemes such as bonus pay and stock options also
help align individual goals with organizational goals.

1.47.
The following table provides the required classifications, including comments pertaining to
the rationale underlying each classification.

Action/Decision Stage Rationale

Whether to hire two or three dental Plan This decision relates to the
hygienists? Dr. Shapiro has narrowed his choice of a resource level.
choices to two or thee hygienists based on Hiring more staff provides
expected patient volume. greater capacity, allowing Dr.
Shapiro to serve more patients,
but also commits Dr. Shapiro
to greater costs.

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Prepare a staffing schedule so that at least Implement This action relates to

one hygienist is available during all times implementing the choice. The
the office is open. associated decision (we could
view each possible schedule as
a decision option) relates to
how resources, in this case
hygienists, will be used to
deliver services.

Track the number of patients seen by Evaluate This on-going control process
each hygienist per week. helps Dr. Shapiro figure out
the efficiency and
effectiveness with which he is
using costly resources.
Moreover, because Dr.
Shapiro sees each patient
during each visit, he also can
personally track the quality of
work done by each of his
hygienists.

Re-evaluate the adequacy of current Revise Over several weeks or months,

staffing levels. Dr. Shapiro will get a sense of
whether his hygienists are
fully utilized. He will also
determine whether additional
hygienists need to be hired or
which, if any, of his hygienists
need to be let go.

This problem illustrates the classical loop between planning and control. We typically begin
with a plan that is based on a set of assumptions (in this case, expected patient volume).
These assumptions are our beliefs about the unknown future. We then implement our
choices. As time passes, we obtain new information about the actual outcomes (in this case,
actual patient volume and the quality of work done by each hygienist). On an on-going basis,
this new information will cause us to adjust how we implement our plans (e.g., change the
schedule for the next week). Over a period, we will accumulate enough information to revise
our original set of assumptions, which might cause us to revisit the decision.

The overall point is that there is a natural cycle of doing something based on a set of
assumptions, comparing actual outcomes with expectations, and then revising our
assumptions. In many instances, the broad loop relating to a decision contains smaller loops
within it. For instance, we can think of creating each week’s schedule as forming a separate
planning and control cycle.

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1.48.
The following table lists the four stages of the planning and control cycle and the associated
decisions/actions. There are many possible decisions for each category.

Stage Action/Decision
Plan One possible decision is whether to price at the same levels as last
year or to raise prices by, for example, 10% to account for the higher
cost of flowers this year. Other decisions include whether to hire
additional help or how much money to spend on advertising.
Implement Based on the chosen price level, order and stock enough bouquets to
meet the expected demand. (Notice that we could view this as a
decision in itself, viewing each volume of order as an option.)
Evaluate Compare actual sales to budgeted sales. Identify reasons for any
deviations. (Again, we could view this as a decision by framing each
possible reason for a deviation as a possible option. We then choose
among possible explanations.)
Revise Shari would use data on actual sales, her prices versus the prices of
other florists, and national trends to revise her expectations about
future sales. This revised belief will be a key input into her pricing
decision for next Mother’s day.
As we see, Shari begins with a plan that is based on a set of assumptions (in this case, how
much demand she might expect for any given price). These assumptions are her beliefs about
the unknown future. She then implements her choices (e.g., post prices, order flowers). As
Mother’s day nears, pre-orders and information about other florists’ prices might give Shari
an impetus to revise her prices. That is, she obtains new information on an ongoing basis,
which in turn causes her to adjust her implementation (e.g., revise prices, run more ads).
Over a period, she will accumulate enough information to revise her original set of
assumptions, which might cause her to improve the next pricing decision.

The overall point is that there is a natural cycle of doing something based on a set of
assumptions, comparing actual outcomes with expectations, and then revising our
assumptions. In many instances, the broad loop relating to a decision contains smaller loops
within it. For instance, we can think of offering a discount at day’s end as forming a separate
planning and control cycle within the overall cycle that we discussed above.

1.49.
a. We classify the data from the financial statements into three broad groups. We interpret
financial statements broadly to mean any documentation filed with the Securities and
Exchange Commission (SEC) or other regulatory bodies.

Financial data such as the firm’s income and cash flow from operations are invaluable in
assessing future prospects. The investor might also perform ratio analysis, such as computing
the debt-to-equity and current ratio, to understand and explore a company’s risk factors.

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Governance data such as the composition of the board of directors and compensation
arrangements help the investor assess the effectiveness of the company’s management and
control systems.

Finally, operating data such as the capacity of the plant, and the number of plants and
employees help investors understand the business. Investors may also examine the firm’s
client base (e.g., does one client account for 10% or more of sales?). In addition, the
management discussion of results section probably will discuss the company’s pipeline of
drugs and their potential.

b. Investors would consider the costs and benefits of other investment options. A firm’s
financial statements provide information only about its own affairs. Thus, the investor has to
look elsewhere to assess the firm’s relative standing (i.e., to assess the opportunity cost of
investing in the firm). For instance, some competitor analysis is necessary to judge whether
the firm is earning similar or higher rates of return than its competitors.

Investors also would likely collect data from pharmaceutical publications about the market
potential for the firm’s current and proposed drugs. For instance, financial statements might
not reveal a lot about obtaining FDA approval for the drugs in-process. Medical publications
and conference presentations might help refine these beliefs. Other data pertinent to market
share and growth (from trade associations) also seem important.

Finally, considerations such as the extent of diversification provided and fit with the
investor’s risk-profile also play an important part in the investment decision.

1.50.
As shown in the table below, Linda may be surprised to find managerial accounting
information invaluable in her new position. As a manager, Linda decides how best to use the
organizational resources entrusted to her, and she will find both financial and non-financial
information from her company’s managerial accounting system to be helpful for making
these decisions.

Information Are the information items financial/non-financial in

Decision Items nature?
Whether actual Budgeted costs Budgeted and actual cost data are financial in nature.
costs are in
line with Actual costs Linda may use non-financial data such as the volume of
expectations? production to adjust her estimates of expected costs. After
Actual volume of all, the more units produced, the greater the expected cost
production as the company will be using more materials and labor.
Linda also may rely on non-financial data such as
absenteeism rates and whether her company was starting a
new product to figure out the source of the cost differences.

Whether to Price charged by The supplier’s price and internal cost data are financial.
make a tool in- the supplier
house or buy it Non-financial data include supplier quality and reliability,

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from a Cost to make the as well as the reliability and quality of the tools if they
supplier? tool internally were manufactured by Linda’s firm.

Supplier quality
and reliability

How many Rate of wear Use data, such as rate of wear, are non-financial. Cost data,
tools to which would be used to determine the amount of safety
purchase for Expected cost of stock, are in financial terms.
making tool
100,000 units
of a product? Expected loss if
tool not available

What is the Expected rate of Data concerning use patterns, including rate of wear and
right inventory use, variance in variance in use rates, are non-financial. Data about cost
level for a use rates across estimates, including storage costs and capital costs, are
given tool? time periods (e.g., expressed in financial terms.
Linda’s firm may
have seasonal
production
cycles)

Cost of tool, cost

of capital, other
storage costs

Whether to Cost to make the Again, the cost data are in financial terms whereas data
make a new new tool pertaining to quality and expected lives are non-financial in
tool or to nature.
refurbish an Cost to refurbish
existing tool? existing tool

Expected lives of
the two tools

Quality of the
tools

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1.51.
Let us begin by computing the expected cost if you had stayed at a hotel:

Cost of hotel for one night $140.00

Per-diem meal allowance $100.00
Total $240.00

Next, let us compute your actual expenses:

Cost of car rental $80.00

Cost of dinner Wednesday $90.00
Cost of other meals $45.00
Total cost $215.00

At least five views exist regarding the appropriate expense report:

 You could turn in a report for $240, arguing that the firm would have spent this amount
for the trip. Any cost savings stemming from your actions should belong to you.

 You have saved the firm some money by staying with Darren rather than in a hotel. Thus,
you should turn in a report for $215, justifying the dinner with Darren and the car rental
as offsetting hotel costs.

 At another extreme, some would argue for a report of $45 only, being the actual meal
cost. Under this view, the car rental and the dinner are personal expenses and non-
reimbursable. Further, you should only claim the lower of actual expenses or the per-
diem allowance.

 You could claim the $100 as the per-diem allowance for two days. After all, company
policy allows you to claim $50 per day for meals, no matter what you actually spend.

 A final view is to claim the car rental and the per-diem for two days ($180 = $80 + 2 days
× $50 per day), reasoning that the car rental is a reasonable off-set to the cost of the
hotel.

As you can tell, there is no clear answer, and different people would reasonably claim
different amounts.

Deciding the reasonableness of travel expenses can be difficult. For instance, some might
argue that the cost savings are fictitious. You might have been more productive if you had
stayed in a hotel and had a restful night. Spending time with friends might adversely affect
your work quality the next day. In addition, perhaps you would have dined with clients or
engaged in other beneficial activities (e.g., having dinner with colleagues to continue the
meeting). These opportunities might have been missed because of your desire to have dinner
with Darren. On the other hand, some might argue that the company is imposing costs by

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having you travel and spend time away from your family. Allowing you to spend time with
friends and sightsee is one way to compensate for these non-pecuniary costs.

Many firms avoid these problems by formulating explicit policies. For instance, they might
reimburse you $100 per day as a flat fee if you do not stay at a hotel.

This exercise nicely illustrates that, just like beauty “lies in the eyes of the beholder,” there
often is no bright line test for what is ethical or unethical. We can see this confusion in
advice columns such as “Ask the Ethicist” that appear in the New York Times Magazine.

1.52.
There are several available options. First, Jerry can bill the client for $5,000, reasoning that
this is the “market rate” for the work. This option maximizes Jerry’s current income and
reduces the chance that the client would be disgruntled after comparing notes. However, this
option is unethical in the view of the American Bar Association (ABA). Specifically, ABA
Formal Ethics Opinion 93-379 says that attorneys can only charge for hours actually spent,
and for fees actually earned. It explicitly disapproves billing the second client for work
already done, on the grounds that you have not "earned" the second set of fees. ABA Formal
Ethics Opinions are not binding, but they are often influential in judicial proceedings.

Another option is to bill the second client for $1,250, the hours actually worked. Clearly, this
strategy is ethical. However, it increases the chance of the first client being discontent.
Further, the strategy is not fully consistent with Jerry’s goal of maximizing income — He is
delivering a quality product for substantially below market wages.

What can be done? Note that the ABA Formal Opinion’s conclusion appears to be limited to
hourly billing. Thus, a third strategy might be to arrange an alternative basis for billing the
client. Notice that the client benefits from Jerry having already done the research and
knowing how to do the work. Thus, if Jerry charges a flat fee, knowing that the work to
accomplish the matter was already done and rendering his effective hourly rate higher than it
would have been otherwise, that would probably be acceptable to the client and to the ABA.
(Of course, we are assuming that the ultimate fee is not "unreasonable.") In case he follows
this strategy, Jerry will need to disclose to the client fully and honestly what the fee was and
the basis on which it would be calculated. He might also be well advised to disclose to the
first client (staying within bounds of client confidentiality) that he did find subsequent use for
work that he believed to be unique. He might also consider giving some kind of a price break
to the first client for future work.

More generally, when doing work that develops transferable skills or knowledge, good
managers do not seek to extract all of the cost from the first client. Rather, they charge for
less than the actual work done, “banking” some costs to be billed to future clients expected to
benefit from the work. Of course, the client is billed to the full extent if the work is judged to
be “unique” or “one-off.” In either case, the key point is to stay in full, open and honest
communication with the clients, and to be fair in appearance and in fact.

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Note: We thank Professor Margaret Raymond of the University of Iowa Law School for
helpful discussions on this topic.

PROBLEMS

1.53.
a. Given the hourly wage rate of $8.25, 40 hours per week, and 12 weeks, the money earned for
working as a checkout clerk this summer is:

Earnings – Working as a checkout clerk = 12 × 40 × $8.25 = $3,960.

b. First, we need to calculate the expected hourly compensation from waiting tables, which
equals the base wage rate of $4 per hour + tips. Your expected tips per hour = (.50 × $3) +
(.50 × $6) = $4.50 (i.e., there is a 50% chance you will earn $3 in tips per hour and a 50%
chance you will earn $6 in tips per hour).

Thus, your expected hourly compensation = $4 + $4.50 = $8.50. Given this wage rate, 40
hours per week, and 12 weeks, we have:

Expected earnings – Waiting tables = 12 × 40 × $8.50 = $4,080.

c. Based solely on our computations in [a] and [b], waiting tables is the preferred option
because it has the highest amount – you expect to earn $4,080 from waiting tables this
summer versus $3,960 from working as a checkout clerk. The additional money from waiting
tables is $120 = $4,080 – $3,960.

The difference between the two options, however, is rather small. Thus, we could readily see
where individuals, based on what they value, might make differing job choices. For example,
there is the risk associated with the tip component of being a waiter. A risk-averse person
might take the sure thing of $8.25 per hour over the possibility that s/he may earn only $7 per
hour waiting tables. Alternatively, someone who is sure of his/her interpersonal skills may
assess a much higher than 50% chance that they will earn $4 + $6 = $10 per hour from
waiting tables. Thus, the “wait tables” option may be more attractive than the checkout clerk
option.

The nature of the two jobs also differs – as a wait person, you are constantly on your feet and
moving – some individuals may (or may not) prefer this to the more sedentary role of being a
checkout clerk, who typically is at his/her station for the better part of the day.

1.54.
a. Wynter has two options: (1) accept the $200,000 offer, or (2) reject the $200,000 offer and
wait for a future offer. If she accepts the offer, then Wynter’s opportunity cost includes the
expected value of a bid from another buyer. In estimating this number, she has to factor in
both the probability of receiving a higher bid and the value of the bid. She also has to factor
in the time until the next bid arrives because, until the house is sold, she will incur costs to

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maintain the house, pay the mortgage, and accrue for insurance and property taxes (by
accepting the offer, these costs will not be incurred). Finally, Wynter has to factor in the cost
of the anxiety associated with selling a house – the house has to be clean all the time; plans to
buy a new house may have to be put on hold. Many of these factors are qualitative and are
based on beliefs about the future.

Neither Wynter’s initial purchase price of $225,000 nor the amount of time and money
(which she values at $40,000) associated with developing a fabulous yard have any relevance
in estimating her opportunity cost – both of these costs are sunk. Wynter currently has to
assess future bids and future costs, taking as given the status of the market and her house’s
relative attractiveness. The fact that the house has not attracted a bid for a month indicates
that the property may be over-priced at $275,000. All in all, Wynter may be well advised to
give the offer serious consideration.

b. Wynter now has a third option – make a counter offer. This option may be preferred over an
outright rejection because it preserves the option of going back to the original offer price but
holds the promise of obtaining a higher price. In making the counter offer, Wynter has to
estimate the final selling price, which would likely result after several offers and counter-
offers. This estimation depends on Wynter’s assessment of the buyer’s opportunity cost.
Wynter also has to factor in the probability that the sale might fall through because the buyer
may come across a better value (from the buyer’s perspective). Overall, Wynter faces a
difficult, and highly subjective, decision. A realtor can often help in such situations by
bringing Wynter the latest market information and the experience of pricing many such
transactions.

1.55.
a. As stated in its website, the mission of the United Way is to improve people’s lives by
mobilizing the caring power of communities. United Way helps raise funds for over 1,400
community-based organizations, each with its own board and volunteers. Other major
charities have equally laudable goals.

b. There is little doubt that the officers and staff subscribe to the charity’s goals. Usually, these
are talented individuals with multiple employment and lifestyle options. They often make
significant financial and professional sacrifices to work for the charity, perhaps because of
the satisfaction they derive from advancing a goal they believe in.

However, the officers are also individuals with their own wants and needs. While they may
be willing to work for a smaller salary or under harder operating conditions, they cannot
typically work for a nominal sum. The question therefore turns on what is “appropriate”
compensation and not whether they need to be compensated or not.

To answer this question, notice that charities such as the United Way are large organizations
that control significant assets (the United Way has revenues in excess of $40 million a year)
and operate in a highly complex political and economic environment. For instance, the
United Way organization itself (not the member organizations) uses the services of several
hundred professional staff and consultants. Discharging these responsibilities is not a trivial
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task and requires the services of competent managers. Competitive market conditions
determine the “going rate” for such professional managers. Often, charities will engage
outside consultants and reviewers to help them assess what is and is not appropriate given the
charity’s operations and the individual’s skill set. Seen in this light, we can justify an annual
compensation package in the hundreds of thousands of dollars for the CEO of a large charity.

1.56.
a. Compare selling 225 confirmed seats to selling only 210 seats. If the airline only sells 210
seats, then there is high likelihood that not all 210 passengers will show up. In this case, the
plane will have one or more empty seats. If these seats could be filled with paying
passengers, then the airline’s profit increases – there are few additional costs associated with
the extra passengers. The chance of lost profit due to empty seats decreases as the airline
sells more than 210 seats.

The airline must balance this cost with the cost of bumping passengers. If the airline sells 225
tickets, then there is a chance that more than 210 passengers will show up. The airline has to
provide compensation to the bumped passengers. The additional rewards (e.g., a travel
certificate, hotel accommodations, meal vouchers, etc.) and negative goodwill reduces the
airline’s profit.

Airlines use sophisticated models to estimate these two costs and to determine the “optimal”
number of seats to sell. (For instance, they would not sell 300 tickets on a 210 seat flight.)
Historical records help agents tailor the amount of overbooking to the time and the day of the
flight, as well as to the profile (business/vacation/family) of the average passenger.

b. If bumped, the passenger gives up the confirmed seat. The major cost of being bumped is the
convenience associated with traveling on the scheduled flight and arriving earlier at the
destination. This cost varies widely across passengers, resulting in some rushing to the
podium to claim their reward while others wait. For instance, a college student going home
for the holidays probably is more willing to give up the seat than a businessperson attending
an important meeting. That is, cost and value are specific to each individual’s goals.

c. Like the airline, the passengers are trading off benefits with sacrifices. Suppose the current
reward exceeds the costs associated with taking a later flight. You know (from prior
experience) that the reward increases with time. You therefore decide to wait to get the
maximum possible reward. However, waiting has a cost. Another passenger may volunteer
before you and claim the (lower) reward. In this case, the option of giving up your seat
expires, and you have given up the chance to get a reward (which had positive value). You
must subjectively tradeoff these two factors when deciding whether to claim the current
reward or to wait for the next reward level.

Note: We consider expected costs and benefits, when unknown future events (will someone
else volunteer first?) affect our realized costs and benefits. The problem also illustrates the
role of uncertainty when making decisions.

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d. If a passenger is involuntarily bumped, the cost of missing the scheduled flight exceeds the
offered reward. That is, the airline is imposing a cost on the passenger by involuntarily
removing them from the flight. This cost will translate into ill will, damage to public image,
and future lost business for the airline.

This cost varies across passengers. The potential cost is much higher if the airline bumps a
full fare-paying businessperson who travels every week than if the airline bumps a discount-
fare passenger who is traveling alone and who is not a frequent flier. Bumping part of a
group is more expensive (image wise) than bumping single passengers. Individual
circumstances again shape the airline’s costs.

Naturally, airlines consider these variations when picking passengers to bump involuntarily.
Airlines develop detailed passenger profiles to help the ticket agent select passengers – the
airline’s options include the set of all passengers with confirmed seats and the decision is
which one to pick.

1.57.
a. For this decision, Terry has two options: (1) keep the old TV, and (2) sell the old TV and buy
the new HDTV. (Terry has ruled out the possibility of keeping both TV sets). The option of
keeping the old TV really just postpones the problem to a later date. Terry can always sell the
old TV a year from now and purchase the new HDTV (of course, the resale value of old TV
and the price for the new HDTV would change in a year).

Terry should consider the following costs and benefits in his decision:

Cash outflow associated with purchasing the HDTV: Terry can objectively estimate this cost
– it is $1,699 + (0.06 × $1,699) = $1,800.94. This cost will only be incurred if Terry
purchases the HDTV.

Cash inflow associated with selling the old TV: Terry can objectively estimate this benefit –
it is $600, or the amount the neighbor is willing to pay Terry for his old TV. Terry will only
receive this money if he purchases the HDTV.

Better quality picture and sound: This is the primary benefit associated with the new HDTV.
Terry must subjectively estimate this benefit.

Utility from being current: Many persons derive utility from their “toys” such as cars,
stereos, boats, televisions, etc. Terry might be such a person and receive a psychological
benefit from owning a “cutting-edge” HDTV. Similar to better quality picture and sound,
Terry must subjectively estimate this benefit.

Terry’s decision hinges on whether the qualitative benefits associated with being current and
having a better quality picture and sound exceed the net monetary cost associated with
purchasing the new HDTV. In other words, if Terry estimates that the benefits exceed
$1,800.94 – $600, or $1,200.94, then he should purchase the HDTV; otherwise, Terry should

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keep his old TV. Different people will attach different weight to the qualitative factors and,
thus, make different purchasing decisions.

Notice that the $1,500 purchase price of Terry’s current TV does not factor into Terry’s
decision. It is a sunk cost and, consequently, is not a relevant cost or benefit.

b. Terry may owe money on his old TV if he purchased it on an installment plan (e.g., he
financed it with a store credit card). Notice that Terry would owe the store $300 regardless of
whether he keeps his current TV or buys the new HDTV. Hence, the $300 is not relevant to
Terry’s analysis and should have no impact on his decision to purchase the new HDTV.

Note: Installment contracts frequently contain clauses that, in this instance, would give the
store a lien on the TV set. This clause may require Terry to pay off the balance if he sells the
TV. Such a requirement affects Terry’s cash flow and, in turn, could affect his decision. The
effect in this instance arises because of Terry’s constrained budget. Absent such a budget
constraint (i.e., if Terry had enough cash to pay off the loan and to purchase the new HDTV),
the amount is not relevant.

c. In this case, Terry has three options: (1) keep the $600 and not replace the TV, (2) use the
$600 to replace his old TV, and (3) use the $600 toward the purchase of the new HDTV.
Compared to part [a], we see that Terry has more options. However, Terry’s option of
keeping the old TV is no longer available.

The value associated with purchasing the HDTV, however, has not changed. Before the
flood, Terry had to pay $1,800.94 – $600 = $1,200.94. After the flood, Terry still needs to
pay $1,200.94 to purchase the new set. In both cases, Terry has $600 to assist with the
purchase of the HDTV – it doesn’t matter where the $600 comes from.

Note: We believe that many people who would have stayed with the old TV in part [a] would
purchase the HDTV in part [c], even though the value has not changed. While value has not
changed, the problem is framed differently. Part [a] frames the problem as selling the old TV
to get a new TV. In part [c], the decision is whether to spend $600 to get a dated TV or
$1,800.94 to purchase a state-of-the-art HDTV. Although there is no economic rationale for
the phenomenon, psychologists have demonstrated that differences in framing often lead to
differences in decision making.

1.58.
This problem captures some of the complexities in administering a complex organization
such as a university in a resource-constrained environment. The following costs and benefits
seem relevant.

Notice that there is very little in the form of incremental revenue to the school as tuition
revenue is independent of Dean Maxton’s decision. One could possibly argue that the
decision could affect future donations to the school (e.g., a student becomes rich and
attributes his/her success to the school and the Dean’s decision to open up the course to

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additional students). This seems unlikely, however, leading us to consider the direct out of
pocket costs vis-à-vis a qualitative assessment of the educational benefits.

The direct costs in this problem are relatively easy to measure. These costs only include the
cost of the instructor in option 2. If, for some reason, the school’s budget is tight and the
school is not in a position to bear this cost, then the Dean would have to choose either option
1 or option 3. More than likely, though, this cost would not limit the Dean’s options.

Thus, the decision seems to hinge on the educational tradeoffs and maximizing student
welfare. Delineating the educational tradeoffs, or even defining student welfare, is a rather
difficult and subjective task. The Dean will have to measure and weigh the following factors
in each option to arrive at the value of each option:

Option 1: What are the costs of not appearing to be responsive to student needs? What are the
lost educational benefits, if any, of capping the enrollment in the Strategic Cost
Management? Are there other high quality courses offered by the school that lead to the
same, or similar, level of educational benefits? How costly is it for students to delay taking
the course by a semester or a year?

Option 2: What are the costs of canceling a class that is “on the books?” Here, the Dean
needs to consider the costs to the six enrolled students in the canceled class as well as any
costs associated with the school reneging on what many might view as a commitment.
Further, in addition to the direct costs of hiring the instructor, the Dean needs to consider
whether the quality of instruction in the course would decline – that is, will the new
instructor deliver the goods? The Dean must weight all of these factors against the
incremental educational value of offering the Strategic Cost Management course to the 15
students who wish to take the class.

Option 3: There are unlikely to be any costs or benefits for the 19 students enrolled in the
other course. Thus, Dean Maxton needs to assess the incremental benefits associated with
allowing the 15 students to take Strategic Cost Management versus the cost to the 20 students
currently enrolled in the course (e.g., due to the instructor changing to a lecture-oriented
teaching style and change in exam format).

Ultimately, the Dean’s decision hinges on the qualitative factors, even though these factors
are difficult to measure with any reasonable degree of accuracy. Overall, it is likely that the
Dean would choose option 3 since the incremental benefits are likely to outweigh the
incremental costs, whereas the costs in options 1 and 2 likely overwhelm any benefits. This is
simply our conjecture, though. One can make plausible arguments to support choosing any of
the options.

1.59.
a. Your decision problem relates to buying the “best” computer, with your goal being to obtain
the maximum value from your computer purchase. Individual preferences dictate the
definition of value. For example, some students may place a premium on price, desiring to
obtain a computer that performs the basics for the lowest possible amount. Other students

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may place a premium on mobility or, alternatively, worry about the potential for theft and
loss. Finally, some students may emphasize computing power or monitor size. The key point
to remember is that “value” is like beauty – it lies in the eyes of the beholder — as it is
measured with respect to an individual’s preferences.

b. A narrow definition yields two options: (1) A desktop machine, and (2) a laptop machine. A
broader definition might include a laptop with a docking station, which gives us a hybrid of a
desktop and a laptop.

It also is important to recognize that external factors (“constraints”) may limit you from
considering other options. For example, a budget of $600 is likely to rule out most laptop
machines. If taking notes in class is the primary role for your new purchase, then desktops
would be eliminated. At an extreme, some schools specify that you choose among limited
configurations from a “vendor of choice,” a constraint that also limits your options.

c. There are numerous costs and benefits to be considered – the following are perhaps the most
salient:

Price: For equivalent computing and storage power, laptops are more expensive than desktop
machines.

Computing power. By virtue of their size, desktop machines offer features (microprocessor
speeds, RAM amounts, ability to handle add-on equipment via their multiple ports)
unavailable in laptop machines.

Monitor size, Video Cards, & Speakers. We can configure desktop machines with larger
monitors and better video cards and speakers. These features may be particularly important to
students who plan to use the machine for gaming and/or watching movies.

Mobility: We can more easily move laptop machines; they can be used in the classroom,
library, cafeteria, and so on.

Safety: Unfortunately, laptop machines can “grow feet.” That is, they are far more
susceptible to theft and loss.

d. Because many of the costs and benefits are qualitative, they will vary across individuals. For
example, students who are always “on the go” may assign more weight to mobility, and
therefore be more likely to purchase a laptop. Similarly, students who love video games may
assign more weight to monitor size and the quality of the video card and speakers, and
therefore lean towards purchasing a desktop.

In the end, each person will add up all of the benefits and subtract all the costs of each
machine type, selecting the option with the highest personal value.

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1.60.

a. The objective is to obtain the maximum value from your vacation. Individual preferences
dictate the definition of value. For example, some individuals may place a premium on
outdoor activities, desiring a vacation that involves golf, scuba diving, fishing, hiking, or
camping. Other individuals may place a premium on rest and relaxation, desiring to vacation
at a spa or resort where guests are pampered. Other individuals may place a premium on
visiting a foreign country or city, visiting historical sites and monuments, or cultural events.
Finally, some individuals may place a premium on cost, desiring simply to take 14 days off
for the lowest possible amount.

Even though you might share many interests, you and your friend’s objectives are unlikely to
be perfectly aligned. By definition, groups comprise multiple individuals, each with unique
preferences. The group’s preferences are some aggregation of individual preferences. As
discussed in the text, goal congruence is the overlap between the group’s and the individual’s
goals and is rarely perfect. Each individual in the group therefore will try to push the group to
make the decision that maximizes his or her own well being. Because of differences in
individual preferences, this can lead to different individuals pushing for different choices.

In this instance, even though you are best friends, it is likely that each of you attaches
differing values to different options. There is both a group and a personal decision here. Each
vacation possibility must be evaluated in terms of the relative benefits it yields to both parties
involved. For example, consider trips to Yellowstone National Park, the Grand Canyon, or
the Smokey Mountains of Tennessee. Being a white water enthusiast, you may prefer the
Grand Canyon trip to the others. Your friend may prefer the Smokey Mountain trip because
of his/her enjoyment of quiet long walks and greenery. As a group, you may settle on the
Yellowstone trip although it is not the first choice for either of you; it offers a bit for both of
you.

b. The option set here is very large and consists of all possible vacation destinations.
Realistically, decision makers “prune” the option set by eliminating an entire class of
choices. For example, you and your friend may restrict your choice to outdoor activities,
thereby eliminating a host of other vacation possibilities (a week in New York City, for
example). Alternatively, you and your friend may restrict your choice to European cities or
warm weather places (thereby eliminating U.S. vacation destinations and cruises to Alaska,
respectively).

It is very difficult, if not impossible, for a decision maker to consider more than a few
choices. Almost all decision makers narrow their options to a manageable number. Good
managers, however, try to make sure that the options they retain dominate those they
eliminate.

It also is important to recognize that external factors (constraints) may limit the options you
consider. For example, a budget of $2,000 for the vacation is likely to rule out a week at the

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Plaza hotel in New York City. (The room rate is several hundred dollars per day) or a week
of golf at Pebble Beach (the green fee is $500 per person per round).

c. There are numerous costs and benefits to be considered – the following seem salient:
Price: This is important to just about everyone and can severely limit one’s options. Most
individuals wish to avoid spending a significant amount of their annual discretionary income
on one vacation, desiring to save money for other goods such as car, television, clothes, and
food.

Time: Most individuals are very conscious of the amount of time the vacation will take – for
example, because of job constraints few individuals could take a 3-month tour of Europe.
Additionally, individuals likely will consider the amount of time spent traveling and the
amount of time actually spent at the vacation destination, wishing to minimize the former and
maximize the latter.

Mode of Travel: Some persons are nervous about flying and may not take any vacation that
involves air transportation.

Activities: What you will be “doing” on vacation, be it fishing, camping, or visiting historical
sites, is clearly important (as discussed above).

Location, Uniqueness: You may attach value to visiting a place you have never been before
and/or doing something “different” from the norm.

Crowds: Some persons like to vacation in relative isolation whereas others are less concerned
about long lines.

d. Because many of the costs and benefits are qualitative, they will vary across individuals.
Indeed, there are a plethora of places to vacation, and we see people making different
vacation choices all the time. In the end, you and your friend will add up all of the benefits
and subtract all the costs of vacation destinations in your option set, selecting the one with
the highest value.

Again, it is important to remember that (as discussed under part [a]) you and your friend will
likely attach differing values to the different vacation options. Thus, your final vacation
destination is likely to reflect a compromise between what you truly desire and what your
friend truly desires. Many students will likely recall that this happens all the time with family
vacations where the preferences of the children and adults do not coincide – invariably, some
compromise is struck.

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1.61.

a. Natalie’s decision problem centers on what to do with the unsold merchandise. Natalie’s goal
is to maximize her profit. For the unsold merchandise, this means maximizing the revenues
received from selling the merchandise less any additional costs associated with selling the
merchandise. The amount that Natalie paid for the unsold merchandise, or ($100,000 –
$65,000) × .50 = $17,500 is sunk and is not relevant to Natalie’s decision.

b. Based on the information provided, Natalie has 5 options:

1. Store the unsold merchandise for 10 months and attempt to sell it next season.
2. Hold an 80% off sale.
3. Hold a 70% off sale.
4. Hold a 60% off sale.
5. Hold a 50% off sale.

We could, of course, conceive of other alternatives such as donating all of the unsold
merchandise, but Natalie does not seem to be interested in evaluating these options.

c. The increase in Natalie’s cash flow under each option is:

1. Store and Sell Next Year:

Revenue next year ($100,000 – $65,000)  .30 $10,500
Packing and storage costs (4,000)
Increase in cash flow $6,500

Hold January after-Christmas Sale

2. 80% off sale 3. 70% off sale 4. 60% off sale 5. 50% off sale
Remaining revenues
at original price $35,000 $35,000 $35,000 $35,000
Discount =
% off  $35,000 28,000 24,500 21,000 17,500
Revenues at
discounted price $7,000 $10,500 $14,000 $17,500
% of items expected
to be sold 100% 80% 55% 40%
Increase in Cash flow $7,000 $8,400 $7,700 $7,000

Note: We focus on cash flows in this problem, rather than profit, because the cost of the
merchandise is sunk and not relevant to the decision at hand. Moreover, if Natalie were to
focus on profit, we would [erroneously] calculate the value of each option as being negative
as the amount Natalie paid for the unsold merchandise exceeds the proceeds received from
sale. What we need to remember is that the cost of the unsold merchandise will be expensed
even if Natalie were to do nothing and hold onto the merchandise (the status quo) – that is,
she would have to write it off due to obsolescence.

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d. The opportunity cost of each option is the value of the next best option. Thus, we have:

1. $8,400
2. $8,400
3. $7,700
4. $8,400
5. $8,400

e. Given the available options, we find that Natalie’s best strategy is to hold a “70% off” sale.
This strategy nets Natalie $700 more than the next-best option, which is the 60% off sale.
Moreover, this option is the only one whose value exceeds its opportunity cost.

You can take the problem a step further and link it to common business practice.
Specifically, we often observe stores using a “staggered” discounting strategy – the store
starts with, for example, a 25% discount and increases the discount rate over time (perhaps
by as much as 15-25% a week). In this way, the store attempts to capture as much consumer
surplus (total revenues) as possible by stratifying customer types according to their
willingness to wait and run the risk of having the item selling out. Such a strategy may work
quite well for Natalie – notice in the problem above Natalie could sell 40% of the items if she
offers a 50% discount. Natalie could then sell an additional 15% of her merchandise by
increasing the discount to 60%, and so on until she sells all of her merchandise. By using
such a strategy, Natalie might be able to earn as much as $13,125, calculated as follows:

Sequential Strategy Detail Revenues

50% off $35,000  .50  .40 $7,000
60% off $35,000  .40  .15 2,100
70% off $35,000  .30  .25 2,625
80% off $35,000  .20  .20 1,400
Expected Revenues $13,125

1.62.
a. Casinos monitor their employees because of the divergence between its goals and its
employee’s goals. The casino’s goal, which is to maximize profit, is at odds with employees’
goals, which is to maximize their personal wealth. Without monitoring, employees would be
tempted to increase their own wealth by stealing money and chips. Such concerns are
particularly salient in casinos because employees handle large sums of money and, without
monitoring, could easily hide the theft by simply claiming that a patron was lucky and won
the money.

Casinos therefore monitor their employees to reduce losses associated with employee theft.
Casinos can use both proactive and reactive controls to reduce this loss. Proactive controls
include video surveillance, physical monitoring by floor supervisors and pit bosses, lock and
key devices for slot machines, safe-keeping of high-value chips by sliding them into a locked

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cabinet, tracking gains and losses and comparing them to peer data, and using background
security checks. Reactive policies could include firing or prosecuting employees caught
cheating. As we see, there are many means casinos use to stop employees and patrons from
cheating – the number is limited only by management’s creativity.

b. Relative to physical monitoring, video monitors are less intrusive. The casino wants to
provide a friendly environment where patrons feel at ease and are more willing to gamble.
Patrons may not like having obvious “security” types hang around. Another advantage is that
video feed can be recorded. This allows events to be reviewed and makes for compelling
evidence in a court of law (while security staff can also testify, their memory is more fallible
and less objective). Finally, the casino must also monitor the security guards themselves to
prevent them from colluding with other employees to cheat the casino.

Video monitoring, however, does have some drawbacks. First, having a visible security
presence may alter people’s behavior and make them more prone to obeying the rules. We all
have slowed down when we see a patrol car in the distance. The patrol car therefore serves a
useful role, even if aerial monitoring from a helicopter is more effective at identifying
speeders. Second, video monitoring may be more expensive than hiring security guards.
Finally, it may be more difficult to pick up subtle behavioral and body language type clues
from a video monitor relative to direct observation. In this regard, physical monitoring may
be more effective than video monitoring.

c. Multiple monitoring systems make sense because, as discussed in part [b], any given system
is likely to have some weak spots. The use of multiple systems increases the probability that
any improper behavior will be detected and corrected. The best mix of monitoring systems
depends on the specific circumstances. For example, casinos rely heavily on video
surveillance because individual employees continuously receive and pay out large sums of
money without physical or electronic documentation (such as a receipt). A fast-food chain,
on the other hand, is less likely to use video surveillance because employees monitor each
other (i.e., work closely together), handle less money, and transactions with customers are
better documented (e.g., all customers receive a receipt for their purchase) – in this case, the
best control may be to reconcile the money in the cash drawer with the tape total at the end of
each day or shift.

To understand this point better, consider why your instructor may use both multiple choice
and essay questions on exams. Each type of question is advantaged in testing one aspect of
learning. Multiple choice questions are easy to grade and can test “fact learning” very well.
Essay questions test student understanding and integration of material, making them much
harder to grade. Because both types of learning are important, an instructor may use both
types of questions.

Note: Another factor to consider is the concept of diminishing marginal returns. Thus, we
usually find a portfolio of controls rather than one control alone.

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1.63.
a. Felix has four options:

 Do not paint the bedrooms now.

 Paint the bedrooms by himself.
 Paint the bedrooms with Oscar’s help.
 Contract out the painting job.

b. There appears to be little conflict between Felix’s and Oscar’s objectives. Both individuals
wish to have a good quality paint job. This congruence in objectives, however, does not
imply that monitoring is not needed. Felix would do well to monitor Oscar’s progress and
work quality. The purpose of this monitoring is to provide feedback and to improve quality
(improve Oscar’s skill as a painter) rather than to evaluate Oscar’s performance.

Translating to organizational settings, we must pay attention to the purpose of the monitoring
mechanism when choosing the mechanisms. A system that is appropriate for monitoring
performance may well be ill-suited to provide diagnostic and feedback information.

c. Felix and the contractor have differing objectives. The contractor’s objective is to make a
profit. The contractor can do this by delivering just the quality (the average customer cannot
discern the difference between good and excellent quality) that the client demands, and by
taking the least amount of time possible. Felix, on the other hand, cares deeply about quality.
Unless Felix is very careful to spell out his quality expectations, it is likely that there will be
a dispute about job quality. Performance evaluation is the key role for control measures and
monitoring in this setting.

Note: It is worthwhile to contrast the differing roles for monitoring in the two settings.
Usually, the purpose of monitoring is to ensure compliance with policies and procedures.
Such monitoring is required because organizational and employee goals differ. For example,
attendance records ensure that employees show up on time. This role for monitoring does not
exist with Oscar but does with the contractor. Although Felix is likely to assess quality in
both settings, the purpose differs.

It also is possible that some types of evaluations contain both performance assessment and
feedback aspects. Some instructors give tests both with the objective of testing student’s
knowledge and with the objective of helping students figure out what they know and what
they do not know. The former is the evaluative aspect of the exam while the latter is a
feedback role.

1.64.

It is true that, as a result of the bonus contract, Sally has a direct interest in maximizing the
Diamond Jubilee’s profit. Thus, the bonus contract does help align Sally’s interests with
those of the casino. However, the bonus contract may not fully align Sally’s interests with
those of the partnership; there are at least two areas of concern:

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1. Sally and the partnership may have different time horizons. Sally may be more interested
in maximizing today’s, or short-run, profit because, for example, she is close to retirement,
she is planning to move, or she is planning to switch jobs. On the other hand, the partnership
probably is more interested in maximizing the long-run stream of profits, or the present value
of future cash flows accruing to the casino.

Such differences in time horizon could lead Sally to take actions that increase current profits
at the detriment of future profits. For example, Sally may not invest in new equipment (e.g.,
slot machines or other gaming devices) or may defer maintenance or upgrades to the
riverboat because such actions would increase expenses, thereby reducing current profit and
Sally’s bonus. The partnership, however, may prefer such actions be taken to ensure the
long-run vitality and success of the casino.

Differences in time horizon also may lead Sally to not invest in increasing customer loyalty
and goodwill. For example, Sally may not offer casino patrons discounted (or free) rooms.
While such actions may increase short-term profits (because they reduce the casino’s costs)
they may jeopardize long-term profits because it has been shown that offering comps gets
people (and their friends) to come back to the casino.

2. A second source of discord may arise because Sally’s contract appears to encourage her to
consume many perquisites. Sally may be motivated to consume perquisites because she
receives all of the benefits while only bearing 5% of the cost (i.e., her lost share of profit).

For example, if Sally orders a new chair for her office that costs $1,000, Sally gets exclusive
use of the new chair and it only costs her $1,000  .05 = $50 in lost bonus income (while
casino profit goes down by $1,000). Sally may decide that, at $50, the new chair is a bargain
– casino partners, though, may view the matter differently. Analogously, Sally may be
motivated to give herself a larger office and/or give her friends and relatives free meals.
Finally, Sally may even engage in unethical and illegal behavior such as falsifying receipts
and expenses. For example, if Sally submits a false receipt asking for a $500 reimbursement,
Sally receives the $500 less the $25 reduction in her bonus ($500  .05 = $25) = $475. We
see that Sally’s contract is indeed imperfect.

These examples show that Sally’s interests are not fully aligned with those of the partnership.
Accordingly, it probably would not be in your best interest to delegate all decisions to Sally
and give her complete control of the casino.

Moreover, the lack of incentive alignment may increase the need for additional performance
measures (above and beyond linking Sally’s compensation to casino profitability) to ensure
that Sally acts in the best interest of the partnership. First, you probably would restrict the
decisions Sally could make – for example, you may require her to obtain approval before she
purchases a chair or submits an expense report. You also may form a committee to oversee
capital expenditures and improvements related to the riverboat and the gaming equipment.
Second, you may decide to more closely monitor Sally. For example, you may engage both
external and internal auditors to ensure that all physical and financial controls are in place
and that no-one has undue access to, or influence over, the books. Finally, you may wish to

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gather data regarding how the numbers from the Diamond Jubilee stack up against the
numbers from similar casinos – such benchmarking data can provide valuable insights
regarding how your casino (and employees) are performing vis-à-vis other casinos and their
employees.

1.65.
a. There clearly is some value to teaching boys the value of work and the dignity of labor.
However, the State’s objective of “reforming delinquent youth” probably encompasses
turning troubled kids into productive members of society. It is unclear how digging holes
accomplishes this objective – i.e., how it will lead troubled kids to not commit crimes, find
gainful employment, and acquire social skills.

It is possible to assess the effectiveness of the Warden’s performance measure. For example,
they would need to track the boys’ progress over a long-term horizon and compare this to the
progress of youths at other juvenile camps (where they use different methods to reform the
kids). In the short-run, it would seem that the State would want to measure the kids’
academic progress (i.e., reading and math skills) so that they are acquiring the necessary
tools to be productive upon release.

b. The measure seems to correspond very well with the Warden’s objective. This is an extreme
case of the Warden using her authority and power to further her own interests at the expense
of others.

c. As discussed in part [a], the State could have put in additional performance measures to
capture other dimensions of reforming delinquent youth. The State also has to closely
monitor the camp and the Warden via surprise visits or formal grievance procedures. Without
additional performance measures or monitoring, the Warden is free to do as she pleases.

Note: The movie Shawshank Redemption has a similar theme. In this movie, a prison warden
abuses his authority to exploit prison labor and build his fortune.

1.66.
a. All else being equal, the partners in Felipe’s firm would like to book the contract as early as
possible. Delaying the order until the next fiscal year subjects the firm to uncertainty (albeit
small) that the order may be canceled or delayed. As the old adage goes, a bird in the hand is
worth two in the bush. Further, the sales shortfall for the year provides additional motivation
for the partners to book the sales now and meet targets.

b. The timing of the sale matters a great deal to Felipe. If he books the sale this year, he will
have overshot last year’s performance by a substantial amount (and he is already over last
year’s target). More importantly, booking the sale this year will make it that more difficult
for Felipe to increase sales next year. Overall, incentive considerations may well spur Felipe
to delay the paperwork sufficiently so that the sale counts for the next fiscal year.

c. This act falls in the gray zone of ethical behavior. There is nothing illegal about the action
and it is not clear that Felipe’s firm will be adversely affected by a few weeks delay in

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processing the order. Such massaging of last minute orders (oftentimes it works the other
way around with managers working hard to pull next year’s orders into this year’s numbers)
is commonplace and unavoidable with budget-based performance measures. Most persons
would view this act to be a natural outgrowth of the incentives in place and that it is neither
unethical nor unprofessional for Felipe to delay the sale until the next fiscal year.

1.67.
a. Stefan’s objectives are clear – he likely will choose the option that maximizes his bonus over
the two-year period. Thus, to understand what Stefan likely will do, we should calculate his
bonus in two cases: (1) he undertakes the sales campaign; (2) he does not undertake the sales
campaign. Notice that we can ignore Stefan’s base salary of €15,000 per month as it is the
same under both options.

(1) Sales campaign undertaken:

Sales = €22 million this year and €12 million next year.

Stefan’s bonus this year = [(€20 million – €10 million)  .02] + [(€22 million – €20 million)
 .05] = €300,000.

Stefan’s bonus next year = [(€12 million – €10 million)  .02] = €40,000.

Thus, Stefan’s bonus over the two years = €340,000.

(2) Sales campaign not undertaken:

Sales = €16 million this year and €16 million next year.

Stefan’s bonus this year = [(€16 million – €10 million)  .02] = €120,000.

Stefan’s bonus next year = [(€16 million – €10 million)  .02] = €120,000.

Thus, Stefan’s bonus over the two years = €240,000.

The net increase in Stefan’s bonus from undertaking the campaign = €100,000 = €340,000 –
€240,000. Stefan clearly should undertake the sales campaign (time value of money
considerations also would suggest adopting the campaign).

b. The firm’s objectives also are pretty clear – to maximize value, the parent company likely
would want Stefan to pursue the intensive sales campaign only if it increased two-year profit.
From the firm’s viewpoint, we can calculate the increased benefits and costs associated with
the campaign:

Increase in profit €800,000 (Increase in sales  $0.40)

less: incremental campaign costs (€1 million) Given
less: increase in commission to Stefan (€100,000) As calculated in part [a]

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Net decrease (€300,000)

Thus, the sales campaign is not profitable from the firm’s viewpoint – accordingly, the firm
would prefer that Stefan not undertake the sales campaign.

c. We indeed see that there is a divergence of interest between Stefan and his parent company.
This conflict stems from two sources. First, Stefan is not held accountable for costs –
Stefan’s current compensation arrangement rewards him strictly for increasing revenues –
thus, Stefan [theoretically] would undertake any action that increased revenues regardless of
the cost to the parent company. For example, Stefan would have an incentive to choose an
option that increased sales by €1 million even if it increased overall cost by €2 million.
Clearly, there is incentive misalignment and, to rectify this problem, the parent company
should hold Stefan accountable for both revenue and costs.

Second, Stefan has clear incentives to manage sales across periods given the structure of his
contract – i.e., the higher rate on sales over €20 million and the lower rate on sales under €10
million. The company likely is using this non-linear contract in a belief that it motivates
Stefan to work hard. Such contracts, though, may also engender gamesmanship and the
company might wish to consider alternative contracts, such as a linear specification.

1.68.
a. The following table provides some key decisions, over the life of the machine, corresponding
to the four stages of the planning and control cycle.

Stage Detail
Plan The decision of whether to buy the new press or not is part of this
stage. The act of committing resources, be it money, time or space, is a
critical piece of this stage. Other decisions might include choosing the
products that will be produced with the new press and the prices at
which these products will be sold.

Implement Implementation would include decisions about when and where to

install the press and how best to schedule production of the various
products. This stage also includes control aspects, such as selecting
performance targets for the new press (both quantity and quality) and
how best to motivate press operators to achieve these performance
targets.

Evaluate This stage would include measuring the quality and quantity of the
output and comparing it to the targets established in the
implementation stage. Managers at Vulcan would seek to understand
the reasons underlying significant deviations between planned and
actual results. Managers would evaluate numerous other results, such
as repair statistics and operating costs.

Revise Vulcan’s management will continually revise their beliefs about the

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wisdom of their choice as they gain experience using the press.

Eventually, this updated information will influence the type of press
they buy next, and might well influence when they buy the next
machine. For example, they might decide to scrap the machine in two
years if it breaks down more often than is expected.

b. As we see, we usually begin with a plan that is based on a set of assumptions – in this case,
the costs and benefits of replacing the current press with a new press. These assumptions are
our beliefs about the unknown future. We then implement our choices and, as time passes,
we will gather more information about the actual costs and benefits of the new press. Over a
period, we will accumulate enough information to revise our original set of assumptions,
which will influence our next purchase.

There are many smaller decisions within this overall cycle. In many instances, the broad loop
relating to a decision contains smaller loops within it. For example, we can think of the
schedule for any given day as a decision – this has its own loop where we commit machine
time and execute the plan. We then figure out whether the schedule indeed worked as
planned and the reasons for any deviations. This information feeds into the next day’s
schedule. The overall efficiency, the outcome of numerous scheduling decisions, then
becomes part of the evaluation stage of the larger cycle. The fundamental point is that every
decision has a natural cycle to it.

1.69.
Drew’s first statement reflects some ignorance about how to make effective decisions. All
decisions concern the future. Thus, most decisions include some uncertainty about future
costs and benefits. Even what seems to be a simple decision, such as whether to watch a
movie a second time, contains uncertainty because we do not know how good the movie will
be the second time around. Some movies age well while others do not. The point is that we
make decisions with some expectations. As the decision unfolds, we obtain actual results and
revise our expectations. This is the planning-control cycle. This cycle does not mean that
people must regret or rethink their decisions. It just means that we constantly evaluate where
we are relative to our expectations and adjust our plans accordingly.

Drew’s second comment is valid. Few decisions cleanly follow the 4-stage PIER process. A
complex decision (e.g., who to start, which machine to buy) usually contains many smaller
decisions. We can legitimately construct a PIER process for these smaller decisions as well.
However, this ability does not remove our need to think about the larger decision as a PIER
process. The cycle is a way of showing that every decision follows a common template.

1.70.

The following are among the many items that Tom and Lynda might consider:

1. Increase in number of members. This non-financial item relates to a benefit, increased

revenues. The correct benchmark for the item is the number of members if yoga were not

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offered. The number has to be subjectively estimated. Examining past data on classes offered
previously and the resulting membership might prove helpful in forming this estimate.

2. Fee per member. This financial item relates to a benefit. It is easily and objectively
measured from the firm’s accounting systems.

3. Increase in cost of supplies and other member-related costs. This financial item relates to a
cost. Using data from Hercules’ managerial accounting system, Tom and Lynda can
reasonably estimate this cost. However, there is inevitably some subjective element – e.g., it
is not clear whether the gym will have data on the variable costs connected with a yoga class
(e.g., number of mats to be replaced each month).

4. Increase in instructor salaries and advertising. This financial item relates to a cost. This
item may have to be estimated based on contract negotiations with the yoga instructor. Some
amount of this item may also be discretionary (e.g., advertising).

5. Image of the gym. This item relates to a long-term benefit. Offering yoga must fit with
Hercules’ overall “image” and “brand.” For example, yoga might not be the best choice if
Hercules primarily catered to men interested in weight lifting and strength training.

1.71.
The following are among the many items that you might consider:

1. Demand for item. This non-financial item relates to a benefit, increased revenues. The
number has to be estimated using some objective data and some subjectivity. Examining past
data on similar products and market research provide quantitative input that is subjectively
converted to an estimated demand.

2. Price for item. This financial item relates to a benefit. It is a choice variable. However,
notice that this choice affects demand (and therefore costs).

3. Costs. This financial item relates to a cost. You need to estimate the cost of making and
selling the item. Costs would include items such as materials, labor, and commissions, as
well as the wear and tear on equipment and warehouses.

4. Capacity. This non-financial item relates to both benefits and costs. This item influences
the best price. A setting with limited capacity might push you toward premium pricing while
excess capacity might enhance the attractiveness of getting volume with low prices.

5. Effect on other products. Introducing this product might have both planned and unplanned
effects on the demands for the firm’s other products. The resulting profit impact (which can
be a benefit or a cost) often is a crucial consideration in product launch decisions.

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MINI-CASES

1.72.
a. To understand Professor K’s motivation, consider what happens if fewer than 32 students
show up and what happens if more than 32 students show up. With too few students, the
experiment must be cancelled. In addition to delaying his research, Professor K now has the
problem of inducing the next set of students to show up. Professor K will incur substantial
costs in time and effort to reschedule the experiment and recruit new students. On the other
hand, consider what happens if too many students show up. In this case, Professor K has to
pay the show-up fee to the excess students.

Professor K’s choice of the show up fee amount tries to balance these two costs and
minimize their total. To see this, consider what would happen if he offers a show-up fee of
$500 and invites 32 students. Not many undergraduate students will pass up a chance to
make $500 for sure. If Professor K invites 32 students, then he can be fully confident that all
32 will show up. This strategy, however, implies that he will have to pay $16,000 (= $500
per student × 32 students) as a show-up fee. Now suppose Professor K offers no show up fee
and still invites only 32 students. Then, a student may or may not show up – The student only
gives up the chance to spend an hour to make $20 or so. But, if less than 32 students show
up, the experiment must be cancelled and re-scheduled. Professor K’s cost of doing so may
be, say, $400 or so. If there is a 90% chance that fewer than 32 students show up, then
Professor K’s expected cost is $400 × 0.9 = $360.

Professor K can reduce his expected cost by reducing the probability of having fewer than 32
students show up. He can do this by increasing the number of students invited (still by
keeping a $0 show-up fee). However, if he increases the number of students invited, word
will soon get out that some (if not many) of the students who show up will go home with
nothing for their trouble. Professor K may then have difficulty recruiting students for future
experiments. As mentioned earlier, a show-up fee also reduces the probability of having
fewer than 32 students show up but is costly to Professor K. The $5 fee is a compromise
between inviting many students and building up a reputation for wasting students’ time and
incurring the cost of the show-up fee.

Note: This problem is useful in highlighting how uncertainty shapes our decisions. Realized
events lead to actual costs and benefits. However, as we do not know the future, we rely on
expectations to compute the value and opportunity cost of decision options (e.g., # of
students to invite). Indeed, we could characterize many decisions as finding the best balance
between the costs and benefits of alternate future possibilities. Capacity choice is a salient
business example that balances the costs of buying too much capacity versus the costs of
buying too little.

b. To assess opportunity cost, consider the student’s options. The student could show up or not
show up. The opportunity cost of showing up is the value of not showing up and doing other
things (e.g., watching TV, hanging out with friends, studying). We do not have a good value
for this measure. However, if a student does show up, then the student earns $5 for sure.
With a 10% probability, the student will be done. S/he can then spend the freed-up time as

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s/he wishes. With 90% probability, s/he can earn $20 over the next hour. We can combine
the two possible outcomes to get an expected value associated with showing up. This
expected value must exceed the student’s subjective value of not showing up and doing other
things. It is not possible to get a quantitative measure of the opportunity cost of showing up.

Note: The opportunity cost is lower than the expected earnings of $23 (= [.90 × $20] + $5)
for the student who does show up, and is likely higher than $23 for the student who does not
show up. It is not possible, though, to get a more precise measure of the opportunity cost.

c. Making the students’ earnings vary is a mechanism to combat the incongruence in goals
between Professor K and the students. Professor K would like the students to take the
decision task seriously so that he can get good quality data to study. The students, on the
other hand, would like to exert the least cognitive effort possible, all else being equal. With a
flat wage, the student has no incentive to work at the problem and make good decisions. This
lack of attention degrades data quality and erodes the value of Professor K’s study. Linking
pay to the quality of decisions (however measured) provides incentives to make good
decisions. The student now has to tradeoff the cognitive effort with the expected increase in
his/her compensation. Professor K will likely structure the pay scheme in a way that students
find it beneficial to work hard for that hour.

Note: One can formally analyze the student’s decision task as well. For simplicity, restrict the
options to working hard and not working hard. The decision to work hard trades off the cost
of effort with the expected increase in take-home pay.

1.73.
a. What does Dr. Cleveland value? The problem suggests three factors: (1) her income, (2)
providing quality medical care to her patients, and (3) making her services available to all.
All three components are important to her and shape her goals.

Dr. Cleveland’s current situation seems to suggest a tradeoff among these factors. The
insurance companies allow her to reach out to many people but potentially compromise
quality. (We note that there is debate regarding whether the restrictions imposed by insurance
companies and HMOs compromise quality. The problem indicates that Dr. Cleveland
perceives a compromise; therefore, we assume that quality would increase if Dr. Cleveland
were to switch to the patient pays billed charges approach). Additionally, it is unclear how
much Dr. Cleveland’s income will be affected by her alternatives.

The presence of a tradeoff among the factors that Dr. Cleveland values suggests that her
relative preferences among these factors will play an important role. That is, Dr. Cleveland
will have to decide which factor she values most – income, quality care, and/or making her
services available to all. The choice is not at all clear cut.

b. The following tables provide the required computations:

HMO’s and Patient Pays

Item Insurance Plans Charges Approach

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Time per patient (average) 15 minutes ½ hour

Patients per hour 4 2
Number of hours in day 8 8
Patients per day 32 16
Number of days worked 225 225
Office visits per year 7,200 3,600
Revenue per patient $40 $75
Annual Revenues $288,000 $270,000

From a purely monetary perspective, the current approach appears to be more profitable than
switching to the patient pays billed charges approach. However, the above comparison
ignores any cost effects. It is possible that costs would decrease under a “patient pays
charges” approach. First, Dr. Cleveland would be halving the number of patients seen. This
reduction in volume could lead to a reduction in the demand for nursing staff as well as a
reduction in ancillary help such as receptionists and record clerks. Second, there will be
fewer hassles connected with following up with insurance firms, reducing the demand for
accounts clerks.

The revenue comparison also leaves out some benefits. Often, clinics conduct many routine
tests such as urinalysis. With reasonable assumptions about patient mix, the revenue from
these tests depends on the number of patients seen. This revenue would decrease under the
proposed plan as well.

Overall, we do not have enough information to estimate fully the monetary impact on Dr.
Cleveland’s practice from switching plans. (This is the topic of future chapters.)

c. Goals: As discussed in part [a], at least three factors impact her goals: (1) income, (2) quality
of care provided, and (3) reach of service. It is clear that Dr. Cleveland values all three
components. Her preferences will affect the individual weightings. Variations in preferences
can lead to differing choices in seemingly similar settings. For example, it is possible that
while Dr. Cleveland chooses the patient pays all approach (attaching relatively low weight to
reach and money), another physician may choose to stay with the HMOs and insurance firms
(attaching relatively low weight to quality of care but higher weights to reach and to
monetary factors.)

Options: The opportunity set consists of two options. Dr. Cleveland’s first option is to stay
with her current practice of contracting with HMOs and insurance plans. Dr. Cleveland’s
second option is to go with the patient pays all approach.

Technically, one can think of more options. For example, Dr. Cleveland can quit the practice
of medicine altogether. Alternatively, she can de-list from some plans and not others. It is
likely, however, that Dr. Cleveland would eliminate such options because the aforementioned
two options appear to dominate these hybrids. Decision makers often simplify the
opportunity set to a few choices, motivated in part by cognitive considerations.

Costs & Benefits: As listed earlier, there are numerous costs and benefits to be considered:

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 Impact on income. The two plans will yield different incomes. One is a low-price high
volume plan while the other is a high price, low volume plan. In addition, the volume
differences may affect overall costs as well.
 Impact on quality. The “patient pays billed charges” approach potentially (at least in Dr.
Cleveland’s mind) allows her to provide superior medical care. This is an important
factor to a committed physician.
 Impact on reach. Dr. Cleveland also believes that good quality medical care should be
available to all. She can reach out to the under-privileged and uninsured by, for example,
providing free care three days in a week. However, doing so would reduce her income.
She seems to have struck a compromise by contracting with many HMOs and insurance
plans (this still leaves out the uninsured). Going to a patient pays charges approach
would further reduce her reach. Few among us can pay the balance not covered by the
insurance payment (we still have to pay the insurance premium). The proposed approach
is therefore likely to change her patient profile toward the more well to do. This shift is
in direct contrast to one of Dr. Cleveland’s core beliefs, and is the crux of the dilemma.

Making a choice: The final step is to pick the option with the highest value – the option that
gives Dr. Cleveland the best “balance” between income, quality and reach.

d. The opportunity cost of this decision is the value obtained from the next best use of that time.
The problem states that Dr. Cleveland expects to be fully occupied even if she switches to the
patient pays billed charges approach. Thus, if Dr. Cleveland devotes three hours to indigent
care, then she gives up the chance to see paying patients. (We are assuming that she is still
working for 8 hours per day. The following paragraph relaxes this assumption.) That is, she
will see 6 fewer patients during a week. At the rate of $75 per office visit, this translates to
$450 per week.

What happens if Dr. Cleveland does indigent care outside her regular office hours (8 hours
per day), such as during the early morning and late evening hours? Specifically, assume that
she keeps the clinic open from 5 PM to 8 PM on Wednesday evenings, devoting the time
only to indigent care. In this case, Dr. Cleveland is giving up leisure time. She could be
pursuing other activities (family time, reading, hobbies) during this time. Spending the time
on indigent care reduces the time available for these other activities. The opportunity cost is
then the value of these other activities. The value of regular patients not seen does not apply
here because there would be no reduction in the number of (paying) patients seen.

e. If she devotes only 25 minutes per patient, Dr. Cleveland can see 19 patients per day, or 19 ×
225 = 4,275 patients per year. This volume yields revenues of $320,625 (4,275 × $75) per
year, a significant increase over the projected revenues of $270,000.

The key tradeoff here is the potential reduction in quality (25 minutes versus 30 minutes per
average visit) with the increase in income (patient reach also is affected). The best decision
from Dr. Cleveland’s perspective is unclear. This change goes against one of her objectives
of providing quality care. Her judgment about the quality loss due to the lower time spent
with each patient is crucial as she assesses her options. The potential loss in quality along

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with any associated loss in reputation is a long-term effect. It is likely that only one in many
patients feels a significant decline in quality because of the lower time commitment.
However, these instances build up over time and lead to the lower overall perception of
quality. Good managers consider both immediate and distant effects in their decision making,
even if they cannot measure well many of the long-term effects.

1.74.
a. The Directors have five options:

1. Do not fund any project – that is, add the entire $50,000 in remaining grant money to
the Foundation’s endowment.

2. Fund project A alone.

3. Fund project B alone, and add the remaining $32,000 to the Foundation’s
endowment.

4. Fund project C alone, and add the remaining $28,000 to the Foundation’s
endowment.

5. Fund projects B and C, and add the remaining $10,000 to the Foundation’s
endowment.

With the given budget, it is not possible to fund project A and some other project. This
constraint removes the choice of funding Projects A and B (or Projects A and C) from the
option set.

In reality, projects can (and often are) funded at less than requested levels. This additional
flexibility expands the number of options. For instance, the flexibility permits the option of
funding Project A at $35,000 and Project B at $15,000.

b. If project A is funded, then the other two projects cannot be funded. The opportunity cost
depends crucially on whether the Directors believe Project B and/or Project C will generate
more value than the amount funded.

If both Projects B and C are perceived as valuable (i.e., the Directors believe each project
will generate more value than the amount of funding requested) then the opportunity cost is
the lost benefit from not funding projects B and C plus the value of adding $10,000 to the
endowment.

Suppose project B is deemed to be valuable whereas project C is not. Then, the opportunity
cost is the lost benefit from funding project B plus the value of adding $32,000 to the
endowment. The opportunity cost is the benefit derived from option 3 in part [a]. (Analogous
arguments apply if project C is deemed worthy but project B is not.)

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Suppose neither project B nor project C is deemed to be valuable. Then, the opportunity cost
is the cost of holding $50,000 in reserve to fund future, yet to be determined, projects. This
opportunity cost is the value attached to option 1 in part [a].

c. The approach has benefits and costs. The benefit is that it makes the decision problem
manageable. Rather than consider combinations of projects (e.g., projects B and C, project C
by itself, project B by itself, and so on), the Directors need evaluate only one project at any
given time. This reduces their cognitive load significantly.

The cost is that we may poorly measure opportunity cost. Specifically, because Project C is
examined in isolation (without reference to other projects), the approach assumes that the
opportunity cost of funding project C is $22,000. It does not consider the other uses for the
$22,000 (e.g., that it may be used to fund Projects A or B). In particular, assume that the
directors value project C at $25,000. Then, project C will be funded. However, this decision
implies that project A will be unfunded, regardless of its merit. For example, project A may
be valued at $150,000 – clearly, a better return for the foundation’s money relative to funding
project C. But, the sequential decision rule leads to a poor decision.

The takeaway point is that the best decision rule should consider all of the options.
Restricting the number of options considered, as the sequential rule does, could therefore
result in bad decisions.

Note: A sequential decision rule is sub-optimal in this setting because of limited resources.
Suppose the foundation had an unlimited budget. Then, it does not matter whether the
projects are evaluated sequentially or simultaneously. The opportunity cost of each project in
this case is the cost of the funds expended, and not the value of a project that the selected
project displaces.

d. Based on the Directors’ assessments, Projects B and C should not be funded (because the
value is less than the requested amount). The decision boils down to whether Project A
should be funded. The opportunity cost of funding Project A is the best other use for the
$50,000 (i.e., the value of option 1). This opportunity cost is likely greater than $50,000.
Retaining the money allows the directors the flexibility of funding a future (but with details
currently unknown) project. The value of this should be included in the opportunity cost of
funding Project A. Attaching a dollar figure to the value of the flexibility, however, is a
difficult task. The Directors have to use their judgment to figure out the chance that a
superior project would materialize if Project A were not funded.

We conjecture that a net value of $500 (= $50,500 – $50,000) is sufficiently small that the
Directors will not fund Project A as well.

1.75.
a. For simplicity, let us assume that management’s goals are the same as organizational goals.
Management then has at least two broad goals. The first goal is to make profit for the
shareholders or at least breakeven if the owner is a not-for-profit entity. The second goal is to
provide quality medical care to as wide a population base as possible.

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Incentives from a profit maximizing perspective are clear. Profit is a percent of cost, and
management therefore will not take any effort to reduce cost. Indeed, given its other goal of
providing quality healthcare, costs are likely to explode. (And, they did.) Patients received
the highest quality medical care available and no expense was spared.

Executing this strategy required very little in the form of detailed cost information. However,
we note the incentives to ‘game’ the system. For instance, as different payors had different
markups on actual cost, hospital accountants spent time in devising allocation schemes that
maximized the hospital’s reimbursement. Management accounting took a back seat in the
hospital administrators’ mind as their focus was to get the latest and best in medical care.

Note: We note that the patients benefited greatly under this system. However, society as a
whole suffered because “too much” healthcare was provided. The PPS system grew out of a
desire to rein in the rampant rise in healthcare costs. Unfortunately, healthcare costs have
continued to outstrip inflation even into the 21st century.

We also note that this discussion is an extremely brief, and incomplete, overview of the
complex changes that have swept the healthcare system in the USA. Numerous books and
journal articles in health economics discuss these changes extensively.

b. Management’s goals do not change because the reimbursement system changed. However,
the change does affect the actions management considers to meet its goals. For instance, cost
control becomes paramount under the PPS system. It is common for hospital administrators
today to get detailed cost information on individual procedures and tests. They also set prices
and negotiate for DRG rate adjustments based on detailed estimates of the cost of various
procedures. Physicians and other medical staff are assessed on their efficiency and utilization
rates. The change in the reimbursement system has triggered a major shift from quality
medicine at any cost to affordable medicine.

Note: The rise of Health Maintenance Organizations (HMOs) creates another set of
incentives. HMOs, which may also operate hospitals, collect a fixed fee from each member
in return for providing all needed healthcare. Under an HMO scheme, the HMO makes profit
when its members get sick at lower than expected rates. Thus, HMOs and affiliated hospitals
encourage preventive measures much more than during earlier times. Notice that a hospital
under a traditional PPS system has little incentive to advocate preventive medicine.

c. The change in the regime affects the information provided to management by changing the
nature of the decisions they face. The information during the cost-plus regime likely
pertained to the efficacy of the medical care provided, more so than its efficiency. Cost
information is accordingly de-emphasized as there is little need to understand and manage
cost at the micro level. The PPS system shifts the focus to cost control, meaning that both
efficiency and effectiveness attain equal footing. Cost information, detailed down to the
individual department, DRG and procedure level, now takes center stage.

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 CHAPTER 2
Identifying and Estimating Costs and Benefits
Solutions

REVIEW QUESTIONS

2.1 Costs and benefits are relevant if they differ across decision options.

2.2 A cost is controllable if the decision maker can avoid the cost by not choosing a decision
option. Equivalently, a controllable cost is one that a decision maker chooses to incur,
relative to doing nothing.

2.3 Because previously made commitments and contractual obligations expire with the passage
of time.

2.4 The ability to change the levels of capacity resources related to plant, equipment, and
salaried staff.

2.5 Because many decisions contain elements of both the short- and long-term. Consider
sleeping through a test – this has immediate and, perhaps, longer-term consequences.

2.6 Costs and benefits are the result of performing activities.

2.7 Revenues typically are variable with respect to sales volume.

2.8 Variable costs are proportional to the volume of activity, whereas fixed costs do not change
as the volume of activity changes. Mixed costs contain both fixed and variable components.

2.9 Traceability is the degree to which we can directly relate a cost or revenue to a decision
option.

2.10 A cost or revenue that we can uniquely relate to a decision option is a direct cost or a direct
benefit. If only a portion of the cost or revenue pertains to a particular decision option, then
it is an indirect cost or an indirect benefit.

2.11 Step costs stay at the same level for a certain activity range, but jump to a higher amount if
the volume of activity increases beyond this range.

2.12 There are four kinds of costs in the cost hierarchy – unit, batch, product, and facility.

DISCUSSION QUESTIONS
2.13 When we define the value of an option as the controllable benefits from that option less the
controllable costs of the option, we are implicitly defining value relative to the status quo
of not doing anything (i.e., not taking any of the options associated with the decision being

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considered). Such a definition allows us to equate the value of the option with the net cash
flow associated with it. However, focusing on relevant costs and benefits will not give us
the same value because some costs and benefits may be common across all options. The
only exception is when the status quo of not doing anything is a feasible option. In this
case, all costs and benefits associated with any option are relevant because there are no
costs or benefits associated with the status quo.

2.14 Qualitative factors are as relevant as cash flows. Consider the decision of buying fruit in a
local grocery store. Let us say that your favorite grocery store is selling fresh grapes for
$3.99 a pound, but in an adjacent store grapes are available for $1.99 a pound but they are
not as fresh. The decision to make is whether you are willing to pay the extra $2.00 a
pound to enjoy fresh grapes. You may well decide to do so. How did you make the trade-
off? Clearly, the additional benefit that you get from fresh grapes is not quantifiable. Yet,
you are able to use your judgment to make the trade-off.

2.15 Suppose you have decided to buy a car. You have already set your heart on buying a
Subaru Outback. There are two Subaru dealers nearby, and both offer exactly the same
price. In this case, the price of the car is controllable because you may choose not to buy
the car (i.e., the status quo). However, given that you have already made the decision to
buy, the price of the car is not relevant in deciding which dealer to buy from.

This example establishes that not all controllable costs are relevant unless the status quo is
also an option. But every relevant cost is controllable because, by definition, relevant costs
are costs that differ across decision options. The fact that they differ means that they are
controllable.

2.16 Generally speaking, sunk costs are not relevant for decision making because these are costs
incurred (or committed to) in the past, and, therefore, do not vary across decision options.
But, in some instances, there are future tax considerations that may arise from past
decisions, and that may be relevant. For example, consider a company that had invested
$10 million dollars five years ago to buy an important piece of equipment. The company
enjoys a tax deduction for depreciation for this equipment over the 20 year life of this
equipment. Since five years have gone by, 15 years of depreciation tax deduction remain.
Let us say, now, the company is contemplating selling this asset and moving into some
other new business. While the $10 million original cost of the equipment is a sunk cost for
this decision, the company has to take into account the fact that it will be foregoing the
remaining 15 years of tax benefit from depreciation by selling the equipment (the sale price
has to be adjusted because the purchaser will now get the tax benefit).

Reputation is another consideration. Let us say a builder implicitly commits to donate his
time to building affordable houses in a suburban community for a charity organization.
Halfway into the project, the builder gets a lucrative commercial contract from a local real
estate developer. While it may not seem financially wise to continue to devote time to the
charity cause, switching has potential long-term reputational consequences in the

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community. The builder must take these consequences into account before pursuing more
profitable avenues.

2.17 Let us say you have aspirations to be elected to the United States Senate in 10 years’ time.
After much research, you realize that the best way to achieve this goal is to first secure a
Law degree, then practice law for a few years, get elected to the local legislature to gain
legislative experience, and finally do a stint in a Washington policy think tank to gain
domestic and foreign policy experience. Over the next few months, you decide to start
preparing for admission into law schools.

2.18 Opening an additional section for an existing class or reassigning rooms among classes is a
short-term decision that most probably applies to the current semester. Offering a new
program of study is a long-term decision because the intent presumably is to continue
offering the new program over the foreseeable future. Remodeling the cafeteria is also a
long-term decision because it is a relatively permanent change (until the next remodeling
which is not likely in the next few years).

2.19 Product life-cycles are relatively long--extending over several years--in some industries
and relatively short—sometimes just a year or two years—in other industries. Consumer
electronics, including televisions, is an example of the latter. For companies such as
Pioneer, Sony, Toshiba, and Mitsubishi, advertising, promotion, and pricing are short-term
decisions that have to be made almost on a weekly basis to stay ahead of the competition.

2.20 Assuming that you have decided which automobile to buy, you are committing to the price
of the automobile, the cost of car insurance, and the cost of expected routine maintenance.
You are not committing to driving the car every day or to buying gasoline on a weekly
basis because you can control these expenditures through your usage of the car.

2.21 You decide to take a small vacation and spend a weekend in Las Vegas and try your luck in
the casinos there. You don’t want to lose too much money and so you decide to limit your
losses to $1,000. Lo and behold, lady luck smiles and you win $50,000! This changes your
life because you can now make a down payment for your dream house.

2.22 Yes, spillover effects are controllable and must be considered in making decisions.
Consider an automobile company like GM which offers two similar SUVs but under
different brand names. The decision to drop one of these brands is likely to increase the
revenues from the other brand (but may decrease the total revenues from the two brands).
On the other hand, consider an auto repair shop that decides to stop doing simple brake
jobs. Such a decision is likely to have negative spillover effects because it will lose
revenues from performing other maintenance services that typically surface when cars are
brought in by their owners to get their brakes serviced.

2.23 When costs or revenues vary, using many possible realizations helps us estimate with
greater statistical confidence what these costs or revenues are going to be on average. That
is, we can estimate their means more reliably. On the other hand, the inability to trace costs
accurately introduces measurement error or “noise” in our estimation. Such measurement

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error increases the variance because we now have to deal with the randomness in this error
as well – i.e., the error can assume different values as well.

2.24 The minimum charge for a service represents the opportunity cost to the company for
committing resources for that service. By not providing that service, the company can use
its resources to make a profit by providing the same service to someone else. Consider the
caterer example. Let us say you have agreed to pay $120 to the caterer to host a small
dinner party for 10 friends. The caterer charges $12 per person because s/he has to arrange
for food items for each individual and make some profit as well. In this case, the number of
persons attending the dinner is a good basis to estimate costs. That is, the caterer’s costs
and charges are proportional to the number of persons s/he is asked to serve.

2.25 This assertion is correct as long as the number of batches produced does not increase, and
the number of different products made does not increase. If the volume of production
increases because the number of units produced within each batch increases, then batch-
and product-level costs will not increase and are therefore not relevant.

2.26 The cost of the service agent is a “customer-level” cost. As the number of customers
increases, this cost increases as the number of service agents will also increase. In business-
to-business marketing involving one company selling its goods and services to other
companies (such as Alcoa supplying Aluminum to Anheuser-Busch to make beer cans),
each customer account constitutes a significant source of revenues. In such instances,
companies usually dedicate service agents to individual accounts. Let us group costs for
such a company serving an industrial market to help decide which company account is
profitable, and which is not:

Customer-level or account specific costs: Examples include costs to maintain a

dedicated field office. These costs vary at the customer level and do not vary with
the volume of business with each customer in the short run.

Order processing costs: Examples include the costs of resources necessary to

process individual orders with each client. These costs are proportional to the order
volume from each client.

Order change costs: These costs are proportional to the number of change orders
requested by each client.

Materials handling and shipment costs: These costs are likely proportional to the
number of shipments.

Client on-site support costs: These costs are likely proportional to the number of
visits (and/or the duration of these visits) that each client requires to provide on-site
support.

Specific details of cost classification will vary from one company to another, but the main
point is that it is necessary to understand and define cost hierarchies as precisely as possible

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to measure costs and benefits of various options in a decision context in order to make the
right choice.

EXERCISES
2.27 Relevance (LO1).
a. The tire cost of $119 is not relevant. This cost is the same across all options Brianna
has.
b. Yes, the disposal of $6 is relevant. Store B does not charge a separate cost for
disposing of the old tires.
c. Yes, installation costs are relevant. The two stores charge different amounts for
installation.
2.28 Relevance (LO1).
a. No, the tuition cost is not relevant as long as you have decided to enroll for the
semester.
b. Because the text book costs mush less and Class B is equally interesting and has the
same reputation as Class A.
c. Both classes A and B meet at the same time. So when choosing between Class A and
B the class time is not relevant. But Classes A and C meet at different times, so the
class time is relevant. Yes, the meeting time is relevant for the overall decision which
class to choose because it differs for one of the options.
2.29 Relevance (LO1)
a. Dinora has two options: (i) the status quo of making 350 pupusas, and selling around
300 pupusas on a typical day and giving away the rest, and (ii) Take the order from
the long-standing customer for 350 pupusas.
b. Yes, the revenues are different across the two options (both on a per unit basis, and on
a total revenue basis).
c. No, Dinora’s expenditures on ingredients are not relevant because she makes the
same number of pupusas under each option. The transportation costs of $25, however,
are relevant.
2.30 Relevance (LO1).
a. No, the cell phone cost of $399 is not relevant because this cost is the same regardless
of the company you buy the cell phone from. This cost would be relevant only when
one of the companies offers it for a different price.
b. Yes, the monthly plan costs are different with each company.
c. If company C, for example, has greater and better coverage and less dropped calls,
then you might be able to justify the extra cost.

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2.31 Relevance of qualitative considerations (LO1).

a. There are many reasons to patronize a particular store other than price differences.
Considerations such as convenience (how close the store is to your home), ambience,
familiarity with where things are, friendly employees that you have come to know
and like over time matter a great deal.
b. Discussed in a. above.
2.32 Relevance (LO1).
a. The amount is not relevant. This is a past expenditure and nothing Felicia could do
now will change this sunk cost.
b. The amount is not relevant. The amount spent on this item will be the same whether
Felicia decides to buy a semester or per-use pass.
c. The amount is relevant. The amount spent on this item will differ based on whether
Felicia decides to buy a semester or per-use pass.
2.33 Relevance and Controllability (LO1, LO2).
a. The amount is not relevant. This is a past expenditure and nothing Alex could do
now will change this sunk cost.
b. The amount is not controllable. Past expenditures are sunk and not controllable.
c. Alex’s only options are to: (1) discard the furniture in the landfill and (2) leave the
stuff on the curbside. However, both of these options will lead to the same $100
penalty being levied by the proprietor. Thus, the amount is not relevant.
d. The $100 would be incurred only if Alex moves the furniture and not under status
quo. Thus, the amount is controllable for the decision.
e. Both options (landfill, leave on curb) in Alex’s opportunity set have negative value.
Thus, he will obtain negative value from his decision, no matter what his choice is.

If he had a choice, Alex would leave his furniture in the apartment itself, rather than
take the effort to landfill it or discard it. However, he does not have this choice, which
is the status quo. By definition, status quo has a value of zero – thus, the status quo
must not be in the opportunity set for a decision to have negative value. This
condition is necessary but is not enough for a decision to have negative value. We
also need that every option in the set to have negative value. Then, the decision maker
incurs negative value from being forced to choose one of the options.

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2.34 Relevance (LO1).

Tom and Lynda have two options: (1) Stay with the status quo, retaining fees at the
current level, and (2) reduce the fee by 10%. More generally, a decision to reduce
prices might have many elements because each new price is a separate decision option.
Relevant costs and benefits are those items that differ across the options.
In this case, the amount of fees received will change. This is a relevant benefit. A second
benefit, which is indirect, might be the effect on Hercules’ reputation. Members now
might perceive the gym as more affordable, potentially expanding its target audience.
The decision affects costs via its effect on the number of members. Reducing the fees
would increase the number of members. In turn, the additional membership would
increase variable costs such as the cost of supplies and water. These costs are therefore
controllable for this decision.

Finally, it also is possible that the additional membership increases the wear and tear on
equipment, and might even lead to Hercules buying more exercise machines. Thus, these
indirect costs too are controllable for this decision. It is quite likely, however, that while
they would surely consider variable costs Tom and Lynda might not attach much weight
to the change in fixed costs. After all, the effects on equipment are likely to be felt in the
long-term and are hard to quantify. Decision makers usually attach lower weight to such
subjective estimates.

2.35 Relevance (LO1, LO2).

Parking costs, mileage costs and shuttle costs are all relevant because they differ across the
two options
Drive – the relevant costs for the round trip are:
Parking $7.50 per day × 3 days $22.50
Operating costs $0.30 per mile × 60 miles (round trip) $18.00
Total relevant cost $40.50
Shuttle – since a one-way trip on the shuttle costs $25, the relevant costs for the round
trip are $25 × 2 = $50.
Thus, the relevant costs of driving = $40.50, and the relevant costs of taking the
shuttle = $50.

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2.36 Relevance and Controllability (LO1).

a. The following table provides the classifications, including comments pertaining to the
rationale underlying each classification.

Controllable? Relevant?
Cost Item (C/NC) (R/NR) Comments
1. Cost of the materials C R The decision affects whether
used to make the HAL incurs this cost.
components. Although the cost relates to
both choices, the amount
differs for the choices
because the supplier expects
to use 5% more in materials.
2. Cost of the C NR The decision affects whether
connectors used to HAL incurs this cost.
make the components. However, the amount is the
same between the choices,
making it not relevant for the
decision.
3. Akawasi Sudawa’s NC NR This cost will be incurred
annual salary of regardless of the decision
$105,000. made.
This exercise highlights that relevance is a subset of controllability. While a relevant cost
is always controllable, a controllable cost is not always relevant.
b. When the status quo is part of the opportunity set, controllability and relevance are
the same. Further, our classification of controllable costs will not change because, by
definition, we measure controllability in terms of the status quo, regardless of whether
it is a feasible option.
Given this, for HAL’s decision the set of relevant costs will expand to match the
controllable costs. What does this mean? It means that the cost of the connectors used to
make the component is both controllable and relevant. All of our other classifications
remain the same.
c. In this case, the set of controllable costs shrinks to the set of relevant costs. Thus,
the cost of the connectors used to make the components is not a controllable cost
because it does not change in relation to the status quo. All of our other classifications
remain the same.
This problem shows how variations in the status quo lead to variations in what is
controllable and relevant. This underscores the importance of understanding exactly what
the “existing state of affairs” is.

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2.37 Relevance (LO1).

a. The following table provides the required classifications, including a brief
explanation for each classification. We note that Olivia seems to be committed to
taking one job or the other – thus, the status quo of doing nothing (not accepting
either job) does not appear to be a viable option.
Cost /Benefit Relevant? Rationale
Salaries Yes The amount of the benefit differs
between Olivia’s two options.
Commissions Yes The benefit is available with one
option only – the stereo store job.
Transportation No It is the same for both decision
options.
Rent and utilities No This cost is the same for both
options.

b. The following table shows the relevant costs and benefits:

Department
Cost/Benefit Store Stereo Store
Salary $640 $400
Commissions 0 300
Total $640 $700

Considering only relevant costs and benefits, we find that the Stereo Store job is
preferred by $60.

2.38 Classifying Decisions According to their Time Horizon (LO2).

a. The following table provides the decision classifications, including comments
pertaining to the rationale underlying each classification (please note that there is
room for discussion/debate regarding some of the classifications – as discussed in the
chapter, the boundaries between the horizons are fuzzy).
Decision Description Horizon Classification & Comments
1 Choosing a major. Long-term. This decision has multi-year
implications such as the prospects of
gainful future employment. Moreover,
we make this decision not expecting to
revisit it for some time.
2 Choosing whether to wake up at Short-term. The decision’s horizon only

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7:30 a.m. when your alarm goes spans several minutes. Additionally, this
off or hit the snooze button and decision is unlikely to have long-term
wake up in another 9 minutes at implications, although repeated use of the
7:39 a.m. snooze button can lead to missed classes,
missed exams, and perhaps poor grades.
3 Choosing whether to buy a desktop Long-term. Individuals tend to use a
or a laptop computer. particular computer for a relatively long
period of time (2-4 years).
4 Choosing whether to bring a car to Short-term/Long-term. The decision is
campus or use university and local like choosing a particular business
transportation (i.e., the “bus”). process (e.g., should a company use
cardboard or plastic to package goods?)
and is likely to be a decision that students
make at the beginning of each year (most
universities issue parking passes
annually). That said, the decision likely
can be reversed without excessive cost
and on a relatively quick basis, which
may lead some to classify it as a short-
term decision.
5 Choosing whether to take a Short-term. This decision spans one to
required course this semester or two semesters, or 4 to 9 months. It is
next semester. unlikely to have any long-term effects.
6 Choosing whether to have pizza or The decision is purely short term. The
a sub-sandwich for dinner this decision’s horizon only spans a few
coming Friday. hours on Friday evening; further, it is
unlikely (although not out of the
question) that any long-term effects will
result from this decision.
7 Choosing whether to stay at your Long-term Similar to choosing a major,
current school or transfer to this decision has multi-year implications
another school. related to employment prospects,
graduate school and, perhaps, where one
ultimately resides.
8 Choosing whether to lease a two- Short-term/Long-term. This
bedroom apartment or stay in the classification could go either way – one
dormitory next year. could argue that there are few long-term
effects from such a choice. On the other
hand, the decision spans roughly a year
because most apartment leases last 9 to
12 months – it can be difficult and costly
if we change our mind.
9 Choosing whether to buy a Short-term. We classify this as a short-

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semester pass for the fitness center term decision even though one can make
or pay on a per-use basis. a reasonable case for classifying this
decision as spanning the long-term. The
short-term reasoning comes about
because the decision only spans a
semester and can be changed at semester
end. Also, few costs are controllable with
respect to this decision. The decision
appears to be one of cost structure (i.e.,
do you want to spend money as a lump-
sum right now or spend it piece meal?)

There is no magic rule that cleanly separates short-term decisions from long-term
decisions. Many decisions fall in the gray zone between the short term and the long term.
Additionally, many seemingly short-term decisions could have longer-term implications.
We use the distinction mostly to organize our thoughts and to give some structure to the
decision problem. Good managers recognize that the classification by horizon is a
convenient simplification and is a good start in structuring the problem and identifying
costs and benefits – the longer the horizon, the more costs and benefits to consider. They
will, however, consider long-term implications as they make their choices from the
decision options.

b. Indisputably, many short-term decisions have longer-term implications, and it

frequently is not possible to cleanly separate decisions. For example, repeatedly
hitting the snooze button could cause you to miss classes and exams, which, in turn,
could lead to poor grades and a less-than desirable job. The decision to buy a laptop
versus desktop may affect your ability to afford having a car on campus (or vice-
versa).
At some level, we can argue that you face one large problem of how best to manage your
life. While true, such a definition is not very helpful to decision making. There are far too
many factors to consider and the opportunity set is infinite. The problem becomes
impossible to solve.
Faced with cognitive constraints, most decision makers therefore decompose the large
problem into many smaller problems. Simplification can take the form of pruning the
opportunity set or considering only the most salient (and quantifiable) costs and benefits.
This way, the problem becomes manageable. Classifying decisions via their time
horizon greatly assists individuals in simplifying decision making – when confronted
with a decision, thinking about the time horizon assists in delineating the costs and
benefits of the decision options and when they are likely to materialize.
Unfortunately, the potential for making bad decisions arises every time we eliminate an
entire class of choices (by, e.g., de-coupling decisions) or reduce the number of costs and
benefits we consider. Good managers excel at making this tradeoff. They can quickly

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narrow the choices to the most viable and exciting options; they also excel at figuring out
which costs and benefits are easily quantifiable, and at getting a “gut feel” estimate of the
hard to quantify costs and benefits.

2.39 Variability and Traceability (LO3).

False. The statement is not correct because variability is not the same as controllability.
For instance, the cost of materials is variable in the number of units made. Yet, suppose
we already have enough material (a special alloy) in stock for the anticipated production.
We plan to discontinue the product after this production run. Then, the cost of this alloy,
a sunk cost, is not controllable for whether to reduce production by 5% or not. The
misconception in the statement arises because variable costs are indeed controllable for
most decisions.
False. Consider Hercules. The cost of the yoga instructor is a “fixed” cost on a monthly
basis. Yet, the cost is controllable for the decision to offer yoga. To reconcile the
statements, notice that the fixed and variable classification is only valid for a given time
period and for a given activity. Thus, a fixed cost could change because of a decision
making it controllable. For another example, most would consider warehouse rent to be a
fixed cost. Yet, if a firm doubles its production, it will increase this “fixed” cost because
it might have to rent more warehouses. This misconception arises because fixed costs
usually are not controllable for short-term decisions.
False. A direct cost might be variable or fixed. In the context of Hercules, the cost of the
yoga instructor is direct to the option of offering yoga. Yet, this is a step-fixed cost that is
not proportional to the number of members.
False. This statement too is incorrect. Classifying a cost as fixed relates to how it
changes in the underlying activity, usually revenue or sales volume. It does not relate to
whether the cost is direct or not. For an example, warehouse rent is a fixed cost. Yet, it is
a direct cost for the decision of whether to lease or buy the warehouse.
True. This statement is correct. A cost is fixed only with respect to a timeframe and an
activity. Almost every cost is variable in the long term. For example, the amount of
warehouse rent is variable in the area leased, if we consider a long-enough period.
2.40 Variability (LO3).
To determine each cost’s variability, you could graph the relation between each cost (y-
axis) and activity levels (x-axis). This graph shows that cost a is variable (the cost
increases proportionately with volume), cost b is mixed (the cost has some fixed and
some variable components), and cost c is fixed (the cost is the same for all volumes).

We can also make an educated guess by calculating the unit cost in each instance.

Cost per unit

a B c
5,000 units $5 $5.60 $10.00
7,500 units $5 $4.67 $6.67

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From this table, we note that the unit cost of A is the same at all production volumes.
Thus, we determine A to be a variable cost. The case for B and C is more complex, as
we need to consider both the total cost and the per unit cost. Inspection of C shows that
the total amount is the same and the per unit amount is decreasing as volume increases.
Thus, C is a fixed cost. However, while the per unit cost of B also decreases, the total
increases as volume increases. Thus, B is a mixed cost.

2.41 Variability: Choice of Activity (LO3).

a.
Cost # Description of Cost Activity
1 Cost of raw materials used Units produced.
2 Electricity used to operate Machine hours consumed, which is likely
machines proportional to units produced.
3 Cost of packing materials Units shipped, which is likely to be
proportional to units produced.
4 Equipment maintenance Machine hours consumed, which is likely
proportional to units produced.
5 Janitorial supplies used to The size of the factory and production
clean factory levels – more production typically leads
to more clean up. In the long-run, factory
size is likely the key determinant.
6 Cost of human resources The number of employees.
department
7 Cost of purchasing Purchasing activity, as measured by the
department number of vendors, the number of
purchase orders, and the number of
distinct products.
8 Sales commission paid Sales volume, in units or in $.
9 Travel expenses for sales Number of sales calls made.
persons
10 CEO salary Intuition suggests a link between firm
size (as measured in revenue or assets)
and CEO compensation. In the short
term, the CEO’s salary is not likely to be
variable in any measurable way, although
the CEO’s bonus is likely to vary with
income or stock price.

b. Production levels (and, in turn, sales volume) appear to be a key determinant for costs
1, 2, 3, 4, and 8. Additionally, one could argue that, in the short-term, costs 5, 6, 7, 9,
and 10 will also bear some relation to production/sales volume. For instance, greater
production volume would lead to a larger factory, all else the same. These linkages
give us insight into why firms frequently use a single measure of activity, sales
volume, to assess the variability of costs – many costs are proportional to this metric.

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2.42 Traceability (LO3).

The following table provides the cost classifications, including comments pertaining to
the rationale underlying each classification.

Cost Classification
Cost # Description of Cost & Comments
1 Eastern plant rent. I – This cost is only partly attributable to
Kappa as both Kappa and Gamma are
produced in the same plant.
2 Raw materials purchased to D – This cost is entirely attributable to
produce Kappa. Kappa. Kappa and Gamma use different
raw materials, allowing us to directly
trace the materials costs to each product.
3 Eastern plant utilities and water I – This cost is only partly attributable to
Kappa as the utilities relate to the entire
plant and the production of both Kappa
and Gamma.
4 Salary of the Eastern plant I – This cost is only partly attributable to
manager Kappa as the plant manager oversees all
activities in the plant (i.e., the production
of both Kappa and Gamma).
5 Equipment maintenance I – This cost is only partly attributable to
Kappa as the equipment is used to
produce both Kappa and Gamma.
6 Salary of a production D – This cost is entirely attributable to
employee who works the day Kappa as the production employee only
shift at the Eastern plant works the day shift (when the firm
produces Kappa but not Gamma).

This exercise distinguishes between direct and indirect costs. Traceability depends on the
unit of analysis. For example, while the salary of the plant supervisor is an indirect cost
with respect to the Kappa product, it is a direct cost with respect to the Eastern plant as a
whole.

2.43 Revenue Variability and Traceability, Not for Profit (LO3).

Option 1: Issue lottery tickets

The proceeds from the sale of tickets is the only controllable benefit. This revenue is
directly traceable to the option of offering the lottery. The revenue also is variable in the
number of tickets sold as revenue = $50 per ticket × number of tickets.

Option 2: Host charity dinner

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The revenue from the dinner is a direct benefit that is variable in the number of
attendees.

The discount from the caterer is also a direct benefit but is fixed. We note that whether
we classify a cost reduction as a benefit or as a smaller cost is semantic.

Finally, the goodwill created in prospective donors is a significant, but indirect benefit.
The benefit is indirect because it is difficult to attribute any future donations solely to the
dinner, as the donation is likely the culmination of sustained effort from Foundation staff.
It is difficult to classify this benefit with respect to its variability; our inclination is to
classify it as fixed as we would be hard pressed to select an activity that makes it
variable. While one might be inclined to think that more attendees might lead to greater
goodwill, fewer attendees might receive greater attention and donate more.

Option 3: Conduct silent auction

The proceeds from the auction are the direct benefit. This benefit is likely variable in the
number of items sold, although the proportionality is not exact.

The other benefit is the exposure received by local artists. We would classify this benefit
as indirect because it is hard to trace the exposure (or incremental exposure) to the silent
auction. Artist recognition and reputation comes from the accumulation of multiple
exposures. Even then, it is difficult to draw a link between exposure and art appreciation.
Nevertheless, as it contributes to the background of arts and arts appreciation in the
community, we would consider the exposure as an indirect benefit. It is difficult to
determine if the benefit is variable. However, one could reasonably expect the exposure
to vary in the number of artists participating and/or the number of items sold or up for
auction.

2.44 Hierarchical Cost Structure: Cost Classifications (LO4).

The following table provides the cost classifications, including comments pertaining to
the rationale underlying each classification:

1 Sand used Unit-Level

This is a unit-level cost because it is directly proportional to the number of tiles made.

2 Oven rental for the year Facility-Level

This annual cost is required to sustain the facility and does not change in response to the
number of tiles, batches, or products. In other words, this cost relates to all of Creative
Tiles’ products.

3 Power for firing the oven Batch-Level

This is a batch-level cost because the tiles are baked in batches of up to 1,000. This cost
will not change much whether we bake 750, 900 or 1,000 tiles.

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4 Molds used Product-Level

This is a product-level cost since each tile designed is a unique product and will require
its own mold. Accordingly, this cost will depend on the number of products. (Note: We
implicitly assume that Creative needs only one mold to produce all the tiles needed with a
given design. If this assumption does not hold, the cost of the molds will vary both in the
number of products and in the number of units of each product).

5 Hourly wages to employees who mix the clay. Unit-Level

This is likely a unit-level cost since the amount of mixing work required likely varies
with the number of tiles to be produced. The classification can be disputed, however, as
one might argue for a batch-level classification if the clay is mixed in batches.

6 CEO salary Facility-Level

This cost relates to the entire business and does not vary at the unit-, batch-, or product-
level.

7 Prepare leaf print for image Product-Level

This is a product-level cost since each tile is unique and will require a unique leaf print.
Thus, we can view each variation in image as a product; the cost therefore depends on the
number of products made.

8 Using forklifts to move finished goods from the factory floor to the storeroom.
Batch-Level
This is a batch-level cost since it varies with the number of pallets moved. Within reason,
this cost will be the same regardless of the number of tiles in a pallet.

This exercise shows that costs oftentimes do not fall neatly into fixed and variable
categories. The cost hierarchy helps managers structure their thinking about the
underlying reason for a cost and why a given cost would increase or decrease. In turn,
such understanding can facilitate decision making; misclassifications could lead to poor
estimates of cost (e.g., assuming a cost is variable or fixed when, in fact, it is a batch- or
product-level cost).

2.45 Hierarchical Cost Structure: Cost Classifications (LO4).

Unit-Level. The cost of food and drinks consumed is likely a unit-level activity – the more
people, the more food and drink. While it is not possible to predict food costs perfectly,
Sun and Sand will consider the number of members in residence when deciding the amount
of food to make. From a control perspective, S&S’s managers likely track the cost of food
per member quite closely.

Batch-Level. S&S incurs many batch level costs. Consider the cost of posting lifeguards
on the beach. The number of lifeguards posted is not strictly proportional to the number of
members on the beach. Rather, the head lifeguard probably follows some kind of a gut feel
(and local regulations) in posting more lifeguards as more people enter the beach. From
experience, the head lifeguard may be able to predict usage patterns and will adjust staffing

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schedules accordingly.

Product-Level. The cost of maintaining the dolphins in good health is a product level cost.
S&S needs to incur this cost even when there are only a few members in residence. That
said, there is some correlation with the number of members; beyond a certain number, S&S
might have to train more dolphins to swim with humans. This point underscores that it is
only the step-size that differs between unit-, batch- and product-level costs. Ultimately, a
firm’s volume of business influences virtually all of its costs.

Facility-level. In addition to rent and executive salaries, the fee charged by the city for
erosion control would be an example of S&S’s facility level cost. S&S incurs this cost as a
part of staying in business. The amount does not depend on the number of members,
lifeguards on duty, or program offered.

2.46 Step Costs (LO4).

a. It is difficult to predict the effects from mis-classifying a step-cost as a unit-level cost.
The estimated cost could be higher or lower than the true cost. To see this,
suppose a supervisor costs $3,200 per month. Further, assume that the analyst
generates the cost estimate with 16 employees and 2 supervisors. In this case, the
analyst would compute the cost as $400 per employee ($3,200 × 2/16).

 For 5 employees, the analyst will estimate a cost of $2,000 but we need one
supervisor at a cost of $3,200. The cost is understated.

 For 20 employees, the estimated cost is $8,000 but we only need 2 supervisors. The
cost equation will over-estimate the cost.

This ambiguity in the direction of error is one reason why it is important to classify costs
well. Else, even if we know that we have a wrong estimate, we do not know the direction
of the error.

b. Again, it is difficult to predict the effects from mis-classifying a product-level cost as

a unit-level cost. The estimated cost could be higher or lower than the true cost.
To see this, suppose the product engineer’s cost is $60,000 per year and the expected
volume of production is 120,000 units. Then, the cost per unit is $0.50. However,
this estimate gives us an expected cost of $30,000 at a volume of 60,000 units and
$120,000 at a volume of 240,000 units. In both instances, our true cost remains at
$60,000. Again, this ambiguity in the direction of error is one reason why it is
important to classify costs well – as mentioned in part (a), even if we know that we
have a wrong estimate, we may not know the direction of the error.

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PROBLEMS
2.47 Relevance and controllability (LO1).
a. The following table provides the required classifications, including a brief
explanation for each classification. We note that the status quo, or the existing state of
affairs, is using 25 suppliers – thus, the status quo is a viable option. As such,
relevance and controllability are the same – all controllable costs are also relevant.
Cost/Benefit Controllable Relevant? Rationale
Cost of goods Yes Yes The cost changes because of the
decision. In addition, the amount of
the cost differs between the two
decision options, as reducing the
number of suppliers eliminates the
possibility of obtaining a 3% price
concession.
Clerical salary Yes Yes The cost changes because of the
decision. Further, the amount differs
between the two options -- reducing
the number of suppliers eliminates
the need for one clerical staff.
Manager salary No No The decision does not influence the
cost. It also is not relevant, as only
controllable costs can be relevant.
Cost savings Yes Yes The amount depends on the decision.
It also is available with one option
only – the reduce suppliers option.
Rams’ salary No No The amount does not depend on the
decision. It also is not relevant, as
only controllable costs can be
relevant. (In the long term, the
quality of this and many other
decisions will influence Rams’ salary
but we ignore this possible effect for
the decision at hand.)

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b. The table below shows the relevant (and controllable) costs and benefits of the
“reduce suppliers to 6”option:
Reduce number
Cost/Benefit of Suppliers Rationale
Increase in cost of ($75,000) $2,500,000 × .03
goods
Reduction in clerical 35,000 1 × $35,000
salaries
Reduction in service 100,000 Given
quality costs
Total $60,000

Considering monetary costs and benefits only, reducing the number of suppliers to 6 has
a value of $60,000. However, the difference between the options is not large. Thus, the
decision may hinge on Rams’ subjective estimate of the cost savings associated with
reducing the number of suppliers. Such savings are hard to quantify, as they are
experienced in small amounts throughout the organization.

2.48 Relevance (LO1).

a. The table below lists the costs associated with each option. As we can see, all cost items
are relevant because they differ across the two options.

Item Option 1 Option 2

Roundtrip fare to Chicago $320
Car rental to drive from Chicago to
Detroit and $150
Hotel stay for Thursday night $195
Estimate for food and incidentals $375
Airfare to Detroit and back from Chicago $350
Car rental to drive to Chicago from
Detroit $225
Hotel stay in Chicago for two nights $390
Estimate for food and incidentals $350

b. There are no such items – all costs are relevant for Kat’s decision.

2.49 Relevance and controllability (LO1).

The following three panels provide the required classification for each decision. Notice
that in this problem, all controllable items are relevant. This occurs because the status
quo is a viable option for each decision. Each decision is of the “whether or not” variety
where the “not” option implies choosing the status quo (or not taking any action
whatsoever). Moreover, all non-controllable items are not relevant.

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Item Give Discount? Rationale

Revenues from homeowners Controllable and Will change by different
relevant amounts based on the decision.
Revenues from contractors Non controllable Not affected by the decision
Direct costs Non controllable. The cost is sunk and therefore
not controllable – i.e., the costs
for the job have already been
incurred.
Rental cost Non-controllable. This cost is unaffected by the
decision.
Trucks & other equipment Non-controllable. The cost is sunk and therefore
not controllable – i.e., the costs
for the job have already been
incurred.
Administrative costs Non-controllable. This cost is unaffected by the
decision.

Item Train Technician? Rationale

Revenues from homeowners Non-controllable. Not affected by the decision as
few homeowners need high-
voltage work.
Revenues from contractors Controllable and Brandt’s revenues to contractors
relevant. likely would increase if the
technician received the high-
voltage training.
Direct costs Controllable and Controllable and relevant as
relevant. there would be additional direct
costs associated with performing
high-voltage work.
Rental cost Non-controllable. This cost is unlikely to be
affected by the decision.
Trucks & other equipment Controllable and It is likely that high-voltage
relevant. work may need additional
equipment. Most certainly, more
work increases truck operating
and maintenance costs.
Administrative costs Non-controllable This cost is unlikely to be
affected by the decision.

Item Replace Truck? Rationale

Revenues from homeowners Non-controllable. Not affected by the decision. The

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amount of work done is likely to

be the same whether or not a
new truck is purchased.*
Revenues from contractors Non-controllable. Not affected by the decision. The
amount of work done is likely to
be the same whether or not a
new truck is purchased.*
Direct costs Non-controllable. Not affected by the decision.
Notice that this item does not
include the operating costs of
trucks, which will change based
on the decision.
Rental cost Non-controllable. Not affected by the decision.
Trucks & other equipment Controllable. Both the cost of the truck and the
operating cost change based on
the decision.
Administrative costs Non-controllable. Not affected by the decision
*
One could argue that an older truck may break down more often and potentially reduces
the ability to service a job. Similarly, newer trucks may present a more “professional”
image and enhance reputation, which in turn increases the volume of business. Both of
these effects suggest that revenues (and therefore direct costs) are also controllable and
relevant. However, these effects seem marginal given that Brandt already enjoys a
sterling reputation. Thus, we ignore these effects.
This problem can help highlight that the decision context determines the controllability
and relevance of a cost or a benefit. Some decisions, such as giving a discount to a
disgruntled customer, may only affect revenue with no discernable cost impact. Other
decisions, such as whether to replace a truck, affect costs with no discernable revenue
impact. Most decisions, however, affect both revenues and costs. Even for these
decisions, only some costs and benefits are controllable. Revenues and direct costs from
other products or market segments are not controllable if the decision pertains only to
some products or market segments.

2.50 Relevance (LO1).

a. The relevant costs for the make option are:
Relevant Costs – Make Option
Amount Total
Item per unit (100 units)
Brass $200 $20,000
Special Wood $75 $7,500*
Labor $250 $25,000
Total Relevant Costs $52,500

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Because $10,000 worth of special wood is already in inventory and its opportunity cost is
zero, the relevant cost is $7,500.
b. The relevant costs for the buy option are:
Relevant Costs – Buy Option
Amount Total
Item per unit (100 units)
Purchase Price $500 $50,000
Total Relevant Costs $50,000

Using the principle of relevance, we find that Motown prefers the buy option because its
cost is $2,500 less than the cost of the buy option.

2.51 Relevance and controllability (LO1, LO2).

a. The following decision options are available to Gamma Machinery:
Option 1: Keep the current lathe and do not purchase the new lathe.
Option 2: Purchase the new lathe today for $400,000 and sell its current lathe
today for $170,000.
Option 3: Purchase the new lathe today for $400,000 and keep its current
lathe for two years.

For Gamma, the status quo is keeping its current lathe and not purchasing the new lathe.
Since this corresponds to option 1, the status quo is a feasible option.

b. The following cash flows are both controllable and relevant for option 2:
Controllable and Relevant Cash Flows – Option 2:
Additional cash inflow of $130,000 per year from the new
lathe (= $250,000 – $120,000)  two years $260,000
+ Cash inflow from selling the existing lathe today $170,000
- Cash outflow to purchase new lathe ($400,000)

Thus, the value of Option 2, measured in terms of net cash inflows, = $30,000.
The following cash inflows and outflows are controllable for option 3.
Controllable and Relevant Cash Flows – Option 3:
Additional cash inflow of $130,000 per year from the new
lathe (= $250,000 – $120,000)  two years $260,000
Cash inflow of $50,000 per year from operating the current
lathe  two years $100,000
- Cash outflow to purchase new lathe ($400,000)

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Thus, the value of Option 3, measured in terms of net cash inflows, = ($40,000).
Because option 2 has the highest value, this is Gamma’s best option. (as the status quo,
the value of option 1 = $0).
c. If the status quo is no longer feasible, controllability and relevance could differ. The
controllable costs and benefits for Gamma’s two options are identical to those we
computed in part [b].
In terms of relevant costs and benefits, the only items that differ between the two options
are the cash inflow from selling the existing lathe ($170,000) and the cash inflow from
operating the current lathe for the next two years ($100,000). While controllable, both the
cash outflow to purchase the new lathe ($400,000) and the cash inflow associated with
the new lathe ($260,000) are not relevant as they do not differ between Gamma’s two
options.

2.52 Classifying decisions by horizon (LO2).

The following table provides the required information.
Decision Price & Quantity effects
Advertising Short term. No price effect is likely. The decision trades off the
outflow for advertising with the additional volume of business.

Points program Short term. There is a price effect as the points program is like
a price discount. A volume effect is also present as the program
breeds customer loyalty and boosts volume.

Increase Long term. Likely, there is no price effect as Terrapin will not
variety in change prices if it adds more flavors of coffee. Market
number of considerations often set the prices for such goods. A volume
coffees effect is likely as customers now may have a more favorable
view of the store.

Add to product Long term. There is a price effect as product differentiation

variety (goat allows Terrapin to charge different amounts. A volume effect is
milk etc) also present; Terrapin needs to estimate the popularity of the new
offerings, and revenue is a function of both price and quantity.

Reconfigure Long-term Again, there is no price effect as it is unlikely that

layout Terrapin will change prices. A volume effect is likely as
customers now may have a more favorable view of the store.

New branch Long-term. There is a possible price effect. Terrapin may be

able to offer products at different prices exploiting the fact that
the two stores cater to potentially differing market segments. (We
note, however, that there are good arguments for keeping the
prices the same at both stores). There is a volume effect. Like
advertising (a tactical decision), the new branch (an investment

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decision) trades off a certain outflow in return for an expected

bump in volume.

The problem highlights at least two points. Except in perfectly inelastic markets where
quantity is price independent, any action that tinkers with price will also affect volume.
This is true for decisions in any horizon. This is because market demand functions have a
negative relation between price and quantity.
We also can conceive of decisions in any horizon that do or do not have a price effect.
Thus, revenue controllability could arise because of price and/or quantity effects in every
horizon.

We also note the fine line between the answers for the decision to increase the number of
coffee flavors and the decision to add product lines. There is a price effect if part of the
expansion in flavors includes “organic” or other coffees that are differentiated from the
“regular” flavors. Adding “organic” coffee is akin to expanding the product line, while
adding more flavors is like adding more colors of an existing product. However, after a
certain point, even the number of flavors (“31 flavors for Baskin-Robbins”) itself
becomes a point of differentiation, and could positively affect the firm’s ability to set
prices.
Note: For advanced classes, it is useful to link this problem with demand functions.
When considering price changes, we must consider both price and quantity effects as
these two go hand-in-hand. Conceptually, tweaking prices takes the demand function as
given. The choices move the firm to a different point in the demand curve. However, we
can also think of advertising and other actions as changing the market size and/or
customer preferences and perceptions. We can view these actions as altering product
demand by tweaking the demand function itself. That is, these are choices among
alternate demand functions.
We also ignore the counter-examples posed by Giffin goods.

2.53 Controllability and Time (LO2).

a. Changing themes is a long-term decision as it fundamentally affects the nature of the
restaurant’s business. This decision entails costly commitments as the décor has to be
changed accordingly. The decision also is not easily reversible as perceptions take
time to change.
Deciding which chefs to invite is a short-term decision. The decision affects a number
of costs and benefits, and alters the demand for the restaurant’s services – thus, one could
classify the decision as having long-term effects. However, almost all costs and benefits
associated with a particular chef are likely realized within a short period.
Accepting a booking for a wedding reception is a short-term decision. The decision does
not fundamentally alter the nature of the business. Few costs and benefits are affected and
they are realized almost immediately.

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b. The following table provides the required classifications.

Cost/Benefit Changing theme Celebrity Chefs Book reception

Average revenue per Controllable Controllable Controllable
patron.
Cost of meals served. Controllable Controllable Controllable

Cost of printing Controllable Controllable Non-

menus. Controllable
Salaries to chef and Controllable Non- Non-
other kitchen staff controllable Controllable
Building rental cost. Non- Non- Non-
controllable controllable Controllable

Notice that the number of controllable costs and benefits increases with the decision
horizon. However, not all costs are controllable, even for some decisions that span an
extended horizon.
2.54 Classifying Decisions by Time; Cost Commitment (LO2).
a. The following table provides the decision classifications, including comments
pertaining to the rationale underlying each classification. We note that there clearly is
room for discussion/debate regarding some of the classifications – as discussed in the
chapter, the boundaries between the horizons can be fuzzy.

Decision Description Classification & Comments

1 Reconsider the decision to get an Long-term. This decision clearly has
MBA. (Anne has not yet quit her multi-year implications as most MBA
job) programs are two years; additionally, this
decision will affect all aspects of Anne’s
life (e.g., her job, where she lives, etc.).

2 Decide whether to pay first Short-term. This decision affects the

semester tuition by check or by timing of Anne’s cash flows by less than
credit card. (Each month, Anne a month. Since Anne pays off her credit
pays her credit card balance in cards each month, this decision has a
full.) very short-term effect on Anne’s life.

3 Choose a major (accounting, Long-term. This decision has multi-year

finance, or marketing). implications such as the prospects of
gainful employment. However, one may
also view this decision like choosing a
product portfolio – the choice of a major

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often can be altered after one or two

semesters. Additionally, it is possible for
Anne to look for an accounting job even
if she majors in finance. Thus, it can be
argued that this decision is a short-term
decision.

4 Choose the courses to take in the Short-term. This decision only commits
first semester. Anne for a semester. Because of program
requirements and pre-requisite courses,
this decision could also affect what Anne
takes next semester – thus, it does have
longer-term implications.

5 Decide whether to buy new Short-term. This decision commits

clothes (to fit the student Anne for several months. Anne can
lifestyle) or to make do with her easily postpone, or reverse, this decision.
current business clothes. For example, halfway into the new
semester, Anne may decide to buy new
clothes.

6 Decide whether to have a part- Long-term. This decision commits Anne

time job while in the MBA for at least several months because most
program. hires (even part time) are made with the
intent of keeping the arrangement going
for several months, if not a year. That
said, the decision can be easily reversed
(Anne can always give two-weeks
notice), and one can make a good
argument for a short-term classification.

7 Decide whether to spend the next Short-term / long-term. This is a tough

few weeks brushing up on math one. At some level, this is a short-term
and economics or to spend the decision because it only lasts for a few
time taking a vacation before weeks. However, the decision to study
school starts. (or vacation) now could have longer-term
implications (e.g., studying now may
translate to better grades and a better job,
etc.).

8 Decide whether to live in a Long-term. This decision commits Anne

studio apartment or to share a for a year or so (most apartments have a
two-bedroom apartment. year long lease).

9 Choosing which of the two MBA Long-term. Similar to deciding whether

programs to join. to obtain an MBA or deciding a major,

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this decision will affect Anne’s life for

years to come. Such a decision possibly
affects Anne’s employment prospects
and her long-term friendships, etc. For a
business, this decision is like deciding
where to site the plant.
b. For decision 1 (reconsider the decision to get an MBA), the costs associated with
tuition, housing, and books have yet to be incurred (i.e., all three costs are
controllable). That is, by making a decision regarding whether to obtain an MBA,
Anne also decides whether she will incur these costs.
For decision 2 (Choosing whether to pay first semester tuition by check or by credit card;
each month, Anne pays her credit card balance in full), the costs associated with tuition,
housing, and books are not controllable. That is, Anne has already made her decision to
obtain an MBA, selected her school, and her courses.
Notice that there is a striking relation between the number of controllable costs and the
decision horizon. For decision 1, an investment horizon decision, all three costs are
controllable. For decision 2, a short-term decision, all three costs are non controllable.
Moreover, more costs become controllable as the decision horizon expands.
Also notice, in line with the framework, the cascading nature of decisions. Decisions such
as whether to pay tuition by credit card or check follow naturally from Anne’s decision
regarding whether to obtain an MBA.

2.55 Variability and relevance (LO1, LO3).

The following provides the cost classifications, including comments pertaining to the
rationale underlying each classification:

1. Sales commissions – Variable & relevant

These costs are directly proportional to sales volume and, thus, are variable. They are
relevant because sales commissions would increase if the new store opens.

2. Cost of merchandise – Variable & relevant

Similar to sales commissions, these costs are directly proportional to sales volume and,
thus, are variable. Additionally, they are relevant because merchandise costs will increase
if the new store opens.

3. Salaries to sales staff – Fixed (at least in the short term) & relevant

This cost is fixed once Malabar has committed to the number of staff – thus, it is not
likely to change with sales in the short term. However, the number of staff likely will
vary in sales volume – increases in sales will necessitate increases in sales staff (as over
the Holidays, for example). Further, the cost will change if a new store is opened, making
it relevant for the decision regarding whether to open the new store.

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4. Salary to the store manager – Fixed & relevant

The cost is fixed, although one might argue that a larger store may need a more
“seasoned” manager who commands a higher salary. However, the change in salary is
likely to be small. The cost is relevant with regard to the decision to open the new store
because Malabar will need a manager to run the Chicago store.

5. Display and Stocking expenses – Mixed & relevant

This is likely a mixed cost because the store would incur a minimum cost (e.g., to change
displays for seasons) even absent any sales revenue. In addition, the amount of shelf-
stocking would depend on sales volume. The greater the sales volume, the greater the
amount of time devoted to restocking goods. The cost also is traceable to a specific store
and would disappear if a store were to close. Thus, it is a relevant cost.

6. Advertising on national television – Fixed & Not relevant

This is a fixed cost with respect to sales volume in any given store. While discretionary,
the cost likely varies with aggregate sales volume. Estimating the cost function, though,
may be difficult, because advertising expenses often lead sales, and can exhibit a negative
relation with contemporaneous sales. For instance, a firm may choose to advertise more
to rectify sagging sales.

The cost is not relevant for opening a store. The total amount of advertising is likely to be
the same whether Malabar opens a new store or not.

7. Advertising in local newspapers – Fixed & relevant

This is a discretionary fixed cost with respect to the sales volume in any given store.
Similar to national advertising, estimating the cost function may be difficult. The cost is
relevant for opening the Chicago store as the cost will only be incurred if the new store is
opened.

8. Store cleaning and maintenance – Mixed & relevant

This is a mixed cost because the store would incur a minimum cost (e.g., to clean the
floors, mop, and dust) even absent any sales revenue. However, the amount needed
would change with sales volume; the greater the traffic through the store, the greater the
amount of cleaning needed.

One can make a reasonable argument that the salary to the cleaning staff is likely a step
cost. The overall cost function is likely quite complex. Detailed analysis requires that we
decompose the overall cost into smaller pieces (e.g., salaries and supplies) so that we can
better predict each cost element.

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The cost is traceable to a specific store and would disappear if the store were to close.
Thus, it is a relevant cost with regard to the decision to open the Chicago store.

9. Transportation of goods to stores – Mixed & relevant

This is a mixed cost because the store would incur a minimum cost (e.g., to deliver new
merchandise) even absent any sales revenue. The amount needed would change with
sales volume. The greater the traffic through the store, the greater the number of trips
needed.

The cost is traceable to a specific store and would disappear if the store were to close.
Thus, it is a relevant cost with regard to the decision to open the Chicago store.

10. Central purchasing department – Fixed & Not Relevant

This cost is likely to be fixed with respect to the sales volume in any given store. It also is
unlikely that Malabar would add more purchasing staff because the firm added one store
to the 70 stores already in place. Thus, the cost is not relevant for the decision regarding
opening the Chicago store.

Note: This problem shows that variable costs, by and large, are relevant. It also illustrates
that while many fixed costs are not relevant, they also can be relevant, particularly for
decisions that span a longer horizon (such as opening a new store).

2.56 Cost Traceability and Decision Contexts (LO3).

The following table provides the required classifications:

Produce Deluxe Drop farm toys

version? line? Shut plant?
Cost of special die used (D)Traceable (D)Traceable. We (D)Traceable.
to make the deluxe as we can will incur the cost We will incur
version of farm toys. attribute the only if we retain the the cost only if
Each die can make entire cost of product line. we retain the
enough toys to meet a the die to the product line
year’s demand. decision to and, thus,
produce the decide to keep
deluxe version. the plant.

Labor used to make the (D)Traceable (D)Traceable. We (D)Traceable.

deluxe farm toy. as we can will incur the cost We will incur
attribute the only if we retain the the cost only if
entire cost to product line. we retain the
the decision to product line
produce the and, thus,
deluxe version. decide to keep

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the plant.
Cost of dedicated (I)Not (D)Traceable as (D)Traceable
machines used to make traceable. The we can attribute the as we can
farm toys. machines are entire cost to the attribute the
used to produce decision to produce entire cost to
both regular and this line. the decision to
deluxe models. keep the plant.

Engineering support (I)Not (D)Traceable as (D)Traceable

provided to maintain traceable. The we can attribute the as we can
the farm toy line. support cost is entire cost to the attribute the
shared with the decision to produce entire cost to
regular model. this line. the decision to
keep the plant.

Advertising for farm (I)Not (D)Traceable as (D)Traceable

toys. traceable. The we can attribute the as we can
cost is shared entire cost to the attribute the
with the regular decision to produce entire cost to
model. this line. the decision to
keep the plant.

Salary paid to the Not traceable. Not traceable. The Traceable as

manager of the Grand The cost is salary cost pertains we can attribute
Junction plant. shared by both to the other product the entire cost
regular and line, miniature cars, to the decision
deluxe models. as well. to keep the
plant.

Factory rent (I)Not (I)Not traceable. (D)Traceable

traceable. The The rental cost as we can
cost is shared pertains to the other attribute the
by both regular product line as entire cost to
and deluxe well. the decision to
models. keep the plant.

IT support provided by (I)Not (I)Not traceable. (I)Not

the head office to the traceable. The The cost pertains to traceable. The
Grand Junction plant. cost pertains to both product lines. IT department
both regular and likely provides
deluxe models. support to many
plants.

This problem illustrates that traceability is context specific. The same cost could be traceable
for some decisions but not for others. We also see that as the unit of analysis increases (i.e.,

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as we move from a version of a product to a product line to the plant), more costs become
traceable. Indeed, virtually all costs are traceable to the firm as a whole.

2.57 Relevance and Cost Hierarchy (LO1, LO4).

a. The following table provides the required classification.

Cost of goods purchased for resale Unit level. This cost changes in direct
proportion to the volume of sales.
Conduct orientation session for new Batch level. It is likely that the firm
employees. conducts this session for groups of
employees. The weekly scheduling
supports this intuition.
Setting up seasonal display of items This is a product level cost. For instance,
the retailer might set up a gardening
display in early spring, or decorate for
Halloween in the fall.
Cost of shelving used in store. This is a facility-level cost. This cost
depends primarily on the size of the
facility and the kinds of items stocked.

b.

Whether to offer a 10% Short-term. This decision affects only

price discount on specific the item on sale, and can be executed or
items? reversed almost immediately.
Whether to schedule Short-term. This decision can be easily
orientation sessions on a altered/reversed within a few months.
weekly or bi-weekly basis.

How often to change This is a Short to Long-term decision. It

seasonal displays. is likely that the store changes displays 10
or fewer times in a year. Changing the
number of displays will affect sales and
costs over the entire store for many
months. Moreover, while such changes
are reversible, they are time-consuming
and somewhat costly.
Whether to change store This is a long-term decision. The choice
layout to improve traffic here is costly and could affect costs and
patterns. revenues for many years.

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c.

Whether to offer a 10% price discount on Only cost A is relevant for this decision.
specific items? The other costs are likely unaffected by
this decision.
Whether to schedule sessions on a weekly B only. This decision is unlikely to
or bi-weekly basis. change the volume of sales (related to
cost A) and surely does not influence
costs C and D.
How often to change seasonal display A, B, and C. Changing the number of
seasonal displays affects C directly. It
also affects A because the decision likely
changes sales volume. The change in
sales might spur changes in the number
hired, leading to a change in cost B.
Whether to change store layout to improve A, B, C and D. Changing the store
traffic patterns. layout is likely to affect all of these costs,
including the amount and types of goods
purchased, employee training, seasonal
displays, and shelving. The choice here is
relatively costly and could affect costs
and revenues for many years to come.

c. One inference that leaps out is that higher-order costs seem relevant when we
consider longer-term decisions. This intuition is generally true. In the long-run, we
can alter the nature of the business and the associated processes. Such change is
required for us to influence facility and product-level costs.
2.58 Traceability and Cost hierarchy (LO3, LO4).
At some level, Erika’s argument is valid. Ultimately, the revenue from the units produced
and sold must cover all costs for the plant to turn a profit. It does not matter whether the
cost is unit-, batch- or a facility-level cost. However, many higher-level costs are not
traceable at the unit level. Consequently, many firms allocate these costs to units in some
fashion (we see more of this in Chapter 3), and determine a unit cost. The idea is that the
product’s price should cover this fully loaded cost.

This thinking is not quite right, however. The cost hierarchy helps us make better
decisions by helping us determine controllable and relevant costs. Usually, the longer the
decision horizon, the greater the number (and level) of costs that become controllable
relevant. Thus, it does not make sense to treat all costs as if they were controllable at the
unit level.

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That said, we still need to recover all costs. The hierarchy just tells us that unit-level costs
are the floor for prices. For a batch of goods, our revenue must exceed unit-level and
batch-level costs. We need to consider product-level revenues when analyzing product-
level decisions, and the revenue for the entire facility when making decisions that affect
facility-level costs. That is, the hierarchy helps us align the costs we should consider with
the unit of analysis for our decisions.

2.59 Traceability and Variability (LO1, LO3). Changing the way we organize for
production changes the traceability of costs. In the traditional organization, we could
trace direct labor costs to units, as workers often were paid on a piece-rate basis.
However, the blurring of the lines between direct and indirect labor means that such
traceability does not exist. A self-directed work team might perform several functions,
and producing units might be just one of the functions. However, traceability at the level
of the product line increases. The concept of a factory within a factory means that
previously allocated costs (e.g., machines, engineers) now become traceable to the
product line.

Many more costs are controllable for decisions that change product lines and such
decisions are often the strategic decisions that make or break the firm. Because it
improves traceability at this level, the modern organization structure gives us greater
confidence regarding decisions at the product line level. We have less control over unit-
level decisions, however. Because of the mingling of direct and indirect labor, firms lose
a degree of control over these costs.
Note: Many managers argue that materials are the only costs that firms could control at
the unit level. These managers claim that labor is more like a semi-fixed cost because it is
difficult, if not impossible, to adjust the labor cost to correspond exactly with production
volume. The controllability of cost under the modern production system meshes nicely
with this world view. The instructor could also tie this problem to the theory of
constraints. This theory advocates that we only consider the cost of materials for short-
term decisions, and that we focus on maximizing the usage of the bottleneck resource.

2.60 Outsourcing usually increases the variability of costs. For example, consider buying units
from a supplier instead of making them internally. With outsourcing, the cost is almost
proportional to volume. But, internal production might involve many indirect costs such
as the cost of supervision, machinery, plant and so on. However, it is not true that
variability always increases with outsourcing. Many such contracts have fixed fee
payments in return for an expected volume of work. Turn-key projects (where the
supplier provides a fully finished project) often are for a fixed amount as well.
Intuitively, it would seem that traceability of costs also increases because we can
uniquely identify the payments to the supplier. However, the opposite is usually true.
Suppose we outsource an entire function. Then, the outsourced cost is traceable to
decisions that affect the entire function but not to individual components. In contrast,
performing the function (e.g., handle customer enquiries) ourselves might allow for finer
traceability of items.

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Cost controllability also usually increases with outsourcing. It is common for firms to
negotiate contracts that specify the unit price but leave the delivery quantity and schedule
open. The buyer then coordinates with the supplier to procure items on a just-in-time
basis. The contracts also are more easily altered than changing one’s own operations.
However, this additional flexibility comes at a cost because the supplier will demand
some margin over their costs and, more important, the buyer loses some degree of control
over intangibles such as quality and design. Firms combat these problems by reducing the
number of suppliers and closely cooperating with the chosen few. In some sense, the
supplier becomes a part of the firm’s “extended family.” This arrangement allows firms
to reap the best of both worlds – having some distance to allow for hard negotiations but
close enough to foster a long-term view.

MINI-CASES
2.61 Traceability, Variability, and Relevance (LO1, LO3).
a. The following table provides the cost classifications, including comments pertaining
to the rationale underlying each classification.

Gasoline Direct for trip, Indirect for person

The friends incur the cost of the gasoline for the trip. It is not possible to figure out how
much gas each person consumed.

Cost of food and drink Direct for both

Because each person pays for his or her own food and drink, we can identify the cost
incurred by each person. Note that shared meals would render the food costs indirect
for persons. Further, (like the cost of gasoline) because food and drinks are consumed
during the trip, the cost also is traceable to the trip as a whole.

Cost of chalet rental Direct for trip, Indirect for person

Like the gas, this common cost is not traceable to any given friend, but clearly relates
to the trip as a whole.

These classifications help the friends identify what costs will be paid directly by each
person and what costs need to be allocated. We also see that traceability depends on the
unit of analysis – costs become more traceable as the unit of analysis increases.

b. The following table provides the cost classifications, including comments pertaining
to the rationale underlying each classification.

Cost of gasoline Variable

Miles driven. The more the friends have to drive, the greater the cost of gasoline.

Cost of food and drink Variable

Number of meals. The amount of food and drink consumed clearly is determined, in
part, by the number of persons and the length of the trip.

Chalet rental for the first 3 nights Fixed

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This cost is fixed as the friends have made a non-refundable deposit.

Chalet rental after the first three nights Variable

Number of nights stayed after the third night. The more nights the friends decide to
stay at the ski resort, the greater the cost of the chalet.

The friends can use these classifications to better estimate the cost of the trip. For
example, the friends can estimate the total fixed and total variable costs as follows (we
note that there may be fixed and variable costs in addition to the ones we are
considering):

Total fixed costs for the trip = Chalet rental for first three nights

Total variable costs for the trip = [Chalet rate × (# of nights – 3)] + (Miles driven ×
cost of gasoline per mile) + (Cost of each meal × # of meals)

The total cost for the trip would then be the sum of the fixed and variable costs (as the
friends have already reserved the chalet for the first three nights, the total controllable
costs are the variable costs, since the friends could still choose not to go on the trip).
This part of the problem shows that costs vary with different activities. Further, the
problem shows that variability and traceability do not necessarily coincide. For
example, the cost of gasoline is variable with respect to miles driven but is not traceable
to each person on the trip.

c. Food and Drink Unit level

This cost is proportional to the number of people on the trip.

Chalet rental Batch level / Step-Cost

Suppose the chalet rental is a fixed amount based on time and the number of people
(up to some maximum). Then, we classify the cost as a batch level cost, with the
occupancy limit as the batch size. We could also describe the cost as a step cost.

Some chalets, however, have a fixed fee plus an additional charge per person (again,
up to a maximum). In this case, the fixed fee is the batch level cost and the additional
charge is a unit level cost. This cost is a variant of the mixed costs that we considered
in the chapter.

Premium TV Product level

This cost uniquely pertains to the activity of watching premium channels. The cost is
unrelated to the number of people or the amount of time spent in front of a TV
(which, we hope is not large at a ski resort).

Time spent in planning Facility level

The determinant or causal reason for this cost is not clear. Further, we must incur this
cost for the trip to occur, whether it is for 3 or 5 persons. This cost, in some sense, is
the administrative overhead for the trip.

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d. Operating costs for car Relevant

This cost is avoidable and is only incurred if the friends decide to drive to the ski
resort.

Bus fare Relevant

This cost is avoidable and is only incurred if the friends decide to take the bus to the
ski resort.

Chalet rental for the first three nights Not relevant

This cost would be the same for both transportation options and is not relevant since
the friends have made a non-refundable deposit.

Chalet rental after the first three nights Not Relevant

This cost is controllable (because the friends have discretion over the length of stay
after the first three days) but would be the same for both transportation options
(unless taking the bus or driving leads the friends to stay longer), rendering it not
relevant.

2.62 Cost Variability, Step Costs (LO3, LO4).

The following table provides the cost classifications, including comments pertaining to
the rationale underlying each classification. Please note that there clearly is room for
discussion/debate regarding some of the classifications. Without knowledge of the exact
operating conditions and contracts with outside parties, there invariably is some
subjectivity involved.

Cost Classification
Cost # Description of Cost & Comments
1 Rent on school building F – The amount of rent paid is unlikely
to vary based on the number of students
enrolled in the coming term. Christine
probably has a long-term lease on her
facility with fixed monthly payments.
2 Lunches and lunch supplies V – One would think that lunch costs
would be proportional to the number of
students. This is likely true for Christine
because she buys lunches from a caterer.
That said, one could argue that the cost is
mixed (M) if the school had, for
example, their own chef on staff, or the
caterer had a minimum volume
requirement.
3 Teacher salaries S – More students imply the need for
more teachers. However, each teacher

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probably can work with 20-30 students

(the class size would be the step).
4 Utilities and water M – Some portion of the utility bill is
fixed. In addition, there probably is a
portion that depends on the number of
students. For example, as the number of
students increases, restroom usage
increases.
5 Bus driver salaries S – More students imply more bus
drivers. However, each bus driver
probably can transport approximately 50
children (in this case, the step size would
be 50).
6 Art supplies V – One would tend to think that the cost
of art supplies (brushes, paints, and so
on) would increase directly with student
volume. We could conceive the cost as
being mixed (M) if we include the cost of
fixed supplies such as kilns or easels.
7 Janitorial services M – The school likely has a full-time
janitor and his/her salary probably is
fixed. Cleaning supply usage, though,
probably relates to the number of
students (more students = more mess).
8 Brochures and pamphlets M – There likely are fixed costs
(including monthly associated with designing and producing
newsletter) the brochures. Additionally, the
production and distribution costs (e.g.,
postage) increase as the number of
students increases.
9 Receptionist salary F – There probably is only one
receptionist for the school and his/her
salary likely is unrelated to the number of
students (unless the school’s size
changed dramatically).
10 Field trip to The Museum of M – There are certain fixed costs
Science and Industry associated with organizing the trip, but
other costs (e.g., admission) likely vary
directly with the number of students.
11 Repainting the hallway F – Once the school has made the
decision to repaint an area of the school,
the cost is fixed and unrelated to the
number of students.
12 Fuel for buses M – This is a tough one. If the school has
pre-specified bus stops (as numerous
public school systems do), we might

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argue that the cost is a fixed cost (F). If,

though, the school picks up and drops off
students at their homes, then the cost
likely is mixed since there are fixed costs
of going to, e.g., a neighborhood and
incremental variable costs for picking up
each child in the neighborhood. The cost
would be purely variable if the school
individually chauffeured each student.

This exercise shows us that few costs are purely fixed or purely variable (of course, in the
long run, all costs are variable). Rather, many of an organization’s costs are likely to be
mixed or follow a step pattern. That said, for many decisions, organizations do classify
costs as being purely fixed or purely variable, perhaps because the ease of resulting
computations outweighs the errors introduced by the classification.

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Cost 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.

3.2 Revenues less product costs = revenues less cost of goods sold or costs of
providing services.

3.3 The matching principle.

3.4 The products service firms offer are not tangible or storable.

3.5 Merchandising firms buy goods from suppliers and resell substantially the same
products to customers.

3.6 Cost of goods sold = cost of beginning inventory + cost of goods purchased
during the period – cost of ending inventory.

3.7 Manufacturing firms use labor and equipment to transform inputs such as raw
materials and components into outputs (finished goods).

3.8 Because they vary proportionally with production volume and can be traced
directly to products.

3.9 Variable manufacturing overhead varies proportionally with production volume,

whereas fixed manufacturing overhead does not change as production volume
changes.

3.10 Prime costs equal the sum of direct materials and direct labor; conversion costs
equal the sum of direct labor and manufacturing overhead.

3.11 Cost pools, cost objects, cost driver (allocation basis), and allocation volume
(denominator volume).

3.12 Determine the allocation rate (overhead rate), and allocate the cost.

3.13 They are equal.

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Discussion Questions
3.14 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 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 of 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.

3.15 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).

3.16 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.

3.17 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 and vegetables).
 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.

3.18 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 includes the cost of
receiving and stocking goods. However, including the cost of receiving and

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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.

3.19 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.

3.20 Research and 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 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 the
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 recognition of expected benefits.

3.21 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.

3.22 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.

3.23 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 manufacturers such Harley-Davidson also have highly
automated facilities.

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3.24 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
hours 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 hours as the cost driver. In this case, the
overhead rate is $20 per machine hour (= $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).

3.25 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.

3.26 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 individuals spend 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.

3.27 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, for example, may bundle
sales of copiers with the 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.

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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.

3.29 The following is the income statement for Abel & Associates.

Revenues $1,600,450
Cost of delivering service 1,150,450
Gross margin 450,000
Marketing & administration 174,600
Profit before taxes 275,400

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3.30 The following is the gross margin statement for Sage Consulting.

Revenues 9,000 hours × $350/hour $3,150,000

Cost of delivering service 9,000 hours × $300/hour 2,700,000
Gross margin $450,000
Marketing & administration Plug figure 220,000
Profit before taxes Given $230,000

We 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.

3.31 We have:

Brad Timberlake
GAAP Income Statement
Item Detail Amount

Seminar Revenue 35 seminars × 125 persons ×

$400 per person $1,750,000

Cost of supplies 35 seminars × 125 persons ×

$75 per person 328,125

Set up costs per seminar 35 seminars × $20,000 per

seminar 700,000
Gross margin $ 721,875
Office administrator 50,000
Other expenses 250,000
Profit before taxes $421,875

3.32 The 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.

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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.

3.33 The 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.

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3.34 The 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.

3.35
The following table provides the required classifications.

Item Classification Comments

Connectors used to Direct materials These items form a part of the product
make a product and vary with the volume of production.

Labor to machine Direct labor Some refer to this as “touch labor”

product components because the workers physically touch
the product.

Steel used to make Direct materials The steel becomes an integral part of the
components product and varies with the volume of
production.

Drill bits, saw blades, Variable These items are used to make many
and other tools manufacturing units of the product and/or many
overhead products. We would classify their cost
as variable, as making more units would
require more tools.

Salary paid to the Fixed This item is a fixed cost; it is not

factory manager manufacturing directly traceable to units of any
overhead product.

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Factory maintenance Partly fixed Some items, such as the salary to the
costs manufacturing maintenance manager, are fixed. Other
overhead and items, such as the supplies used to
partly variable maintain equipment, might vary with
manufacturing usage and the number of units made.
overhead
Depreciation on Fixed The amount does not vary with any
materials handling manufacturing obvious volume-related cost driver.
equipment overhead

Holiday pay paid to Direct labor/ This item likely varies with labor cost.
assembly workers. variable Some firms include it as a part of direct
manufacturing labor. Others treat the item as variable
overhead 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.

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3.37
Inventoriable costs are another term for product cost. Only manufacturing costs
can be inventoried. Thus, we have:

Direct materials cost $2,400,000

Direct labor cost 720,000
Factory overhead 1,008,000 (140% x $720,000 labor cost)
Total costs 4,128,000
Number of units 120,000
Cost per unit $34.40 ($4,128,000 / 120,000)

3.38 a. 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 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 therefore compute cost of goods sold as:

$85,000 = $40,000 + $840,000 – Cost of goods sold

Cost of goods sold = $795,000.

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3.39 a. Considering 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.

b. 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 = cost of goods sold.

3.40

a. The inventory equation for the raw materials account is:

Ending balance = Beginning balance + Raw materials purchased – Raw materials

issued to production. Thus,

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$75,000 = $90,000 + raw materials purchased – $200,000.

Raw materials purchased = $185,000.

b.

Total manufacturing costs charged to production = raw materials issued to

production + direct labor cost + manufacturing overhead.

$900,000 = $200,000 + Direct labor cost + 1.5 * direct labor cost.

Direct labor cost = $280,000.

c.

Manufacturing overhead costs = 1.5* direct labor costs

Thus, manufacturing overhead costs = $280,000 * 1.5 = $420,000

d.

Prime costs = Direct materials used (used to production) + direct labor

Thus, prime costs = $200,000 + $280,000 = $480,000

e.

Conversion costs = direct labor + manufacturing overhead

Thus, conversion costs = $280,000 + $420,000 = $700,000

f.

The inventory equation for the work-in-process account is:

Ending balance = Beginning balance + Total manufacturing costs charged to

production – Cost of goods manufactured.

100,000 = $80,000 + $900,000 – Cost of goods manufactured.

Cost of goods manufactured = $880,000.

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g.

We can express cost flows through the finished goods account using the following

equation:

Ending balance = Beginning balance + Cost of goods manufactured – Cost of

goods sold.

$175,000 = $125,000 + $880,000 – Cost of goods sold.

Cost of goods sold = $830,000.

3.41

We need to work backwards to solve this problem.

We first find COGM = $750,000 = $800,000 COGS + $75,000 FG(ei) – $125,000

FG(bi)

Next, we find materials usage = $340,000 = $750,000 COGM + $30,000 WIP(ei)

– $220,000 OH – $160,000 DL – $60,000 WIP(bi)

Finally, we find materials purchases = $380,000 = $340,000 materials usage +

$120,000 Materials(ei) – $8,0000 MAT(bi)

3.42
a. For this particular job, Kim and Tim’s cost sheet might look like the following:

Materials Estimated based on gallons, quality etc $250

Labor Estimate based on job features
($12 per hour × 45 hours) 540
Brushes, etc. Included in markup --
Mgmt Time Estimate (4 hours × $20 per hour) 80
Total cost $870
Markup 40% of total cost 348
Bid $1,218

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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:

Materials Estimated based on gallons, quality, etc. $250

Materials overhead 20% of materials cost 50
Labor Estimate based on job features 540
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.

3.43
80%, or $160,000 of the overhead is allocated using bushels produced, and the
remaining 20%, or $40,000 is allocated using acres.

Focusing on acres, ½ of the overhead is allocated ($20,000) to corn and the other
½ ($20,000) is allocated to soybeans. This obtains because both corn and
soybeans each use 400 acres.

For bushels, corn produces 150*400 = 60,000 total bushels, and soybeans
produces 50*400 = 20,000 total bushels. Thus, ¾ of this overhead ($120,000) is
allocated to corn and the remaining ¼ ($40,000) is allocated to soybeans.

Collecting this information, we find that $140,000 is allocated to corn and the
remaining $60,000 is allocated to soybeans.

3.44
a. The following table provides the required computations:

Allocation Basis
Head count Revenue Profit

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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 $4,000/person $0.020/ $0.64/profit $
driver 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.
2
: $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.

3.45

a. There are several methods the two friends could use, including:

1. Equal split because each person gets to use the house. This
mechanism is simple and easy to implement.

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.

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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, perhaps, 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 other has no interest).

Food: This can be 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 ice cream where we can easily keep the items separate. For each specialty food item,
each person pays for the items she buys and consumes. The grouping is arbitrary to
some degree and depends on the mutual trust among the friends.

Problems
3.46
Shawn’s Lawn Mowing Service
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

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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

3.47 The 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 year 879,830
- Ending inventory 178,450
= 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 List Discount Actual Expected

sales price price revenue
10% $100 $0 $100 $10.00
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 $300,793.60
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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
Item Detail Amount
Gross revenue (= cost of
goods sold × 2) $1,879,960.00
Discounts & rebates 639,186.40
Net revenue $1,240,773.60
Cost of goods sold As computed above 939.980.00
Gross margin $300,793.60
Store rental and utilities 136,800.00
Staff salaries 64,500.00
Profit $99,493.60

3.48 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

+ Purchases 23,125,000
= Total available for sale $25,575,000
- Ending inventory 2,225,000
= 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. We 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:

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Unadjusted COGS $23,350,000.00

Allocation for transportation in 164,111.93
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 Comfort 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 Comfort’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.)

3.50

a. COGS = $375,000 = $500,000 in revenues * (1 – .25)

b. COGM = $350,000 = $375,000 CGS + $50,000 FG(ei) – $75,000 FG(bi)

c. OH = .40 * ($150,000 in DL + OH); solving yields OH = $100,000.

d. The cost of materials used in production = $115,000 = $265,000 (Prime Costs)

– $150,000 (direct labor)

e. WIP(ei) = $65,000 = $50,000 in WIP(bi) + $265,000 in Prime Costs + $100,000

in OH – $350,000 in COGM

3.51

Prime costs = materials + labor

Labor = $130,000
Material usage = $80,000 = $30,000 BB + $70,000 purchases – $20,000 EB

Prime costs = $210,000 = $130,000 + $80,000.

b.

The overhead rate = $125,000/$250,000 = $0.50 OH rate per DL$

OH charged to LC1 = $0.50 * 130,000 = $65,000.

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Thus, COGM = $295,000 = $45,000 WIP (bi) + $210,000 prime costs + $65,000 OH –
$25,000 WIP (ei)

In turn, COGS = $290,000 = $45,000 FG (bi) + $295,000 COGM – $50,000 FG (ei)

c.

Conversion costs = DL + OH

The OH allocated to LC2 = $0.50 * 120,000 = $60,000.

In turn, we have: Conversion costs = $180,000 = $120,000 + $60,000

d.

Materials purchased = RME + Usage – RMB

= $30,000 + ? – $45,000

There are two with two unknowns, thus we need to work backwards.

Let’s find the materials used in production

Usage = WIPEI + COGM – DL – OH – WIPBI

= $25,000 + $260,000* – $120,000 – $60,000 – $50,000
= $55,000

* COGM = FGEI + COGS – FGBI

= $90,000 + $250,000 – $80,000
= $260,000

Substituting back…

Materials purchased = $30,000 + $55,000 – $45,000

= $40,000

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3.52

We apply the inventory equation to determine the value of ending inventory.

Beginning inventory + Costs added – COGM = Ending inventory.

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, we find:

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

3.53
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.

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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.”

3.54
Examining controllable costs, we would argue that fixed overhead is probably not
controllable over the 6 month 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.

With the correction for fixed costs, we have the costs for making the component as:

Materials $12.00 per unit

Direct Labor 9.00
Variable overhead 4.50 50% of labor cost
Total $25.50 per unit.

This amount is smaller than the cost ($32 per unit) associated with purchasing the units
from the supplier. Thus, the firm should continue making the units.

3.55
Many firms perform the kinds of analysis like that done by the consulting firm. Such
analyses consider all costs and allocates 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 not necessarily meaningful 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

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in the short-term by her decision. More importantly, she appears to be hurting revenue. A
reputation for poor after-sales service would lower the firm’s sales.

3.56
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:

Model Model Model

X-5 XV-10 XV-20
Materials cost $100 $175 $300
Labor cost 300 400 700
Allocated overhead 200 200 200
Inventoriable cost $600 $775 $1,200

Again, we emphasize that selling and administrative costs are not included in
inventoriable costs.

b. The 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:

Model Model Model

X-5 XV-10 XV-20

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Materials cost $100 $175 $300

Labor cost 300 400 700
Allocated overhead 150 200 350
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.

3.57
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.

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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 $6.50 $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 $63.25

b. 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.

3.58
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
Number of Allocated cost (= allocated = % of
setups per number of setups driver units from
Product year × rate per setup) the product line
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.

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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 Allocated cost (= % of cost allocated =

of setups number of setup hours % of driver units from
Product per year × rate per setup hour) the product line
24” Two-suiter 7 $24,500 = 98 setup 61.25%
hours × $250 per setup
hour.
26” Three-suiter 2 $9,000 = 36 setup 22.50%
hours × $250 per setup
hour.
30” Jumbo Wheeler 1 $6,500 = 26 hours × 16.25%
$250 per setup 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.

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3.59

This a “non-standard” problem in that we are dealing with a not-for-profit. Thus,

the notions of a gross margin or other margins do not really 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 income 2,396.48
Total operating inflows $13,510.86
Administration expenses:
Office expenses $2,440.00
Postage and printing 845.00
Board meetings 143.50
Total administration expenses 3,428.50
Funds available from operations $10,082.36

Source and Use of funds

Funds available from operations $10,082.36
Cash donations 14,000.00
Total available for scholarships $24,082.36
Scholarships awarded 23,000.00
Net surplus / deficit 1,082.36

Fund balances
Beginning balance of funds $47,500.00
Current year surplus / deficit 1,082.36
Ending balance of funds $48,582.36

Naturally, it is possible to come up with alternate presentations. The idea is to

provide the board with a perspective on where the money is coming from and how
it is being spent. There also is a question of how to account for the in-kind
donations (e.g., food at the party, or free use of speaker system). We recognize them
both as revenue and costs. To see the logic, suppose that the sponsor had purchased

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an amount equal to the donation in ticket sales, but also billed us for services
rendered. We would show the contribution as revenue and the billed amount as a
cost. Our situation is the same except that the “ticket sales” are implicit—the person
did not bill us for services rendered. Rather than leave this out, we believe that
recognizing such ‘in kind’ contributions provides useful information to the board.

MINI-CASES

3.60
a. The accounting equation for the raw materials account is:

Ending balance = Beginning balance + raw materials purchased – raw materials

issued to production.

$42,000 = $23,000 + 190,000 – Materials issued out

Therefore, raw materials issued to WIP = $171,000.

b. Total material costs charged to production = $171,000.

The materials related overhead charged to WIP
= 20% of $171,000 = $34,200

Labor costs charged to production = $145,000.

The labor related overhead charged to WIP
= 150% of $145,000 = $217,500

Therefore,
Total manufacturing overhead charged to production = $34,200+$217,500 =
$251,700.

c. The accounting equation for the work-in-process account is:

Ending balance = Beginning balance + costs charged to operations – cost of goods

manufactured.

Costs charged to operations include materials, labor and overhead.

Costs added to WIP (i.e., operations) = $171,000 + 145,000 + $251,700 =
$567,700.

Thus,

$76,400 = $98,500 + 567,700 - Cost of goods manufactured.

Cost of goods manufactured = $589,800.

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d. 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.

$138,750 = $124,350 + $589,800 – Cost of goods sold.

Cost of goods sold = $575,400

e. The following is the required gross margin statement.

Baber, Inc.
Income Statement for Year
Revenue $694,740
Beginning FG inventory $124,350
+ Cost of Goods Manufactured $589,800
- Ending FG inventory $138,750
= Cost of Goods Sold $575,400
Gross margin $119,340
Selling & Administration 87,600
Profit before taxes $31,740

f. Inventoriable cost is the sum of all manufacturing costs charged to the product.

We have:

Materials cost $7,800

Labor cost 12,300
Materials related overhead (20% of materials) 1,560
Other overhead (150% of labor cost) 18,450
Total inventoriable cost $40,110

g. The amount of inventoriable costs in not enough for making effective decisions.
From a decision making view, we need 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, for example, sales
commissions. This means that we need to consider sales commission when
evaluating profitability. The point to remember is that the product/period cost
classification (which leads to inventoriable costs) is useful from a financial
accounting purpose. It often is not useful from a decision making perspective.

3.62

a.

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Using the inventory equation, and labeling materials purchases as “x” we have the
following:

$80,000 + x (purchases) – 0.80x (materials usage) = $150,000

Solving, we find x (purchases) = $350,000

b.

Materials issued to production = 80% of materials purchases.

Thus, we have: materials issued to production = $280,000 = 0.80 * $350,000

c.

We know that total manufacturing costs charged to production = DM + DL + OH

Additionally, we know that manufacturing overhead = 150% of direct labor

Thus, we have: $800,000 = $280,000 + DL + 1.50*DL

Solving, we find: DL = $208,000

d.

Overhead costs = 1.5*DL; Thus, overhead costs = $312,000 = 1.5*$208,000

e.

Prime costs = DM used + DL

Thus, prime costs = $488,000 = $208,000 + $280,000

f.

Conversion costs = DL + OH

Thus, we have: conversion costs = $520,000 = $208,000 + $312,000

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g.

Let us use the inventory equation for WIP, which is:

Beginning WIP + materials usage + direct labor + manufacturing overhead – Ending WIP
= COGM

Thus, we have:

COGM = $850,000 = $200,000 + $280,000 + $208,000 + $312,000 – $150,000

h.

Using the inventory equation for FG, we know:

Beginning FG + COGM – Ending FG = COGS

We know the beginning FG balance ($125,000) and COGM ($850,000), but we do not
know the ending FG balance or COGS. To calculate the ending FG balance, we need to
determine cost of goods sold. Fortunately, the problem informs us that Iron Pit’s gross
margin % is 40%. This means that COGS = 60% of revenues, or $900,000
(=$1,500,000*.60).

Thus, we have: Ending FG = $975,000 = $125,000 + $850,000 – $900,000.

i.

As computed above COGS = $900,000.

j.

We have the following for Iron Pit for the year:

Revenues $1,500,000
Cost of goods sold 900,000
Gross margin $600,000
Sales commissions (3% of revenues) 45,000
Shipping costs (2% of revenues) 30,000
Advertising 60,000
Fixed administration costs 140,000
Profit before taxes $325,000

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k.

The current overhead rate for the Iron Pit = 150% of direct labor costs and the overhead
associated with producing dumbbells is, as computed in part (d), $312,000.

If Doug and Matt start producing barbells, total overhead will equal $450,000 (=
$312,000 + $138,000), and total labor costs will equal $360,000 (= $208,000 +
$152,000). Thus, the new overhead rate will be 125% of direct labor
(=$450,000/$360,000).

In turn, the overhead allocated to dumbbells will equal 1.25 * $208,000 = $260,000. This
is $52,000 less than is currently being allocated and, in steady state, is the amount by
which the gross margin from producing dumbbells will increase. This example illustrates
why firms frequently produce multiple products – there are economies of scope (in
addition to the economies of scale associated with producing more units of the same
product).

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 CHAPTER 4
Techniques for Estimating Fixed and Variable Costs
Solutions

Review Questions

4.1 Because the statement groups costs by business function rather than variability.
That is, the traditional income statement combines fixed (non-controllable) and
variable (controllable) costs.

4.2 Revenues less variable costs. It is the amount that contributes toward recovering
fixed costs and earning a profit.

4.3 The GAAP-based income statement, which is used for external reporting, groups
costs by business function, separating product costs from period costs (as
discussed in Chapter 3). In contrast, the contribution margin statement groups
costs by variability, separating fixed costs from variable costs.

4.4 Yes, along with revenues and variable costs.

4.5 By separating out fixed costs, which relate to the costs of capacity resources and
usually do not change in the short-term, from revenues and variable costs, which
vary with activity volume and usually are controllable in the short term.

4.6 Account classification, the high-low method, and regression analysis.

4.7 (1) Sum the costs classified as variable to obtain the total variable costs for the
most recent period; (2) Divide the amount in (1) by the volume of activity for the
corresponding period to estimate the unit variable cost; and (3) Multiply (2) by
the change in activity to estimate the total controllable variable cost.

4.8 The primary advantage is that it can provide very accurate estimates because it
forces us to examine each cost account in detail. The primary disadvantages are
that the method is time-consuming and subjective.

4.9 The two observations pertaining to the highest and lowest activity levels. These
two values are most likely to define the normal range of operations.

4.10 The primary advantage is that the high-low method is easy to use and only
requires summary data. The primary disadvantages are that it only uses two
observations (“throwing away” much of the data) and yields only rough estimates
of the fixed costs and unit variable costs.

4.11 While the high-low method only uses two observations, regression analysis uses
all available observations to come up with a line that best fits the data.

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4.12 (1) R-square, which indicates the goodness of fit – this statistic is between 0 and
1, with values closer to 1 indicating a better fit; (2) p-value, which indicates the
confidence that the coefficient estimate reliably differs from 0.

4.13 The relevant range is the normal range of operations, where we expect a stable
relationship between activity and cost.

4.14 We compute a segment margin by subtracting traceable fixed costs related to the
segment (e.g., a product, customer, geographical region) from its contribution
margin. The two margins differ by the traceable fixed costs.

4.15 (1) products; (2) customers; (3) stores; (4) geographical regions; and, (5)
distribution channels are some of the many ways an organization might segment
its contribution margin statement.

Discussion Questions

4.16 A 5% decrease in selling price would result in a larger decrease in unit contribution
margin than a 5% increase in variable costs. To see why, keep in mind that unit
selling price is a larger number than unit variable cost (otherwise, unit contribution
margin will not be positive). Therefore, a 5% decrease in selling price will also be
proportionately larger than a 5% decrease in variable cost. For example, if the unit
selling price is $10 and the unit variable cost $6, then the unit contribution margin
is $4 (= $10 - $6). With a 5% decrease in selling price, the selling price decreases
by $0.50 to $9.50; the unit contribution margin also decreases by the same $0.50 to
$3.50 (= $9.50 - $6). With a 5% increase in variable costs, the unit variable cost
increases by $0.30 to $6.30, and the unit contribution margin decreases by the same
$0.30 to $3.70 (= $10 – 6.30).

4.17 Investors are external users of the financial reports prepared by firms. Investors
might prefer the income statement using the gross margin format because the cost
of goods sold as reported in this format includes allocated fixed costs such as
depreciation, factory overhead and so on. These allocated fixed costs represent a
rough measure of the opportunity cost of capacity resources. Thus, investors get an
idea of profitability after taking into account the opportunity cost of the usage of
capacity resources.

4.18 A key aspect of the contribution margin statement is that it clearly separates fixed
costs from variable costs associated with various decision options. Because
contribution margin is revenues less variable costs, the decision maker can correctly
compute the contribution margin associated with each decision option. In the short
run, fixed costs do not change, and therefore contribution margin constitutes the
right basis for decision making. In the long run, however, many fixed costs become
controllable and relevant for decision making.

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4.19 As is often said, “A picture is worth a thousand words.” Plotting the data helps in
quickly assessing the behavior of various cost items i.e., whether a cost is fixed or
variable with respect to the volume of production, just by inspection. Plotting the
data also helps us determine the appropriate technique to use to estimate fixed and
variable costs. Moreover, plots often reveal a few data points that do not appear to
conform to the general pattern emerging from other data points. Such “outliers” or
extreme observations are typically the result of recording errors or unusual activities
in a specific period. We can identify and eliminate such observations from
consideration because they are not likely to reflect typical behavior.

4.20 The reason for plotting is to examine how a cost item increases in activity volume.
Some months may have high activity volumes and other months may have low
activity volumes in no particular order. But we would like to know how costs vary
as the activity volume increases or decreases. For this reason, if we sort by activity
volume and plot it on the X-axis, and plot the corresponding cost on the Y-axis, the
resulting plot will indicate how cost increases as the activity volume increases along
the X-axis.

4.21 Account classification requires us to examine each cost account in detail, and
provides very accurate estimates. Often, this analysis requires us to plot each cost
account and examine the graph and exercise some judgment to determine its
behavior. Grant proposals often require the proposal preparers to exercise
considerable judgment. They typically involve a manageable number of line items
so that an accurate line-by-line estimation of costs using the account classification
method is not such a tedious task.

4.22 Large projects are often unique and dissimilar. Smaller and routine decisions tend to
be more alike. Therefore using mechanical methods such as the high-low method
work reasonably well for small and routine decisions. On the other hand, such
methods will likely result in much greater estimation errors for large projects. And,
erroneous estimation of costs can in turn prove quite costly if they lead to bad
decisions relating to large projects. Even though tedious, the account classification
method is more suited for large and unique projects.

4.23 One can visually verify that high and low data points are representative by making
sure they do not seem to be “outliers” with respect to the rest of the data points.
That is, these points do not seem out of step or pattern with other points.

4.24 One reason could be that either the high data point or the low data point (or both) is
an “outlier.” Another reason could be a change in the fixed cost that may have
occurred in the interim. The high-low method will not be able to detect this change.
The accounting classification method will.

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4.25 True – the high-low method relies completely on just two data points to separate
fixed costs and variable costs. If one of these points turns out to be an outlier, the
estimates can be completely off. In contrast, a regression detects the cost behavior
using all available data points. Consequently, each individual observation has far
less influence on the estimates than the high or low data points in the high-low
method.

4.26 Yes, going back to obtain historical data from many years does increase the number
of data points we use in a regression. However, we would be assuming that the cost
structure – the mix of fixed and variable costs – stays the same over all these years.
In practice, firms change with time. Fixed costs change as more capacity is added or
some capacity is reduced. Unit variable costs may decrease as production becomes
more efficient. Therefore, the longer is the time period, the less applicable is the
assumption that the cost structure remains the same. And, such cost structure
changes limit the extent to which we can use historical data for estimation purposes.

4.27 We can use number of batches and number of products as additional variables in the
right hand side of the regression equation along with the activity volume. In such a
regression, we can interpret the intercept as “facility level costs” because these costs
do not vary at all.

4.28 In estimating the revenues and costs using this kind of a two-part fee structure, it
becomes necessary to estimate the number of families, average family size, and the
number of individual memberships. Revenues would be determined by the number
of families multiplied by the family membership fee plus the number of individual
memberships multiplied by the individual membership fee. On the cost side, one
needs to estimate the total membership as number of families multiplied by the
average family size plus number of individual members, and then multiply this total
membership by the cost of serving each member. In principle, this setting is similar
to situations in which firms bundle their products for market penetration (e.g., a
vacation “package” comprising of airline tickets, hotel costs, and cruises, as
opposed to just airline tickets, hotel costs and cruises). Bundles are priced
differently than individual products, and bundling is an integral part of the
marketing strategy.

4.29 Yes, it does. Such a contribution margin statement will help measure how much
contribution each major customer makes to the fixed costs of the company. It will
help in customer-related decisions such as whether to keep or drop a particular
customer, whether some customer-specific promotions and discounts can improve
the contribution from that customer and so on. “Customer Profitability Analysis” is
an important strategic tool that we will discuss in Chapter 10.

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4.30 If a grocery store stops selling 1% lowfat milk, its revenues from 2% lowfat milk is
likely to go up, as customers who routinely buy 1% lowfat milk settle for the next
best option. This is an example of a positive spillover effect. On the other hand, if
an automobile repair shop stops doing routine maintenance services, it is likely to
lose revenues from other repair issues that typically crop up during routine
maintenance services. This is an example of a negative spillover effects. Yes,
spillover effects are controllable and must be considered in the decision to drop the
1% lowfat milk in the case of the grocery store, and the routine maintenance service
in the case of the automobile repair shop.

4.31 Here is the income summary of operating segments of General Electric Corporation
extracted from its 2006 Annual Report.

Exercises

4.32 Unit contribution margin = Price – all variable costs

We first calculate price = ($15,000 revenue/500 units) = $30 per unit. Given that
variable manufacturing costs = $10 per unit and variable selling costs = $2 per
unit, then unit contribution margin = $30 - $10 - $2 = $18 per unit.

Contribution margin = number of units × unit contribution margin

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Thus, contribution margin = 500 units × $18/unit = $9,000.

The following is the contribution margin statement.

Contribution Margin Income Statement

Revenue 500 units × $30 per unit $15,000
Variable manufacturing costs 500 units × $10 per unit 5,000
Variable selling costs 500 units × $2 per unit 1,000
Contribution margin $9,000
Fixed manufacturing costs 6,000
Fixed selling costs 2,000
Profit $1,000

4.33 The following is the contribution margin statement for Isaac’s Ice Cream Shop for
the month of December:

Isaac's Ice Cream Shop

Contribution margin statement for December
Item Amount
Revenues (15,000 scoops @ $1.70) $25,500
Variable cost (15,000 svoops @ $0.65 9,750
Contribution margin $15,750
Fixed costs $5,000
Income before taxes $10,750

4.34 The following table presents the required statement.

Ajax Corporation
Contribution Margin Income Statement for
the most recent Year
Revenue $1,525,000
Cost of goods sold 900,000
Sales commissions 91,500
Variable cost of transport in 6,500
Contribution margin $527,000
Fixed transportation cost 18,000
Administration costs 220,000
Selling costs 148,500
Profit $140,500

Notice that the contribution margin statement regroups the costs into fixed and
variable costs. Moreover, because it is a merchandiser, Ajax buys and sells goods
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without substantially transforming them. Thus, its cost of goods sold is a variable
cost; this cost is the amount Ajax would have paid its suppliers. We obtain sales
commissions as 6% of sales revenue (0.06 × $1,525,000 = $91,500). We then
back out fixed selling costs as the remainder ($240,000- $91,500 = $148,500).

4.35 The following table presents the required statement.

Jindal Corporation
Contribution Margin Statement for the most
recent Year
Revenue $2,435,000
Variable cost of goods sold 998,010
Sales commissions 121,750
Contribution margin $1,315,240
Fixed manufacturing costs 248,750
Fixed administration costs 425,000
Fixed selling costs 437,200
Profit $204,290

Notice that the contribution margin statement regroups the costs into fixed and
variable costs. We obtain sales commissions as 5% of sales revenue (0.05 ×
$2,435,000 = $121,750) and back out fixed selling costs as the remainder
($558,950 - 121,750 = $437,200).

Note: Instructors may wish to point out that inventories would substantially
complicate the problem. The complication arises because GAAP (which governs
the gross margin statement) classifies fixed manufacturing costs as product costs,
whereas the contribution margin statement classifies them as period costs. We
address this issue in Chapter 9.

4.36 Fabricare’s GAAP based income statement is as follows:

[EXTB]Fabricare
GAAP income statement for the Most Recent
Month
Revenue $8,000,000
Cost of goods sold 4,200,000
Gross Margin $3,800,000
Variable selling costs 800,000
Fixed selling costs 500,000
Fixed administrative costs 450,000
Profit $2,050,000

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4.37 The following table provides the required detail.

Item Estimate Detail

Student related variable $2,500 × 50 = $125,000 Variable in number
costs of students
Faculty related costs 2 faculty × $150,000 = Variable in number
$300,000 of faculty hired
Administration costs 1 person × $60,000 = Variable in number
$60,000 of staff hired.
Building maintenance No change Fixed for this
decision.
Total $335,000

Notice that we would find it difficult to make this estimate using techniques such
as the high-low method. Each cost element has a different driver, and major cost
items such as faculty and staff costs are step functions.

4.38 A simple analysis is to argue that the cost per unit is total product cost / total units
(=$400,400/10,000 units), or $40.04. Adding 2,500 units a month for 2 months would
add 5,000 units × $40.04 = $200,200 to Mega’s cost.

However, this approach is incorrect. It does not distinguish between controllable and non-
controllable costs. And, as we know from Chapter 2, the cost of making the additional
units should only include controllable costs. How should we estimate controllable costs
though? The following table identifies controllable costs, making the usual assumption
that all variable costs are controllable and fixed costs non-controllable over the short
term.

Variable items
Materials and components These costs vary proportionately with
the number of units made. The logic is
Direct labor easy to see for items such as materials,
freight out, and labor. However, costs
Supplies of supplies and oils also vary with
production volume, even though these
Oils and lubricants are indirect cost. These costs are the
Freight out product’s variable overhead. The sales
commissions also vary because
Sales commissions revenue varies with volume.
Fixed costs items
Machine depreciation None of these costs change if we
Plant heating and lighting change production volume, especially
Plant rental in the short-term.
Sales office administration
Corporate office costs

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We estimate the total variable costs as $273,500 or $27.35 per unit. (Add up all of the
variable cost amounts to obtain $273,500 as the cost of 10,000 units.) Thus, the expected
increase in costs from adding 2,500 units a month for 2 months is 5,000 units × $27.35 =
$136,750.

4.39 Judging by the nature of the costs, we assume that supplies, promotional items
and sales commissions will vary in direct proportion to sales. We also assume that
utilities will stay fixed because the store is in operation anyway. With these
assumptions, we compute the expected incremental contribution from the new
line as:

Incremental revenues $25,000

Cost of shoes $12,500
Supplies $1,000
Promotional items $500
Sales commissions $2,000
contribution margin $9,000
Incremental fixed costs (additional salary) $1,500
Net incremental income from new line $7,500

In this calculation, supplies are calculated at $0.04 per sales dollar, promotional items at
$0.02 per sales dollar, and sales commissions at $0.08 per dollar based on past data.

4.40 The following is the required statement.

Singapore Executive MBA Program

MidWest University
Tuition revenue $1,400,000 40 students × $35,000
Partner fees 490,000 Traced
$200 per course × 40 students
Text books etc 128,000 × 16 classes
Contribution margin $782,000
Instructor salaries 320,000 $20,000 × 16 courses
Instructor travel 72,000 $4,500 × 16 courses
Program assistance 81,000 1.5 FTE × $54,000 per FTE
Program related travel 19,500 3 trips × $6,500 per trip
Program margin $289,500
Associate Dean (allocated) 22,500 10% of salary
Dean’s time (allocated) 17,500 5% of compensation
Profit $249,500

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This statement, which incorporates the cost hierarchy, shows that for each student
enrolled in the class, the program generates $782,000/40 students = $19,550 in
contribution margin. These costs and revenues are controllable for the decision to
add students to the program.

Program related costs amount to $320,000 + $72,000 + $81,000 + $19,500 =

$492,500. These costs are controllable for the decision of whether to keep or drop
the program.

Finally, there is some allocated cost ($40,000) which is not likely controllable for
any decision concerning the program. After all, the dean is unlikely to reduce her
salary if the program shuts down.

b. For this decision, we only consider controllable costs and benefits, at the
participant level. Notice that we cannot directly use the contribution margin
statement because the revenue has changed, which changes some costs as well.

Increase in tuition revenue $75,000

Partner fees 26,250
Textbooks 9,600
Net gain $39,150

Thus, it appears that the Dean should accept this offer. However, the Dean also
needs to consider long-term and other spillover effects. For example, other
students might also demand the same discount once word gets out about the fee
concession. Further, there is a strong price-quality association with graduate
degrees (particularly Executive MBA programs). Thus, lowering the price also
might harm the program’s image. Finally, the class is already at a good size;
additional members might put it over the top in terms of a manageable class size.
Overall, the decision is not clear-cut.

Note: Instructors may wish to point out that account analysis is particularly useful
for this decision. The high-low method or regression analysis is needlessly
complex for a decision that only affects a few costs and revenues.

4.41 a. Silk Flowers and More’s shipping costs likely contain both fixed (e.g., employee
costs) and variable (e.g., cartons, tape, and postage) elements. For convenience, let UVC
(Unit variable cost) represent the variable cost per flower arrangement. Using the high-
low method and the data provided, we have:

HIGH (February) $33,750 = Fixed costs + (UVC  7,500)

LOW (January) $27,500 = Fixed costs + (UVC  5,000)

Now we can solve for the unit variable cost.

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UVC = $33,750 - $27,500 = $6,250 = $2.50 per flower arrangement sold.

7,500 – 5,000 2,500

Substituting our estimate of UVC into either equation, we find that Fixed costs =
$15,000. For example,

Fixed costs = $33,750 – ($2.50 per arrangement × 7,500 arrangements) = $15,000

Thus, Silk Flowers & More’s monthly shipping cost equation is:

Total shipping costs per month = $15,000 + ($2.50  Number of flower

arrangements sold)

b. Once we have our cost equation, we can plug in the anticipated sales volume to obtain
an estimate of shipping costs. For June, we have:

Estimated June shipping costs = $15,000 + ($2.50  5,500) = $28,750.

Additionally, based on the data provided, a volume of 5,500 flower arrangements appears
to be well within Silk Flower and More’s relevant range of activity.

c. Stated simply, management would like to know the cost of “free shipping.” As
estimated in part [b], at a volume of 5,500 arrangements, management should expect free
shipping to cost $28,750 for the month of June. This number allows management to make
an informed comparison between the costs and the benefits of offering free shipping
(presumably, offering free shipping increases sales volume and contribution margin).
Moreover, separating costs into fixed and variable components helps management assess
those costs that vary with the number of flower arrangements sold and those that do not.

Instructors also may wish to point out to students that management of Silk Flowers &
More would be likely to refine their shipping costs equation to incorporate factors such as
the type of package shipped (small versus large), the type of flowers shipped (some may
required more packaging materials and labor), and the distance shipped. Such
refinements allow management to estimate the profit of the various types of floral
arrangements sold and the various customers that they serve (e.g., profit by region of the
country). This may lead management to restrict free shipping to some product lines.

For a salient example, consider Amazon.com, which offers “free” shipping. However,
only some products in Amazon.com qualify for free shipping. A book usually does, but a
plasma TV usually does not. In addition, Amazon requires a minimum order size to
qualify for free shipping. Exploring the rationale for these practices underscores how cost
structure influences a firm’s policies and procedures.

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4.42

a. We can use the two data points to decompose supervision costs into fixed and variable
components. Specifically, using the cost information from May and July (the months with
the lowest and highest activity levels), we have:

(May): $8,350 = FC + (Cost per hour  2,000)

(July): $42,000 = FC + (Cost per hour  8,000).

Solving for the unit variable cost, or Cost per Hour, we have:

Cost Per Hour = $42,000 - $8,350 = $33,650 = $5.61 per Hour

8,000 – 2,000 6,000

By substituting the cost per hour = $5.61 into the cost equation for July (using May will
also work), we find that

FC = $42,000 – (8,000  $5.61) = -$2,880

We know however that fixed costs should not be negative. Therefore, one of the points
used is for estimation is perhaps an “outlier.”

b. Using the cost information from October and December ,we have:

(October): $18,150= FC + (Cost per hour  5,500)

(December): $9,750 = FC + (Cost per hour  2,500).

Solving for the unit variable cost, or Cost per Hour, we have:

Cost Per Labor Hour = $18,150 - $9,750 = $8,400 = $2.80 per Hour
5,500 – 2,500 3,000

By substituting the cost per hour = $5.61 into the cost equation for October (using
December will also work), we find that

FC = $18,150 – (5,500  $2.80) = 2,750

The point here is that the High-Low Method is dependent on the two data points selected,
because it ignores information in all other data points.

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4.43

a. We can use the two data points to decompose supervision costs into fixed and variable
components. Specifically, using the cost information from January and March (the
months with the lowest and highest activity levels), we have:

(January): $27,500 = FC + (Cost per labor hour  2,400)

(March): $32,540 = FC + (Cost per labor hour  3,360).

Solving for the unit variable cost, or Cost per Labor Hour, we have:

Cost Per Labor Hour = $32,540 - $27,500 = $5,040 = $5.25 per Labor Hour
3,360 – 2,400 960

By substituting the cost per labor hour = $5.25 into the cost equation for January (using
March will also work), we find that

FC = $27,500 – (2,400  $5.25) = $14,900.

Thus, we express total supervision costs as:

Total supervision costs = $14,900 + ($5.25  Number of labor hours)

Notice that we use the observations with the highest activity level. We do not use the data
for May even though it has the highest cost.

b. We can use the two data points to decompose total supervision costs into
fixed and variable components. Specifically, using the cost information from
January and May (the months with the lowest and highest activity levels), we have:

(January): $27,500 = FC + (Cost per machine hour  5,040)

(May): $32,630 = FC + (Cost per machine hour  6,750).

Solving for the unit variable cost, or Cost per Machine Hour, we have:

Cost Per Machine Hour = $32,630 - $27,500 = $5,130 = $3.00 per Machine Hour
6,750 – 5,040 1,710

By substituting the cost per machine hour = $3.00 into the cost equation for January
(using May will also work), we find that

FC = $27,500 – (5,040  $3.00) = $12,380.

Thus, we express total supervision costs as:

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Total supervision costs = $12,380 + ($3.00  Number of machine hours).

c. We believe that the equation based on labor hours might better represent cost
behavior because supervision is likely related to the number of workers. However,
there usually is a strong correlation between labor and machine hours in many
settings. Thus, we could justify either equation.

d. A manager might believe neither equation to be valid because the data indicate
that supervision might be a step cost. For instance, the cost did not change when the
number of labor hours increased from 2,400 to 2,560 but jumped $2,500 when the
labor hours increased from 2,560 to 2,880. Such jumps and intuition lead us to
conclude that supervision costs might be step costs, which means that our task
changes to estimating the step size. (This material might be covered in an advanced
class.)

4.44
a. We can use the two data points in the condensed income statements to decompose
Frame & Show’s total costs into fixed and variable components. Specifically, using
the cost information from years 1 and 2, we can express Frame & Show’s total costs
as:

(Year 1): $310,000 = FC + variable cost per frame × 3,000

(Year 2): $332,500 = FC + variable cost per frame  3,500.

Solving for the unit variable cost, or variable cost per frame, we have:

Variable cost per frame = $332,500 - $310,000 = $22,500 = $45.00 per frame
3,500– 3,000 500

By substituting variable cost per frame = $45 into the cost equation for Year 1 (using
year 2 will also work), we find that

FC = $310,000 – (3,000  $45) = $175,000.

Thus, we express Megan’s annual cost equation as:

Total Costs = $175,000 + ($45  Number of items framed).

b. The cost of participating in the Thieves Market equals the sum of the controllable
fixed and variable costs associated with this decision alternative.

The controllable fixed cost associated with participating in the Thieves Market is the
$2,500 booth fee. Megan’s annual fixed costs of $175,000 are not controllable for this
short-term decision.

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The controllable variable cost equals the number of framings multiplied by the variable
cost per framing. Megan expects to sell 150 framings at the market. From the cost
equation we developed in part [a], the estimated variable cost per framing is $45.
Consequently, Megan’s expected controllable variable costs = $45  150 = $6,750.

Adding the controllable fixed cost to the controllable variable costs, we have:

Cost of participating in the Thieves Market = $2,500 + $6,750 = $9,250.

To determine the expected profit from participating in the Thieves Market, we need to
determine the revenue from participating in the market. Since revenue = selling price 
number of framings, we can use the data in either Year 1 or Year 2 to find the average
selling price. Using the data from Year 2, we find that the sales price per frame =
$318,000/3,000 = $106.

Thus, the revenue from 150 frames = 150  $106 = $15,900.

Subtracting the cost from the revenue associated with participating in the Thieves
Market, we find that Megan’s profit is expected to increase by $15,900 – $9,250 =
$6,650.

Participating in the Thieves Market therefore appears to be a “steal.”

4.45
a. Following the procedure outlined in the text, we find the following:

Standard
Coefficients Error t Stat P-value
Intercept $15,320.95 689.8844 22.20799 0.0002
Number of shipment $2.445946 0.106834 22.89489 0.000183
R-Square =0.992

Based on the above data, we estimate the monthly shipping cost equation as:

Total shipping costs per month = $15,320.95 + ($2.446  Number of flower

arrangements sold)

We note that the regression has a high R-square (the Excel output shows an adjusted R-
square of 0.992) indicating an excellent fit. Moreover, the p values are low, indicating a
statistically meaningful relation between the cost driver (the number of shipments) and
the cost. This statistical relation confirms our intuition about an economic relation
between the cost driver and the cost.

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b. Once we have our cost equation, we can plug in anticipated sales volume to obtain an
estimate of shipping costs. For June, we have:

Estimated June shipping costs = $15,320.95 + ($2.445  5,500) = $28,768.45.

Additionally, based on the data provided, a volume of 5,500 flower arrangements appears
to be well within Silk Flower and More’s relevant range of activity.

Note: The instructor can observe that while we obtain similar answers with the high-low
and the regression method for estimating costs, this is often not the case.

4.46

Using Excel, we obtain the following regression equation and output:

Regression Statistics
R Square 79.21%
Observations 12

Standard
Coefficients Error t statistic p-value
Intercept -1886.79 3357.53 -.5619 0.58
Volume 4.08 0.6613 6.17 0.00

4.47 We would argue that the second equation is likely to be a better predictor of monthly
materials handling costs. We base our conclusion on the following reasons.

 Equation 2 has a much higher R-square (76.34%) than equation 1

(54.17%). The higher R-square indicates a better fit, meaning that the cost driver
(the independent variable in the regression equation) “number of material moves”
is able to explain more of the variation in the dependent variable (monthly
materials-handling costs) than the independent variable “value of materials
handled.”

 The p-values of the coefficients are low in both equations, indicating that
all estimates reliably differ from zero. However, the p-values are lower in
equation 2 than in equation 1, again indicating a stronger association between
material moves and materials-handling costs than the association between the
value of materials and materials-handling costs.

 We have to consider more than just R-squares and p-values when

choosing an activity. For example, we need to consider whether there is a cause-
effect relationship between the activity and the cost. The answer for our problem

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is not obvious. We can visualize the number of moves being the cause for
materials-handling costs. We also can conceive of the value of materials being
correlated with handling expenses because we are likely more careful with more
expensive materials. However, there could be situations where the association
between value of materials and handling cost is weak. Ultimately, we will have to
rely on situation specific knowledge to make the choice.

Overall, this exercise highlights that we can employ many independent variables in a
regression and that the choice among the resulting equations must rely on both statistical
and economic criteria. More sophisticated multiple-regression models can portray the
joint effect of many independent factors.

4.48
a. Using Excel, we obtain the following regression equation and output:

Regression Statistics
R Square 34.57%
Observations 12

Standard
Coefficients Error t statistic p-value
Intercept 13,059.78 1991.153 6.558907 0.00
Cases shipped 2.153 0.936829 2.298816 0.04

b. This equation indicates a somewhat poor fit. The fit is not excellent as the R-square
value is only around 35%. Moreover, the explanatory variable is only marginally
significant (p of 0.04). O’Conner would be well advised to consider alternate drivers
and/or to collect more data to refine its estimates.

4.49

a. The GAAP income statement classifies costs according to their function – it groups
costs by whether they pertain to manufacturing (product costs) or non-manufacturing
(period costs) activities. The GAAP income statement also aggregates the data to the firm
level because the income statement pertains to the firm as a whole and not any particular
product, geographical region, or customer. (Note: Generally, investors buy and sell shares
in the entire firm and not individual pieces of the firm. A few firms do issue tracking
shares that permit an investor to invest in specified operations only.)

In contrast, a contribution margin statement groups costs as per their variability,

presenting the data at the sub-unit level. The sub-unit, which can be products (as in the
Caylor example), divisions, regions, or customers, depends on the decision context.

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Re-grouping costs per their variability gives rise to the following income statement for
Caylor:

Product Contribution Margin Statement

Caylor Company

RX-560 VR-990 Total

Revenues1 $5,400,000 $12,000,000 $17,400,000
Variable costs (Manufacturing)2 540,000 2,000,000 2,540,000
Variable costs (SG&A)3 720,000 8,000,000 8,720,000
Contribution margin $4,140,000 $2,000,000 $6,140,000
Traceable fixed costs
(Manufacturing) $500,000 $500,000 $1,000,000
Traceable fixed costs (SG&A) 1,000,000 1,350,000 2,350,000
Product (Segment) margin $2,640,000 $150,000 $2,790,000
Common fixed costs
(manufacturing) $1,300,000
Common fixed costs (SG&A) 1,200,000
Profit before Taxes $290,000
1
$5,400,000 = 180,000 × $30; $12,000,000 = 2,000,000 × $6.
2
$540,000 = 180,000 × $3; $2,000,000 = 2,000,000 × $1.
3
$720,000 = 180,000 × $4; $8,000,000 = 2,000,000 × $4.

b. The product contribution margin statement is more informative for decision making
than the GAAP income statement. The product contribution margin statement shows that
RX-560 is clearly more profitable than VR-990. (The GAAP income statement obscures
this fact). Thus, management of Caylor may wish to increase its emphasis on RX-560 and
de-emphasize VR-990. Additionally, we clearly see the traceable fixed and variable costs
associated with producing each drug; this information can facilitate special order
decisions, pricing decisions, and keep or drop decisions.

Note: Caylor’s profit before taxes is the same regardless of which way we group revenues
and costs. This equivalence occurs because of the absence of inventory. As discussed in a
later chapter (Chapter 9), inventory can cause the two income numbers to differ.

4.50
a. The following table provides the required calculations:

Omega Corporation
Monthly Contribution Margin Statement
(by Geographical Region)
Eastern Western Total
Revenue $2,000,000 $600,000 $2,600,000
Variable manufacturing costs1 1,300,000 370,000 1,670,000
2
Variable selling costs 50,000 16,000 66,000
Contribution margin $650,000 $214,000 $864,000

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Traceable fixed costs 250,000 225,000 475,000

Segment margin $400,000 ($11,000) $389,000
Common fixed costs 275,000
Profit before Taxes $114,000
1
$1,300,000 = ($1,000,000 × 0.55) + ($1,000,000 × 0.75); $370,000 = ($400,000 × 0.55) +
($200,000 × 0.75)
2
$50,000 = ($1,000,000 × 0.03) + ($1,000,000 × 0.02); $16,000 = ($400,000 × 0.03) + ($200,000 ×
0.02)

b. The following table provides the required information:

Omega Corporation
Monthly Contribution Margin Statement
(by Product)
Standard Deluxe Total
Revenue $1,400,000 $1,200,000 $2,600,000
1
Variable manufacturing costs 770,000 900,000 1,670,000
Variable selling costs2 42,000 24,000 66,000
Contribution margin $588,000 $276,000 $864,000
Traceable fixed costs 275,000 225,000 500,000
Product margin $313,000 $51,000 $364,000
Common fixed costs 250,000
Net Income $114,000
1
$770,000 = ($1,000,000 × 0.55) + ($400,000 × 0.55); $900,000 = ($1,000,000 × 0.75) +
($200,000 × 0.75).
2
$42,000 = ($1,000,000 × 0.03) + ($400,000 × 0.03); $24,000 = ($1,000,000 × 0.02) +
($200,000 × 0.02).

c. The contribution margin statements clearly show that the Eastern region currently is
more profitable than the Western region and that the standard product is more profitable
than the deluxe product. Thus, management may need to devote more efforts to
increasing the profits associated with the deluxe line. (Management may also use the
information to support a strategy of emphasizing the standard line given the low
contribution margin of the deluxe line relative to the standard line).

Similarly, management may need to devote even more resources to the Western region to
ensure that its expansion efforts are successful. Alternatively, management may decide,
based on the geographic contribution statement (i.e., the loss in the Western region), to
discontinue its presence in the Western region.

4.51
a. Atman expects to spend 8 × 20,000 hours = 160,000 hours to assemble 8 satellites. Its
expected cost is 160,000 hours × $25 per hour = $4,000,000.

b. The following table provides the average hours required with learning

Unit number Average Hours per unit

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1 20,000 (Given)
2 18,000 (=20,000 × 0.9)
4 16,200 (=18,000 × 0.9)
8 14,580 (=16,200 × 0.9)

Thus, the total labor hours needed are 116,640 (8 × 14,580) and the associated cost is
$2,916,000 ($25 × 116,640).

Note: Some students think of 14,580 hours as the time needed for the eighth unit (i.e., the
marginal time for the eighth unit) rather than the average time per unit for the first eight
units. In this context, we note that it is possible to re-express an average cost learning
equation (which we illustrate) into a marginal cost learning equation. However, such
transformations are beyond the scope of this book.

c. Incorporating learning effects reduces Atman’s expected cost by more than 25%.
Ignoring this factor could lead to a significant overbid, potentially costing Atman the job.

Problems

4.52
a. The classification of each of Amy’s costs is as follows:

Cost Hierarchy
Cost Item Classification Explanation
$1,200 variable Unit level Varies directly with
costs per person the number of
persons taking the
tour.

$98,000 cost per Batch level Varies with the

tour number of tours.

$50,000 central Facility level Required to sustain

office and the business.
administration costs

One might be tempted to classify Amy’s $50,000 in central office costs as “product-
level” costs because, at the present time, Amy only offers tours to Southeast Asia. These
costs, however, probably are best classified as facility-level because they are required to
sustain Amy’s business. They probably won’t change even if, for example, Amy starts
offering tours to Europe.

b. The table below presents Amy’s total quarterly costs under each scenario:

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2 tours 5 tours
with 40 with 50
persons persons
Cost item each each Detail
Variable costs $96,000 $300,0002 × 40 × $1,200; 5 × 50
× $1,200
Cost of tours $196,000 $490,0002 × $98,000; 5 × $98,000
Fixed expenses $50,000 $50,000Facility-level cost
Total costs $342,000 $840,000

c. Based on our cost classifications, the controllable cost of offering any particular tour =
$98,000 + ($1,200 × number of persons on the tour). With 35 persons, this cost = $98,000
+ ($1,200 × 35) = $140,000. Furthermore, with 35 persons Amy receives 35 × $4,000 =
$140,000 in tour revenue. Thus, Amy just “breaks even” when 35 persons are in the tour
and loses money with fewer than 35 persons. This explains why Amy has this stipulation.

4.53 Let us begin by classifying the items as being controllable or not for this decision.

Item Classification
Direct materials Controllable
Direct labor Controllable
Departmental overhead: Direct Controllable
Departmental overhead: Indirect Not controllable
Factory overhead Not controllable
Selling & administration overhead Not controllable

How can we make the above classification? Notice the per-unit amounts for the
controllable costs are the same at different production volumes. This equality suggests
that these costs are proportional to production volume, or that they are variable. Thus,
these costs are likely controllable for this decision.

Indirect overhead declines on a per-unit basis as volume increases. This is a classic sign
of a fixed cost. Indeed, we can verify that the amount is $31,000 for both volumes.

We now consider the two allocated amounts: factory overhead and selling costs. From
Chapter 3, we know that allocations take an indirect cost and split it among cost objects
in proportion to the number of cost driver units. Suppose we allocate rent (a fixed cost) in
proportion to labor hours. Suppose further that we increase production of a product (with
one labor hour per unit) from 1,000 units to 2,000 units. The number of labor hours used
by this product will then double. The mechanics of the allocation then mean that the
amount allocated for rent will also double because the allocated cost is proportional to the
number of driver units! Thus, a casual examination of cost per unit at the different
volumes might well conclude that rent is a variable cost because the allocation process
has made a fixed cost look like a variable cost.

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This phenomenon is at work here. Indeed, note that factory overhead is constant per unit,
suggesting that it is variable. But, appearances could be deceiving. The allocated amount
per unit is the same for different volumes because we calculate the allocated amount as
100% of a controllable cost (labor). However, the total amount the firm spends on
factory overhead is likely the same at both volumes. Thus, factory overhead is not
controllable for this decision. A similar logic applies to selling and administration
overhead.

With this classification, we have the controllable costs as $2.50 + 2.14 + $0.45 = $5.09
per unit. Thus, increasing production by 1,500 units will increase costs by $7,635.

Note: This problem underscores that allocated costs, particularly when presented as a
cost per unit, have the potential to confuse. If you encounter an allocated amount in a
product cost report, do not consider just the amount allocated to an individual unit of the
product or to the product line alone to determine whether the cost is controllable. Rather,
consider whether the total expenditure on the cost (across all products) by the firm will
change due to the decision.

4.54
a. The table below classifies each of Comfort Pillows’ cost items as being relevant or not
relevant for accepting the department store’s order. The table also presents the increase in
the cost item, if any, as a result of accepting the order and the detail supporting this
calculation. That is, the status quo is not accepting the order.

Cost for
Cost Item Relevant? store order Detail
Fabric Relevant. The cost $12,500 5,000 pillows × $2.50 per
will increase if the pillow.
order is accepted.

Fill Relevant. The cost $90,000 5,000 pillows × $18 per

depends on pillow.
whether the order
is accepted.

Industrial sewing Not relevant. The $0

machines cost is the same
regardless of
whether the order
is accepted.

Labor Relevant. The cost $30,000 5,000 pillows × ½ hour

will increase if the per pillow × $12 per hour
order is accepted.

Plastic wrap & other Relevant. The cost $2,500 5,000 pillows × $0.50 per
packing increases if the pillow
order is accepted.

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Cartoning & crating Relevant. This $2,000 (5,000/25) × $10

batch-level cost
changes because of
the order.

Transportation Relevant. Similar $3,000 (5,000/2,500) loads ×

to cartoning and $1,500 per load
crating, this is a
batch-level cost.

Purchasing & Relevant. This cost $15,000 Accepting the order will
manufacturing support will increase since mean that Comfort will
only 12,000 produce 17,000 pillows
pillows per month in the coming month,
are being produced thereby triggering an
currently. additional $15,000 in
cost.

Advertising brochures Not relevant. The $0

cost is the same
whether the order
is accepted or not.

Office expenses Not relevant. The $0

cost is the same
whether the order
is accepted or not.

Sales & support Relevant. These $1,000 Additional $1,000 will be

costs will increase incurred.
if the order is
accepted.

Total cost $156,000

The relevant cost per pillow is therefore: $156,000/5,000 $31.20

Markup at 25% 0.25 × $31.20 $ 7.80
Price per pillow $39.00

b. The point to note here is that, on a per-pillow basis, the batch- and order- (product-)
level costs will change. The following table (which only shows the controllable costs)
highlights this point.

Per-pillow
Per-pillow cost cost
Item 5,000 pillows 4,000 pillows Detail
Fabric $2.50 $2.50 $2.50 per pillow

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Fill $18.00 $18.00 $18.00 per pillow

Labor cost $6.00 $6.00 ½ hour × $12 per hour

Plastic wrap & other $0.50 $0.50 $0.50 per pillow

packing
Cartoning & crating $0.40 $0.40 Although this is a batch
cost, notice that the per-
unit cost has not changed
because both orders are
divisible by 25, which is
the batch size.

Transport $0.60 $0.75 $3,000/5,000;

$3,000/4,000. Still need
two trips even though the
order is smaller.

Purchasing & $3.00 $3.75 $15,000/5,000;

manufacturing $15,000/4,000
support
Sales & support $0.20 $0.25 $1,000 / number of
pillows.

Cost per pillow $31.20 $32.15

The revised price per pillow is therefore $40.19 = $32.15 × (1 + 0.25).

Notice that the unit cost has increased due to the presence of batch- and order-(product-)
level costs. Because the batch size is smaller than the step size for transportation costs
under the revised order, the unit cost will increase. Similarly, the product costs related to
purchasing and manufacturing support and sales support are spread over a smaller
volume level, thereby increasing the cost per pillow.

4.55
a. By inspection, we see that the highest and lowest activity levels (pizzas sold) occurred
in the fourth and first quarter, respectively. Accordingly, we have:

HIGH (Fourth quarter): $190,000 = FC + (40,000  cost per pizza sold)

LOW (First quarter): $115,000 = FC + (25,000  cost per pizza sold).

Solving for the UVC, or cost per pizza sold, we find

UVC = $190,000 - $115,000 = $75,000 = $5.00 per pizza

40,000 – 25,000 15,000

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Substituting UVC into either equation, we find that FC = –$10,000. Thus, Pizzeria
Paradise’s total quarterly cost equation is:

Total Quarterly Costs = –$10,000 + ($5.00  number of pizzas).

b. As shown in part [a], our estimate of Pizzeria Paradise’s fixed costs is indeed
negative. Clearly, Pizzeria Paradise will not incur negative fixed costs (i.e., receive
money) if it produces 0 pizzas in a quarter. What we need to keep in mind is that any
estimated cost model is only valid within a particular range of activity – usually defined
by the range in the data used to estimate the model. Projections outside of this range may
not be accurate because the linear approximation implied by the model may no longer be
valid.

In the Pizzeria Paradise example, we estimated the cost model using activity levels
between 25,000 and 40,000 pizzas. However, interpreting the –$10,000 as a “fixed cost”
requires that we apply the model at a value of 0 pizzas. This value is well outside the
relevant range. The model likely is only applicable for activity levels between 25,000 and
40,000 pizzas.

c. Using the model developed in part [a], our estimate of total costs at a volume of
50,000 pizzas is:

Estimated Quarterly Costs = –$10,000 + ($5.00  50,000) = $240,000.

Building on the discussion in part [b], we need to be concerned about this estimate
because it falls outside the range of data used to estimate the cost equation. Thus, we
should issue a caveat to management that our estimate may not be valid because it falls
outside the relevant range. In addition, it probably also is worth pointing out issues
related to drawing inferences and/or estimating cost from just a year’s worth of data –
particularly the startup year. It will be important to closely monitor Pizzeria Paradise’s
cost patterns in the coming months/quarters as the business settles into a more stable
pattern.

4.56
a. By inspection, we see that the highest and lowest activity levels (ZAP kits sold)
occurred in the fourth and second quarter, respectively. Accordingly, we have:

HIGH (Second quarter): $268,200 = FC + 9,600  Variable cost per kit.

LOW (Fourth quarter): $181,500 = FC + 4,500  Variable cost per kit

Solving for the UVC, or variable cost per kit, we find

UVC = $268,200 - $181,500 = $86,700 = $17.00 per kit

9,600 – 4,500 5,100

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Substituting UVC into either equation, we find that FC = $105,000. Thus, ZAP’s
quarterly cost equation is:

Total Quarterly Costs = $105,000 + ($17.00  number of kits sold).

b. The following graph depicts the relation between total quarterly costs and ZAP kits
sold:

$300,000

$250,000
Q2
Total Cost ($)

$200,000
Q1 Q3
$150,000 Q4

$100,000

$50,000

$0
3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000
ZAP Kits Sold

One of the observations, 9,600 ZAP kits for Quarter 2, does not appear to be in the same
relevant range or fall along the same line as the other three observations. This observation
may reasonably be classified as an “outlier” or extreme observation and may unduly
influence our cost model.

c. This information confirms our intuition. The observation for the second quarter is not
representative of the model that governs the other observations. Thus, we need to re-
estimate the quarterly fixed costs and the variable cost per ZAP kit sold.

After eliminating the second quarter, the third and fourth quarter have the highest and
lowest activity levels, respectively. Thus, we have:

(Third quarter): $192,000 = FC + (6,000  variable cost per kit),

(Fourth quarter): $181,500 = FC + (4,500  variable cost per kit).

Solving, we find UVC = $7.00 and FC = $150,000. Thus, our cost equation is:

Total Quarterly Costs = $150,000 + (number of kits sold  $7.00).

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Using this cost equation on the second quarter’s activity level, we would expect second
quarter total costs to be: $150,000 + (9,600  $7) = $217,200. Because actual total costs
were $268,200 during the second quarter, our model suggests that ZAP spent $51,000 on
advertising. This conclusion, though, should be tempered because the activity level of
9,600 kits is likely beyond the relevant range over which we estimated the cost equation.
Other questions to consider are whether there were any step increases in staff – whether
production, order fulfillment, or marketing – to go along with the increases in units sold.

d. Graphing the data and ensuring data reliability are crucial steps before employing any
model to estimate costs. Graphing the data is an excellent way to gain intuition regarding
the relation between activity levels and costs. Graphs also alert the user to outliers and
potential non-linearity in the relation between activity levels and costs. Advanced users
also check the data to ensure that the cost and the activity are recorded in the same time
interval. For example, some of the costs associated with one month’s activity may be
recorded in another month. In this case, we must adjust the data so that the activity and
the associated cost line up in the same observation.

4.57
a. The cost of employees is a step cost. Specifically, Scott needs to hire one person until
the number of cars detailed reaches 900 per year (900 = 3 cars per day  300 days a year).
Beyond 900 cars, Scott needs to hire two people, until the volume reaches 1,800 cars, at
which point he needs to hire three people, and so on. Thus, the step size is 900 cars
detailed and every 900 cars per year triggers a step-increase in the employee costs. In
other words, employee costs are “fixed” from 0 to 900 cars, from 901 to 1,800 cars, from
1,801 to 2,700 cars, and so on.

Realistically, Scott may need to hire more than one person even if demand were fewer
than 900 cars per year because of seasonal and/or daily variations in demand – for
example, it is likely that many more people will want their car detailed in June than in
January. In addition, if Scott can hire part-time employees (say, on a daily basis), the
“step-size” becomes much smaller. For every 3 cars demanded, he needs to pay for an
additional day. The step is now an hour instead of a full-time employee. With a sufficient
reduction in the granularity of a resource (e.g., the minimum size for purchase), one can
turn a fixed cost into a variable cost. While such reduction appears feasible in this
business, it may not be technologically or economically feasible in other businesses.

b. First, we write out Scott’s annual cost equation:

Total Costs = fixed costs + (# of employees  cost per employee) + (variable cost per car
detailed  # of cars detailed).

Using the data for years 1 and 2, we can estimate the variable cost per car detailed. Such
estimation is feasible because both the fixed costs and the employee costs are the same
for both years.

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(Year 1): $129,000 = fixed costs + (2  cost per employee) + (1,200  VC per car)
(Year 2): $137,000 = fixed costs + (2  cost per employee) + (1,600  VC per car)

Because the employee costs are the same for these two years, we can solve for the UVC,
or detailing cost per car, as we have in the past, and find:

UVC = $137,000 - $129,000 = $8,000 = $20.00 per car detailed

1,600 – 1,200 400

We can now use our variable cost estimate in the cost equations for years 2 and 3, where
we do have variation in the number of employees (which is necessary so that the
employee costs do not, excuse the pun, wash in our estimation). We also could use years
1 and 3 in our estimation.

(Year 2): $137,000 = fixed costs + (2  cost per employee) + (1,600  $20)
(Year 3): $183,000 = fixed costs + (3  cost per employee) + (2,400  $20).

First we simplify these equations:

(Year 2): $137,000 = fixed costs + (2  cost per employee) + ($32,000)

(Year 3): $183,000 = fixed costs + (3  cost per employee) + (48,000).

Subtracting $32,000 and $48,000 from both sides of the respective equations leads us to
the following set of equations.

(Year 2): $105,000 = fixed costs + (2  cost per employee)

(Year 3): $135,000 = fixed costs + (3  cost per employee)

We now can solve for the UVC, which in this case is the annual cost per employee.

UVC = $135,000 - $105,000 = $30,000 = $30,000 per employee

3–2 1
We can now plug in the cost per employee and the variable cost per car detailed into any
of the years to estimate Carlton’s annual fixed costs. Using, for example, year 1 we have:

(Year 1): $129,000 = fixed costs + (2  $30,000) + (1,200  $20).

Solving, we find fixed costs = $45,000. Thus, Scott’s annual cost equation is:

Total Costs = $45,000 + (# of employees  $30,000) + ($20  # of cars detailed).

Please note that we need at least three data points to solve this problem. This occurs
because there are three unknowns in the cost model: (1) fixed costs, (2) the cost per
employee, and (3) the variable cost per car detailed. In general, we need at least as many
data points as unknowns in cost estimation.

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4.58
a. Based on the data provided, we have:

HIGH (September) $560,000 = FC + (15,000  variable cost per pillow)

LOW (March) $420,000 = FC + (10,000  variable cost per pillow)

Solving for the UVC, or variable cost per pillow, we find

UVC = $560,000 - $420,000 = $140,000 = $28.00 per pillow

15,000 – 10,000 5,000

Substituting our estimate of UVC into either equation, we find that FC = $140,000. Thus,
Comfort Pillows’ monthly total cost equation is:

Total costs per month = $140,000 + ($28.00  number of pillows sold)

b. For a short-term order like the one from the store, fixed costs generally are non-
controllable as Comfort would incur theses costs whether the order is accepted or not.
The variable cost is the estimate of the additional cash outflow from making one more
pillow and, thus, would be the controllable amount.

With a 25% markup and using the estimate of the variable cost, the price per pillow
would be $28.00 × (1 + 0.25) = $35.00.

Notice that this price is $4.00 less than the $39.00 price in part [a] of the previous
problem and is independent of the volume of pillows ordered.

c. The difference stems from variations in the detail considered. The account
classification method considered details such as changes in batch size and, as a result, is
likely to be more accurate. For instance, the method yielded different cost estimates at
differing volume levels (as expected with any batch processes). The high-low method, in
contrast, classifies all costs as fixed or variable. Consequently, it misclassifies some costs
and does not represent their behavior well. This method may yield a good and easy to
compute first approximation but is not as reliable. Moreover, it is likely that, under the
high-low method, some of the costs that were classified as batch- or product-level under
the account classification method would be classified as fixed. The estimates between the
high-low method and the account classification method will be close when the
magnitudes of the batch- and product-level costs are small relative to the magnitudes of
the fixed and variable costs.

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4.59
a. The following graph depicts the relation between the total costs of making course
packets and class size:
$400

$350
$300
Total Cost ($)

$250

$200

$150
$100

$50

$0
0

10

20

30

40

50

60
Number of Students

The relation between the number of students and the total cost of making course packets
indeed appears to be linear. The plot indicates that the observed data points deviate only
slightly from a straight line – this deviation could arise from measurement error or from
other factors such as the number of pages in a course packet that determine the cost of a
course packet.

b. Using Excel, we obtain the following regression equation and output:

Regression Statistics
R-Square 98.85%
Adjusted R-Square 98.57%
Observations 6

Standard
Coefficients Error t statistic p-value
Intercept 143.133 8.121 17.624 0.00
Class size 3.877 0.208 18.591 0.00

We estimate the fixed costs of preparing a course packet at $143.133 per class and
the variable cost at $3.877 per student. (Note: the high fixed costs relate to
obtaining copyright permission, assembling the master packet, and charges for the
copy machine and machine operator).

Thus, the cost equation is:

Cost of making packets for a class = $143.133 + $3.877 × Class size.

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c. The reported regression results indicate an excellent fit. The R-square is 98.8%,
consistent with a high association between the number of students and the cost of course
packets. Economically, the story is plausible as a greater number of students increases the
number of copies made and, in turn, cost.

We might be able to improve the accuracy of the estimate by adding the size of the
course packet (in number of pages), although the high association for Watson could be
because the size of the course packet does not vary much across classes. More data might
help shed light on the costs and benefits associated with adding other explanatory
variables to the regression equation.

4.60
a. Using Excel, we obtain the following regression equation and output:

Regression Statistics
R Square 1.1%
Adjusted R Square 0.0%
Observations 9

Standard
Coefficients Error t statistic p-value
Intercept 787.933 379.463 2.076442 0.076486
Machine
hours 0.007847 0.02771 0.283192 0.785222

Thus, the cost equation is:

Maintenance hours = 787.933 + (0.007847 × Machine hours)

This equation indicates a lack of relation between machine hours and maintenance hours.
The R-square is extremely low (1%) and the coefficient on machine hours is not
significant.

b. As discussed in part [a], the equation indicates a poor fit between machine hours and
maintenance hours. The R-Square is low (1%) and the p-value for machine hours is 0.78,
meaning that it is statistically indistinguishable from zero. The result is surprising
because we expect a greater number of machine hours to lead to more maintenance.

Frank’s practice alerts us to one potentially source of error. It is possible that

maintenance hours lag machine hours. That is, if there is high machine usage in quarter 1,
the associated maintenance may occur in quarter 2. If we regress (as we did in part [a])
the maintenance hours in quarter 1 with the machine hours in quarter 1, we will not
capture this association because of the lag effect.

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c. In this specification, we lag the machine hours by one quarter to “match up” machine
hours and maintenance hours. That is, we will treat the machine hours for quarter 1, 2007
as the predictor for the maintenance done in quarter 2 of 2007, the machine hours in Q2,
2007 as the predictors for maintenance in Q3, 2007 and so on.

Estimating the equation after such aligning of data yields:

Regression Statistics
R Square 86.95%
Adjusted R Square 84.78%
Observations 8

Standard
Coefficients Error t statistic p-value
Intercept -39.6145 151.3295 -0.26178 0.802249
Machine hours (in
prior quarter) 0.069039 0.010915 6.32514 0.00073

Maintenance hours = 787.933 + (0.007847 × Prior quarter Machine hours)

This equation indicates an excellent fit, as shown by the high value for the R-square and
the low p-value for the independent variable (prior quarter machine hours). Notice,
however, that we “lose” one observation because we employ lagged data.

In essence, this problem highlights the importance of understanding the data and their
economic relations before employing statistical methodologies.

4.61
a. The following graph depicts the relation between advertising costs (y-axis) and sales
revenue (x-axis).

$300,000

$250,000
Advertising ($)

$200,000

$150,000

$100,000

$50,000

$0
1,100,000

1,150,000

1,200,000

1,250,000

1,300,000

1,350,000

1,400,000

1,450,000

Sales ($)

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The graph indicates that the relation between advertising expenditures and sales
revenue is reasonably linear.

b. Using Excel, we obtain the following regression equation and output:

Regression Statistics
R-Square 75.6%
Adjusted R-Square 71.5%
Observations 8

Standard
Coefficients Error t statistic p-value
Intercept -94,515.1 73659.78 -1.28313 0.24
Sales Revenue 0.2446 0.056707 4.315095 0.00

This equation indicates a good fit between the two variables. The R-square is at a high
level and the coefficient for the independent variable has a low p-value.

c. Using the equation from part [b], we have:

Advertising cost = - $94,515 + (0.2446 × $1,750,000) = $333,535.

We urge caution when using this estimate. First, we are using the equation to predict
costs for a value that could be outside of the relevant range for the model. Second, the
direction of the economic linkage between sales and advertising is ambiguous. One can
plausibly argue that advertising expenses trigger sales and not vice versa. Moreover, there
could be a lag between the time of advertising and the sales realization. Thus, while the
cost equation may be a good fit statistically, the economic underpinnings of this model
are debatable.

4.62
a. The key is to realize that the service department currently is incurring the variable
costs associated with all of the repairs, regardless of whether the repairs are internal or
external. However, revenue is only recognized on sales made to external customers (no
revenue is recorded for repairs to cars purchased for inventory or “courtesy” repairs to
used cars sold). If the service department could charge the used car department for these
repairs (i.e., as if it were a separate stand-alone service station), then its revenues would
double (since half of their time is spent on such repairs). Meanwhile, its variable costs
would stay at the same level. In addition, the used car costs would increase by $200,000,
reflecting the value of the services received. The revised contribution margin statement
below reflects these changes:

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Used Cars Service Total

Revenue $2,500,000 $200,000 $2,700,000
Revenue – used cars ----------- 200,000 200,000
Variable costs 1,200,000 200,000 1,400,000
Service costs 200,000 ----------- 200,000
Contribution Margin $1,100,000 $200,000 $1,300,000
Traceable fixed costs 750,000 250,000 1,000,000
Segment Margin $350,000 ($50,000) $300,000
Common fixed costs 200,000
Profit before Taxes $100,000

Notice that Carousel’s overall profit has not changed – it remains at $100,000. The
revised income statement simply paints a “truer” picture regarding the stand-alone
revenues and costs associated with each of Carousel’s departments. Moreover, the service
department is not performing as poorly as previously thought.

b. Based on the nature of the common fixed costs, it is unlikely that these costs will
decrease if the service department is closed. All other revenues and costs associated with
the service department, however, likely will go away. As calculated in part [a], the
service department is losing $50,000 before considering common fixed costs – thus, all
other things being the same, Carousel’s profit is expected to increase by $50,000 if the
service department were closed. This effect also can be seen (and verified) by
constructing an income statement with used car sales only. We present such an income
statement below (again, this income statement assumes that the used car department will
pay for minor repairs on the cars it buys and still provide courtesy repairs and
maintenance on used car purchases – all of this will be done via an independent service
station at market price, or $200,000 as calculated earlier):

Used Cars
Revenue $2,500,000
Variable costs* $1,400,000
Contribution margin $1,100,000
Traceable fixed costs $750,000
Common fixed costs $200,000
Profit before Taxes $150,000
* = $1,200,000 + $200,000

Again, we see that Carousel’s overall income is expected to increase by $50,000 to

$150,000.

There are, of course, other factors that should be considered, perhaps the most important
of which relates to the effect on used car sales. For example, it is quite possible that
closing the service department will decrease used car sales. That is, the service
department likely entices customers to look at and purchase a car (e.g., someone who is

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waiting on a repair might roam the used car lot). Other considerations relate to whether
the entire service department’s traceable fixed costs will go away (e.g., those related to
equipment or space) and whether some of the common fixed costs will go away (e.g., the
general manager’s salary may decrease since his/her responsibilities have decreased).

c. A 10% decrease in used car sales implies that used auto revenues, variable costs, and
contribution margin will all decrease by 10%. However, it is unlikely that, at least in the
short term, either traceable fixed costs or common fixed costs will decrease. With this,
our revised income statement for used cars looks as follows:

Item Used Cars Detail

Revenue $2,250,000 $2,500,000  .90
Variable costs $1,260,000 $1,400,000  .90
Contribution margin $990,000 $1,100,000  .90
Traceable fixed costs $750,000
Common fixed costs $200,000
Profit before Taxes $40,000

Here, we see that Carousel’s overall income decreases by $60,000 to $40,000.

Assuming the accuracy of the various estimates underlying the revised income statement,
Carousel should not close the service department. This problem underscores the
importance of considering interdependencies among departments and/or products –
oftentimes it is difficult to evaluate products or departments on a “stand alone” basis.
Moreover, the contribution margin statement helps us assess these interdependencies.

4.63
a. The total variable costs are comprised of materials, labor, and variable overhead.
Because materials and variable overhead are expected to remain the same for each of the
32 guidance systems, we calculate the sum of these costs as:

Total expected materials and variable overhead costs = 32  ($400,000 + $200,000) =

$19,200,000.

We need to factor in the 90% learning curve to estimate the total labor costs of producing
the 32 guidance systems. The following table shows the average labor cost per guidance
system as well as the total labor cost, assuming a 90% learning curve.

Number of Average Labor Total Labor Cost*

Guidance Systems Cost per system
1 $600,000 $600,000
(given)
2 $540,000 $1,080,000
(600,000  .90)
4 $486,000 $1,944,000
(540,000  .90)

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8 $437,400 $3,499,200
(486,000  .90)
16 $393,660 $6,298,560
(437,400  .90)
32 $354,294 $11,337,408
(393,660  .90)

Thus, the total expected variable costs = $19,200,000 + $11,337,408 = $30,537,408.

b. Bid = 1.50  total variable costs = 1.50  30,537,408 = $45,806,112.

In turn, the expected contribution margin = bid – total variable costs = $45,806,112 –
$30,537,408 = $15,268,704.

c. The revenue that FlyWell will receive from the contract = .50  $45,806,112 =
$22,903,056.

To determine the contribution margin, we need to determine the total variable costs of
producing the 16 systems. For materials and variable overhead, we have: 16  ($400,000
+ $200,000) = $9,600,000. For labor costs, we have (from the table in part [a])
$6,298,560. Thus, FlyWell’s total costs = $9,600,000 + $6,298,560 = $15,898,560 and
the actual contribution margin = $22,903,056 – $15,898,560 = $7,004,496, less than
the 50% of the anticipated contribution margin of $15,268,704.

Furthermore, the actual markup percentage = 7,004,496/15,898,560 = 44%.

The actual markup is lower than the 50% target. This is because the cost of producing the
first 16 systems is higher than the cost of producing the next 16 systems. If Flywell had
known that the order was for 16 systems only, it should have priced the 16 systems at a
total of $23,847,840 (= $15,898,560  1.50) to achieve a 50% markup. If the government
scales back the order volume, FlyWell should attempt to renegotiate the price – because
of learning effects, expected total costs (and profit) depend crucially on volume.

4.64
a. To arrive at the unit selling price, we first need to determine the learning rate. Next,
we need to calculate the total labor hours required to complete batches 1 through 16 and
batches 1 through 32. Third, we need to calculate the average time to complete a batch
for batches 17 through 32. Finally, we use the average time to arrive at the unit selling
price. Each of these steps is detailed below.

Step 1: Determine the learning rate

The problem provides the actual time to complete batches 1 and 2. To determine the
learning rate, we need the average time for batches 1 and 2.

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Total time to complete batches 1 and 2: 32,000 + 22,400 = 54,400

Average time to complete batches 1 and 2: 54,400/2 = 27,200
Average time to complete batch 1: 32,000 (given)
Learning rate 27,200/32, 000 = 0.85 or 85%

Step 2: Determine the total time to complete batches 1-16 and batches 1-32

The following table shows the cumulative average labor hours per batch as well as the
cumulative total labor hours, assuming an 85% learning curve.

Cumulative Cumulative Total

Number of Batches Average Labor Labor Hours*
Hours
1 32,000 32,000
(given)
2 27,200 54,400
(32,000  .85)
4 23,120 92,480
(27,200  .85)
8 19,652 157,216
(23,120  .85)
16 16,704.20 267,267.20
(19,652  .85)
32 14,198.57 454,354.24
(16,704.20  .85)

* = cumulative average labor hours  number of batches

Step 3: Determine the average time to complete batches 17-32

Total time for batches 1-32 454,354.24 hours

Total time for batches 1-16 267,267.20 hours
Total time for batches 17-32 187,087.04 hours (454,354.24 – 267,267.20)
Average time for batches 17-32 11,692.94 hours (187,087.04/16 batches)

Step 4: Determine the unit selling price

Materials cost $150,000.00 (given)

Variable overhead cost $ 50,000.00 (given)
Labor cost $292,323.50 (11,692.94 labor hours  $25 per labor hour)
Total variable cost $492,323.50
Markup $369,242.63 ($442,323.50  .75)
Price for batch $861,566.13
Price per unit $8,615.66 ($861,566/100 units per batch)

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b. We can calculate Zeron’s expected profit in year 1 as follows:

Revenue $861,566  16 $13,785,058

Materials costs $150,000  16 ($2,400,000)
Variable overhead costs $50,000  16 ($800,000)
Labor costs $267,267.20  $25 ($6,681,680)
Fixed costs ($3,000,000)
Profit in year 1 $903,378

c. We can calculate Zeron’s expected profit in year 2 as follows:

Revenue $861,566.13  16 $13,785,058

Materials costs $150,000  16 ($2,400,000)
Variable overhead costs $50,000  16 ($800,000)
Labor costs $187,087.04  $25 ($4,677,176)
Fixed costs ($3,000,000)
Profit in year 2 $2,907,882

Notice the sharp increase in profit from year 1 to year 2 even though the firm has sold the
same number of units and for the same unit price. The increase is attributable to the
decrease in labor costs. Generally, the profit per unit will steadily increase for products
subject to a learning effect.

Note: Some instructors may wish to discuss the financial accounting implications of costs
subject to learning. Oftentimes, firms will smooth reported profit by estimating the total
profit over the product life and then using a reserve account (called “deferred learning
costs”) to recognize the difference between the average profit and the actual profit for the
period. This asset account will accumulate balances in the early years (less cost than
actually incurred will be recognized in the income statement). The balances decline in
later years and will be zero at the end of the project (more cost than actually incurred will
be recognized in the income statement).

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Mini Cases

4.65
a. The following graph depicts the relation between Yin-Yang’s total costs and cups of
yogurt sold.
$14,000

$12,000

Dec
Total Cost ($)

$10,000

$8,000
Aug
Feb
$6,000

$4,000 Jan
$2,000

$0
500

1,000

1,500

2,000

2,500

3,000
Cups of Yogurt
b. We want to estimate the following cost equation:

Total monthly costs = Fixed costs + (Variable cost per cup of

yogurt  cups of yogurt).

For convenience, write the variable cost per cup of yogurt = UVC or unit variable cost.
Using the data from January and February, we have:

January: $5,500 = FC + (UVC  1,000)

February: $6,200 = FC + (UVC  1,200).

Solving for UVC, we have:

UVC = $6,200 - $5,500 = $700 = $3.50 per cup

1,200– 1,000 200

Substituting the value for UVC into the January cost equation yields

FC = $5,500 – (1,000 cups  $3.50 per cup) = $2,000.

Thus, we would model Yin-Yang’s cost function as:

Total monthly costs = $2,000 + ($3.50  cups of yogurt).

The following graph shows this estimate vis-à-vis the actual data:

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$14,000

$12,000
Total Cost ($)

$10,000
Dec
$8,000
Feb
$6,000 Jan
$4,000

$2,000

$0
500

1,000

1,500

2,000

2,500

3,000
Cups of Yogurt
Note: The first data points for January and February are “hidden” behind the estimated
line.

c. Again, we want to estimate the following cost equation:

Total monthly costs = Fixed costs + (Variable cost per cup of yogurt  cups of yogurt).

The months with the highest and lowest total costs are December and January,
respectively. Accordingly, we have:

December: $8,500 = FC + (UVC  1,100)

January: $5,500 = FC + (UVC  1,000).

Solving for UVC, we have:

UVC = $8,500 - $5,500 = $3,000 = $30.00 per cup

1,100– 1,000 100

Substituting the value for UVC into the January equation yields

FC = $5,500 – (1,000 cups  $30.00 per cup) = –$24,500.

Thus, Yin-Yang’s cost function would be modeled as:

Total monthly costs = –$24,500 + ($30.00  cups of yogurt).

The following graph shows this estimate vis-à-vis the actual data:

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$50,000
$45,000
$40,000
Total Cost ($)

$35,000
$30,000
$25,000
$20,000
$15,000
$10,000 Dec
$5,000 Jan Aug
$0
500

1,000

1,500

2,000

2,500

3,000
Cups of Yogurt
Note: The first two actual data points (for December and January) are “hidden” behind
the first two points of the estimated line.

d. The months with the lowest and highest activity levels are January and August,
respectively. Accordingly, we have:

January: $5,500 = FC + (UVC  1,000)

August: $8,125 = FC + (UVC  2,500).

Performing procedures analogous to those in parts [b] and [c] we find UVC = $1.75 and
FC = $3,750. Thus, Yin-Yang’s cost function would be modeled as:

Total monthly costs = $3,750 + ($1.75  cups of yogurt).

The following graph shows this estimate vis-à-vis the actual data:

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$14,000

$12,000
Total Cost ($)

$10,000

$8,000
Aug
$6,000 n
Jan
$4,000

$2,000

$0
500

1,000

1,500

2,000

2,500

3,000
Cups of Yogurt

e. Using Excel, we obtain the following regression equation and output when we include
the data for December:

Regression Statistics
R-Square 34.5%
Adjusted R-Square 28.0%
Observations 12

Standard
Coefficients Error t statistic p-value
Intercept 5223.91 796.46 6.55 0.00
Cups sold 1.03 0.44 2.29 0.04

This equation indicates a questionable fit between the two variables. The R-square
is somewhat low and the p-value for the independent variable is only marginally
significant.

The picture changes dramatically if we exclude the outlier (the observation

for December). We obtain the following:

Regression Statistics
R-Square 96.3%
Adjusted R-Square 95.95%
Observations 11

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Standard
Coefficients Error t statistic p-value
Intercept 4074.47 186.190 21.883 0.00
Cups sold 1.578 0.102 15.424 0.00

This equation indicates an excellent fit between the two variables. The R-square is at a
high level and the coefficient for the independent variable has a low p-value.

f. Using the highest and lowest activity levels (i.e., the cost equation estimated in part
[d]) appears to lead to the best estimate of Yin-Yang’s cost structure. The differences
between the actual and predicted costs using this estimate are rather small, indicating a
very good (exceptional) fit. This estimate clearly leads to a better specification of costs
than the estimates arrived at in parts [b] and [c] even though the month of January was
used in all of our specifications. Notice that we get markedly different specifications
depending on the other month chosen.

The estimate in part [b] is biased because there is little difference in the January and
February activity levels – only 200 cups of yogurt. Small deviations in cost vis-à-vis the
true underlying cost structure can lead to a biased estimate of variable costs (because the
denominator is small) and, in turn, fixed costs. For example, assume one of Yin-Yang’s
employees was sick for a week in January with the flu and that other employees had to
“cover” for his/her absence. Assume the sick employee was scheduled to work for 30
hours and would have made $200 for the week. This relatively “small” change would
have resulted in a variable cost estimate of $2.50 rather than $3.50 and a fixed cost
estimate of $3,200 rather than $2,000.

The estimate in part [c] is biased because the December cost data appears to be an outlier
(an extreme observation). For example, Ying-Yang could have paid its employees a
Christmas bonus and/or paid its annual property taxes in December. While these costs
would be incurred and recorded in December, they do not relate to cups of yogurt sold in
December. Including data tainted by such features might lead to inaccurate measures of
fixed and variable costs – indeed, we see that our estimate of fixed costs is negative
$24,500.

By itself, a negative fixed cost estimate is not enough to conclude that cost estimates are
incorrect. However, it is suggestive of errors, particularly when the relevant range is close
to zero. Moreover, this aspect of the problem illustrates that there is often more bias, or
measurement error, in total costs than in activity levels. Costs can be erratic and lumpy;
accounting systems can fail to capture the relation between spending and consumption.
This reinforces why activity levels, rather than costs, typically are the basis for selecting
data points.

More generally, instructors may wish to note that accounting conventions (e.g., cash
accounting) may result in costs for one month being recorded in another month. Because
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the high-low method uses only two observations, it is particularly susceptible to this kind
of error. Using the two activity levels rather than the two cost levels reduces such
concerns. These kinds of classification error have smaller effects on analyses that use all
available data, such as the regression method.

However, the exercise on the regression, part [e], shows the effect of an outlier even on
methods such as regression. This one observation skews the data considerably,
underscoring the importance of plotting data before analyzing it using regressions.

4.66
a. The high and the low observations correspond to year 3 and year 2, respectively.
Writing out the cost equation for these two data points, we have:

$1,475,000 = Fixed costs + (Variable cost per participant × 5,000 participants)

$1,122,500 = Fixed costs + (Variable cost per participant × 3,500 participants)

Solving for the UVC, or variable cost per participant, we find

UVC = $1,475,000 - $1,122,500 = $352,500 = $235 per participant

5,000 – 3,500 1,500

Variable cost per seminar participant = $235.00

Plugging this estimate into the high or the low value equation, we have:

Fixed costs = $300,000

Thus, we estimate Brad’s total annual cost equation as:

Total costs = $300,000 + ($235.00  number of seminar participants)

b. If Brad offers 20 seminars under the new format, then he will have 20 seminars × 230
participants per seminar = 4,600 participants for the year. Let us plug this number into the
cost equation to estimate total costs:

Total costs = $300,000 + ($235 × 4,600) = $1,381,000.

In turn, total revenues are:

Total revenues = $350 per participant × 4,600 participants = $1,610,000.

Subtracting total costs from total revenues, we find:

Profit before taxes = $1,610,000 – $1,381,000 = $229,000.

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 4-45

Comparing this profit estimate to Brad’s profit with offering 35 seminars under the
current format, it appears that Brad would make substantially less money ($229,000
versus $421,875) if he were to switch his seminar format.

c. Our classification of each cost is as follows: We note that the central office and
administration costs of $250,000 could be classified as either product-level or facility-
level costs, depending on how they are viewed. If the costs relate solely to running
seminars, then they would rightfully be classified as product-level costs. If the costs
relate to Brad’s entire business, which not only includes seminars but also includes
selling books and tapes, then they would be facility-level costs.

Cost Hierarchy
Cost Item Classification Explanation
Variable costs Unit level Varies with the
number of
participants
The cost for each Batch level Varies with the
seminar number of seminars
Cost of seminar Product level Required for
coordinator offering seminars.
Central office and Product Required to sustain
administration level/Facility level the business.

d. This question helps us see that the high-low method does not account well for batch-
and product-level costs. Let us re-estimate Brad’s costs and profit using account
classification:

35 Seminars 20 Seminars
Item Detail (125 per (230 per
seminar) seminar)
Total number of # of seminars × 125
participants persons per seminar; # of
seminars × 230 persons
per seminar. 4,375 4,600
Revenue Number of participants ×
$400; Number of $1,750,000 $1,610,000
participants × $350.
Variable costs $75 × total number of
participants 328,175 345,000
Costs for setting up $20,000 × number of
the seminars seminars; $25,000 ×
number of seminars. 700,000 500,000
Cost of seminar $50,000 – given
coordinator 50,000 50,000
Annual fixed $250,000 – given
operating costs 250,000 250,000
Profit before Taxes $421,875 $465,000

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The above detailed analysis suggests that Brad’s profit actually will be $465,000 if he
switches to the new seminar format. Moreover, Brad’s profit will increase by $465,000
– $421,875 = $43,125 if he switched to the new format.

e. The methods do lead to dramatically different answers. Based on our analysis in part
[b], it appeared that Brad would forego roughly $200,000 in profit if he were to switch
his seminar format. In part [d], however, we find that Brad’s profit would actually
increase if he were to switch formats.

Why do the two methods yield such different answers? The answer is that the high-low
method implicitly classifies batch-level and product-level costs as being variable (unit
level) or fixed (facility level). Thus, any cost estimates using the high-low method
implicitly assume no change in the production technology – that is, the batch size will
stay the same and the cost per batch or product will not change. For Brad, as long as the
batch size stays at 125 participants per seminar, our cost and profit estimates will be the
same under the two methods – notice that our profit estimates under the high-low method
and the account classification method are equivalent for 35 seminars with 125
participants per seminar.

The proposed seminar format changes the batch size from 125 to 230. Thus, Brad can
accommodate the same (or more) participants with fewer seminars – that is, the number
of batches decreases. In turn, the batch-level costs will decrease. (Equivalently, the batch
cost per participant decreases.) While the account classification method includes the
consequent decrease in cost, the high-low method, however, is still estimating costs as if
there were only 125 participants per seminar (or, approximately 4,600/125 = 36.8
seminars). Consequently, this method over-estimated costs by approximately $320,000 =
(16 “phantom” seminars × $20,000 per seminar).

Note: Instructors can use this exercise to note that methods such as the high-low method
estimate parameters of the cost function from historical data. Using these estimates to
project future costs implicitly assumes that the underlying cost structure is stable. (An
additional assumption, not covered in this case, is that we are operating within the
relevant range.) If the assumption is not valid, poor decision making can occur. The
account classification method is less subject to this error because it examines each cost
item individually.

4.67
a. Molly’s response indicates that she believes all of her costs are variable. That is, she
appears to believe that it costs $16.50 per CD regardless of the number of CDs sold.
Molly does not appear to realize that some of her costs are fixed, and therefore invariant
to sales volume (CDs sold), while some of her costs are variable and, indeed, increase
proportionally with sales volume. Many of Molly’s costs are likely to be fixed, including
costs associated with leasing the land and building, having full-time employees, a
computer network, etc.

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For this particular decision, Molly’s fixed costs are not controllable since she is operating
within the relevant range of activity. Thus, only variable costs will differ between the
decision to keep the selling price at $16.95 per CD or lower it to $14.95 per CD.

Going a step further, we would suggest that Molly’s decision should be made on the basis
of whether the increase in revenue associated with reducing the selling price is more than
the increase in variable costs associated with reducing the selling price.

b. The following graph depicts the relation between Molly’s total costs and CDs sold.

$200,000

$160,000
Total Costs

$120,000

$80,000

$40,000

$0
0 2,500 5,000 7,500 10,000 12,500 15,000
CD's Sold

The graph appears to confirm our intuition from part [a]. Indeed, a portion of Molly’s
costs appear to vary directly with the number of CDs sold and a portion appears to be
fixed. Based on the plotted data, it appears that we can reasonably represent Molly’s costs
by a straight line with a positive slope and a positive intercept. That is, Molly’s total costs
can reasonably be represented as:

Total Costs = Fixed costs + (variable cost per CD  # of CDs sold).

c. The high-low method stipulates choosing the highest and lowest levels of activity. For
Molly, this corresponds to December and August, respectively. Accordingly, we have:

HIGH (December): $170,000 = fixed costs + 12,000 CDs sold  Variable cost per CD
LOW (August): $125,000 = fixed costs + 6,000 CDs sold  variable cost per CD.

Solving for the UVC, or variable cost per pillow, we find

UVC = $170,000 - $125,000 = $45,000 = $7.50 per CD sold

12,000 – 6,000 6,000

Plugging this estimate into either equation yields fixed costs = $80,000. Thus, Molly’s
monthly cost equation is:

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Total Monthly Costs = $80,000 + (# of CDs sold  $7.50).

The following graph shows this estimate in terms of the actual data:

$200,00
0
$160,00
0
$120,00
Total0
Cost $80,00
s 0
$40,00
0
$
0 0 2,50 5,00 7,50 10,00 12,50 15,00
0 0 0 0 0 0
CDs’ Sold

The estimated cost equation appears to fit the data extremely well as the differences
between actual and predicted costs are very “small.” This good fit indicates a strong
relation between the number of CDs sold and total costs.

d. As a first step, it probably is useful to restate Molly’s model in terms of annual costs.
This requires us to multiply monthly fixed costs by 12. The variable cost per CD,
however, remains unchanged. Thus, we have:

Total Annual Costs = ($80,000  12) + (# of CDs sold  $7.50).

Total Annual Costs = $960,000 + (# of CDs sold  $7.50).

If reducing the selling price to $14.95 increases volume by 30%, then annual CD sales
are expected to be: 1.30  106,900 = 138,970. In turn, our estimate of Molly’s total
annual costs = $960,000 + (138,970  7.50) = $2,002,275.

At this new level of volume, revenue is expected to be 138,970  $14.95 =

$2,077,601.50. Thus, expected profit = $2,077,601.50 – $2,002, 275.00 = $75,326.50.

Compared to last year’s profit, Molly’s profit would increase by $75,326.50 – $48,105.00
= $27,221.50.

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A student might ask if last year’s profit is the right benchmark for computing the change
in expected profit. This question arises because last year’s data is the actual cost. That is,
it includes any random factors that might have affected costs last year (e.g., an
unanticipated increase in utility rates because of a cold winter.) Thus, we also need to use
the model to estimate profit if volume in the coming year were to remain the same as the
previous year. Assuming Molly sold the same number of CDs this year as last year, we
would estimate Molly’s profit as $1,811,955 – [$960,000 + (7.50  106,900)] = $50,205.
Thus, Molly’s expected increase in profit is $75,326.50 – $50,205.00 = $25,121.50.

Based on these calculations, Molly should follow your advice as her profit is
expected to increase by 50%.

e. Here, we can compare the controllable revenues associated with hiring the new
employee to the controllable costs associated with hiring the new employee.

The controllable costs associated with hiring the new employee equal the employees
salary plus the variable costs associated with selling another 750 CDs a month, or 750 ×
12 = 9,000 CDs per year. Specifically, we have:

Annual cost of hiring new employee = $52,150 + (9,000 × $7.50) = $119,650.

The annual revenues associated with hiring the new employee = $14.95 × 9,000 =
$134,550.

Thus, the new employee is expected to increase Molly’s profit by $134,550 – $119,650
= $14,900. Molly should therefore hire the new employee. Notice that knowledge of
Molly’s cost structure, i.e., that the variable cost per CD = $7.50, is extremely helpful in
making this decision – without this piece of information, we would not be able to
calculate the controllable costs associated with hiring the new employee and, in turn,
whether the new employee should be hired.

f. The amount paid for the CDs is long-gone (sunk) and is not relevant to the decision at
hand. In holding on to the CDs, Molly needs to consider the likelihood that she will sell
the CDs in the future and the amount that she will receive from selling the CDs. The
expected revenue from future sales is Molly’s opportunity cost of declining the offer.
Thus, if Molly does not expect to make more than $15 in the future, then she should sell
them now. Since Molly has not sold a single CD in the past 7 years, it is unlikely that a
better offer will come along. Overall, Molly would be hard-pressed not to accept the
offer.

Note: As we will learn in Chapter 5, Molly’s opportunity cost also depends on whether
her shelf space is constrained. If yes, then the opportunity cost of selling the CD would
include the amount lost from not being able to use the space to sell other CDs.

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4.68
a. Casey’s annual customer contribution statement is presented below:

Annual Customer Contribution Statement

Item Commercial Residential Total

Fee per engagement $150 $80
Engagements per week 6 6
Revenue per week $900 $480 $1,380

Variable Costs per week

Supplies1 180 120 300
Cost of labor2 450 180 630
Weekly contribution margin $270 $180 $450
# of weeks 50 50 50
Annual Contribution Margin $13,500 $9,000 $22,500

Traceable fixed costs

Advertising cost $5,000 $5,000
Direct equipment $1,500 1,500
Hired help for 2 weeks3 300 300
Segment Margin $11,700 $4,000 $15,700

Common fixed costs

Common equipment4 $5,500
Office Expenses $1,500
Profit before Taxes $8,700
1
$180 = $30 × 6; $120 = $20 × 6
2
$450 = 10 hours per day × $15 per hour × 3 days per week; $180 = 6 hours per day ×
$15 per hour × 2 days per week;
3
= 6 motels per week × 2 weeks × ($175 cost – $150 fee). Note: We classify this as a
traceable fixed cost as it is a constant amount per year and it is purely associated with
Casey’s motel business.
4
= $7,000 – $1,500 in equipment attributable solely to motel cleaning jobs.

Thus, we see that Casey earns a total of $8,700 in profit + ($630 × 50 weeks per year) =
$40,200 in proceeds from his cleaning business. We also see the source of Casey’s
concern – he earns $300/10 = $30 per hour in revenue from the motels and $240/6 = $40
per hour in revenue from his residential business. This, however, does not take into
consideration the differential costs incurred to serve the residences and motels. Indeed,
the segment margins seem to indicate that the motel business is more profitable than the
residential business – we explore this further below.

b. Casey should not drop his motel business. His profit from doubling his residential
business is:

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Twice the current contribution margin $18,000

Less: Advertising 10,000
Less: Common equipment 5,500
Less: Office expenses 1,500
Profit before Taxes $1,000

Adding his wages, Casey receives $1,000 + (30 hours per week × $15 per hour × 50
weeks per year) = $23,500 in proceeds from his business. Thus, Casey receives $40,200 –
$23,500 = $16,700 less in annual proceeds if he drops the motel business.

However, Casey would be putting in fewer hours if he drops the motel business (i.e.,
comparing proceeds is not an “apples to apples” comparison). Casey saves (10 – 6) × 3
days per week × 50 weeks per year = 600 hours per year, and if he values this time at $15
per hour, this amounts to $9,000 = (600 hours × $15 per hour). This savings, however,
does not make up for the $16,700.

We do note the importance of being careful when using estimates for the opportunity cost
of time. We are implicitly assuming that Casey values his time at $15 per hour, regardless
of the number of hours of leisure. This may not be a reasonable assumption as there is
decreasing marginal utility for any normal good. This problem underscores the value of
contribution margin statements and their ability to aid decision making.

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 CHAPTER 5
Cost-Volume-Profit Analysis
Solutions

Review Questions

5.1 Profit before taxes = [(Price – Unit variable cost) × Sales volume in units] – Fixed
costs = Unit contribution margin × Sales volume in units – Fixed costs.

5.2 The contribution margin statement.

5.3 The sales volume at which profit equals zero.

5.4 The sales dollars at which profit equals zero.

5.5 The unit contribution margin divided by price.

5.6 Taxes reduce profit by a certain percentage beyond the breakeven point. Above
the breakeven point, the slope of the profit line decreases by taxes paid.

5.7 We can use the CVP relation to estimate profit at each price, quantity
combination.

5.8 The amount by which sales exceed breakeven sales. It equals (Sales in units –
Breakeven volume)/Sales in Units or, equivalently, (Revenues – Breakeven
revenues)/Revenues.

5.9 The percentage change in profit = the percentage change in sales volume (or
revenues) × (1/Margin of safety).

5.10 Operating leverage is a measure of risk from having more fixed costs. It equals
Fixed costs/Total costs.

5.11 The relative proportion in which a company expects to sell products – e.g., two
units of product A for every unit of product B.

5.12 The contribution margin per average unit.

5.13 The contribution margin per average sales dollar.

5.14 It is easier to work with revenues directly and comparing contribution margin
ratios across products makes more sense than comparing unit contribution
margins.

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5-2

5.15 (1) Revenues increase proportionally with sales volume, (2) variable costs
increase proportionally with sales volume, (3) selling prices, unit variable costs,
and fixed costs are known with certainty, (4) a single-period analysis, (5) a known
and constant product mix, (6) CVP analysis does not always provide the “best”
solution to a short-term decision, and (7) the availability of capacity.

Discussion Questions

5.16 Unit contribution margin equals unit selling price less unit variable cost.
Assuming that unit contribution margin is positive, unit selling price is a bigger
number than unit variable cost, and therefore a 10% increase in unit selling price
will increase the unit contribution margin more than a 10% decrease in unit
variable cost. To illustrate, let the unit selling price be $50 and the unit variable
cost be $30. The unit contribution margin will be $20 (=$50 - $30). A 10%
increase in unit selling price will increase the unit contribution margin to $25
(=$55 - $20), but a 10% reduction in unit variable cost will increase the unit
contribution margin to only $23 (= $50 - $27).

5.17 Profit before taxes = .15 * Revenues (fact 1)

Profit before taxes = .40*Revenues – $200,000 (fact 2)

Setting these equations equal to each other, we have:

Revenues = $200,000/.25 = $800,000.

5.18 It is generally advisable to conduct CVP analysis on a cash basis. Non-cash items
such as depreciation are not relevant. However, it is not uncommon to see CVP
analysis being used in conjunction with accounting profits---which would include
depreciation as an expense---rather than net cash flow. Such an analysis can be
particularly erroneous for start-ups and growth firms because the magnitude of
non-cash items or accruals is likely to be large.

5.19 Yes. Let us consider an example. Suppose the unit contribution margin is $5 and
the fixed costs are $200,000. The breakeven quantity then is 40,000 units
(=$200,000/$5). Let us say that the fixed costs increase by $100,000 to $300,000
but the unit contribution margin stays at $5. The new breakeven quantity is
60,000 (=$300,000/$5). That is, we need an additional volume of 20,000 units to
breakeven. We can also calculate this additional volume needed to breakeven by
dividing the change in fixed costs by the unit contribution margin (=$100,000/$5).

5.20 Many countries use a progressive tax structure. That is, the tax rate increases for
higher income brackets. However, the CVP analysis is fundamentally the same

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except that the profit equation is more elaborate. Consider an example where the
tax rate is 30% up to $300,000, but increases to 40% beyond $300,000. In this
case, we have to modify the computation of profit after taxes as:

If profit before taxes is less than or equal to $300,000 then

Profit after taxes = Profit before taxes × (1 – 30%)

If profit before taxes is greater than $300,000 then

Profit after taxes = $300,000 × (1 – 30%) +
(Profit before taxes - $300,000) × (1 – 40%)

Thus, for the first $300,000 of profit, the company would pay taxes at the rate of
30%; beyond $300,000 the applicable tax rate would be 40%. Keep in mind,
however, that having multiple tax brackets has no consequence for the calculation
of the breakeven point because, at the breakeven point, the profit is zero and there
are no taxes.

5.21 Yes, we can modify the CVP relation to include step costs. With step costs, fixed
costs do not stay fixed for all volumes. It stays fixed for a volume range beyond
which it increases to the next level. Consider, for example, a company that leases
a copier for its needs and pays a monthly rent. The copier has a certain fixed
capacity to make copies over a certain time. Until this capacity is reached, the rent
does not vary with the volume of copies made. However, once the company’s
copying needs exceeds its capacity, another copier may have to be rented and the
rent payment increases by a step to include the rent of the next copier.

When fixed cost increases in steps, the CVP analysis may have to be repeated a
few times to converge to the answer. Think about computing the breakeven point.
First, assume that the breakeven point would fall within the first step. With this
assumption, we can calculate the breakeven point in the usual manner described
in the text. If this calculation yields a breakeven point that is within the volume
range over which the fixed cost does not increase to the next step, we are done.
Otherwise, we change the fixed cost to the next step value and repeat our
breakeven calculation. We repeat this process until we reach a point where the
breakeven volume falls within the range of the assumed step fixed cost.

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5.22 Software companies typically have a high proportion of fixed costs in their cost
structure (i.e., high operating leverage) because their primary resource is trained
software professionals. Most of these professionals are paid fixed salaries and
wages that do not vary with the volume of software programs they generate, or
the number of software programs a company like Microsoft sells. Relatively
speaking, an automobile company such as Ford would have a greater proportion
of variable costs in its cost structure, although over time this proportion has
decreased because of increased automation.

5.23 The practice of selling the same good at different prices to different customers is
called discriminatory pricing. In general, the Robinson-Patman Act of 1936
prohibits discriminatory pricing in certain situations (such as, for example, a
wholesaler selling the same product to two retailers at different prices with the
purpose of influencing their competitive standings). However, in other situations,
such differential pricing may well be necessary depending on the nature of the
customer or the specific market (because of customer-specific or market-specific
costs). We discuss this aspect later in Chapter 10, when we discuss Customer
Profitability Analysis.

5.24 Margin of safety is a “cushion” that the existing level of operations allows
managers in dealing with operating risk. The smaller this cushion, the closer is the
manager to making a loss. Thus, when demand uncertainty increases
unexpectedly, this cushion “protects” managers from incurring losses. In such
situations, it gives them some room to offer discounts or promotions to keep up
the volume in the short-term in order to preserve profitability.

5.25 As the sales volume increases, the total variable costs increase but fixed costs stay
the same. Recall that operating leverage is the ratio of fixed costs to total costs.
Because fixed costs stay the same and the total costs increase (because of the
increase in variable costs), the operating leverage decreases.

5.26 As demand conditions fluctuate, short-term profits are more sensitive to

consequent changes in sales volume for firms with higher operating leverage. This
is why operating leverage is viewed as measure of risk. Referring to the text, the
operating leverage of Sierra Plastics increases with the new technology. Notice
that its profits (profit before taxes) fluctuate more with the sales volume with the
new technology than without the technology.

5.27 In general, divisions of large firms often have very different cost structures and
serve different markets. Because the CVP analysis is essentially a tool for short-
term decision making that helps managers in deciding the level of operations, it
makes more sense for individual divisional heads to perform CVP analysis at their
respective divisions. At the firm level, the effects of these short-term decisions
can then be aggregated to determine the overall state of the firm in the short run,
and which divisions are contributing in what measure in this respect.

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5.28 Yes. In general the unit of one product is not necessarily comparable to a unit of
another dissimilar product because they require different amounts of resources---
such as raw materials, labor, machining time, finishing time---to produce.
Therefore, we cannot say that the sports car is more profitable to produce because
its unit contribution margin is higher than the contribution margin of an entry-
level vehicle. However, with the contribution margin ratio, we can express
relative profitability in terms of sales dollars. We can say for instance that for
every sales dollar, the sports car contributes twenty cents toward profit (i.e., CMR
of 20%), and the entry-level vehicle contributes ten cents toward profit (i.e., CMR
of 10%).

5.29 CVP analysis should be considered as a convenient tool to understand the

relations between cost, volume and profit. It makes many assumptions as
discussed in the text. Let us consider a few assumptions and identify a setting in
which it would be violated.

 Assumption 1: Revenues increase proportionally with sales volume. This

assumption essentially means that price per unit is constant and does not vary
with volume. However, it is well known that as you decrease price per unit, you
can sell more and vice versa. In other words, price per unit and sales volume are
inversely related. When we allow for this possibility, this assumption is violated.
 Assumption 2: Variable costs increase proportionally with sales volume. In other
words, unit variable cost stays the same over the relevant range of operations so
that variable costs increase linearly with volume. This assumption will be violated
whenever the sales volume goes beyond relevant range (e.g., when firms stretch
existing capacity to meet demand). In such cases, variable costs can increase
more than proportionately.
 Assumption 3: Selling prices, unit variable costs, and fixed costs are known with
certainty. In the real world, we have to deal with uncertainty all the time. The
assumed selling price, and variable/fixed costs may turn out be different from the
actual price and costs because of changes in demand conditions or resource
availability.
 Assumption 4: Single-period analysis. Most business relationships extend beyond
a single period, and most short-term decisions have longer-term implications.
Please refer to a discussion of such implications in Chapter 2. Such implications
would result in a violation of this assumption.
 Assumption 5: Product-mix assumption. With many products, CVP analysis
assumes a known and constant product mix. However, in most instance, the
product-mix itself has to be decided. Changing the product-mix may be best the
way to react to changes in demand for the different products in the mix.

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Exercises

5.30 a. Clarissa’s contribution margin per cupcake = $2.00 = $2.50 – $0.50.

b. Breaking even implies a profit of zero. Thus, we have:

$0 = ($2.00  Breakeven volume) – $3,000

$3,000
Or, monthly breakeven volume = = 1,500 cupcakes
$2.00

c. We have:

$2,000 = $2.00  Required number of cupcakes – $3,000.

$3,000  $2,000
OR, Required cupcakes = = 2,500 cupcakes
$2.00

5.31 a. Clarissa’s contribution margin ratio = 80% = ($2.50 – $0.50)/$2.50.

b. We have:

$0 = (0.80  Breakeven revenues) – $3,000

Or, monthly breakeven revenues = $3,750

c. We have:

$2,000 = 0.80  Required revenues – $3,000.

OR, Required revenues = $6,250

5.32
a.

Unit contribution margin = Unit selling price – Unit variable cost.

= $3.00 – $1.00 = $2.00 per package.

The problem also informs us that Ajay’s fixed costs for the month = $600.

Thus, we have:

$0 = ($2.00  Breakeven volume) – $600,

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$600
Or, breakeven volume in packages = = 300 packages.
$2.00
b.
Substituting Ajay’s target profit of $1,400 into the expression for profit we
developed in part [a], we have:

$1,400 = $2.00  Required number of packages – $600.

$600  $1,400
OR, Required sales = = 1,000 packages.
$2.00

5.33 a.
A 50% increase changes Ajay’s variable costs from $1.00 per package to $1.00 
(1 + .50), or $1.50 per package.

Consequently, the revised unit contribution margin = $3.00 – $1.50 = $1.50 per
package.

Setting target profit to zero in the expression for profit, we obtain:

0 = $1.50  Breakeven volume – $600.

$600
OR, Breakeven volume = = 400 packages.
$1.50

b. Writing-out Ajay’s profit in detail, we have:

Profit before taxes = (Price – Unit variable cost)  number of packages – Fixed
costs.

Substituting using the given data, we have:

$2,400 = (Price – $1.00)  3,000 – $600.

OR, Price = $2.00.

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5.34
a.

For Shari, her contribution margin ratio is ($1.00 - $.25

$1.00
) = 0.75.
Additionally, her fixed costs amount to $6,000 per month. Thus, we have:

setting profit equal to $0, we have:

$0 = (.75  Breakeven revenue) – $6,000.

Breakeven revenue = $8,000.

b. Substituting sales of $10,000 into Gina’s profit calculation yields:

Profit before taxes = (0.75  $10,000) – $6,000 = $1,500.

5.35
a. We know that the profit equation is:

Profit before taxes = (unit contribution margin  sales volume in units) – fixed
costs.

At breakeven profit before taxes = 0. For Hercules, unit contribution margin is

revenue – variable costs = $100 - $35 = $65 per member per month. Fixed costs
are $40,950 per month. Substituting, we have:

0 = $65 × Breakeven volume - $40,950

Thus, breakeven volume = $40,950/$65 per member = 630 members.

b. First, let us gross up the after-tax target to a required pre-tax amount. We

know:

After tax profit = Pre-tax profit × (1- tax rate).

Plugging in the numbers, we have:

$11,375 / 0.65 = $17,500 = required pre-tax profit.

Using this estimate in the pre-tax profit equation, we have:

$17,500 = $65× required volume - $40,950

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Required volume = $58,450/$65 per member = 899 members (rounded).

c. We know from part [b] that Hercules needs to earn $17,500 before taxes to
reach its goal. We calculate the contribution margin ratio as $65/$100 = 0.65
or 65%. We know:

Profit before taxes = contribution margin ratio × required revenue – Fixed costs.
$17,500 = 0.65 × required revenue - $40,950

Required revenue = $89,900 (rounding down). Of course, we also can calculate

this answer from the answer to part [b]: 899 members × $100 per member =
$89,900.

d. The Margin of safety = [current sales – breakeven sales] / current sales.

Using the answer from part [a], we have: [950 - 630] /950 = 33.68 %

e. Operating leverage = Fixed cost / Total cost

= $40,950 / [40,950 + 950 × $35] = 55.19%

5.36

First, we need to calculate unit contribution and fixed costs. We have unit
contribution = (price – variable costs) = ($800 - $440 - $40) = $320. At a volume
of 15,000 units, fixed costs are $110 + $50 = $160 per unit, or $2,400,000 in total.

Then, from the profit equation:

0 = unit contribution × breakeven volume – fixed costs

0 = $320 per unit × breakeven volume - $2,400,000

Breakeven volume = $2,400,000 / $320 per unit = 7,500 units.

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5.37

a. Substituting a target profit of $3,600 into the monthly profit equation, we

have:

$3,600 = (0.75  Required revenue) – $6,000.

 $3,600
OR, Required revenue = ($6,0000.75 ) = $12,800 per month.
b. Substituting the data into Shari’s profit equation, we have:

$4,000 = (0.75  $15,000) – Fixed costs.

Maximum expenditure on fixed costs = $11,250 – $4,000 = $7,250.

5.38

a. Since profit and taxes = $0 at the breakeven point, we know that the profit
expression reduces to:

$0 = $1.00  Breakeven volume – $600,000.

Thus, Breakeven volume = 600,000 pounds.

b.

SpringFresh’s profit before taxes = ($1.00  750,000 pounds) – $600,000 =

$150,000.

Taxes paid = $150,000  .25 = $37,500.

Profit after taxes = $150,000  .75 = $112,500.

5.39

Profit after taxes = [(Unit contribution margin × Quantity) – Fixed costs]  (1 –

Tax rate).

$120,000 = [($1.00  Required volume in pounds) – $600,000] × .75.

Thus, Required volume = 760,000 pounds.

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5.40
a. In this case, “profit” is the amount left over after paying for fixed costs. We
have:

$21,000 = (# of attendees × $50) - $15,000

Or, we need 720 attendees.

b. Let us first write out the profit equation:

$21,000 = (# of attendees × $50) + (# of attendees × 0.50 × $20) - $15,000

Solving, we find # of attendees = 600

Effectively, the cash bar raises the contribution per member to $60, which
lowers the required volume.

5.41
a.

For Arena, the contribution margin ratio is 1 – 0.30 = 0.70 (70% of billings).

Further, Arena’s monthly fixed costs = $14,000 and the tax rate is 35%.

Consequently, Arena’s monthly profit is:

Profit after taxes = [(.70  Billings) – $14,000] × .65.

At the breakeven point, profit after taxes = profit before taxes = $0 (i.e., no tax is
due because there is no profit). Consequently, we have (since the tax rate is
irrelevant at breakeven):

$0 = (0.70  Breakeven revenue) – $14,000.

Solving, we find breakeven billings = $20,000.

b. Using the profit expression in [a], we have:

Profit before taxes = (0.70  $50,000) – $14,000 = $21,000.

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Profit after taxes = $21,000  .65 = $13,650.

c. Again, using the profit expression in (a), we have:

$7,280 = [(0.70  Required billings) – $14,000] × .65.

Required billings = $36,000.

5.42
a. The contribution margin ratio = ( Price - Unit variable cost ) .
Price

With Zap’s information, we have the contribution margin ratio

$22.00 - Unit variable cost
=( ) = 0.60.
$22.00

Unit variable cost = $8.80 for each “ZAP” kit.

Alternatively, from the formula for contribution margin ratio, notice that
Contribution margin ratio = 1 – (Unit variable cost/Price). The latter term is the
“variable cost ratio.” Then,

Contribution margin ratio = 1 – Variable cost ratio.

Applying the data from the problem, we have:

0.60 = 1 – Variable cost ratio, or Variable cost ratio = 40% of sales price

That is, unit variable cost = 0.40 × $22 = $8.80 per unit.

b. Let us use the profit expression:

Profit before taxes = (Contribution margin ratio  Revenue) – Fixed costs.

We know that Zap expects to break even at 17,500 “ZAP” kits – thus, Breakeven
revenue = 17,500 × $22.00 = $385,000. Additionally, we know that profit = $0 at
the breakeven point. Thus, we have:

$0 = (0.60  $385,000) – Fixed costs.

Solving, we find that fixed costs = $231,000.

Alternatively, we could use the unit contribution margin formulation. We can

calculate the breakeven point as:

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$0 = (Unit contribution margin  Breakeven volume) – Fixed costs.

From part [a], we know that the unit variable cost = $8.80. Because the selling
price = $22.00, we know that the unit contribution margin = $22.00 – $8.80 =
$13.20. Thus, we have:

$0 = ($13.20  17,500) – Fixed costs.

Again, we find that fixed costs = $231,000.

c. The free shipping and handling offer reduces Zap’s revenue per “ZAP” kit to
$20.00. With the knowledge acquired in parts [a] and [b] (i.e., the variable
cost per “ZAP” kit and Zap’s monthly fixed costs, respectively), we can
calculate Zap’s breakeven volume as:

$0 = (Unit contribution margin  Breakeven volume) – Fixed costs.

or, $0 = [($20.00 – $8.80)  Breakeven volume] – $231,000

Breakeven number of kits (Breakeven volume) = 20,625.

Consequently, Zap must sell an additional 20,625 – 17,500 = 3,125 kits to break
even if the company decides to offer “free” shipping.

Note: Instructors may wish to use this problem to emphasize the importance of
knowing both the unit contribution margin approach and the contribution margin
ratio approach. In part [a], it was necessary to use the contribution margin ratio to
arrive at the variable cost per unit. In part [c], however, the unit contribution margin
approach more readily accommodates a reduction in the sales price – i.e., it is
relatively straightforward to calculate the unit contribution margin. Calculating the
new contribution margin ratio is somewhat more involved, although it will lead to
an equivalent answer as the unit contribution margin approach. Moreover, the new
contribution margin ratio is (20 – 8.80)/20 = 0.56 or 56%.

5.43

Employing the CVP relation, we can compute the profit at alternative prices to
determine the price that yields the maximum profit. The following table contains
the detailed computations.

Variable
Price Revenue Costs Fixed Costs Profit
$32.50 $9,750 $1,800 $3,000 $4,950
$30.00 $10,500 $2,100 $3,000 $5,400
$27.50 $11,000 $2,400 $3,000 $5,600

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$25.00 $11,250 $2,700 $3,000 $5,550

$22.50 $11,250 $3,000 $3,000 $5,250

By inspection, we find $27.50 to be the profit-maximizing price. Greg earns

$5,600 in profit at this price.

Note: Instructors may wish to point out that firms may use a demand function
instead of using a demand schedule like the table above. A demand function gives
the revenue for every possible price. (For example, based on the data provided,
Greg’s demand function is: Quantity = 950 – 20 × Price). In this case, we use
calculus or numerical approximation techniques (via a spreadsheet such as
Excel’s solver function) to determine the profit-maximizing price.

5.44

a. One’s first inclination is to compare the profit across the various popcorn
machines. However, for the same number of customers, revenue is equal
across the three machines. Thus, we can rank order popcorn machines
according to their total costs. In other words, the problem can be formulated
as a cost minimization problem as the machine that minimizes cost also
maximizes profit.

We start by assessing the number of patrons at which the small popcorn machine
will cost the same as the medium popcorn machine. We have:

$6,000 + (0.50  number of patrons) = $12,000 + (0.35  number of patrons).

$6,000
The number of patrons at which the cost is the same = = 40,000.
.15

Thus, when a theater expects less than 40,000 moviegoers a year (or
approximately 110 per day), it is optimal to rent the small popcorn machine.

Comparing the medium and the large popcorn machines, we have:

$12,000 + (0.35  number of patrons) = $18,500 + (0.25  number of patrons).

$6,500
The number of patrons at which the cost is the same = = 65,000.
.10

Thus, when a theater expects more than 65,000 moviegoers a year (or
approximately 178 per day), it is optimal to rent the large popcorn machine.

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Additionally, the above analysis informs us that when a theater expects between
40,000 and 65,000 moviegoers a year, it is optimal to rent the medium popcorn
machine.

Thus, we have the following decision rule:

Midwest Cinema Theaters

Popcorn Machine Rental Model
Annual # of Moviegoers (M) Popcorn Machine Size
M < 40,000 Small
40,000 < M < 65,000 Medium
M > 65,000 Large

Note: Instructors also may wish to graphically represent the tradeoff – this is
perhaps best accomplished by asking students to graph, for each size popcorn
machine, how popcorn costs (y-axis) varies as a function of the number of patrons
(x-axis). This allows students to see where the lines cross – The instructor can
then shade the low cost frontier to see how the preferred machine depends on
expected volume.

b. Operating leverage = Fixed costs/Total costs

= Fixed costs/(Fixed costs + Variable costs).
For each popcorn machine, we have:

Fixed Costs Variable Costs Operating Leverage

Small $6,000 $32,500 .1558
(= 65,000 × $0.50)
Medium $12,000 $22,750 .3453
(= 65,000 × $0.35)
Large $18,500 $16,250 .5323
(= 65,000 × $0.25)

As discussed in the text, operating leverage frequently is used as a measure of risk

– ceteris paribus, the higher the operating leverage, the higher the risk. Thus,
while we see that the large popcorn machine is preferred for volumes of 65,000
moviegoers and higher, it also carries the highest risk, a factor that Leticia may
wish to consider in her decision.

5.45
Current sales - Breakeven sales
a. Margin of safety = ( )
Current sales

We first need to determine Cottage Bakery’s breakeven sales. Using the

contribution margin ratio to write the profit equation, we have:

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Profit before taxes = (Contribution margin ratio  Revenue) – Fixed costs.

Because we do not know Cottage Bakery’s fixed costs, we first have to use the
model to “back out” fixed costs and then derive breakeven sales. Accordingly,

$7,500 = (0.4  $150,000) – Fixed costs

Fixed costs = $52,500.

Next, setting target profit equal to $0 will allow us to calculate breakeven

revenue:

$0 = (0.4  Breakeven revenue) – $52,500

Breakeven revenue = $131,250.

Cottage Bakery’s Margin of safety = ($150,000 - $131,250

$150,000
) = 12.5%.
In dollars, the margin of safety equals $150,000 – $131,250 = $18,750.

b. Operating leverage = Fixed costs/Total costs.

We know that the contribution margin (in dollars) = Contribution margin ratio 
Revenue. Thus, we have:

Contribution margin = 0.4  150,000 = $60,000.

Because contribution margin = revenues – variable costs, variable costs can be

calculated as $90,000. Given that fixed costs are $52,500, the total costs are
$142,500.

Consequently, Operating leverage = fixed costs / total costs

= $52,500/$142,500 = 0.368 (rounded)

c. If 30% of the fixed costs represent non-cash expenses, the cash fixed expenses
equal: 0.70  $52,500 = $36,750.

We are now in a position to write the cash profit as:

Cash profit = (Contribution margin ratio  Revenue) – Cash fixed costs.

To calculate the breakeven point, we set cash profit = $0.

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$0 = (0.40  Cash breakeven revenue) – $36,750.

Cash breakeven revenue = $91,875.

Notice the large difference between the revenue required to breakeven on a cash
basis ($91,875) and the revenue required to breakeven on a non-cash (accrual)
basis ($131,250). Moreover, this problem presents a nice opportunity to talk with
students about which profit model is more germane to the firm. While cash basis
accounting may paint an unusual picture of the organization’s health (due to the
slippage between cash-basis accounting and “economic reality”), many
organizations (and people) need to ensure that they remain solvent/liquid in the
short-term and that cash expenditures do not exceed cash revenues.

5.46
a. Let us employ a weighted unit contribution margin approach to solve the
problem. For Mountain Maples, we have:

2,400 total trees sold – 800, or 1/3 are Butterfly, and 1,600, or 2/3, are Moonfire.
Thus, we have:

Weighted unit contribution margin = 1/3  $100 + 2/3  $50.

= $66.67.

In turn, Mountain Maples’ profit becomes:

Profit before taxes = ($66.67  total number of trees sold) – $75,000.

At the breakeven point, we have: $0 = ($66.67  Breakeven number of trees) –

$75,000.

Solving, we find that the total number of trees sold to breakeven = 1,125.

Of these, 1,125  1/3 = 375 Butterfly; 1,125  2/3 = 750 Moonfire.

b. Using the weighted unit contribution margin approach, we have:

$50,000 = ($66.67  total number of trees) – $75,000.

The total number of trees = 1,875.

Of these, 1,875  1/3 = 625 are Butterfly, and

1,875  2/3 = 1,250 are Moonfire

c. The change in the product mix affects Mountain Maple’s weighted

contribution.

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With the new information, we have:

Weighted contribution margin = (.50  $100) + (.50  $50)

= $75.00

The weighted contribution margin is higher than in part [a] because the product
mix has shifted toward Butterfly, which has the highest contribution margin per
tree.

Consequently, the total number of trees required to break even will decrease:

0 = ($75.00  Breakeven number of trees) – $75,000.

Breakeven number of trees = 1,000.

Of these, 1,000  .50 = 500 are Butterfly, and

1,000  .50 = 500 are Moonfire

5.47

Let’s use a weighted contribution margin ratio approach:

CMR (T1) = .75

CMR (T2) = .50

In turn, WCMR = .75 * .30 + .50 * .70 = .575

So, profit = .575 * total revenue – $161,000

Revenue (BE) = $280,000

This translates to .30 * $280,000 = $84,000 in revenue for T1; dividing by the selling
price of $40 gives us 2,100 units for T1.

This translates to .70 * $280,000 = $196,000 in revenue for T2; dividing by the selling
price of $60 gives us 3,267 (rounded) units for T2.

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5.48

a. In this setting, we must use the weighted contribution margin ratio approach
given the absence of unit-level data. Accordingly,:

Profit before taxes = (RevenueN  Contribution margin rationN) +

(RevenueU  Contribution margin ratioU) – Fixed costs,

The subscripts ‘N’ and ‘U’ stand for new and used. Additionally, we know that
$1,500,000/$2,000,000, or 75% of the revenue is from new cars, and
$500,000/$2,000,000, or 25% of the revenue is from used cars.

Further, we can calculate the contribution margin ratio for each product using the
product-level financial data. We have:

1,500,000  750,000
(Contribution margin ratio)N = = .50.
1,500,000

500,000  200,000
(Contribution margin ratio)U = = .60.
500,000

Thus, the weighted contribution margin ratio = (.50 × .75) + (.60 × .25) = .525.

We can now write Select’s profit in terms of the weighted contribution margin
ratio and total revenues:

Profit before taxes = (.525 × Total revenue) – $840,000.

Setting profit equal to $0, we find:

Breakeven total revenue = $1,600,000.

This translates into $1,600,000  .75 = $1,200,000 in new auto sales and
$1,600,000  .25 = $400,000 in used auto sales.

b. To answer this question, we plug in our desired profit in the equation for
profit developed in part [a]. We now have:

$1,050,000 = (.525  Total revenue) – $840,000.

Solving, we find:

Total revenue = $3,600,000.

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This translates into $3,600,000  .75 = $2,700,000 in new auto sales and
$3,600,000  .25 = $900,000 in used auto sales.

5.49
a. We know that individual and family memberships have a 3:1 ratio (900
individual to 300 families). Thus, the weighted contribution margin is:

[3 × ($100-$35) + 1 × ($150 -$60)] / 4 = $71.25.

Then, plugging into the profit equation, we have:

0 = $71.25 × total memberships - $42,750,

Total memberships = $42,750/$71.25 per average membership= 600.

At this volume, Hercules has (3/4) × 600 = 450 individual and (1/4) × 600 = 150
family memberships.

b. We calculate the contribution margin for individual and family memberships

at 0.65 (= [($100-$35)/$100] and 0.60 (= [($150-$60)/$150] respectively.

We know that individual and family memberships have a 2:1 ratio in terms of
total revenue (Individual revenue is 900 members × $100 per month = $90,000
and family revenue is 300 memberships × $150 per month = $45,000.) Thus, the
weighted contribution margin ratio is:

[(2/3) × 0.65 + (1/3) × 0.60] = 0.6333 = 63.33%.

Please note that we weight the individual contribution margin ratios by their
revenue shares. In contrast, we used the share of memberships to weight
individual contribution margins in part [a].

Plugging into the profit equation, we have:

0 = 0.63333 × total revenue - $42,750

Total membership revenues = $42,750/0.63333 = $67,500.

Note: You can verify this answer by using the answer for part [a]. Total revenue
realized at the answer to part [a] is 450 × $100 + 150 × $150 = $67,500.

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PROBLEMS
5.50
a.

Plugging in both the membership fee and the fixed and variable cost information
for Garnet’s Gym, we have:

Profit = [($500 – $200)  Number of members] – $1,200,000.

= ($300  Number of members) – $1,200,000.

To calculate the breakeven point in members, we set profit equal to $0 in the

expression for profit in [a]:

$0 = 300  Breakeven volume – $1,200,000.

Number of members required to break even = 4,000.

b. Here, we plug in the number of members from the previous year into the
profit equation developed in part [a]. Doing so yields:

Profit before taxes = ($300  5,000) – $1,200,000 = $300,000.

c. This strategy changes the annual membership fee to $500  .90 = $450. In
turn, this changes the per-member contribution margin to $450 – $200 = $250.
If membership increases to 6,500 because of the discount, then expected profit
is:

Profit before Taxes = ($250  6,500) – $1,200,000 = $425,000.

This action would increase profit by $125,000 (i.e., $425,000 – $300,000)

compared to the previous year.

This seems like a good option to increase profit unless there are significant
“congestion costs.” The owners probably should think through the soundness of
increasing membership by 1,500 persons, or 1,500/5,000 = 30%. It is possible that
this will translate to increased waiting time for machines and equipment, or
difficulty finding a parking spot. The owners may wish to survey current
members to assess their preferences.

d. We start with our finding from part [d] that profit is expected to be $425,000
if the owners reduce the membership fee. We set this amount equal to our
target profit and solve for the advertising expense. Accordingly, we have:

$425,000 = ($300  6,500) – $1,200,000 – Advertising.

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We find that the maximum advertising expenditure = $325,000.

In terms of comparing the options, the owners should assess which option is likely
to be more costly, in terms of foregone contribution margin or out-of-pocket
expense, and which option is likely to lead to the greatest increase in membership
(if this is the desired outcome).

5.51
a. Given the absence of unit-level data, we need to employ the contribution
margin ratio approach. Additionally, since we are asked to find the breakeven
point, and profit = $0 at the breakeven point, taxes are not relevant. Thus, we
have:

$0 = (Contribution margin ratio  Breakeven revenue) – Fixed costs.

For Precious Stone Jewelry, the contribution margin ratio is:

($1,000,000 - 600,000
$1,000,000
) = 40%.
Additionally, Precious Stone Jewelry’s fixed costs = $260,000. Thus, we have:

$0 = (0.40  Breakeven revenue) – $260,000.

Solving, we find breakeven revenue = $650,000.

b. Increasing the selling price by 20% will increase revenues by 20% (because
quantity stays the same) and, in turn, increase the contribution margin ratio.
First, we have:

Revised revenues = 1.20  1,000,000 = $1,200,000.

The new contribution margin ratio is: ($1,200,000 - 600,000

$1,200,000
) = 50%.
Thus, we have:

$0 = (0.50  Breakeven revenue) – $260,000.

Solving, we find breakeven revenue = $520,000. Thus, breakeven revenue

would decrease by $650,000 – $520,000 = $130,000.

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c. If variable costs decrease by 20%, new variable costs will be:

Variable costs = .80  600,000 = $480,000.

In turn, the new contribution margin ratio becomes: ( $1,000,000 - 480,000 ) =

$1,000,000
52%

Thus, we have:

$0 = (0.52  Breakeven revenue) – $260,000.

Solving, we find breakeven revenue = $500,000. Thus, breakeven revenue

would decrease by $650,000 – $500,000 = $150,000.

d. As discussed in part [a], taxes have no effect on the breakeven point. Since
taxes are a percentage of profit, any percentage of $0 is always $0. Thus, the
tax rate is not relevant. As illustrated in part [e], however, taxes are relevant
when the firm earns positive profit.

e. If all changes do take place, we have:

Revenues = $1,000,000  1.20 $1,200,000

Variable costs = $600,000  (1 – .20) 480,000

Contribution margin $720,000

Fixed costs (stay the same) 260,000

Profit before taxes $460,000

Taxes .30  $460,000 138,000

Profit after taxes $322,000

Thus, profit is expected to increase by $217,000, from $105,000 to $322,000.

Both the change in price and unit variable cost increase Precious Stone’s
contribution margin and, in turn, profit. The increase in the tax rate diminishes the
amount of Profit before taxes that Precious Stone retains – that is, the increase in
the tax rate reduces the slope of the profit after taxes line.

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5.52
a. The general model for the city’s snow removal costs looks like (notice that
there is no need for a revenue, or profit, component as the problem deals
strictly with cost):

Total costs = Fixed costs + (Variable cost per snowfall  Number of snowfalls).

We are provided with total costs and snowfall data for two separate years:

$300,000 = Fixed costs + Variable cost per snowfall  20.

$228,000 = Fixed costs + Variable cost per snowfall  12.

We now have two equations with two unknowns – accordingly, we can subtract
the second equation from the first equation. Doing so yields:

$72,000 = Variable cost per snowfall  8.

OR, variable cost per snowfall = $9,000.

Plugging this back into either year we find that fixed cost = $120,000. Thus, the
city’s snow removal costs can be calculated as:

Total Snow Removal Costs = $120,000 + ($9,000  Number of major

snowfalls).

b. For this question, it is simply a matter of plugging in the anticipated number

of snowfalls into the expression for snow removal costs developed in part [a].
We have:

Expected Snow Removal Costs = $120,000 + ($9,000  26) = $354,000.

Thus, the city should request $54,000 more than it spent this year.

5.53

The first step is to write Diamond Jubilee’s after-tax profit as follows:

Profit after taxes = (Total wagers – Winnings – Variable costs – Bonus – Fixed
costs)
 (1 – Tax rate).

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Because we are not provided with data regarding how much was wagered in total,
we will need to work with the contribution margin ratio approach. The model is
more involved because the bonus is a function of pre-tax income. We begin by
modeling pre-tax and pre-bonus profit:

Pre-tax and pre-bonus profit = (Contribution margin ratio  Total wagers) –

Fixed costs.

Here, contribution margin ratio is the contribution margin ratio without the
bonus; it is $1.00 – $0.82 – $0.08 = $0.10 or 10%. Further, fixed costs equal
$27,500. Thus, we have:

Pre-tax and pre-bonus profit = (.10  Total wagers) – $27,500.

We are now in a position to add the bonus payment to the model as the manager’s
bonus equals 5% of the pre-tax and pre-bonus profit. After subtracting the bonus,
which is 5% of the pre-tax and pre-bonus profit, we have pre-tax (but after bonus)
profit as:

Pre-tax profit = [(.10  Total wagers) – $27,500]  (1 – .05).

We can next add taxes to the model. With a tax rate of 25%, we have:

After-tax profit = {[(.10  Total wagers) – $27,500]  (1 – .05)}  (1 – .25).

At this point, we need only substitute the desired monthly after-tax, after-bonus
profit of $28,500. Thus,

$28,500 = {[(.10  Total wagers) – $27,500]  (1 – .05)}  (1 – .25).

Solving, we find that the required monthly level of total wagers (gross
gambling revenue) = $675,000.

This problem demonstrates how the fundamental CVP relation can be expanded
to incorporate additional short-term profit considerations such as bonuses and
taxes.

5.54
a. To calculate breakeven revenue, we start with the profit calculation using the
contribution-margin ratio:

Profit = (Contribution margin ratio  Revenue) – Fixed costs.

Setting profit = $0,

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Breakeven revenue = Fixed costs/Contribution margin ratio.

Given the information in the problem for each cost structure, we have:

Monthly breakeven revenue under current cost structure:

Fixed costs $36,000 per month
Contribution margin ratio 40%
Breakeven Revenue $36,000/0.40 = $90,000

Monthly breakeven revenue under new cost structure:

Fixed costs $60,000 per month
Contribution margin ratio 60%
Breakeven revenue $60,000/0.60 = $100,000

Thus, Cecelia’s breakeven revenue will increase by $10,000 if she acquires the
new machines. Even though her contribution margin ratio increases (which,
ceteris paribus, pushes the breakeven point down) by acquiring the new
machines, the substantial increase in fixed costs drives the breakeven point up.

b. As in part [a], the profit is:

Profit = (Contribution margin ratio  Revenue) – Fixed costs.

We now plug in the various parameters to determine profit under each cost
structure.

Current cost structure:

Profit at $95,000 in revenue = (0.40  $95,000) – $36,000 = $2,000.
Profit at $150,000 in revenue = (0.40  $150,000) – $36,000 = $24,000.

New cost structure:

Profit at $95,000 in revenue = (0.60  $95,000) – $60,000 = ($3,000).
Profit at $150,000 in revenue = (0.60  $150,000) – $60,000 = $30,000.

Thus, Cecelia prefers her current cost structure if monthly revenues are expected
to be $95,000, and she prefers to acquire the new machines if revenues are
expected to be $150,000.

c. We can find this point of indifference, or crossover point, by equating the

profit equation under the two cost structures and solving for revenue. Let the
required revenue level be $R. The profit at $R is:

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Current cost structure: (0.40  $R) – $36,000.

New cost structure: (0.60  $R) – $60,000.

Equating the two profit equations, we have:

(0.40  $R) – $36,000 = (0.60  $R) – $60,000.

$R = ($60,000 – $36,000)/(0.60 – 0.40) = $120,000.

With $120,000 of revenue, Cecelia makes the same profit of $12,000 with
either cost structure. Also notice that for sales greater than $120,000, Cecelia
prefers to acquire the new machines whereas for sales less than $120,000 Cecelia
prefers her current cost structure. That is, the slope of the profit line is higher
under the new cost structure than the old cost structure. Instructors may wish to
graph the two cost structures to illustrate this point.

5.55
a. The following table provides the profit computations (and comparisons) if
fixed costs were $1,500,000 per year and variable costs were $1 per copy.

Introductory Price $25/copy $15/copy $5/copy

Users (copies sold) 75,000 150,000 300,000
Year 1
Price per copy $25 $15 $5
Variable cost per copy $1 $1 $1
Contribution margin per copy $24 $14 $4
Total contribution margin $1,800,000 $2,100,000 $1,200,000
Fixed costs $1,500,000 $1,500,000 $1,500,000
Profit before taxes $300,000 $600,000 $(300,000)

Year 2
Price per copy $25 $25 $25
Variable cost per copy $1 $1 $1
Contribution margin per copy $24 $24 $24
Total contribution margin $1,800,000 $3,600,000 $7,200,000
Fixed costs $1,500,000 $1,500,000 $1,500,000
Profit before taxes $300,000 $2,100,000 $5,700,000

Year 1 + Year 2 Profit $600,000 $2,700,000 $5,400,000

The table clearly shows that Innova Solutions maximizes two-year profit by
setting an introductory price of $5 per copy (this would be true for just about any
discount rate).

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b. The following table provides the profit computations (and comparisons) if

fixed costs were $200,000 per year and variable costs were $15 per copy.

Introductory Price $25/copy $15/copy $5/copy

Users (copies sold) 75,000 150,000 300,000
Year 1
Price per copy $25 $15 $5
Variable cost per copy $15 $15 $15
Contribution margin per copy $10 $0 ($10)
Total contribution margin $750,000 $0 ($3,000,000)
Fixed costs $200,000 $200,000 $200,000
Profit before Taxes $550,000 ($200,000) ($3,200,000)

Year 2
Price per copy $25 $25 $25
Variable cost per copy $15 $15 $15
Contribution margin per copy $10 $10 $10
Total contribution margin $750,000 $1,500,000 $3,000,000
Fixed costs $200,000 $200,000 $200,000
Profit before Taxes $550,000 $1,300,000 $2,800,000

Year 1 + Year 2 Profit $1,100,000 $1,100,000 ($400,000)

Here, we see that Innova Solutions’ optimal pricing strategy changes – the table
shows that Innova Solutions probably is best off by setting an introductory price
of $25 per copy (inter temporal considerations also would lead Innova Solutions
to go with $25 rather than $15).

c. In an industry where an “installed base” of customers is important (as in

software or video games), firms often sacrifice today’s profit to build market
share and tomorrow’s profit. The key idea is that that the firm can increase
profitability in future years by taking advantage of consumers’ switching
(transaction) costs.

The efficacy of this strategy depends on the current period tradeoff between
demand and price. If demand increases sufficiently with a price drop, then the
strategy of going for a low introductory price can generate significantly more
profit in the long-run. However, as the tables show, the required increase in
demand increases as variable costs increase. For Innova, “low-balling”
maximized profit when the variable cost was low but not when the variable cost
was high. Thus, we often find such a pricing strategy being followed only by
those firms with low variable costs (equivalently, high contribution margin ratios)
as a percentage of price. While such a strategy may work for software or video
games, it is unlikely to work for auto manufacturers.

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By using Excel, it is relatively straightforward for firms to model the relationship

between price and resulting demand. Moreover, firms often spend considerable
effort and resources in constructing sophisticated models that capture the
economic forces of supply and demand.

5.56
a. This is a non-standard problem in the sense that there is no variable cost. That
said, we can view the commission as Brenda’s contribution margin ratio. With
this interpretation, the profit is:

Profit = (Contribution margin ratio  Transactions in dollars) – Fixed

costs.

To calculate monthly breakeven transactions, we set profit = $0 and fixed costs

equal to $18,000. This yields:

$0 = (0.03  Breakeven Transactions) – $18,000.

Thus, the volume of monthly transactions required to breakeven = $600,000.

current sales - breakeven sales

b. Margin of safety = ( ).
current sales

= ($1,000,000 - $600,000
$1,000,000
).
= 40%.

Thus, Brenda’s transaction volume could decrease by 40%, or $400,000 before

she incurs a loss in a month.

c. Using the setup from part [b], we find Brenda’s margin of safety for a
transaction volume of $1,200,000 to be:

Margin of safety = ($1,200,000 - $600,000

$1,200,000
) = 50%.
Similarly, for a transaction volume of $1,600,000, we find:

Margin of safety = ( $1,600,000 - $600,000 ) = 62.50%.

$1,600,000

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d. First, we notice that margin of safety only makes sense at a given sales
volume. As sales change, the margin of safety also changes. Second, we
notice that that margin of safety increases as transaction volume increases,
reflecting the additional sales over the breakeven volume of sales (and, hence,
a larger “cushion”). Finally, we notice that the relationship between sales and
margin of safety is non-linear. In Brenda’s case, 20% and 60% increases in
transaction volume lead to 25% and 56.25% increases in her margin of safety
— i.e., 25% = (50-40)/40; 56.25 = (62.50-40)/40.

5.57
a. We have enough information to construct condensed income statements for
each proposal:

Proposal 1 Proposal 2
Revenues $2,750,000 $2,750,000
Variable Costs* 1,100,000 1,925,000
Contribution Margin** $1,650,000 $825,000
Fixed Costs 1,500,000 675,000
Profit before Taxes $150,000 $150,000

* = (1 – .60)  $2,750,000; (1 – .30)  $2,750,000.

** can also be calculated as: .60  $2,750,000; .30  $2,750,000.

Thus, expected profit is equal under both proposals. Turning to operating

leverage, we have:

Operating leverage = Fixed costs/Total costs.

The condensed income statements provide us with all of the information

necessary to compute operating leverage:

Operating leverage (proposal 1) = $1,500,000/$2,600,000 = 0.577 (rounded).

Operating leverage (proposal 2) = $675,000/$2,600,000 = 0.260 (rounded).

The margin of safety = (current sales – breakeven sales)/current sales. Thus, we

need to calculate the breakeven revenue under each proposal. To do so, we
calculate profit using the contribution margin ratio. We have:

$0 = Contribution margin ratio  Breakeven revenue – Fixed costs;

Breakeven revenue = Fixed costs/Contribution margin ratio.
Thus:

Breakeven revenue (proposal 1) = $1,500,000/.6 = $2,500,000.

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Breakeven revenue (proposal 2) = $675,000/.3 = $2,250,000.

We are now in a position to calculate the margin of safety:

Margin of safety (proposal 1) = ($2,750,000 – $2,500,000)/$2,750,000 = .0909

(rounded).

Margin of safety (proposal 2) = ($2,750,000 – $2,250,000)/$2,750,000 = .1818

(rounded).

Now that we have performed all of the requisite calculations, we are in a position
to think about which proposal the bank is likely to support. This is a difficult
question. First, notice that expected profit is identical under each alternative.
Thus, we need to consider the proposals on some other dimension – the upside
potential and/or the downside risk. In terms of the upside, each additional dollar
of revenue generated under proposal #1 contributes $.60 to profit, whereas under
proposal 2, each additional dollar of revenue generated contributes only $.30 to
profit. Thus, proposal 1 has higher upside potential than proposal 2.

Both operating leverage and margin of safety provide us with some measure of
business risk and, hence, the downside. Operating leverage is a measure of the
extent of fixed costs in the business – notice that the first proposal has much
higher operating leverage. This is because the first proposal has significantly
higher fixed costs than the second proposal. The margin of safety provides us the
amount by which sales revenue could decrease before Dan is in the red. Notice
that the second proposal has a higher margin of safety than the first proposal –
thus, there is more of a cushion in the second proposal (as reflected by the lower
break-even point). Thus, proposal 1 has more downside risk than proposal 2.

We really need to get inside the banker’s head and think about his/her objective,
which likely is “will I get my money back?” Given this objective, a prudent (and
probably risk-averse) banker is likely to push the less risky proposal #2. This
conclusion is not, however, a fait accompli and this question can generate
interesting discussions about risk preferences and decision-making under
uncertainty.

b. To calculate profit, operating leverage, and margin of safety, we can repeat

our approach from part [a]. We have:

Proposal 1 Proposal 2
Revenues $4,500,000 $4,500,000
Variable Costs* 1,800,000 3,150,000
Contribution Margin** $2,700,000 $1,350,000

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Fixed Costs 1,500,000 675,000

Profit before Taxes $1,200,000 $675,000

* = (1 – .60)  $4,500,000; (1 – .30)  $4,500,000.

** = can also be calculated as: .60  $4,500,000; .30  $4,500,000.

Turning to operating leverage, we have:

Operating leverage (proposal 1) = $1,500,000/$3,300,000 = .455 (rounded).

Operating leverage (proposal 2) = $675,000/$3,825,000 = .176 (rounded).

For margin of safety, we have:

Margin of safety (proposal 1) = ($4,500,000 – $2,500,000)/$4,500,000 = .4444

(rounded).

Margin of safety (proposal 2) = ($4,500,000 – $2,250,000)/$4,500,000 = .50.

Notice that as sales increase, proposal 1 becomes more attractive relative to

proposal 2. First, expected profit is significantly higher ($525,000) under proposal
1 than proposal 2. Second, the upside potential of proposal 1 is higher than
proposal 2 – as discussed in part [a], each additional $ of revenue contributes
$0.60 to profit under proposal 1, but only $0.30 under proposal 2. Finally,
compared to part [a], the differences in operating leverage and, particularly, the
margin of safety between the proposals are smaller – proposal 1 is only slightly
riskier than proposal 2. Given the profit difference and minimal risk, a prudent
lender would likely push proposal 1 in this setting.

5.58
a.

Substituting for Campus Bagels’ specific information, we have:

Profit = [($1.00 – $0.25)  number of bagels sold] – $75,000.

At breakeven, $75,000/$0.75 = 100,000 bagels need to be sold.

b. Campus Bagels will now have two different products, bagels and bagel
sandwiches. Given the relative sales volumes (4 bagels to every 1 bagel
sandwich), let us calculate the weighted average contribution margin.

Weighted average contribution margin = 0.80*.75 + 0.20*3.25 = 1.25

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In turn, with the additional fixed costs of $27,350, we can express profit as:

Profit = [$1.25  number of “units” sold] – $102,350.

At breakeven, $102,350/$1.25 = 81,880 bagels and bagel sandwiches are sold.

This translates to 81,880*.8 = 65,504 bagels, and 81,880*.2 = 16,376
bagel sandwiches.

c. As calculated in part (b), this price is $4.

5.59
a.
The following table provides the required computations.

Retail Institutional
Traceable fixed costs 175,000 80,000
Allocated fixed cost 100,000 100,000
Total 275,000 180,000
Contribution margin ratio 66.67% 40%
Breakeven revenue $412,500 $450,000

At this volume, Jan breaks even for the entire company as well. After all, his total
fixed costs are $175,000 + $80,000 + $200,000 = $455,000. Then, at the
computed volumes, he generates a contribution of $412,500 × 0.6667 + $450,000
× 0.4 = $455,000. The firm also breaks even at the total level of $862,500.

b. Jan’s weighted contribution margin ratio is $480,000/$900,000 = 53.33%. With

this estimate, we can calculate breakeven revenue as

$455,000 / 0.53333 = $853,125

Or, $426,562.50 each in retail and institutional sales.

c. The answers in parts a and b differ because we “fix” different items. In part (b),
we fixed the sales mix to be 50% from each segment. With this assumption, the
breakeven sales are $853,125. However, sales mix is not fixed in part (a). Rather,
we have “fixed” the allocation to be $100,000 to each segment. Thus, the final
answer has a sales mix that is not 50-50 across the segments. Moreover, the fixed
cost also is not allocated in proportion to the sales mix at breakeven. In general, it
makes more sense to fix the sales mix as in part (b) in multi-product CVP
analysis.

d. In general, we perform multi-product CVP for the entire firm. This is

particularly appropriate when the products are similar (e.g., car dealership), are

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substitutes and share considerable fixed cost. However, we also encounter situations
in which products are distinct with few common fixed costs. In this case (e.g.,
divisions of General Electric or John Deere), it makes sense to compute a division
level break even.

5.60
a. Determining the product mix is the first step in computing the breakeven point
in a multi-product setting. In Kim’s case, we have the following per 10
customers:

Sandwich Soup Salad Drink

Price $4.00 $3.00 $3.00 $1.00
Unit variable cost $1.25 $1.00 $0.75 $0.25
Unit contribution $2.75 $2.00 $2.25 $0.75
margin
# of orders 5 7 4 6
Total contribution $13.75 $14.00 $9.00 $4.50
margin
Total Price: $20.00 $21.00 $12.00 $6.00

Thus, we can calculate Kim’s weighted contribution margin ratio as $41.25/$59 =

69.91%.

We are now in a position to write down Kim’s profit and compute her breakeven
sales. We have:

Profit = (0.6991 × revenue) – $4,950.

Setting profit = $0, we find:

Breakeven revenue = $4,950/0.6991 = $7,080.

Because 10 customers represent $59 in revenue, Kim needs to serve $7,080/$59 =

120 sets of customers = 1,200 customers per month to break even. At this volume,
Kim will serve 600 sandwiches (120  5), 840 bowls of soup (120  7), 480 salads
(120  4), and 720 bottles of water or cans of soda (120  6).

b. The “free” drink offer creates inter-relations among the products. Perhaps the
easiest way to deal with such complications is to modify the profit equation to
include both paid and free drinks. We can then re-compute the contribution
margin and selling price for a ‘bundled’ product. The following table provides
the detailed computations:

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Paid Free
Sandwich Soup Salad Drink Drink
Price $4.00 $3.00 $3.00 $1.00 $0.00
Unit variable cost $1.25 $1.00 $0.75 $0.25 $0.25
Unit contribution $2.75 $2.00 $2.25 $0.75 -$0.25
margin
# of orders 5 7 7 3 3
Total contribution $13.75 $14.00 $15.75 $2.25 -$.75
margin
Total Price: $20.00 $21.00 $21.00 $3.00 $0.00

Thus, the price for the product mix is $65.00, and its contribution margin is
$45.00.
In turn, Kim’s profit and breakeven sales are:

Profit = ($45  Quantity) – $4,950.

Setting profit = $0, we find:

Breakeven number of units = $4,950/$45 = 110.

Because each bundle represents 10 customers, Kim needs to serve 10  110 =

1,100 customers per month to breakeven. At this volume, Kim will serve 550
sandwiches (110  5), 770 bowls of soup (110  7), 770 salads (110  7), and 660
bottles of water or cans of soda (110  6). Kim also will generate 110  $65 =
$7,150 in revenue (i.e., her breakeven point in sales dollars is the breakeven
number of bundles multiplied by the revenue per bundle).

Thus, Kim needs to serve fewer customers) because the contribution margin for
every ten customers has increased. Notice that Kim’s required revenue, however,
has changed very little because her bundle selling price has increased by $6
compared to part [a] – this can be calculated as (3  $3 per salad) – (3  $1 per
water/soda) = $6.

5.61
a. We start by setting a price for a new textbook – this will allow us to calculate
the price of a used textbook and all of the associated variable costs. Let’s say
Pricenew = $100.

If Pricenew = $100, then Unit variable costnew = (.75  $100) + (.05  $100) = $80.

In turn, the contribution margin ratio on a new book = ($100$100- $80) = 20%.

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For Priceused we have .75  $100 = $75. The unit variable costused is: (.25  $100)
+ (.05  $100)* = $30.

* Note that the variable selling costs (in $ per book, not %) are the same between
new and used textbooks, or $5.

Accordingly, the contribution margin ratio on a used book = ($75$75- $30) = 60%.
If 40% of University Bookstore’s revenues come from used books and 60% come
from new books, we can write University Bookstore’s profit model as:

Profit = (.40 × Total revenues × .60) + (.60 × Total revenues × .20) – $360,000.

That is, the weighted contribution margin ratio = (.40 × .60) + (.60 × .20) = .36.

Setting profit equal to $0, we solve for the breakeven revenue as:

$0 = (.36 × Breakeven revenue) – $360,000.

Thus, Breakeven revenue = $1,000,000.

We can pick any number for the selling price of a new book because we
employed a contribution margin ratio formulation, where everything was
expressed as a % of selling price. Thus, breakeven revenue is invariant to the
selling price we choose (encourage students to try it!). Moreover, University
Bookstore needs to generate $1,000,000 in revenue to break even – the price per
book affects only the number of textbooks sold at the break-even point, not the
required revenue.

b. The important factor to consider here is the contribution margin in dollars ($),
not the contribution margin ratio (because the selling prices are different).

The contribution margin on a new book = $100 – $80 = $20.

The contribution margin on a used book = $75 – $30 = $45.

Thus, the University Bookstore makes $25 more per book on used books versus
new books. Therefore, it strictly prefers to sell used textbooks rather than new
textbooks. This explains why bookstores exert significant effort to acquire as
many used books as possible – the profit is higher!

Note: This relation holds regardless of the number students pick for the selling
price of a new book. For any selling price, x, University Bookstore receives .20x
in contribution margin (x – .75x – .05x); On a used book, University bookstore
receives .45x (.75x – .25x – .05x). Of course, for any positive selling price, .45x
strictly exceeds .20x.

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c. To provide for an equal contribution margin in $, University Bookstore would

set the price of a used textbook such that (based on our assumed numbers):

$20 = price (used) – $30. OR, price (used) = $50.

Thus, the price of a used textbook would be 50/100 = 50% of the price of a new
textbook.

Notice that the contribution margin ratio on a used textbook is now 20/50 = 40%.
Moreover, when considering the “bottom line” we need to consider the absolute
contribution margin, not necessarily the contribution margin ratios (unless, of
course, the selling prices are equal).

5.62
a. Tornado’s profit for the most recent year can be calculated as follows:

F1 F3 F5 Total
Revenues* $3,750,000 $3,000,000 $4,000,000 $10,750,000
Variable costs** $1,875,000 $1,650,000 $2,400,000 $5,925,000
Contribution margin $1,875,000 $1,350,000 $1,600,000 $4,825,000
Fixed costs $3,860,000
Profit $965,000

* = quantity sold  selling price per unit

** = quantity sold  variable cost per unit

b. There are at least two ways to answer this question. The longer and more
tedious way is to convert the increase (decrease) in sales to units for each of
the three alternatives – i.e., assume that Tornado focuses its advertising
campaign on the F1, F3, or F5 market. We can then multiply the sales
quantities by the appropriate contribution margin to compute the net increase
in margin under each alternative. Naturally, we select the option with the
highest margin.

The second, and more straightforward, approach is to use contribution margin

ratios – which deal with dollars directly. Using the given data, we have:

F1 F3 F5
Selling price per unit $150 $200 $400

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Variable cost per unit $75 $110 $240

Contribution margin .50 .45 .40
ratio*

* = (unit selling price – unit variable cost)/ unit selling price

That is, an increase of $1 in sales yields the greatest contribution if it is from the
F1 market. Consequently, it makes most sense for Tornado to focus its campaign
on the F1 market. The net effect on profit will be:

Gain from F1 market $300,000 .50  $600,000

Loss from F3 market ($27,000) .45  $60,000
Loss from F5 market ($24,000) .40  $60,000
Increase in fixed costs ($150,000) given
Net increase in profit $99,000

The skeptical student may wish to construct tables assuming the advertising
campaign were focused on the F3 or F5 market to verify that the strategy of
focusing on these markets indeed leads to lower profit than focusing on the F1
market.

This problem is useful in highlighting the difference between unit contribution

margins and contribution margin ratios. The unit contribution margin calculates
the absolute profit, and the contribution margin ratio calculates profitability. Thus,
we see that although the F5 has the largest contribution margin and, thus, on a per
unit basis contributes the most to absolute profit, it has the lowest profitability per
$1 of sales.

c. Management is making a number of assumptions. First, they are assuming that

the advertising campaign will work and lead to a substantial increase sales for
the targeted vacuum cleaner. Second, by assuming that the increase in revenue
will be constant at $600,000 regardless of the vacuum cleaner chosen,
management is assuming that the “demand kick” in units will be smallest for
the F5 and largest for the F1 (the F3 will be in the middle). Specifically,
estimated demand for each vacuum cleaner, should it be selected is:

F1: $600,000/150 = 4,000 units.

F3: $600,000/200 = 3,000 units.

F5: $600,000/400 = 1,500 units.

These proportions are roughly comparable to the current sales mix. Moreover,
management is assuming that the market is “thinner” for the F1 and “thicker” for
the F5 – this assumption makes some sense since, ceteris paribus, as price

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increases we expect quantity demanded (in aggregate) to decrease, particularly

when there are substitute products available.

Finally, management is assuming that the advertising campaign will cannibalize

existing sales – in other words, if the advertising campaign were targeted toward
the F3 market, some consumers who would have purchased the F1 or the F5
would, instead, purchase the F3. Again, the constant loss in revenue assumption
stipulates that fewer F5 customers will defect than F1 customers, and so on.
Moreover, this assumption reflects that while the vacuum cleaners are, to some
extent, substitutes, the elasticity of demand likely differs across the products.

5.63
a. The following graph depicts the relation between the number of families, Q,
and Jackrabbit Trails’ weekly total costs for 0  Q  20.

$8,000

$6,000
Total Cost ($)

$4,000

$2,000

$0
10

12

14

16

18

20
0

Quantity

Students may recognize that the shape of this cost function is similar to the cost
functions they studied in economics (students may also remember that the cubic
cost function closely approximates any cost function). The non-linearity reflects
economies/diseconomies of scale – i.e., average cost decreases up to a point, but
then increases. Such non-linearities are necessary to have a well-defined profit
maximization problem – with the typical linear setup if price exceeds variable
cost then the firm would push production up to arbitrarily high levels and make
unboundedly large profits.

b. The linear cost model is developed using the endpoints of Jackrabbit Trails’
relevant range, Q = 4 and Q = 16. The total cost at each of these points is:

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Total cost(4) = 1,000 + (300  4) – [20  (4)2] + 43 = $1,944.

Total cost(16) = 1,000 + (300  16) – [20  (16)2] + 163 = $4,776.

We are now in a position to find the slope (unit variable cost) and intercept (Fixed
cost):

Slope (unit variable cost) = ($4,776 – $1,944)/(16-4) = $236.

Thus, $1,944 = intercept + (4  236); or intercept = $1,000.

Jackrabbit Trails linear cost function is: TC = $1,000 + ($236 × Quantity).

The following graph depicts both the linear and non-linear cost functions:

$8,000

$6,000
Total Cost ($)

$4,000

$2,000

$0
10

12

14

16

18

20
0

Quantity

The fit looks reasonably good, and we can see that the deviations between the
linear and non-linear models are not very large (except, perhaps, for Q = 19, 20).
Moreover, the following table delineates the total cost under each model and the
corresponding difference in total cost:

Total Costs
Non-Linear Model Linear Model
1,000 + 300Q – 20Q2
Quantity + Q3 1,000 + 236Q Difference
0 $1,000 $1,000 $0
1 $1,281 $1,236 $45
2 $1,528 $1,472 $56

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3 $1,747 $1,708 $39

4 $1,944 $1,944 $0
5 $2,125 $2,180 -$55
6 $2,296 $2,416 -$120
7 $2,463 $2,652 -$189
8 $2,632 $2,888 -$256
9 $2,809 $3,124 -$315
10 $3,000 $3,360 -$360
11 $3,211 $3,596 -$385
12 $3,448 $3,832 -$384
13 $3,717 $4,068 -$351
14 $4,024 $4,304 -$280
15 $4,375 $4,540 -$165
16 $4,776 $4,776 $0
17 $5,233 $5,012 $221
18 $5,752 $5,248 $504
19 $6,339 $5,484 $855
20 $7,000 $5,720 $1,280
AVG: $3,367 $3,360 $7

c. The following table shows the profit for 0 to 20 families under each cost
structure (the quantity, price combination that would be chosen under each
structure and the resulting [expected] profit is in bold).

Profit
Non-Linear Linear
Quantity Price 1,000 + 300Q – 20Q2 1,000 + 236Q
+ Q3
0 1200 -$1,000 -$1,000
1 1150 -$131 -$86
2 1100 $672 $728
3 1050 $1,403 $1,442
4 1000 $2,056 $2,056
5 950 $2,625 $2,570
6 900 $3,104 $2,984
7 850 $3,487 $3,298
8 800 $3,768 $3,512
9 750 $3,941 $3,626
10 700 $4,000 $3,640
11 650 $3,939 $3,554
12 600 $3,752 $3,368
13 550 $3,433 $3,082
14 500 $2,976 $2,696
15 450 $2,375 $2,210
16 400 $1,624 $1,624

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17 350 $717 $938

18 300 -$352 $152
19 250 -$1,589 -$734
20 200 -$3,000 -$1,720
AVG: 700 $1,800 $1,807

Notice that Jackrabbit Trails would choose Price = $700 and Quantity = 10
families per week. This yields an expected profit of $4,000 under the non-linear
cost model and $3,640 under the linear cost model. One might be tempted to
conclude that the cost of using the linear model = $4,000 – $3,640 = $360, but
this would not be appropriate because costs will behave in their “true” fashion
once the pricing decision is made and, thus, yield identical profit as long as the
decision being made is the same (which it is).

We could, of course, push the problem around somewhat to show that linear
approximation of non-linear relations leads to errors in decision making. The
robustness of the linear model, though, is quite remarkable. In this problem, for
example, one would have to fit a rather poor linear relation to lead to an error in
pricing – e.g., use 0 and 20 families to compute the linear relation.

There are multiple benefits/reasons for using a linear model. First, organizations
often do not know their true cost curve and a linear setup is likely to be as good an
approximation as any other setup. Second, pragmatic considerations lead to linear
approximation – non-linear expressions are overbearing/overwhelming – there are
diminishing returns to keeping track of detail. Moreover, linear approximation is
one of the building blocks of accounting systems. In the particular problem at
hand, Jackrabbit Trails likely sacrifices little (if anything) by using a linear
approximation of its cost curve.

5.64
a. The profit is:

Profit before taxes = [(Price – unit variable cost)  Quantity] – Fixed cost.

The above equation assumes that the quantity sold is independent of price. This is
not a good assumption where markets are not perfect and the firm can influence
demand via its pricing strategy. As students recall from their microeconomics
course, we can represent the relation between selling price and demand by
constructing a demand curve.

Substituting the relation between quantity and price into the profit equation, we
get:

Profit = {(Price – unit variable cost)  [32,500 – (10  Price)]} – Fixed cost.

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Substituting the variable cost and fixed cost information gives us:

Profit = {(Price – 750)  [32,500 – (10  Price)]} – 14,000,000.

Re-arranging terms, we have:

Profit = 40,000Price – 10(Price)2 – $38,375,000.

b. Solving the revised profit equation for price is a bit more complicated than
before. We can solve for this by using calculus or numerically (e.g., using
Excel).

Using calculus, we find the profit maximizing quantity by differentiating the

profit equation with respect to price, setting the derivative equal to zero, and
solving for price. Thus, we have:

0 = 40,000 – (20 ×Price)

or, Price = $2,000 per unit.

Students trained in calculus can readily verify that the associated second order
condition (obtained by differentiating the first derivative with respect to P) is
negative, assuring us that the above equation yields the profit-maximizing price.
(i.e., the profit function is strictly concave).

Note that the fixed costs of $14,000,000 plays no role in setting the profit-
maximizing price. This is because fixed costs do not change as the price changes.
In the short-term, maximizing contribution margin is the same as maximizing
profit.

We also can solve for the profit-maximizing price by numerically approximation.

Consider the following table (with price ranging from $1,000 to $3,000 in
increments of $100).

Price Profit
$1,000 ($8,375,000)
$1,100 ($6,475,000)
$1,200 ($4,775,000)
$1,300 ($3,275,000)
$1,400 ($1,975,000)
$1,500 ($875,000)
$1,600 $25,000
$1,700 $725,000
$1,800 $1,225,000
$1,900 $1,525,000
$2,000 $1,625,000

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$2,100 $1,525,000
$2,200 $1,225,000
$2,300 $725,000
$2,400 $25,000
$2,500 ($875,000)
$2,600 ($1,975,000)
$2,700 ($3,275,000)
$2,800 ($4,775,000)
$2,900 ($6,475,000)
$3,000 ($8,375,000)

By inspection, we see that $2,000 is the profit-maximizing price within this set of
choices. By construction, this also turns out to be the profit-maximizing price. We
could also use the “solver” function in Excel to find the optimal price.

As a final point, instructors may wish to point out to students the “cost of getting
it wrong” – notice that if Mr. Park sets price in some random fashion, his business
could lose over $8,000,000 rather than earn a profit of $1,625,000. This can really
bring home the point regarding the importance of constructing an accurate profit
model.

MINI-CASES

5.65 Made to Order Caps.

a. The profit is:

Profit before taxes= [(Price – unit variable cost)  Quantity] – Fixed cost.

Based on the information provided, we have the following:

Profit = ($20.00 price – $4 cost of cap – $2 royalty per cap – $2.50 supplies per
cap – [.02  .75  20] expected credit card fees per cap) × Quantity – ($250 for
leaflets and brochures + $100 for phone lines + $1,970 for space and equipment +
$1,040* for additional help)

* = (76 hours the shop is open per week – 50 hours worked by Jessica each week)
 $10 per hour for temporary help × 4 weeks per month.

This reduces to:

Profit = [$11.2  Quantity] – $3,360

b. The breakeven point can be obtained by setting profit in the model from part
[a] above equal to $0. Thus, we have:

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$0 = ($11.20  Breakeven volume) – $3,360.

Solving, we obtain Breakeven volume = 300 caps.

At a planned price of $20 per cap, this translates to 300  $20 = $6,000 in revenue
per month.

Thus, in order to breakeven on a monthly basis, Jessica needs to sell

approximately 10 caps per day.

c. If Jessica sold 1,000 caps per month, her expected profit would be:

Profit = ($11.20  1,000) – $3,360 = $7,840

If Jessica wished to earn $4,032 per month, she would need to sell:

$4,032 = ($11.2  Q) – $3,360, or Q = 660 caps, roughly 22 caps per day.

d. First, notice that Jessica’s research informs her that at a price of $20, demand
is expected to be 300 caps per month – as we calculated in part [b], this is
Jessica’s breakeven point. Things don’t look good, but perhaps Jessica can do
better by exploiting her market research and newfound knowledge of the
demand schedule. Let us expand the table to compute Jessica’s expected profit
at alternate prices.

Note that expected profit in the table is based on the profit equation we developed
in part [a]. Specifically, we plug price and quantity into the following equation to
arrive at expected profit. Importantly, as the selling price and quantity change, so
too do the credit card company charges, which equal 2% of the selling price.

Profit = {[Price – 4 – 2 – 2.50 – (.02  .75  Price)] × Quantity} – $3,360.

OR, Profit = [(.985Price – 8.50) × Quantity] – $3,360.

Expected
Price per cap Demand Profit
$20 300 $0.00
$25 250 $671.25
$28 220 $837.60
$30 200 $850.00
$32 180 $783.60
$34 160 $638.40

Jessica maximizes her profit if she sets her price at $30 per cap as her expected
profit is highest ($850.00) at this price. Relative to setting the price at $20 per cap,

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the $30 price results in a lower volume (200 caps versus 300 caps). However, the
higher contribution margin per cap ($21.05 rather than $11.20) offsets this.

Note (can be skipped without loss of continuity) : Students with a background

in economics will notice that we can substitute the demand schedule with a
demand function. In this case, the relation between demand and price is

Quantity = 500 – (10 × Price).

We can modify the expression for profit to incorporate this new piece of
information. Thus, we have:

Profit= {[500 – (10  Price)]  (.985  Price – 8.5)} – $3,360.

This simplifies to:

Profit = 492.50(Price) – 9.85(Price)2 – 4,250 + 85P – 3,360.

Or, the relation between Jessica’s profit and price is:

Profit = 577.50(Price) – 9.85(Price)2 – 7,610.

We can solve for the best P using calculus or Excel’s solver function. The exact
answer is
P = $29.31 and expected profit is $854.63

e. Taxes affect profit in a relatively straightforward fashion. We can take the

profit model developed in part [d] and add the tax variable – doing so yields:

Profit after taxes = Profit before taxes – taxes paid.

Here, because taxes are proportional to income, taxes paid = (tax rate  pre-tax
profit). Adding this column yields:

Expected After-tax
Price per cap Demand Profit profit
$20 300 $0.00 $0.00
$25 250 $671.25 $503.44
$28 220 $837.60 $628.02
$30 200 $850.00 $637.50
$32 180 $783.60 $587.70
$34 160 $638.40 $478.80

The optimal price continues to be $30 per cap.

Notice that the optimal price does not change – this occurs because (in this

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example), taxes are a linear function of pre-tax profit. Thus, Jessica still wishes to
maximize pre-tax profit which, in turn, will also maximize after-tax profit. This
aspect of the problem allows instructors to discuss the relation between pre-tax
income and tax rates, including extending the discussion to non-linear relations
between pre-tax and after-tax income.

Taxes will, of course, reduce the amount of Jessica’s profit. In our example,
Jessica will now earn an after-tax monthly profit of:

$850  .75 = $637.50.

Note (Can skip without loss of continuity): In the calculus approach,

incorporating taxes yields

Profit after taxes = (577.50(Price) – 9.85(Price)2 – 7,610)  (1 – tax rate).

Since t = .25, we have:

Profit after taxes = (577.50(Price) – 9.85(Price)2 – 7,610)  (.75).

Profit after taxes = 433.125(Price) – 7.3875(Price)2 – 5707.50.

Again, we can solve for the best P using calculus or Excel’s solver function. The
exact answer is Price = $29.31 (which is exactly what we arrived at earlier).

f. While Jessica’s venture has intuitive appeal and our original calculations
seemed to indicate that the venture might be a “go” (after all, selling 22 hats a
day does not seem like a lot) the numbers simply do not add up. Given the
totality of the costs involved and Jessica’s market research, it appears that (at
best) Jessica will earn a very modest profit and will be unlikely to maintain a
reasonable lifestyle with this business.

We can see, though, how modest amounts add up – for example, if Jessica were to
“manage” 10 kiosks in various malls around the state, she could earn a reasonable
sum of money – this is precisely what franchisers seek to do.

5.66 Rick’s English Hut.

a. Currently, Rick’s is generating $60,000 in sales. For alcohol and food, this
translates to:

Alcohol Sales: $60,000  .55 = $33,000, or $33,000/$4 = 8,250 “alcohol units.”

Food Sales: $60,000  .45 = $27,000, or $27,000/$5 = 5,400 “food units.”

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Monthly profit can then be calculated as:

[8,250  ($4 – $2)] + [5,400  ($5 – $4)] – $10,950 = $10,950.

Because the proportions are defined in terms of revenue, it may be easier to solve
the problem using a contribution margin ratio approach.

The contribution margin ratio for food = (5 – 4)/5 = .20, and the contribution
margin ration for alcohol is (4 – 2)/4 = .50.

Thus, the profit can be calculated as:

Profit = ($33,000  0.50) + ($27,000  0.20) – $10,950 = $10,950.

To determine breakeven sales, we need to calculate a weighted contribution

margin ratio. Since 45% of revenue is from food and 55% is from alcohol, we
have:

Weighted contribution margin ratio = (0.45  0.20) + (0.55  0.50) = 0.365 or

36.5%.

The profit is then:

Profit = Weighted contribution margin ratio  Total Revenue – Fixed cost.

At the breakeven point, we have:

$0 = 0.365  Breakeven revenue – $10,950.

Breakeven revenue = $30,000.

Note: It is tempting to calculate a weighted unit contribution margin as (0.45 

$1) + (0.55  $2) = $1.55 – this is not appropriate, though, because the weights
are the ratio of revenue and not the ratio of the number of units sold.

For weighted unit contribution margin, we use unit contribution margins; the
weights must also be the ratio of units. If students employ this approach, the
weighted unit contribution margin = $1.60.

For weighted contribution margin ratio, we use the contribution margin ratio (i.e.,
contribution per revenue dollar); thus, the weights must be the ratio of revenue.
Students can go awry because they combine the revenue weights with unit
contribution margins.

b. Under this option, the proprietors of Rick’s have decided to change the
licensing status from a restaurant to a bar. In terms of calculating profit,

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revenue stays the same but Rick’s fixed costs have changed. Accordingly, we
have:

Profit = ($60,000  0.365) – $10,950 – $850 – $318 = $9,782.

Rick’s monthly profit has decreased by $1,168, which is the exact amount by
which fixed costs have increased.

For the breakeven point, the weighted contribution margin ratio stays the same;
the fixed costs, however, increase by $1,168 to $12,118:

Thus, Breakeven revenue = $12,118/0.365 = $33,200.

As would be expected, the breakeven point in revenue has increased.

c. Under the second option, Rick’s plans on closing early so that alcohol sales
equal the current level of food sales (the revenues from both products are
equal). With the new sales mix, the Weighted contribution margin ratio is:

Weighted contribution margin ratio (option 2) = 0.5  0.2 + 0.5  0.5 = 0.35.

Additionally, total revenues = $27,000 + $27,000 = $54,000 and fixed costs have
decreased by $450 to $10,500. Thus, we have:

Profit = $54,000  0.35 – $10,500 = $8,400.

This action has reduced Rick’s profit by $2,550 and, at this point, Rick’s would
prefer option 1 over option 2.

We also have:

$0 = 0.35  Breakeven revenue – $10,500.

Breakeven revenue = $10,500/0.35 = $30,000.

Notice that, compared to part [a] Rick’s breakeven point in revenue has stayed the
same even though total fixed costs have decreased. This occurs because the sales-
mix has shifted to a higher proportion of food items, which is the lower
contribution margin product.

Notice also that compared to option 1, the breakeven revenue is lower under
option 2 (although profit is higher under option 1). The increase in fixed costs
under option 1 requires Rick’s to sell more to breakeven – however, it does not
restrict the percentage of alcohol sales, so the upside potential is higher. If Rick’s
can maintain their current level of sales, they likely would pursue option 1 and bar
status.

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d. Under this option, Rick’s is planning to offer a brunch to make up for the
revenue shortfall from current food sales. From part [a], we know that the
difference in revenue is $6,000; thus, 6,000/4 = 1,500 brunches need to be
sold on the weekends. The brunches also have a negative contribution of -0.08
or a contribution margin ratio of -0.02 = ($4 – $4.08)/$4.

The mix of the revenue has also changed. The new weighted contribution margin
ratio is:

Weighted contribution margin ratio = (27/66)  0.2 + (33/66)  0.5 + (6/66)  (-

0.02) = 0.33.

With this Weighted contribution margin ratio, Rick’s profit is:

Profit = 0.33  $66,000 – $10,950 – $105 = $10,725.

Notice that this turns out to be Rick’s best option – profit is only $225 lower than
the most recent month.

For the breakeven point, we have:

Breakeven revenue = Fixed cost/ Weighted contribution margin ratio =

$11,055/0.33 = $33,500.

Notice that compared to option 1, the breakeven revenue is highest under option
3, although it is still considerably below the current sales level of $60,000 (and
anticipated sales level of $66,000). Profit also is $943 higher than option 1 and
$2,325 higher than option 2.

All in all, Rick’s would be hard-pressed not to select option 3.

e. Rick’s has learned the value and importance of profit planning at the portfolio
(aggregate or business) level rather than at the individual product level. What
in isolation appears to be a poor strategy, selling a product at a loss, turns out
to be the best strategy for the business as a whole. In essence, when
companies offer multiple products or services they need to consider the
relationships/externalities among these products and services. The profitability
of the business as a whole is of utmost concern, not the profitability of
individual products and services.

We frequently see such behavior by restaurants and bars – an establishment offers

very cheap food/appetizers (e.g., happy hours) to stimulate demand for higher
margin alcohol sales. In a similar vein, we also observe restaurants offering “kids
eat free” nights.

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Casinos in Las Vegas or Atlantic City perhaps provide the prototypical example
of this behavior. Casinos routinely offer “loss leaders” such as low-price meals
(e.g., buffets for $2 or $3), free drinks, and heavily discounted hotel rooms in
order to attract and retain customers on the more highly profitable gambling
activities. Casino owners make such concessions and offer “comps” to increase
profit on their primary product line.

Yet another example is banks – banks routinely offer free checking in an attempt
to get customers to keep their savings in the bank and/or purchase higher margin
home or auto loans. Finally, supermarkets frequently offer loss leaders – they
advertise specials on milk, bread, eggs, and the like. Such items are commonly
purchased goods and attract customers to the store. Once inside the store,
supermarkets hope that customers do the remainder of their shopping there,
buying fruits and vegetables, meats, chips, soda, and so on.

In all the examples, the fundamental point stays the same – it is important to do
profit planning and such planning is appropriately done at the “portfolio” level. In
short, the case makes a critical point – we need to think about the
interdependencies among the products and services being offered.

5.67
a. The cost graph would have units (in this case, cups of yogurt) on the x-axis
and dollars (total costs) on the y-axis. With regard to the total cost line, the
intercept, $3,000, represents Yin-Yang’s monthly fixed costs and the slope,
$2, represents Yin-Yang’s variable cost per cup of yogurt. The following
graph depicts Yin-Yang’s total costs as a function of the number of cups of
yogurt sold:

$10,000

Slope = unit variable costs

$8,000
= $2.00
Dollars ($)
$6,000

$4,000

$2,000 Intercept = Fixed Costs

= $3,000

$0 1,000 1,500 2,000 2,500

0 500

Cups of Yogurt

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b. We can readily add Yin-Yang’s revenue line to our previously-constructed

cost graph. The revenue line will start at the origin (after all, if we sell 0 cups
we have $0 in revenue) with a slope of $4, representing the price per cup of
yogurt. The point where the revenue line crosses the total cost line is the
breakeven point. We can drop a line down to the x-axis to read off the
required unit sales. We can drop a line to the y-axis to determine the required
revenue.

If the revenue line is above the total cost line, Yin-Yang will earn a profit.
Conversely, if the revenue line is below the total cost line, Yin-Yang will incur a
loss. All of these relationships are depicted on the following graph:

$10,000

$8,000 Profit Area

Loss Area
Dollars ($)
$6,000

$4,000

Breakeven Point =
$2,000 1,500 Cups of Yogurt

$0 1,000 1,500 2,000 2,500

0 500

Cups of Yogurt

c. By subtracting total costs from revenue, we obtain Yin-Yang’s profit graph.

This gives us the standard profit equation:

Profit before taxes = (Price – unit variable cost)  Quantity – Fixed costs.

For Yin-Yang, we have:

Profit before taxes = $2  Number of cups of yogurt sold – $3,000.

This line is depicted on the following graph.

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$4,000
Slope = unit contribution margin
= $2
Breakeven point =
$2,000 1,500 Cups of Yogurt
Loss Area
Profit ($)
$0 1,000 1,500 2,000 2,500
0 500

-$2,000 Profit Area

Intercept = - Fixed Costs

= -$3,000
-$4,000
Cups of Yogurt

The point where the profit line crosses the y-axis represents the net profit when
zero cups of yogurt are sold. That is, revenues, variable costs, and contribution
margin are all zero. Thus, profit at zero cups of yogurt = –fixed costs = –$3,000.

The slope of the profit line = the unit contribution margin; in Yin-Yang’s case,
this is $4 - $2 = $2. The point where the profit line crosses the x-axis represents
the breakeven point, or the point at which profit = $0. The profit and loss areas
can be identified by the profit line’s position relative to the x-axis. If the profit
line is above the x-axis, Yin-Yang earns a positive profit. Conversely, if the profit
line is below the x-axis, Yin-Yang will incur a loss.

d. Yin-Yang’s revised profit graph is presented below. Notice the kink in the
profit line because of the tax. The dotted line represents the original, untaxed
profit, and the solid line represents the after tax profit. The two lines are the
same below the breakeven point because no tax is due if the firm makes a loss.
The after-tax profit line is below the pre-tax profit line when the firm makes a
profit. The slope of the after tax line is smaller by the tax paid.

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$3,000
This portion
"disappears" with taxes

$1,500 No Change for

Profit < 0
Profit ($)

$0

1,000

1,500

2,000

2,500
500
0

-$1,500
Revised Profit Line
for Profit > 0

-$3,000
Cups of Yogurt

e. It is possible to construct a “revised” CVP graph without using data on units,

as indicated below. In this case, we represent Yin-Yang’s profit as:

Profit before taxes = (.50  Revenue) – $3,000.

Notice that we are plotting a net contribution line in place of the revenue and total
cost lines. The slope (or the steepness) of the contribution line is determined by
the contribution margin ratio, which in this case is .50. Moreover, the higher the
contribution margin ratio, the steeper the contribution line.

Note: Instructors may wish to mention to students that the contribution line will
always be less than the 45ْ line because the contribution per sales dollar cannot
exceed one.

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$3,000

Breakeven revenue =
$1,500 $6,000 = (1,500  4)
Loss Area
Revenue < $6,000
Profit ($)
$0 2,000 4,000 6,000 8,000 10,000
0

-$1,500
Profit Area
Revenue > $6,000

-$3,000
Revenue ($)

5.68
a. We have the following data regarding each technology:

Labor-Intensive Capital-Intensive
Technology Technology
Selling price per unit $75 $75
Variable cost per unit $50 $25
Unit contribution $25 $50
margin
Fixed costs $500,000 $2,500,000

We are now in a position to use the profit equation and solve for the breakeven
point under each technology. The profit is:

Profit = (Unit contribution margin  Quantity) – Fixed costs.

We know the contribution margin and level of fixed costs for each technology.
Additionally, we know that profit = $0 at the breakeven point. Thus:

Breakeven volume (labor intensive) = $500,000/$25 = 20,000 fishing rods.

Breakeven volume (capital intensive) = $2,500,000/$50 = 50,000 fishing rods.

b. We can use the profit for each technology to compute profit at the two sales
levels:

Profit (Labor-Intensive) = ($25  Sales in units) – $500,000.

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Profit (Capital-Intensive) = ($50  Sales in units) – $2,500,000.

Plugging-in sales of 40,000 and 90,000 units to each equation yields:

Technology
Labor-intensive Capital-intensive
Sales = 40,000 units  = $500,000  = ($500,000)
Sales = 90,000 units  = $1,750,000  = $2,000,000

Thus, at sales of 40,000 units Kai prefers the labor-intensive technology and at
sales of 90,000 units Kai prefers the capital-intensive technology. We can find the
indifference point by setting the two profit equations equal to each other:

($25  Sales in units) – $500,000 = ($50  Sales in units) – $2,500,000.

We find that sales in units at which profit is equal between the options is:
80,000.

c. We present a graph of the profit line for each technology below:

$2,500,000
Labor-intensive
$2,000,000
Technology
$1,500,000
$1,000,000
$500,000
Profit

$0
0

20,000

40,000

60,000

80,000

100,000

-$500,000
-$1,000,000
Capital-intensive
-$1,500,000
Technology
-$2,000,000
-$2,500,000
Quantity

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The graph illustrates that the unit contribution margin is higher under the capital-
intensive technology, but so are the fixed costs. The net effect on breakeven sales
is ambiguous – in this particular case, breakeven sales increases under the capital
intensive technology as indicated in part [a]. Moreover, we see that for sales <
80,000 units Sally strictly prefers the labor-intensive technology, and for sales >
80,000 Sally strictly prefers the capital-intensive technology.

d. Using the probabilities given and the profit #’s calculated in part [b], we can
calculate expected profit as follows:

Expected profit (labor-intensive) =.5  $500,000 + .5  $1,750,000 =

$1,125,000.
Expected profit (capital-intensive) = .5  -$500,000 + .5  $2,000,000 =
$750,000.

Thus, expected profit is higher under the labor-intensive technology.

e. The range of profit is: $1,750,000 – $500,000 = $1,250,000 under the labor-
intensive technology. The corresponding range for the capital-intensive
technology is: $2,000,000 – ($500,000) = $2,500,000.

The capital-intensive technology has the greater range – it is twice as great as the
labor-intensive technology. The profit is much more variable with the capital-
intensive technology because each unit contributes a great deal more to profit than
under the labor-intensive technology. Looking at the graph from part [c], this
difference manifests itself via a steeper slope (unit contribution margin) under the
capital-intensive technology.

In terms of a choice of technology, the labor-intensive technology really seems to

be the preferred choice. Almost over the entire range, the labor-intensive
technology has the greater profit and, additionally, has much lower variability in
profit, implying less risk.

5.69
a. Note to Instructor: Many human rights organizations have (in our view)
rightfully condemned the bidi industry for its extensive exploitation of labor
and, in particular, child labor. Bidi workers frequently are afflicted with lung
disorders and skin infections because of the hazardous nature of their job
where they are constantly exposed to fine tobacco dust. Additionally, bidi
workers typically are deprived of even minimum health benefits and
education. Finally, like cigarettes, smoking a bidi poses significant health
hazards to the user. Instructors may wish to use this problem to raise students’
social and health awareness.

To calculate the number of packs of bidis Ganesh must sell, we start with the
profit equation:

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Profit before taxes = (Unit contribution margin × Quantity) – Fixed costs.

Additionally,

Unit contribution margin = Price – unit variable cost.

= 3.00 – .75 – .25 = 2.00 Rupees per pack.

Finally, fixed costs = 1,075,000 Rupees and target profit = 750,000 Rupees.

With these pieces of information, we have:

750,000 = (2.00  required sales volume in units) – 1,075,000.

1,825,000
OR, required sales volume in units = = 912,500 packs.
2.00

b. We need to modify Ganesh’s CVP model to incorporate income taxes. We

start with the CVP model that includes taxes:

Profit after taxes = [(Unit contribution margin  Quantity) – Fixed costs] × (1 –

Tax rate).

With a 40% tax rate, we have:

750,000 = [(2.00  Required sales volume in units) – 1,075,000]  (1 –

.40).

OR, required sales volume in units = 1,162,500 packs.

We see that Ganesh now needs to sell 1,162,500 – 912,500 = 250,000 more packs
of bidis to earn a take-home profit of 750,000 Rupees per month.

An alternative method is to convert the after-tax profit to a pre-tax profit target.

Using the equation after-tax profit = (1 – tax rate)  pre-tax profit, we have:

750,000 = (1 – .40)  Pre-tax profit

Pre-tax profit = 1,250,000 Rupees.

We can then substitute this amount into the standard CVP model:

1,250,000 = (2.00  Required sales volume in units) – 1,075,000.

Again, we find that the number of packs = 1,162,500.

We currently have:

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c. Profit after taxes = [(2.00  Required sales volume in units) – 1,075,000] × (1

– .40).

The value-added tax can be viewed as an additional variable cost per pack of bidis
of:

(3.00 selling price – .75 materials cost)  .20 = 0.45 Rupees per pack; Thus,
Ganesh’s contribution margin is now 2.00 – 0.45 = 1.55 Rupees. In turn, if
Ganesh still desires an after-tax profit of 750,000 Rupees, we have:

750,000 = [(1.55  Required sales volume in units) – 1,075,000] × (1 – .40).

OR, Required sales volume in units = 1,500,000 packs.

Again, we see that taxes place additional demands on Ganesh’s business.

Compared to part [b], the firm needs to sell 1,500,000 – 1,162,500 = 337,500
more packs because of the VAT. Compared to part [a], the firm needs to sell
1,500,000 – 912,500 = 587,500 more packs because of both taxes.

Finally, notice that the value-added tax is deducted when calculating pre-tax
profit.

d. After part [c], Ganesh’s CVP model is now:

750,000 = [(1.55  Required sales volume in units) – 1,075,000] × (1 – .40).

The excise tax further reduces Ganesh’s contribution margin per pack of bidis – it
is now 1.55 – .05 = 1.50 Rupees. Accordingly, the new model is:

750,000 = [(1.50  Required sales volume in units) – 1,075,000] × (1 – .40).

Required sales = 1,550,000 packs of bidis (notice again that the excise tax is
deducted from pre-tax profit). We see that this tax further increases the amount
that must be sold to maintain a desired take-home profit. Collectively, all three
taxes require Ganesh to sell 1,550,000 – 912,500 = 637,500 more packs of bidis
to earn a take-home profit of 750,000 Rupees per month.

e. Both the value-added tax (VAT) and the excise tax are treated as variable
costs. Ganesh will incur these costs regardless of his profit level (as long as
the firm continues to produce bidis). The excise tax varies as a function of the
number of packs of bidis sold – it is a constant 0.05 Rupees per pack, and,
therefore, behaves like a variable cost. The VAT also varies with the packs of
bidis sold, but the amount of the tax depends on the ultimate selling price and
materials cost. Thus, this tax is a function of these two variables. To reduce
the VAT, notice that Ganesh has an incentive to “inflate” his materials cost

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numbers. Doing so reduces the added “value” and thus reduces the VAT
payable.

The income tax varies with pre-tax profit – it varies with all cost and revenue
variables that affect profit. It is, however, typically structured in steps – no tax on
negative or $0 in profit, with the percentages increasing as income increases.
Thus, we see that taxes alter firm’s CVP model in significant ways – the exact
nature of the change depends on the type and structure of the tax.

With regard to a sales tax (or tax on revenue), this tax is borne by consumers. As
such, firms ignore it in the CVP model (because sales taxes are explicitly
collected from customers). This does not, however, mean that sales taxes do not
affect a firm’s profit – sales taxes might indirectly affect profit by affecting
consumer demand – it is a cost consumers will consider in their
purchasing/consumption decisions. (Instructors may wish to link this to the
significant sales tax levied on tobacco products – states increase the costs to
consumers to discourage smoking. These are often termed “sin taxes.”)

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 CHAPTER 6
Decision Making in the Short Term
Solutions

REVIEW QUESTIONS

6.1 The temporary gaps between the demand and supply of available capacity.

6.2 The maximum volume of activity that a company can sustain with available
resources.

6.3 Because organizations make capacity decisions based on the expected volume of
operations over a horizon spanning many years. They build plants, buy
equipment, rent office space, and hire salaried personnel in anticipation of the
demand for their products and services.

6.4 (1) Decisions that deal with excess supply. Examples include reducing prices to
increase demand, running special promotions, processing special orders, and
using extra capacity to make production inputs in-house; (2) Decisions that deal
with excess demand. Examples include increasing prices to take advantage of
favorable demand conditions, meeting additional demand by outsourcing
production, and altering the product mix to focus on the most profitable ones.

6.5 This method focuses only on those costs and revenues that differ from the
benchmark option.

6.6 This method considers the gross revenues and costs associated with each option,
rather than the incremental amounts relative to the benchmark option.

6.7 The totals approach requires more computations because it includes some
noncontrollable benefits and costs.

6.8 In decisions involving many costs and benefits – it helps us ensure that we do not
“forget” to include a relevant cost or benefit.

6.9 Excess supply – usually, the firm cuts prices to increase demand.

6.10 In a make or buy decision, the firm is deciding whether to make a product, or
piece thereof, internally or outsource and buy them from a supplier.

6.11 When demand is high and a resource is in short supply.

6.12 To maximize profit when capacity is in short supply, maximize the contribution
margin per unit of capacity.

6.13 Typically on a qualitative basis – by considering how customers, suppliers, and

competitors might respond to the decision being made.

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DISCUSSION QUESTIONS

6.14 Yes, the definition of what is short-term and what is long-term depends on the
business context. For General Motors anywhere from few weeks to a few months
may be considered short-term, as pricing and promotion decisions depend on how
fast different models of cars and trucks are moving from the dealers’ inventories.
For a baker, a day or two days may be too long as baked goods do not retain their
“freshness’’ for long. Thus, product characteristics often play a critical role in
determining how “long” the short-term horizon is.

6.15 The reason why the lots are overflowing is that vehicles are not being sold at the
expected rate. Unsold vehicles occupy space in the lot. Thus, it is not correct to
define capacity in terms of the lot space available. Rather, capacity should be
defined in terms the number of vehicles that can potentially be sold per day. When
demand falls short of supply based on the anticipated number of vehicles to be sold
per day, lots overflow, and price-cutting and other promotions become necessary to
move the vehicles.

6.16 Raising prices, when unexpected demand for any product or service creates
temporary shortages, can often hurt businesses in the long run because such actions
can create customer ill will and lead to a loss in reputation. This is especially the
case when it comes to emergency situations. Think of how you would feel if a
grocery store that you frequent in your neighborhood raises prices on bottled water
as you prepare to deal with an approaching 4 hurricane.

6.17 Most of us drive to work, and so the demand for gasoline is fairly stable. One way
to economize on gasoline consumption is to car pool with your colleagues or others
that work near where you work.

6.18 Yes, it is. The gross method considers all cash inflows and cash outflows that are
associated with the options being considered in the context of a particular decision,
even though some of them may be non-controllable. But, it does not consider cash
flows associated with many other decisions that the companies may be considering.
From an overall organizational standpoint, each decision has an incremental effect,
and, therefore, the gross method is also incremental when viewed in this context.

6.19 Increasing prices is a natural way of decreasing demand. In fact, in most market
settings, demand for a product decreases as its price increases. When a firm does
not have enough capacity to meet a sudden spurt in demand, it can reduce the
demand by increasing prices and “turning away” some customers to a point where
the demand can be met. The airline industry is a good example. In peak times, an
increase in airfare induces some travelers to seek other means of travel or postpone
their travels. Only those that are able to afford the higher prices, or have rigid and
noncancelable schedules, will continue to travel.

Airlines often face few long-term adverse implications from increasing prices to
deal with peak demand situations. Air travelers usually understand this behavior

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and plan their travel accordingly. On the other hand, consulting companies rely on
longstanding relationships with their customers. Raising their rates when their
business is good usually backfires because it hurts reputation and goodwill in the
long-run.

6.20 Yes, it does. This is typically referred to as “production smoothing” and makes
good business sense as long the product is storable for sale in the future period, and
as long as inventory carrying costs are manageable. The toy industry and the
apparels industry are good examples.

6.21 Companies can produce and stock up during periods of lean demand to be ready for
peak periods whenever demand outstrips capacity. However, such use of inventory
is beneficial when demand follows reasonably predictable cycles of high and low
demand. On the other hand, whenever demand is low and there is considerable
uncertainty as to whether demand would rise again, producing and stocking for the
future may backfire.

6.22 One strategy is to invest less in capacity and rely more on outsourcing. By doing so,
the company would embrace a cost structure with less fixed costs and more variable
costs – that is, a cost structure with lower operating leverage. Another strategy is to
find other uses for capacity so that excess capacity can be put to profitable alternate
use during periods of lean demand (such as accepting special custom jobs, turn key
projects and so on).

6.23 The idea is to make the most profitable use of critical and expensive resources. The
opportunity cost of such a resource is by assumption, high. Any situation in which
such a resource has to wait because some other “cheaper” resource is in short
supply is undesirable. To avoid such situations, it makes more economic sense to
install excess capacity in other resources.

6.24 When a resource is in short supply, and it is used in a lumpy manner, calculating
contribution margin per unit of the resource to allocate its use to various products is
at best approximate and can often lead to wrong decisions. Advanced techniques
such as integer programming may have to be employed to come up with the right
way to allocate scarce resources to products in such settings.

6.25 Products requiring minimum production quantities involve committing requisite

amounts of capacity to these products if they are chosen production. Whenever
capacity is in short supply, such products may well necessitate leaving out products
with higher contribution margins per scarce capacity unit in order to meet their
minimum production requirements. The alternative is to not lock up capacity by
scheduling such products, but instead use the capacity to schedule products that
yield lower contribution margins per unit of the scarce capacity resource. The
consequent trade-off will determine whether it is profitable to make products with
minimum production requirements.

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6.26 Outsourcing reduces the amount of capital that needs to be invested in capacity
resources. It reduces the fixed costs in the cost structure, but increases the variable
costs. In other words, outsourcing increases the operating leverage. Unit variable
costs are usually higher with outsourcing relative to in-house production because
the profit margins of suppliers are part of the variable costs with outsourcing.
Therefore, unit contribution margins are usually lower with outsourcing. However,
outsourcing helps companies respond quickly to competitive pressures and to
advances in technology. Investing in capacity resources commits a company to a
certain technology over the longer term. If the technology becomes obsolete and the
demand drops, it is much costlier for the company to divest its assets and change
course.

6.27 Test marketing is a way to minimize the risk associated with large investments.
Offering a new product often involves putting in place and committing to various
organizational resources. Once the product is launched it is often extremely costly
to cut back should the product fail. The risk of failure is an inherent part of
business, and products do fail. But one way to reduce this risk is to do a small scale
launch aimed at representative customers. If this test marketing effort fails, then a
larger scale launch is unadvisable. Moreover, feedback from the test market is often
useful in redesigning the product to reduce the risk of failure.

6.28 Employee morale is a very important factor in outsourcing decisions – a loss in

morale adversely affects productivity and can lead talented personnel to leave the
organization on their own volition. Such costs can be substantial and, as such,
managers need to carefully consider these factors and weigh them against the
potential cost savings associated with outsourcing.

EXERCISES
6.29
a. Anja’s decision deals with excess demand. Due to the holidays, Anja expects
a surge in gift-wrapping needs. To handle this surge, Anja is considering
hiring a helper. This is akin to a manufacturing firm outsourcing some
production in periods of high demand.
b. We can approach this problem in two ways. One way is to calculate profit =
revenues – variable costs – fixed costs. We can construct the entire CVP
model for Anja. We then compare the profit under each option, selecting the
option with the higher profit. With the information provided, we have:

Without Helper With Helper

60 packages 110 packages
Per day per day
Daily revenue ($3  60; $3  110) $180.00 $330.00
Daily variable costs ($1  60; $1  110) 60.00 110.00
Daily pay for help (0; $8.50  10) 0.00 85.00

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Daily contribution Row 1– rows 2 & 3 $120.00 $135.00

Total contribution Row 4  30 $3,600.00 $4,050.00
Total fixed costs Given 600.00 600.00
Profit $3,000.00 $3,450.00

Comparing the total profit, we find that Anja’s profit increases by $450 ($3,450 –
$3,000) for the season, if she hires the helper. Accordingly, if she wishes to
maximize profit then Anja should hire the helper.

In constructing the income statement for each option, we could leave out the non-
controllable fixed costs of $600. While the absolute profit numbers would change,
the difference in profit would be preserved. Thus, the gross approach provides
decision makers some flexibility in terms of what is included and excluded from
the income statement.

We also could compute only the incremental revenues and costs associated with a
particular decision option relative to the status quo. Since operating without the
helper is the status quo, we have:

Incremental revenue 50 packages per day  $3 $150

Incremental variable cost (packages) 50 packages per day  $1 50
Incremental cost (helper) $8.50  10 hours 85
Incremental profit per day $15
Value of hiring helper $15  30days $450

Again, we see that Anja increases monthly profit by $450 if she hires a helper.
The difference in profit derived with controllable cost analysis exactly equals the
difference in profit under the gross approach. This underscores the equivalence of
the two approaches.

6.30
a. Dave and his brothers are dealing with excess supply situation because they
do not have any other job that day. If the offer is firm, they probably should
accept it because it is better to make $800 than to do nothing.
b. Now, they have an excess demand situation for five hours of their time
because they can only take one job. The new five hour job would pay them
$625. So they will make $175 less than the first job, but they have to work
three hours more on the first job to get this extra money. However, based
solely on the monetary considerations, they should accept the first job.

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6.31
a. Frank is offering a discount when faced with a low demand because lower
prices will induce more people to buy. Frank is charging a premium when
faced with high demand to take advantage of the high demand. By charging a
premium, Frank hopes to make a higher contribution margin. Purely
considering the demand and supply relation, Frank is behaving rationally.
b. The current contribution ratio is 0.40. So, variable costs are $0.60 per dollar.
With a ten percent discount, the variable cost does not change. The additional
discount is like a variable cost. So, Frank is making $0.30 for every dollar.
With a ten percent premium, Frank will be making $0.70 for every dollar.
c. The reason is that he is driving away loyal customers by his varying pricing
policy. A loyal customer does not want to pay more for the same bouquet s/he
has been buying for a long time just because there is unexpectedly high
demand on a given day. Such a policy is impersonal and does not build good
customer relations. Consequently, over time as these customers stop buying
flowers, demand decreases and Frank has to sell at a discount more often.

6.32
a. Magic Maids’ decision appears to feature both excess supply and excess
demand. It is likely that Magic Maids fixed overhead costs (rent and
administrative salaries) will not change due to the special job – it appears that
there is enough administrative capacity to handle the job. There is excess
demand for cleaning supplies; if the current jobs do not use up available stock,
the firm could store the supplies for use later. Finally, there might be limited
excess capacity for some resources. If 60% of the job could be completed
during normal business hours, then the company clearly has some slack and
excess capacity in terms of labor hours. For the remaining 40% of the job,
however, Magic Maids’ employees will have to work overtime – thus, there is
excess demand for this input. This shows us that different resources in the
firm have differing capacity levels – a decision may impose constraints on one
resource but not another. We have to consider the opportunity cost of each
resource when computing the total cost of a job.

Note: A precise definition of capacity is at the level of individual resources. Thus,

when computing the cost of an option, we have to consider opportunity costs at the
level of individual resources.

b. The following table details the incremental cost associated with cleaning the
150 offices, compared to the status quo of not cleaning the offices:

Item Detail Amount

Cleaning materials 150 offices × £12.50 per office £1,875
Labor1 150 × 3 × .40 × 15 × 1.5 £4,050
Variable overhead 150 offices × £7.50 per office £1,125
Incremental cost £7,050

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1
: There are 150 offices that need to be cleaned, and each office requires 3 hours
to clean. Since 60% of the job could be completed during regular business
hours, Magic Maids will only have to provide extra remuneration for 40% of
the hours. Further, employees are paid 1.50 times their hourly wage of £15 for
each overtime hour worked.

Note that fixed overhead, which is comprised of rent and administrative salaries,
is not relevant as it is very unlikely that the total amount of fixed overhead will
change if Magic Maids accepts the engagement.

Magic Maids incremental cost associated with cleaning the conglomerates 150
offices amount to £7,050.

c. Magic Maids can use the cost number for pricing the local conglomerate’s
request to clean the 150 offices. £7,050/150 = £47 per office likely would
represent the minimum price that Magic Maids would charge. This price is
well below Magic Maids normal price of £120.

The actual price charged will consider other factors. For instance, the client’s
other options become relevant. If this is a one-time deal with no prospect of repeat
business, then Magic Maids might well charge a premium over the normal price.
The prospect of “getting a foot in the door” to bid for future business would push
the price downward. Long-term implications also matter. If the conglomerate
becomes part of Magic Maids client base, then the company likely would wish to
make sure that the price charged in the long term would cover all incremental
costs (measured over the long term), and not only the incremental costs measured
over the short-term.

6.33
a. While set in a service setting, this is a classic example of an organization that
has excess capacity and is attempting to figure out how to price a special
order. It is like having open seats at a sporting event – it appears that the
rooms would otherwise remain idle if Erin and Kyle do not accept the
customer’s offer.

b. Because the rooms would otherwise remain idle, the lost profit associated with
turning down the customer is $200 – (3  $10) = $170 per customer, for a
total of $170  4 = $780 for four customers. Notice that the standard rate of
$180 per day is not relevant for computing this amount.

Erin and Kyle might be concerned that renting the rooms for a substantial
discount will tarnish the image of their Inn or adversely affect weekend (or other)
rentals. It is unlikely that this will occur because “time-based’ pricing is very
common. Hotels, airlines, and utility companies all charge more when demand is

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expected to be high and less when demand is expected to be low. (Think about the
cost of renting a hotel room in New Orleans during Mardi Gras versus renting the
same hotel room in mid-August when the temperatures and humidity are high) In
other words, customers naturally expect prices to reflect demand.

All things considered, Erin and Kyle would be hard pressed not to accept the offer
or to at least make a reasonable counter-offer (e.g., ask for $250 per person or
require the customers to share a room). Moreover, Erin and Kyle probably should
consider running weekday specials, perhaps reducing the rate to $100 a night
during the week to increase occupancy and maximize contribution margin.

However, we also note that such strategies might tarnish the “exclusive” nature of
the facility, depressing Erin’s ability to charge premium rates during the weekend.
Also, there would be higher wear-and-tear costs in the long run if occupancy were
to increase substantially. Erin’s decision turns on whether she considers this to be
a one-time deal or if this is the start of a new business strategy.

6.34
a. Jen’s decision deals with excess supply – due to the reduced demand for her
work, Jen finds herself with time to spare.

b. Jen’s variable cost of framing her own work is $300 = $10  30. Her
payments to the framing shop would be $750 = $25  30.

Thus, Jen will save $450 if she does her own framing. Notice that this
estimate is over-stated because it ignores the cost of the additional time it will
take Jen to frame her prints. The additional time has value because Jen could use
it for other activities that she might enjoy more than framing.

c. Jen’s problem is now more complex. By outsourcing the framing, Jen is able
to produce and sell an additional 15 prints; in turn, these prints generate an
additional contribution margin of $75 – $25 – $ 8 = $42 per print or $42  15
= $630 in total. Rightfully, we should add this amount to the cost of framing
of $100 per print or $100  15 = $150 for 15 prints, to obtain a total framing
cost of $150 + $630 = $780. Now, we see that Jen prefers to use the framing
shop rather than do her own framing.

What does our answer change? Compared to part [b], Jen does not have enough
idle time to keep up her current volume of prints and do her own framing. Thus,
the problem switches from one of excess supply (where we assumed the
opportunity cost of Jen’s time to be $0) to one with excess demand, where we find
the opportunity cost of Jen’s time to be $630. The nature of the imbalance drives
Jen’s preferred solution.

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Note: A preferred option is to frame some but not all of the prints. Using the
notion of allocating time per the contribution margin per unit of the scarce
resource, we could derive this formally.

6.35
a. Vroom has excess machining capacity that it can potentially gainfully use by
making the part that it currently is buying from an outside supplier.
b. The relevant costs for buying the part are $3,250,000 (= 20,000 * $150 per
component + $250,000 in supplier coordination costs). The relevant costs of
making are $1,900,000 (= 20,000 * $90 variable cost per part + $100,000 in
additional fixed costs). Note that the applied fixed overhead charge is not
relevant for this decision. So, Vroom saves $1,100,000 annually by making
the part.

6.36
The following table provides the estimated profit impact at the two prices considered:

Item Price for valet

parking
$5 per $10 per
month month
Revenue from service $2,000 $3,000
(400 × $5; 300 × $10)
Revenue from new members 2,000 1,000
(20 × $100; 10 × $100)
Cost of new members 700 350
(20 × $35; 10 × $35)
Cost of valet service 2,500 2,500
(given)
Net profit $800 $1,150

Based on the above estimates alone, Tom and Lynda should offer the valet service
and price it at $10 per month (not $5).

Please note the tradeoff between price and quantity. The tradeoff depends on how
much demand (for different products) changes as price changes. The tradeoff
from increasing price is favorable if we consider the revenue from current
members only. However, the effect on new members is unfavorable and large.
Also taking into consideration the increases in variable costs due to additional
membership, it appears that asking for $10 provides the best tradeoff.

Please also note that we are not considering any change in the club’s fixed costs
from adding new members. As we know from the earlier chapters, Hercules has
been losing members to Apex, meaning that it has excess capacity in terms of
members.

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6.37
a. Tom and Lynda’s decision turns on alternate uses for the space, or its
opportunity cost. The problem indicates the room is unused during this time.
There is minimal disruption of operations. Increases to direct costs, if any, are
small. Thus, the $600 offered by Marjorie would flow directly to profit.
Overall, Tom and Lynda should accept the offer.

b. The change in class timings changes the problem from one of excess supply to
one of excess demand. During the peak evening hours, there is considerable
demand for the room (which is why scheduling Marjorie’s class will displace
existing classes). Tom and Lynda therefore need to consider the best use of
the space during the evening hours. Using it for regular classes benefits the
membership, and prevents a loss of members. Using it for Marjorie’s classes
generates additional revenue. But, the opportunity cost is the loss of members,
valued at 8 × ($100 - $35) = $520 per month. The net gain from accepting
Marjorie’s offer is $700 - $520 = $180 per month.

c. We have:

Incremental fee due to evening class $100 $700-$600

Incremental membership fee lost ($800) 8 × $100
Incremental variable costs saved $280 8 × $35
Incremental profit ($420)

Based on the above, adding the evening class is an unwise move.

Notice that the value of the daytime only option is $600 (as calculated in part [a].)
The incremental value of the evening class, relative to the daytime class, is a loss
of $420, as calculated above. Adding these two numbers together, leads to $180,
the value (relative to status quo or doing nothing) for the evening option.

6.38
Similar to the Superior Cereals problem in the text, the key to this problem is to
realize that the variable costs associated with manufacturing the greeting cards are
sunk – thus, they are not relevant to Déjà Vu’s decision. Additionally, Déjà Vu’s
fixed costs are non-controllable for the decision, as they are not expected to
change. Thus, the problem is one of revenue maximization.

At a 50% off sale, Déjà Vu’s profit increases by $0.50 × 1,500 = $750.

At an 80% off sale, Déjà Vu’s profit increases by $0.20 × 4,000 = $800.

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Thus, Déjà Vu maximizes its profit by holding the 80% off sale, even though the
resulting price is below the $0.23 (= $0.15+$0.08) in variable costs associated
with producing and selling a card. What we need to remember is that this is the
variable cost of a card yet to be produced, not a card that has already been
produced.

Note: This problem links to a common business practice. Specifically, we often

observe stores employing a sequential discounting strategy – the store starts with,
for example, a 25% discount and increases the discount rate over time (perhaps by
as much as 15-25% a week). In this way, the store attempts to capture as much
consumer surplus (gross revenue) as possible by grouping customer types
according to their willingness to wait and run the risk of having the item selling
out. Such a strategy may work quite well for Déjà Vu – i.e., the company could
sell the first 1,500 cards at $0.50 and 4,000 – 1,500 = 2,500 cards at $0.20. By
employing such a strategy, Déjà Vu could earn:

Expected Profit = ($0.50 × 1,500) + ($0.20 × 2,500) = $1,250.

This amount represents a $450 (= $1,250 - $800) increase over its best option.

6.39
a. Under the gross approach, we include all of the costs connected with each
decision. We do not worry too much about whether they are controllable or
not. However, all of the costs listed in the problem appear to be related to the
trip and are controllable – costs such as apartment or dormitory rent and
tuition, which are not mentioned in the problem, clearly would not be related
to the decision being made. That said, we could include them under the gross
approach as they would preserve the rank ordering of options.

Using the gross approach, we arrive at the following per-person, round-trip cost of
driving:

Cost per
Item Detail Total Cost Person
Automobile-related costs $0.30 per mile × 800 miles $480 $96
× 2 segments
Cost of refreshments $20 per person per $200 $40
segment × 5 persons × 2
segments
Total Cost $680 $136

The following table summarizes the per-person, round-trip cost of flying:

Cost per
Detail Total Cost Person
Item

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Airline ticket $169 × 5 persons $845 $169

Cost of refreshments $5 per person per segment $50 $10
× 5 persons × 2 segments
Cost of travel to and $6 per person per segment $60 $12
from airport × 5 persons × 2 segments
Total Cost $955 $191

It is $191 – $136 = $55 per person cheaper to drive than to fly. From a cost
structure perspective, the bulk of the savings obtain because the auto-related costs
are fixed. The automobile operating costs will be $0.30 per mile, or $480 in total
for the round-trip, regardless of the number of persons traveling. Splitting this
cost five ways results in a relatively low cost per person. In contrast, the cost of
airfare is variable with respect to the number of persons traveling. There is no
“scale economy” that results.

Alternatively, with the airline trip, the cost is $191 for each person traveling,
regardless of the number of people. In contrast, the additional cost for person #2
in the auto trip is only $20 each way – the remainder of the cost is committed
even if only one person is traveling. The scale economy for driving results
because the cost structure contains more fixed and less variable cost (per person)
than the amounts for flying.

Note: This problem also highlights the subtle distinction between the timing of
cash flow and cost. The immediate cash outflow connected with flying will equal
the number computed above. However, the current cash outflow connected with
driving is likely lower. This is because the $0.30 cost per mile includes an
allowance for depreciation, repairs, insurance and so on. These costs eventually
will be paid out in cash (e.g., when you actually pay for repairs) but the timing
need not coincide with the duration of the trip. Naturally, costs related to gas
(which are included in the $0.30 per mile rate) will lead to immediate cash
outflows.

b. The key here is to realize that the per-person cost of flying will not change
even though the group’s size has changed. The entire cost of flying is variable
with respect to the number of persons traveling. Thus, the total cost will
change, but the per-person cost ($191) will be the same regardless of group
size. This can readily be seen in the following table:

Cost per
Item Detail Total Cost Person
Airline ticket $169 × 2 persons $338 $169
Cost of refreshments $5 per person per segment $20 $10
× 2 persons × 2 segments
Cost of travel to and $6 per person per segment $24 $12
from airport × 2 persons × 2 segments

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Total Cost $382 $191

The per-person cost of driving, however, will change. Here, the fixed costs of
driving will be spread over two rather than five people. In essence, the per-person
cost of driving will increase substantially because the total cost of driving does
not decrease much (it only decreases by the round trip cost of refreshments for 3
people). The following table provides the revised computations:

Cost per
Item Detail Total Cost Person
Automobile-related costs $0.30 per mile × 800 miles $480 $240
× 2 segments
Cost of refreshments $20 per person per $80 $40
segment × 2 persons × 2
segments
Total Cost $560 $280

It is now cheaper to fly than to drive. The logic essentially is the same as in part
[a]. From a cost structure perspective, the cost of driving is essentially fixed – in
other words, it will be $0.30 per mile, or $480 in total for the round-trip,
regardless of the number of persons traveling. Splitting this cost only two ways,
rather than five ways, results in a relatively high cost per person. In contrast to
part [a], you are not taking advantage of the potential scale economies associated
with driving.
Note: Instructors also can relate the above discussion to the rationale for a
monopoly, as discussed in students’ economics courses. What is the scale
economy associated with a cable company or an electric utility?

c. There are numerous other factors that might come into play regarding this
decision, including the following three:
 From an enjoyment perspective, the trip is potentially a great deal more
fun, if you drive together rather than fly separately.
 Each method offers differing types of flexibility. Driving allows the group
to plan around the weather, while internet-only tickets come with
numerous restrictions and change penalties. Driving also provides you
with available transportation at home over winter break. However, unlike
flying, driving also requires that you and your friends coordinate your
schedules.
 From a safety perspective, statistics show that flying is safer than driving.
Indeed, many parents might worry about five college students taking a
long road-trip over the winter months.

d. We characterize this problem as one of excess demand. Money is the resource

in short supply. Then, because the “revenue” is the same for both options, we
wish to find the option that uses the smallest amount of the scarce resource, or
equivalently, has the lowest cost.

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6.40
a. Let us begin by calculating relative sales values.

Gravel: 9,000 tons × 0.8 × $30 $216,000

Sand: 9,000 tons × 0.2 × $40 $72,000
Total $288,000

Thus, 75% of the joint cost (=$216,000/$288,000) would be allocated to gravel

and the 25% to sand. We have the cost allocated as 0.75 × $225,000 = $168,750
and 0.25 × $225,000 = $56,250.

Alternatively, we can calculate the rate per sales $ at the split off as
$225,000/$288,000 = $0.78125. We then allocate $216,000 × $0.78125 =
$168,750 to gravel and $72,000× 0.78125 = $56,250 to sand.

b. We know that only incremental revenues and costs are important for this
decision. Let us therefore calculate the net gain from processing the sand
further.

Value of sandbox quality 900 tons × $160 $144,000

Lost value at split off 9,000 tons × 0.2 × $40 $72,000
Net gain in revenue $72,000
Cost of additional processing given ($18,000)
Net value $54,000
Thus, Myers should process the sand at split off into sandbox quality sand
because it increases profit by $126,0001 - $72,000 = $54,000.

Note: The important point to note is that the joint cost, or how it is allocated, is
not relevant for the decision in [b]. The joint cost is sunk for this decision. These
allocations are usually done only for the purpose of valuing inventory.

6.41
Mihir has two options: (1) run the promotion or (2) do not run the promotion.
Option (1), or not running the promotion, is the status quo. We can then answer
the question regarding whether Mihir should run the promotion by calculating the
incremental costs and revenues associated with running the promotion. Based on
the information provided, the incremental revenues and costs are:

Decreased ticket sales (200 tickets @ $3.95 per ticket) ($790)

Increased profit from concession stand:
Number of customers 250 = 50% of 500

1
$126,000 = Value of sandbox quality minus further processing costs = $144,000 - $18,000.

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Average revenue $6.00 per patron

Increased concessions sales (250 patrons @ $6.00 per patron) $1,500
Average cost $0.90 = 0.15  $6.00
Increased concessions cost (250 patrons @ $0.90 per patron ($225)
Net profit $1,275

Value of promotion $485

Mihir should run the promotion as weekly profit is expected to increase by $485.
Note: This problem is one of excess supply as Mihir has available seats during the
matinee shows.

6.42
a. One approach is to construct a profit model for the laser tag arena, a profit
model for the video arcade, and a profit model for LazerLite as a whole. This
problem, though, lends itself nicely to employing an incremental approach.
Because we know the status quo, we can figure out controllable costs and
revenues.

From Greg’s perspective, we can delineate the following incremental benefits and
costs:

Increase in contribution margin from customers attracted by after-school special =

500 × ($5.00 – $3.00) = $1,000

Decrease in contribution margin from losing customers paying normal price = 300
× ($7.50 – $3.00) = $1,350

Incremental fixed costs = $150

The overall effect is to decrease the laser tag arena profitability by $500 per
week = $1,000 – $1,350 – $150.

Thus, from Greg’s standpoint the after-school special probably is not such a hot
idea. The annual profit of the laser tag arena will decrease by $500 × 52 weeks =
$26,000.

Note: It is also possible to solve the problem by computing the profit under two
options. That is, we could employ the gross approach. Under this approach, the
profit reported decreases from $3,800 per week to $3,300 per week.

b. From LazerLite’s perspective, we also need to consider the effect of the after-
school special on the video arcade. The effect on the video arcade can be
calculated as follows:

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Incremental profitarcade = (net increase in laser tag customers × .75) × [6.00 – (.10
× 6.00)]

= (200 × .75) × (6.00 – .60) = $810 increase per week.

Thus, LazerLite as a whole increases weekly profits by $310 per week = $810
– $500, or approximately $310 × 52 weeks = $16,120 per year. Consequently,
the after-school special is a profitable move for LazerLite as a whole.

The key point of this exercise is to emphasize that we cannot look at each product
in isolation (e.g., laser tag sales only) when the business model has considerable
product interdependencies. Other examples of this behavior include software
firms giving away the reader (e.g., Adobe Acrobat) in the hope of making money
selling the writing software. This idea of a loss leader, covered in
microeconomics, often occurs in casinos (cheap food and free drinks) and
supermarkets (low milk prices) or restaurants (kids eat free).

Note: Greg’s compensation arrangement appears to be misaligned with the

company’s goals. To this end, LazerLite probably is better off if Greg’s
compensation is linked to overall company profitability. In this way, Greg will not
believe that he is competing for customers with the video arcade.

6.43
a. Based on the problem data, Gerry has two options: (1) Continue with the
current arrangement of using the upstairs space for music lessons, or (2)
Converting the upstairs space to retail space. Option (1) is the status quo, and
evaluating option (2) relative to the status quo yields:

Item Detail Total

Revenue from new space 150 square feet × $5,000 per $750,000
square foot
Variable costs from new space $750,000 × 75% variable costs $562,500
Contribution margin from retail $750,000 × 25% contribution
space per $1 of revenue $187,500
- Revenue from cubicle rentals 6 cubicles × 40 rentals per
week × 50 weeks per year × $5 60,000
per rental
- Cost of additional sales persons 2 × 50,000 100,000
- Additional fixed costs $10,000 – $7,500 2,500
Increase in profit $25,000

Our calculations reveal that Gerry’s profit will increase by $25,000 if he decides
to convert the upstairs to retail space. In arriving at this solution, notice that the
contribution margin from the existing retail space is not included because it is
assumed to be the same with and without the remodel. Additionally, the cost of

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existing sales persons is also constant in the decision to remodel as are the
downstairs fixed costs of $92,500 (= $100,000 – $7,500).

b. Oftentimes, decision makers need to consider the implicit assumptions

contained in the numerical computations. The following assumptions seem
particularly important:

 The lessons must surely generate a lot of goodwill and traffic through the
store. They also help Gerry keep himself in the “loop” of the music
business in the city. Closing the cubicles likely will trigger a loss in sales.
It is unlikely that the new space will have the same sales per square foot.
Indeed, closing the cubicles may lower the sales in the existing space as
well.
 The above computations also ignore the one-time cost of the remodel.
Gerry’s decision has to incorporate whether the remodel will cost $5,000,
$15,000, or $50,000. The latter involves a much riskier gamble.

6.44
a. The key is to realize that Justine has excess demand as the pumps currently
use all available capacity. Thus, taking the order requires Justine to give up
some pumps. At 500 valves x 3 hours per valve, the valve order will consume
1,500 hours. Dividing the total 10,000 hours available by the total production
of 2,500 pumps, Justine calculates that it takes 4 hours to produce a pump. At
this rate, 1,500 hours can be used to make 375 pumps. Justine divides the
$125,000 in monthly contribution by 2,500 pumps to calculate that each pump
yields $50 in contribution margin. Thus, we have:

Contribution from Valves 500 valves × $30 per valve $15,000

Less: Lost contribution from pumps 375 pumps × $50 per pump 18,750
Net change in profit ($3,750)

Justine will lose $3,750 if it takes the order. The fixed costs of $75,000 (CM of
$125,000 – profit of $50,000) are not relevant for this decision.

Alternate approach

We could also solve the problem by examining the contribution per labor hour.
Each pump yields a contribution of $50 / 4 hours = $12.50 per labor hour. In turn,
each valve yields a contribution of only $30/3 hours = $10 per labor hour.
Accepting the valve order diverts resources toward less profitable uses. Because
1,500 hours would be diverted, the loss is 1,500 hours × ($12.50 – $10.00) per
hour = $3,750.

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b. Profit will be unchanged if valves also contributed $18,750 to profit. Thus, the
contribution margin per valve should be $18,750/500 valves = $37.50 per
valve.

Alternately, profit will be unchanged if valves also contribute $12.50 per labor
hour. As each valve consumes three hours, the minimum contribution margin is
$12.50 x 3 hours = $37.50 per valve.

6.45
a. The “traditional” allocation of a sales person’s 125 hours would lead to the
following revenue per month for a typical sales territory:

Customer
Type # of Time Total Time Revenue Total
Customers per Visit Time* Left** per Visit Revenue
Large 10 5 hours 50 hours 75 hours $45,000 $450,000
Medium 25 2 hours 50 hours 25 hours $30,000 $750,000
Small 25 1 hour 25 hours 0 $15,000 $375,000
$1,575,000
Total Revenue

* = (# of customers)  (Time per visit).

** = 125 hours – cumulative total time.
Thus, the typical sales person generates monthly revenue of $1,575,000.
b. The key to Trey’s success is to realize that time is a scarce resource. Since
sales persons cannot visit all potential customers, the revenue-maximizing
strategy prioritizes customers by their revenue per hour of time (spent in
visits). As shown below, this ranking changes the traditional ordering of
customers:
Customer Time Revenue Revenue per
Type per Visit per Visit Hour of Time
Large 5.0 hours $45,000 $9,000
Medium 2.0 hours $30,000 $15,000
Small 1.0 hours $15,000 $15,000

Thus, medium and small customers should get top priority because they generate
$15,000 in revenue per hour of time spent whereas large customers generate only
$9,000 in revenue per hour of time spent.
Such an allocation leads to the following revenue per month:

Customer
Type # of Time Total Time Revenue Total

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Customers per Visit Time* Left** per Visit Revenue

Medium 25 2 hours 50 hours 75 hours $30,000 $750,000
Small 50 1 hour 50 hours 25 hours $15,000 $750,000
Large 5* 5 hours 25 hours 0 $45,000 $225,000
$1,725,000
Total Revenue
* = (# of customers)  (Time per visit).
** = 125 hours – cumulative total time.

Thus, we see why Trey is SuperSound’s top sales person – he generates revenue
of $1,725,000, or $1,725,000 – $1,575,000 = $150,000 more than other sales
persons. Moreover, Trey optimally allocates his time across SuperSound’s
customer base.

Note: Does prioritizing by sales per visit hour maximize not only revenue but also
company profit? The answer is “it depends” – such a strategy also maximizes
profit only if the contribution margin ratio is the same for all three customer types.
If different customer groups order a different mix of products (resulting in
different contribution margin ratios), the firm needs to prioritize customers by
their contribution per visit hour to maximize profit.

Note (advanced): Instructors could also use this problem to underscore the agency
conflict and choice of performance measures. For instance, the provided solution
of maximizing revenue might be optimal from the sales person’s perspective if
their incentives are based on revenue. However, the effort allocation might not be
optimal from the firm’s perspective. The store can manage this discrepancy by
compensating the sales person based on contribution margin. However, there is
more room for dispute in measuring contribution margin, which reduces its value
as a performance measure. Formally, while contribution margin aligns incentive
more (is more congruent), it also is harder to measure (has greater noise) than
revenue.

6.46
a. The following table summarizes the quantitative analysis, or the net monetary
benefit associated with accepting the assignment (compared to the status quo
of not accepting the assignment):

Item Detail Amount

Fee from new assignment Given $50,000
- Additional tuition cost Given 8,000
- Salary given up due to $10,000 per month 40,000
delayed graduation × 4 months
Net benefit to accepting offer $2,000

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From a purely financial perspective, Christine should accept the assignment. In

this context, notice that:

 Christine’s savings prior to entering the MBA program and the amount of
her loan are not relevant as they do not differ between her two decisions.

 The $2,000 a month in living expenses (e.g., rent, utilities, and groceries)
is not relevant as Christine will incur this cost regardless of her decision.
That is, Christine expects to spend $2,000 a month in living expenses
regardless of whether she is working or in college.

b. The net [immediate] monetary benefit associated with accepting the assignment
is somewhat small and likely is not large enough for Christine to accept the
assignment. Consequently, Christine’s decision likely will hinge on qualitative
considerations. Some qualitative considerations include:

 Does Christine desire to return to her old employer upon graduating? If so,
the prospects for doing so certainly increase if she accepts the assignment.

 Will the assignment help Christine land a better job by, for example,
demonstrating how her MBA degree has allowed her to go solo on
projects?

 Will this assignment provide a nice change of pace from the grind of
schoolwork?

 Will accepting the assignment unduly disrupt Christine’s MBA studies?

Christine may worry about getting off track and/or being able to even take
the same classes next trimester (i.e., some classes are only offered
periodically) and/or graduating with her cohort (classmates and friends she
developed in the first 2 trimesters).

All in all, Christine’s decision is not clear cut.

6.47
a. Charlie’s decision deals with excess demand. There are competing demands
for Charlie’s time this evening, as he could either attend the Knick’s game or
have dinner with the important client. Charlie cannot perform both activities
this evening, giving rise to his dilemma.

b. The price paid for the two tickets is sunk and is not relevant to Charlie’s
decision. The $600 is spent regardless of whether Charlie attends the game or
has dinner with the client. Moreover, Charlie faces the same tradeoff if he had
found the tickets on the street or if he had paid $2,000 for the tickets.

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Note: In such decisions, many people do consider the price paid for the
tickets, in seeming contradiction to the idea that a sunk cost is not relevant.
One explanation could be that the price paid is a good measure of the
minimum opportunity cost of attending the game. (Charlie must expect to get
at least $600 worth of joy from the game. Why else would he pay that much
for the tickets?). From a psychological perspective, having a readily available
estimate of the lower bound for a qualitative cost may cause people to focus
on the number as the opportunity cost.

c. Unless Charlie can sell the tickets under the “dinner with the client” option,
his decision hinges on qualitative factors. Charlie needs to weigh the lost
enjoyment from not being able to attend the Knicks game against the cost of
upsetting the client if Charlie chooses to go to the game (and not have dinner
with the client). Both of these factors are qualitative – the enjoyment from the
game is a function of Charlie’s interest in sports, who he is going with, the
Knicks’ chances of winning the series, and so on. Similarly, the cost of
upsetting the client depends on the client’s personality, the volume of
business, the client’s options, and so on. Essentially, Charlie has to
subjectively determine which option has the greater utility per hour. Charlie
has a difficult decision to make.

PROBLEMS

6.48
a. In this problem, it perhaps is easiest to construct an entire income statement
for Pete’s Pets assuming he drops the birds and fish line and compare overall
profit to that reported in the problem text.

The following table computes the profit associated with the choice to discontinue
selling birds and fish, and use the space to expand dog and cat offerings.

Dogs Cats Total

1
Revenue $244,160 $159,600 $403,760
Variable costs2 97,664 47,880 145,544
Contribution margin $146,496 $111,720 $258,216
Traceable fixed costs3 44,000 30,600 74,600
Common fixed costs4 52,500 52,500 105,000
Profit $49,996 $28,620 $78,616

1
: Dog revenue = $218,000  1.12 = $244,160; Cat revenue = $142,500  1.12 =
$159,600.

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2
: Dog variable costs = $87,200  1.12 = $97,664; Cat variable costs = $42,750 
1.12 = $47,880.
3
: Dog traceable fixed costs = $31,500 + $12,500 = $44,000; Cat traceable fixed
costs = $22,600 + $8,000 = $30,600.
4
: The common fixed rental cost would not decrease as Pete would incur this cost
whether or not he chooses to discontinue selling birds and fish. However, the
traceable fixed costs associated with this product line are avoidable. For instance,
Pete would not need aquariums and equipment for cleaning fish tanks.

Based on our analysis, Pete should not discontinue selling Birds and Fish as
doing so lowers his profit by $11,584, from $90,200 to $78,616.

b. As alluded to in the problem, Pete organizes his data at a very broad level,
classifying all revenues and costs vis-à-vis the type of pet (i.e., is the item
related to dogs, cats, or birds and fish). While this presents one snapshot of the
business, it is possible that Pete would benefit from organizing the data
differently. For example, the current format does not lend itself to examining
whether certain types of dogs or dog supplies are losing money. It may be that
the overall profitability of dogs is hiding losses on a certain types of dog
treats, dog apparel, etc. To examine such issues, Pete may opt to report data at
a finer level – for example, in the “dogs” category he may wish to report data
by breed of dog and type of supply. In such a way, it may be possible for Pete
to perform a more comprehensive evaluation of his business. Naturally, Pete
needs to balance the benefits of more detailed reporting against the increased
costs of collecting and reporting more disaggregated data. For instance, detail
might lead to more classification errors (e.g., it may be difficult to parse out
the direct fixed costs associated with a particular breed of dog or dog supply).
In turn, this error may lead Pete to draw an incorrect inference about the
profitability of a particular breed or supply.

6.49
a. Since fixed costs are unlikely to change, the criterion is that the incremental
contribution margin should be at least equal to the value of the prize ($6,000).
Accordingly, we start by figuring out the contribution margin on each table.
Using the data provided, we have:

Contribution margin per table = $187,500/1,500 = $125. Thus, salespersons

would need to sell an additional $6,000/$125 = 48 tables each quarter to justify
running the sales contest.

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Companies frequently offer a bonus or prize only after a certain goal is met; this
goal may be based on sales in units, sales in dollars, net income, return on
investment, or residual income. In this example, management may stipulate that
the prize will only be awarded if at least 1,550 tables are sold, which is 50 more
than the current level of table sales. This effectively ensures that the company will
not lose money on the contest, thereby minimizing the downside risk of offering
the prize.

b. Using the information from part [a], the incremental contribution margin
associated with selling 288 more tables at $125 per table is $36,000. Thus,
profit on the tables product line is expected to increase by $36,000 – $6,000 =
$30,000.

6.50
a. Based on the information provided, Cottage Bakery’s opportunity set consists
of three options – the first option is the status quo and, indeed, this option is
viable:

1. Do nothing with the remaining counter space. That is, continue to donate the
excess muffins and do not sell raspberry-filled croissants.

2. Use the remaining counter space to sell day-old muffins. That is, do not
donate the excess muffins to the homeless shelter and do not sell raspberry-
filled croissants.

3. Use the remaining counter space to sell raspberry-filled croissants. That is,
continue to donate the excess muffins to the homeless shelter and donate any
excess raspberry-filled croissants to the homeless shelter.

b. Option 2: Use the remaining counter space to sell day-old muffins. That is, do
not donate the excess muffins to the homeless shelter and do not sell
raspberry-filled croissants.

Revenue from “day old” muffins 15  $1.50  50% $11.25 per day
Net increase in profit $11.25 per day

Notice that the cost of making the muffins is not relevant – it is a sunk
cost. Cottage incurs this cost regardless of whether the excess muffins are
sold as “day old” or donated to the homeless shelter.

Option 3: Use the remaining counter space to sell raspberry-filled croissants. That
is, continue to donate the excess muffins to the homeless shelter and donate any
excess raspberry-filled croissants to the homeless shelter.

Revenue from raspberry croissants 20  $2.00 $40.00 per day

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Costs of making raspberry croissants 22  $1.20 ($26.40) per day

Net increase in profit $13.60 per day

Notice that the cost of making the croissants is relevant because this cost will
only be incurred if management decides to make the raspberry-filled
croissants.

c. The Cottage Bakery should choose option 3 and use the remaining counter
space to sell raspberry-filled croissants, continuing to donate the excess
muffins to the homeless shelter, in addition to donating any excess raspberry-
filled croissants to the homeless shelter. This option leads to the largest
increase in Cottage Bakery’s daily profit, or $13.60. This option also seems to
be preferred from a social standpoint – the homeless shelter will now receive
an average of 2 croissants per day, in addition to the 20 muffins they currently
receive.

Note: While the problem examines profit before tax, we note that tax
considerations also arise. For example, the donation to the charity might be tax
deductible.

6.51
a. Let us begin by calculating relative revenue.

JAV-100 $80,000
YAZ-200 $40,000
Total $120,000

Thus, 2/3rd of the joint cost (= ($80,000/$120,000) × $100,000 = $66,667) would

be allocated to JAV-100 and the remainder to YAZ-200.

We then have:

Item JAV-100 YAZ-200 Total

Revenue $80,000 $40,000 $120,000
Allocated cost $66,667 $33,333 $100,000
Profit $13,333 $6,667 $20,000

b. Let us begin by calculating relative revenue.

JAV-100 $80,000
YAZ-400 $80,000
Total $160,000

Thus, half the joint cost is allocated to each product.

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Item JAV-100 YAZ-400 Total

Revenue $80,000 $80,000 $160,000
Allocated cost 50,000 $50,000 $100,000
Traceable cost 25,000 25,000
Profit $30,000 $5,000 $35,000

c. Comparing the product-level profits alone, it would appear that Chemco

should not process YAZ-200 further. Doing so reduces profit from $6,667 to
$5,000. However, we know that such a conclusion is erroneous because only
incremental revenues and costs are important for this decision. Let us
therefore calculate the net gain from processing YAZ-200 further.

Value of YAZ-400 $80,000

Lost of YAZ-200 lost ($40,000)
Net gain in revenue $40,000
Cost of additional processing ($25,000)
Net value $15,000

Thus, Chemco gains $15,000 by processing YAZ-200 further. The amount of

the joint cost, or how it is allocated, is not relevant for this decision.

6.52
a. The following table classifies each of the aforementioned items as being
relevant or not relevant and provides a succinct explanation for each
classification.

Relevant?
Item (Y or N) Reason
Regular selling price No The regular sales price is not relevant
($175) because Award Plus will not receive
this amount from the little-league
organization. Additionally, even with
the special order, Award Plus will be
operating below 100% of their
production capacity (i.e., 7,500 +
1,800 < 10,000); thus, Award Plus
will not sacrifice any regular business
by accepting the special order.
Special order selling price Yes The additional revenue associated
($100) with the special order clearly depends
on this value.
Direct materials cost Yes Presumably, the special order medals
will require the same amount of
materials as other medals. Thus, the
cost is relevant.

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Direct labor cost Yes Presumably, the special order medals

will require the same amount of labor
as other medals. Thus, the cost is
relevant.
Fixed manufacturing cost No Fixed manufacturing costs will be the
same in total regardless of whether
the special order is accepted. (Since
Award Plus will still be operating in
the relevant range if they accept the
special order).
Fixed marketing & No Fixed marketing and administrative
administrative cost costs will be the same in total
regardless of whether the special
order is accepted. (Since Award Plus
will still be operating in the relevant
range if they accept the special
order).

b. Using the classifications in the above table, the following table summarizes
the amounts by which each relevant cost or revenue will change if the special
order is accepted. The net of the increased revenues less the increased costs
provides us with the incremental profit (or loss) associated with accepting the
special order. That is, we are using the incremental approach with status quo
as the benchmark option. (In the text, we also called this method “Controllable
Cost Analysis.”)

Item Detail Total

Additional revenue $100 × 1,800 medals $180,000
Direct materials cost $50 × 1,800 medals $90,000
Direct labor cost $40 × 1,800 medals $72,000
Incremental profit $18,000

Thus, Award Plus’s profit is expected to increase by $18,000 if they accept the
special order.

c. Referring to part [a] of the problem, the regular sales price is now relevant
since, by accepting the special order, Award Plus will sacrifice sales of 300
medals to their regular customers. Moreover, Award Plus will lose ($175 –
$50 – $40)  300 = $25,500 in contribution margin on regular business if they
accept the special order. Thus, the net benefit from accepting the special order
= $18,000 – $25,500 = ($7,500). In other words, Award Plus’s profit will
decrease by $7,500 if they accept the special order.

We can also see this effect by comparing the contribution margins from accepting
or not accepting the special order (since fixed costs will be the same across

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decisions). Here, we employ the gross method to compute the contribution from
the two options.

Contribution Margin (accept special order) = [7,200  ($175 – $50 – $40)] +

[1,800  ($100 – $50 – $40)] = $630,000.

Contribution Margin (reject special order) = 7,500  ($175 – $50 – $40) =

$637,500.

Again, we see that Award Plus’ profit is $7,500 higher if they reject the special
order.

This problem reinforces that, in the short-term, capacity is fixed and, accordingly,
short-term decisions center on the best use of available capacity. Oftentimes, it is
profitable to find uses for excess capacity, as shown in part [b]. However, there
also are situations where it is best to let some capacity remain idle, as shown in
part [c]. In short, the optimal use of available capacity does not necessarily mean
that all available capacity should be used.

6.53

CleanCo has two options: (1) run the special promotion or (2) do not run the
special promotion. Calculating the incremental revenues and costs associated with
running the promotion is more difficult than it first appears. First, we need to keep
in mind that, while the price charge on winter items will decrease to $6, the
variable cost per item will not decrease. That is, the variable cost per winter item
will equal $9  .40 = $3.60. This implies that the incremental contribution margin
due to the increased sales volume = ($6.00 – $3.60)  1,500 = $3,600. Second, we
need to consider the lost contribution margin on regular business related to winter
items – that is, the $4,500 in regular business means that Cleanco typically cleans
$4,500/9 = 500 winter items each month. Presumably, these customers (in the
coming month) also will be charged $6 for each winter item cleaned, implying
that the contribution margin on “regular” winter item business will go down by
500  ($9 – $6) = $1,500. These two numbers, coupled with the increased
advertising expenditure, allow us to calculate the change in profit from running
the special promotion:

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Incremental contribution margin (6.00 – 3.60)  1,500 $3,600

from increased sales

Lost contribution margin on 500  ($9 – $6) ($1,500)

regular winter item business

Incremental advertising Given ($1,000)

Net change in monthly profit $1,100

CleanCo should run the promotion as profit in the coming month is expected to
increase by $1,100.

6.54
a. In this problem, it is important to recognize that all of the common fixed costs
allocated to the dry cleaning operations would not disappear if the dry
cleaning business were to be closed. Specifically, the dry cleaning business
currently generates a segment margin of $300,000 ($800,000 – $500,000).
This margin would not be available if the dry cleaning business were to close.
However, the common fixed costs would decrease by $200,000; thus, the net
reduction in profit is $300,000 – $200,000 = $100,000. That is, SpringFresh’s
profit will decrease by $100,000 to $200,000 if it eliminates the dry cleaning
department.

This effect is perhaps most easily seen (and verified) by constructing an income
statement without the dry cleaning business. We present such an income
statement below:

Laundry Only
Revenue $3,000,000
Variable costs $1,000,000
Contribution margin $2,000,000
Direct fixed costs $1,000,000
Common fixed costs* $800,000
Profit $200,000

* = $1,000,000 – $200,000.

Again, we see that SpringFresh’s overall profit decreases by $100,000 to

$200,000. Assuming the accuracy of the estimate of the reduction in common
fixed costs, SpringFresh should not eliminate its dry cleaning operations.

This particular problem underscores that income statements can be misleading in

terms of what a particular department or product actually contributes to overall

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profitability. The key in making this assessment is determining what revenues and
costs actually disappear if the department is eliminated.

b. Increasing the volume of laundry will increase the contribution margin

available to cover fixed costs. Based on the data provided, we find that each
$1.00 of revenue in laundry provides $0.67 in contribution margin
($2,000,000 in contribution margin divided by $3,000,000 in revenue). Thus,
an increase of 10% in laundry sales will increase the laundry contribution
margin by 10% as well. This implies that the laundry contribution margin will
increase to $2,200,000. Our revised income statement with laundry only looks
as follows:

Laundry Only
Revenue $3,300,000 $3,000,000  1.1
Variable costs $1,100,000 $1,000,000  1.1
Contribution margin $2,200,000 $2,000,000  1.1
Direct fixed costs $1,000,000
Common fixed costs* $800,000 $1,000,000 – $200,000
Profit $400,000

Here, we see that SpringFresh’s overall profit increases by $100,000 to

$400,000. Assuming the accuracy of the estimates, SpringFresh should eliminate
its dry cleaning operations as profit increases.

In constructing this income statement, however, notice the assumption that neither
the traceable fixed costs nor the common fixed costs would increase if the volume
of laundry were to increase by 10%. This is a questionable assumption.
Management judgment is key in determining whether the increase in the fixed
costs, if any, would exceed $100,000, or the expected net increase in the firm’s
profit.

6.55
a. GoGo Juice’s decision deals with excess supply. The competition has moved
in, soaking up some of GoGo Juice’s monthly gasoline and merchandise sales.
Consequently, GoGo Juice finds itself in a position with “excess” gasoline and
merchandise (i.e., GoGo Juice has the supply to accommodate more
customers). A short-term promotion is one way to spur additional demand.
b. Because the question asks for the change in profit, we employ the incremental
approach with the status quo as the benchmark option. That is, we employ
controllable cost analysis. The following table calculates the expected change
in monthly profit if GoGo Juice runs the special promotion:

Item Detail Total

Additional sales of gasoline .08 × $150,000 $12,000

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Additional sales of merchandise .12 × $75,000 9,000

- Cost of additional gasoline sales 0.75 × $12,000 (9,000)
- Cost of additional merchandise sales 0.50 × $9,000 (4,500)
- Free merchandise sales 0.01 × [($150,000 (8,100)
+ $12,000)/$0.20]
Incremental profit ($600)

GoGo Juice’s monthly fixed costs are not relevant to running the special
promotion because they will be incurred regardless of whether GoGo Juice runs
the special promotion. In short, running the special promotion does not appear to
be a good idea because GoGo Juice’s monthly profit is expected to decrease by
$600.
c. By using a threshold, GoGo Juice is trying to give customers the impression
that they are receiving $0.01 in free merchandise for every $0.20 spent on
gasoline (after all, $0.50/$10.00 = $0.05 per $1.00, or $0.01 per $0.20). In
reality, this is not the case since customers only receive $0.01 per $0.20 spent
on gasoline if their purchase equals $10, $20, $30, etc. (i.e., some whole
number multiple of $10). Otherwise, customers receive strictly less than $0.01
per $0.20 spent. For example, a customer spending $9.99 on gasoline receives
$0.00 per $0.20 spent on gasoline in free merchandise and a customer
spending $12.50 on gasoline receives $0.50/$12.50 = $0.04 per $1.00, or
$0.01 per $0.25 in free merchandise. Conceptually, the scheme converts a
variable discount to a step-discount, with $10 as the step-size. This change
ensures that the actual discount provided will always be lower than $0.01 per
$0.20 of gasoline sales.

Management of GoGo Juice may believe that such a threshold will stimulate the
same increase in gas sales as before, thereby increasing monthly gas profit by
$3,000 (= $12,000 - $9,000; as shown in part [b]). Additionally, because of the
threshold the scheme would reduce the “loss” on free merchandise sales (since
customers effectively receive less than $0.01 per $0.20 spent on gasoline, there
will be less than $8,100 in free sales). The cost (or risk) is that some savvy
customers may not respond to GoGo Juice’s promotion and, as a result, demand
for both gasoline and merchandise will not increase as expected.

Note: Organizations devote much time and resources to structuring coupons and
promotions that look more attractive to customers than actually is the case. For
example, businesses frequently offer rebates, but require customers to fill out
detailed paperwork to receive the rebate. The rebate then comes 6-8 weeks later in
a package that looks like “junk mail” (the company is hoping that the consumer
throws the letter away along with the other junk mail). In a similar fashion,
companies often issue coupons that can only be used later – here, the company is
hoping the person will lose the coupon, thus lowering the redemption rate.
Similarly, lottery organizations advertise the total payout in the jackpot without
taking into the present value for money or taxes. The lesson is that organizations

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frequently do what they can to increase sales, but minimize the cost of increasing
sales.

6.56
a. Neutron’s overall profit equals all revenues less all costs. One could quickly
calculate profit for battery testers as ($35 – $28)  20,000 = $140,000 and
profit for solenoid testers as ($20 – $22)  10,000 = ($20,000). Thus, overall
profit = $140,000 + ($20,000) = $120,000.

More formally, one might depict overall profit and the profit for each product as
follows:

Battery Solenoid
Testers Testers Total
Revenue $35  20,000; $700,000
$20  10,000 $200,000 $900,000
Fixed costs:
Manufacturing $10  20,000; (200,000)
$10  10,000 (100,000) (300,000)
Marketing & $4  20,000; (80,000)
administrative $4  10,000 (40,000) (120,000)
Variable costs:
Manufacturing $12  20,000; (240,000)
$6  10,000 (60,000) (300,000)
Marketing & $2  20,000; (40,000)
administrative $2  10,000 (20,000) (60,000)
Profit $140,000 ($20,000) $120,000

b. Neutron’s contribution margin equals revenues less all variable costs. Thus,
Neutron’s contribution margin on battery testers equals [$35.00 – ($12 +
$2)]  20,000 = $420,000 and Neutron’s contribution margin on solenoid
testers equals [$20.00 – ($6 + $2)]  10,000 = $120,000. Thus, the total
contribution margin = $420,000 + $120,000 = $540,000. More formally, one
might show overall contribution margin and contribution margin for each
product as (by re-arranging the income statement calculated in part [a]):

Battery Solenoid
Testers Testers Total
Revenue $35  20,000; $700,000
$20  10,000 $200,000 $900,000
Variable costs:
Manufacturing $12  20,000; (240,000)
$6  10,000 (60,000) (300,000)
Marketing & $2  20,000; (40,000)

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Administrative $2  10,000 (20,000) (60,000)

Contribution Margin $420,000 $120,000 $540,000
Fixed costs:
Manufacturing $10  20,000; ($200,000)
$10  10,000 ($100,000) ($300,000)
Marketing & $4  20,000; (80,000)
Administrative $4  10,000 (40,000) (120,000)
Profit $140,000 ($20,000) $120,000

c. The key here is to realize that, as stipulated in the problem, the overall fixed
costs of $420,000 will not decrease if Neutron drops the solenoid testers.
Thus, if Neutron stops producing the solenoid testers profit will decrease by
$120,000, which is the contribution margin from the solenoid testers
calculated in part [b]. In essence, this question illustrates the value associated
with restating income statements using a contribution margin format. The
profit effect of dropping solenoid testers also can be verified by constructing
an income statement with battery testers. Such an income statement is
presented below:

Battery Testers
Revenue $700,000
Variable costs* (280,000)
Contribution margin $420,000
Fixed costs (420,000)
Profit $0

* = $240,000 + $40,000

Again, we see that Neutron’s overall profit is expected to decrease by $120,000

to $0.

d. We see that unitizing fixed costs (expressing them on a per-unit basis) can
allow us to quickly calculate overall profitability or the reported profitability
of any particular product. That is, we can simply take the price per unit less
the cost per unit multiplied by the number of units sold. Unfortunately,
unitizing fixed costs could lead to disastrous effects in terms of decision-
making. This outcome occurs because decision makers can be tempted to
multiply the unitized fixed cost by some new level of volume to arrive at total
fixed costs. Over many ranges of activity, however, fixed costs in total will
not change – thus, it is important to remember that total fixed costs equal the
fixed cost per unit multiplied by the level of volume used to arrive at the fixed
cost per unit. By using one volume to calculate the fixed cost per unit and
multiplying it by another volume, the decision maker is treating the fixed cost
as if it were variable, which it is not. This feature [again] underscores that
fixed costs often are not relevant to short-term decisions.

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6.57
a. The incremental cost associated with the show appears to be $250, or the
variable cost of running the show. The [allocated] fixed cost per show is not
relevant because the total amount of fixed costs for the year will not change as
a result of the special screening. Further, the stated ticket prices are not
relevant because the show will take place in the mid-morning hours when the
IMAX is not traditionally open – thus, the students will not be displacing any
regular customers. Based on the financial data provided, the minimum price
quote appears to be $250.

b. At a minimum, Randy should consider the following:

 Does the Science Station have a gift shop and/or cafeteria? If so, many students
are likely to buy food and/or gift items, thereby increasing the Science Station’s
contribution margin. In turn, this would reduce the minimum price quote in part
[a].

 What is the impact on future revenue? What proportion of the students and
teachers would have seen the show at the regular price? (That is, what is the
opportunity cost in the form of lost revenue?). Alternatively, after seeing the
show, many students may return with their parents, thereby increasing future
revenue.

 Are there costs associated with the special showing that are not captured by the
$250 variable cost number? For example, will the Science Station have to pay an
overtime premium for a projectionist and/or usher?

c. Randy probably should consider the educational mission of the Science Station. Such
screenings directly contribute to this mission, the station, and, hopefully, the
betterment of the students. The special screening may be an excellent way to expose
some students to science – these students may have never gone through the Science
Station if it were not for the school outing.

Overall, the “best” price to charge is unclear and requires some managerial judgment
as Randy needs to balance an array of financial and non-financial factors.

6.58
We can address this problem from both quantitative and qualitative perspectives.
From a quantitative perspective, the incremental costs and revenues associated
with reducing the length of stay from 1.8 days to 1.5 days are as follows:

Increment due to
reducing LOS
Number of patients 10,000
Reduction in average LOS 0.30

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Decrease in number of days (10,000  .30) 3,000

Variable cost per day $125
Cost savings from reducing LOS (3,000  125) $375,000
Revenue from increased re-admissions (200  100,000
500)
Cost of increased re-admissions (50,000)
Total additional savings/change in profit $425,000

From a financial perspective, Quincy’s plan makes sense – the analysis suggests
that the hospital’s annual profit would increase by $425,000. One might also
sympathize with Quincy’s logic – the quest for survival in an era where hospital
revenues are fixed and medical costs are increasing have pushed many healthcare
administrators into making similar decisions (for example, maternity stays have
been reduced dramatically in recent years).

There are, however, other important considerations. One has to consider the effect
on patients being discharged “early.” At a minimum, many patients will
experience added discomfort and disruption in their lives. Further, approximately
200 patients will have to be re-admitted and undergo additional treatment – there
are both monetary and non-monetary costs that will be borne by these individuals.
Finally, some patients may even die as a consequence of being discharged early.
Here, the hospital’s and the management’s value systems play a key role in
determining these intangible, but very real and relevant, costs. Finally, one might
reasonably argue that by discharging patients early the hospital will incur negative
reputation costs or come under the scrutiny of the press/media and/or medical
review boards.

There is no “correct” answer to this problem – the problem shows that for many
decisions in life it is important to balance quantitative and qualitative
considerations. Decision models invariably incorporate both types of factors, and
students [rightfully] may place different weights or values on the various factors.
Moreover, it is important to recognize and think about such tradeoffs – hopefully,
the discussion the problem generates helps demonstrate the value of viewing
decision making as an exercise in model building and measurement, and also see
that decision models are unique, somewhat like an individual’s fingerprints.

6.59
a. We first calculate the incremental cost associated with offering the free web-
based tax-filing product, which is:

Cost of developing product sunk

Cost of maintaining product given $420,000
Value of names obtained 250,000  0.80  $0.09 (18,000)
Incremental cost $402,000

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Next, since the unit contribution margin from the personal-finance software is
$25.00 – $1.00 = $24.00, the increased volume required can be calculated as
$402,000/$24.00 = 16,750 software packages. Because 250,000 individuals are
expected to use the free web-based product, the required proportion is
16,750/250,000 = 6.7%. This seems eminently reasonable.

b. There are many other factors to consider. Perhaps the most prominent relates
to the cannibalization of the stand-alone tax product. That is, offering the free-
web-based tax product is likely to eat into the sales of the stand-alone tax
product. The lost contribution margin on these sales needs to be factored in as
an incremental cost – the problem does not, however, provide us with enough
information to calculate this opportunity cost.

There also are likely to be legal liability issues – in offering the free web-based
product, TaxPlan needs to be concerned about system breakdown, loss of data,
incorrect transmission, and so on. Should the system fail for any reason, TaxPlan
likely exposes itself to legal action as well as negative publicity. Other factors
may relate to issues of how long returns need to be stored and how many names
will be “new” to the system.

c. The IRS has a financial interest because the costs (to the IRS) associated with
receiving paper returns are substantially higher than the costs of receiving
electronic returns. Some of the incremental costs include having staff to
receive and open the paper returns, keying (inputting) the data from the paper
returns into the computer, correcting any errors in keying, storing the paper
returns, handling any checks, and so on. Thus, the IRS vastly prefers
electronic filing. This aspect of the problem reminds students of the
importance in considering externalities in their decision making – invariably,
the decisions we make affect others.
6.60
a. Compared to the status quo of keeping the recently acquired machines, the
table below presents the change in profit associated with acquiring the better
video poker machines:

Proceeds from sale of

recently purchased $1,000  250 $250,000
machines
Profit from increased $30,000  250  .10 1,500,000
wagering on better  2 years
machines
Cost of better machines $5,500  250 (1,375,000)
Increased Profit $375,000

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The casino would gain $375,000 over the two years by replacing the recently
acquired video poker machines with the better model. Notice that the cost of the
recently acquired video poker machines, or $1,250,000, is sunk and not relevant
to the analysis.

b. As shown above, the casino gains $375,000 by replacing the recently acquired
video poker machines. The original acquisition cost is sunk and is not relevant
for this decision. However, if Lucy goes forward with the purchase of the
better machines, she risks damage to her reputation. After all, it is her job to
foresee industry trends and she might appear to be careless in her duties.
Moreover, management of the Diamond Jubilee might attribute a $1,000,000
“error” to Lucy ($1,000,000 = ($5,000 – $1,000)  250, or the difference
between the purchase and disposal price of the recently purchased video poker
machines multiplied by 250 machines). The magnitude of this error may be
difficult to forget or live down. All in all, Lucy probably would think long and
hard before she recommends acquiring the better machines.

c. From the standpoint of the Diamond Jubilee, the change has no effect – the
cost is still sunk and the casino would still favor acquiring the better machines
as 2-year profit increases by $375,000.

One could argue, however, that the potential damage to Lucy’s reputation
increases as the magnitude of the price paid for the recently acquired machines
increases. The “error” attributed to Lucy would no longer be $1,000,000 but,
rather, $375,000 ($375,000 = ($2,500 – $1,000)  250). That is, from Lucy’s
perspective, the cost to acquire the old machines is not sunk because it affects the
magnitude of the damage to her reputation. Compared to our earlier analysis,
Lucy likely will be more inclined to recommend purchasing the better machines.

The classification of a cost as sunk is only valid within a decision context and for
the specified decision maker (please also see the continuation problem). This is
because a sunk cost can influence the value for relevant items such as reputation.
Because different parties may care differently about factors such as personal
reputation, a cost that is sunk for one decision maker may be a relevant item for
another decision maker.

6.61
a. As shown in part [a] to previous problem, the $1,250,000 cost of the recently
acquired video poker machines does not affect the decision to purchase the
better video poker machines. This cost is sunk and it does not lead to
differential cash flows across options. Moreover, in a world without taxes it
does not matter whether the acquisition cost was $1,250,000 or, for that
matter, $10,000,000.

b. In this case, the acquisition cost, while sunk, does lead to differential cash
flows across options. Suppose the new machines are not purchased. Then, the

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existing machines will be depreciated over the next two years. The
depreciation expense will reduce taxable income, thereby reducing taxes paid.
(Spend a few minutes reviewing the difference between a cash outflow and an
expense.)

Given the data for the Diamond Jubilee, keeping the existing machines produces
an overall tax benefit of 0.25 × $1,250,000 = $312,500.

Now, consider the option of buying the new machines. The acquisition cost of the
old machines affects taxes paid in this case as well. If the better video machines
are purchased, the Diamond Jubilee will reap a tax benefit from the loss on selling
the “old” machines. This loss and concomitant tax benefit are shown below:

Purchase price $1,250,000

Proceeds from sale of recently purchased
machines ($1,000  250) 250,000
Loss $1,000,000
Tax Rate .25
Tax Savings $250,000

The important points to notice are that the tax in either case depends on the
purchase price of the old machine and that the tax benefit is different across
options. That is, the tax effect is not a wash. Keeping the old machines yields an
additional tax savings of $62,500 = $312,500 - $250,000.

The acquisition cost, while sunk, clearly “matters” in a world with taxes because
it leads to differential cash flows between the options.

c. Above and beyond our calculations in part [b], there are two other tax effects
we need to consider when we compute the profit impact of replacing the old
machines: (1) The taxes on profit from wagering, and (2) the tax shield due to
the depreciation on the new machine.

Proceeds from sale of $1,000  250 $250,000

recently purchased
machines
Profit from increased
wagering on better $30,000  250  .10  2 1,500,000
machines
Tax on profit from
increased wagering Previous row × 0.25 (375,000)
Cost of better machines $5,500  250 (1,375,000)
Tax benefit due to
depreciation on new $5,500 × 250 × 25% 343,750
machine
Net tax benefit lost if old

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machines are sold Computed in part b (62,500)

Increased Profit (Value of machine) $281,250

The casino would gain $281,250 over the two years by replacing the recently
acquired video poker machines with the better model.

The above table presented the incremental approach for buying the new machines,
with status quo as the benchmark (i.e., performed controllable cost analysis). For
completeness, we present the gross approach. First, we compute the profit if we
keep the old machines. (Note: Because we do not know the wagers over the two
years associated with the recently acquired “old” machines, let us call it W. This
term “washes” out because it is common to both options.)

Wagers on old machine Not known W

Tax on profit from wagers

in old machine W × 25% (0.25W)
Tax shield because of
depreciation of old $1,250,000× 0.25 312,500
machines
Profit if we keep old $312,500+ 0.75 W
machines

Next, we compute the profit if the casino purchases the new machines.

Proceeds from sale of recently

purchased machines $1,000  250 $250,000
Tax shield because of loss due ($5,000-$1,000) ×
to sale 250 × 0.25 250,000
Profit from wagering on better W + ($30,000  250
machines  .10  2) W + $1,500,000
Tax on profit from wagering Previous row × (0.25W + $375,000)
25%
Tax shield because of $5,500 × 250 × $343,750
depreciation of new machines 25%
Cost of better machines
$5,500  250 ($1,375,000)
Profit if we buy the new 0.75W + $593,750
machines

The difference in profit is $281,250, as calculated before. The incremental method

has fewer steps and is less tedious. However, the gross method has fewer chances

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for omitting items, and often is preferred by decision makers when the number of
options becomes large and/or the cash flow pattern is complex.

d. Similar to the previous problem, this problem reinforces the notion that the
classification of a cost as sunk and irrelevant is only valid within a decision
context and for a specified decision maker. While the earlier problem focused
on a multi-person, or strategic, setting the current problem illustrates that the
relevance can change in a single-person setting. This is because a sunk cost
can influence the value for relevant items such as taxes. Moreover, a cost that
is sunk and irrelevant for one decision context may be relevant for another
decision context.

6.62
a. The key aspect of this problem is to recognize that the original cost of the
existing case ($20,000) is a sunk cost and, therefore, is not relevant for the
decision to repair the existing case or buy a new case. Additionally, the book
value of the existing case also is not relevant. The controllable costs
associated with each option follow (Note: rather than deducting the utility
costs from the purchase price of the new case, these savings could be added to
the costs of repairing and keeping the existing case – the net difference is still
$4,500 in favor of repairing the existing case):

Cost of the New Case

Purchase price $21,000
Utility savings 100  12  10* (12,000)
Net Cost $9,000

Cost to Repair Existing Case:

New motor and wiring $4,500

* $100 per month for 10 years

We see that it is cheaper for Shari to fix the existing case than buy the new case.
Shari saves $4,500 by repairing the existing case.

b. This information does not change the analysis in any way. The purchase price
of the existing machine and its current book value are simply not relevant for
the analysis (given the current setup).

Note: The current book value could become relevant for the analysis if Shari
could claim a tax deduction for the loss incurred on the sale of the existing case.
Thus, a seemingly sunk cost (the book value of the old case) can become relevant
because it influences the value of a relevant cost (the tax loss). This issue is more
fully explored in requirement [d] below.

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c. Absolutely. The ability to sell the existing case for $5,000 reduces the cost of
buying the new case from $9,000 to $4,000 (alternatively, one could view this
as an opportunity cost associated with keeping the existing case; here, we
would add the $5,000 to the cost of the existing case). The cost of repairing
the existing case remains unchanged at $4,500. Consequently, Shari now
favors buying the new case by $500.

d. Shari’s tax status can affect her decision because taxes will alter Shari’s out-
of-pocket costs associated with repairing the existing case versus buying the
new case. For example, if Shari sells the existing case then she can claim the
loss on the sale as a tax deduction. Additionally, Shari’s expenses associated
with operating the cases will be deductible for tax purposes. That is, each
dollar of expense will reduce taxable income by $1, thereby saving $0.30 in
taxes. The net after-tax cost of a dollar is thus only $0.70. Such savings
frequently are referred to as a “tax shield.”

The controllable after-tax costs associated with each option follow. (Again, please
note that costs such as expenditures on utilities can be framed as either reducing
the cost of buying the new case or increasing the cost of repairing the existing
case); the net difference between the options is what we are after:

Cost of the New Case

Purchase price $21,000
Proceeds – sale of old case not taxed (5,000)
Utility savings $100  12  10 (12,000)
Tax savings from purchase of new .30  $21,000** (6,300)
case
Taxes on utility savings .30  $12,000 3,600
Tax savings – loss on sale of old case .30  $11,000* (3,300)
Net Cost ($2,000)

Cost to Repair Existing Case:

Before tax cost for motor and wiring $4,500
Tax savings of 30%** .30  $4,500 (1,500)
Tax savings from depreciating .30 × $16,000 (4,800)
current
Case
Net Cost ($1,800)
*
Loss = $16,000 (book value) – $5,000 (proceeds) =
$11,000
**
Both the original book value and the cost of
improvements will be depreciated over time, yielding a tax
shield.

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Shari is better off (to the tune of $200) if she buys the new case. Indeed, the
negative cost of getting the new case suggests that Shari should have purchased
the new case even if the motor had not burned out – perhaps Shari should thank
her assistant for leaving the case’s door open.

Note: This problem features a non-standard treatment of the tax shield on the
purchase of the new case. Typically, the new case would be depreciated over
time, and the depreciation provides a tax shield. Absent a time value for money,
however, the net effect is a tax shield on the purchase price.

e. These types of “open-ended” questions are important to address because there

are numerous factors that are relevant to any decision but may be difficult to
quantify. Such measurement difficulties, however, do not relieve us from our
obligation to consider certain variables in the decision model. In this particular
example, Shari likely should consider whether the new case would have better
climate control and extend the shelf life of her flowers (this could increase
sales and/or reduce costs). The new case also may be more or less attractive,
have a larger or smaller storage capacity, and so on. In turn, these factors
likely affect sales and, as such, can tilt the analysis in favor of buying the new
case or repairing the existing case.

6.63
a. First, we should determine Renaldo’s capacity to ensure that the professor’s
order will not impose any constraints on Renaldo’s business. At $675,000 in
sales, Renaldo expects to operate at 90% of capacity; thus, we can calculate
Renaldo’s capacity as $675,000/.90 = $750,000. Since the order is for $50,000
(with pre-discount price), Renaldo has enough idle capacity to fulfill the order
without eating into his regular business.

The next key is to realize that fixed costs would not change whether Renaldo
provides the professor with a discount. Further, Renaldo will incur $0.45 in
variable costs for each pre-discount sales dollar.

We are now in a position to calculate, relative to the status quo of not accepting
the order, the incremental costs and benefits of accepting the order as:

Incremental revenue $50,000  .75 $37,500

Incremental costs $50,000  .45 ($22,500)
Net Increase in Profit $15,000

Thus, Renaldo’s profit increases by $15,000 as a result of providing the professor

with the 25% discount. This assumes, of course, that some of Renaldo’s other
customers also will not demand a similar discount, in which case, Renaldo needs
to factor in the lost contribution margin on these orders.

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b. If Renaldo is operating at 96% of capacity at a sales level of $675,000 we can

calculate Renaldo’s capacity in sales dollars as $675,000/.96 = $703,125.
Since the order is for $50,000, this implies that Renaldo will have to sacrifice
$725,000 ($625,000+$50,000) – $703,125 = $21,875 in regular business.

If Renaldo sacrifices $21,875 in regular business he will lose $21,875  .55 =

$12,031.25 in contribution margin. This amount reduces the increase in profit we
arrived at in part [a], resulting in a net increase in profit of $15,000 – $12,031.25
= $2,968.75 by providing the professor with the discount.

c. In this case, Renaldo will lose $50,000 in regular business, which amounts to
$50,000  .55 = $27,500 in lost contribution margin. In turn, by providing the
professor with the discount Renaldo’s profit will decrease by $15,000 –
$27,500 = $12,500. Notice that this corresponds perfectly to the amount of the
discount, or $50,000  .25 = $12,500. Barring some unusual circumstances,
Bob should not provide the professor with the discount.

This problem helps illustrate the opportunity cost of capacity. In part [a] capacity
was not binding and, as a result, the opportunity cost of capacity was $0. In part
[b], acceptance of the special order meant that capacity did bind, resulting in a
loss of some regular business. However, the opportunity cost of capacity was such
that it did not exceed the increased contribution margin associated with giving the
professor the 25% discount. In part [c], acceptance of the special accepting again
meant that capacity did bind, in this case resulting in a 1-for-1 loss of regular
business. Here, the opportunity cost of capacity does exceed the increased
contribution margin associated with giving the professor the 25% discount.
Moreover, the opportunity cost exactly equals the discount itself, as all other costs
are unaffected.

6.64
The incremental revenue to Rita from accepting the project = 20 hours  0.50 
$100 per hour = $1,000. Based on the information provided, the incremental
financial cost appears to be $0 as Rita’s costs are mostly fixed. Additionally,
because this is the slow season, Rita likely has enough free time (idle capacity) to
do the project. That is, Rita probably will not be foregoing another job by taking
on this project. Thus, from a purely quantitative standpoint, Rita increases her
profit by $1,000 from accepting the project.

From a qualitative standpoint, accepting the project may curtail Rita’s recreational
activities. Thus, Rita needs to consider the value she attaches to her “free” time –
it is quite possible that Rita values 20 hours of free time during the off-peak
months at an amount greater than $1,000.

From a qualitative standpoint, Rita also needs to consider whether accepting the
project will lead other clients to demand similar loyalty discounts during the slow

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season – surely, this is a position Rita does not wish to be in. Finally, Rita needs
to assess whether rejecting the project will lead to a loss of all future business
with this client.

Because the increase in profit from accepting the project is rather small, it is
likely that Rita’s decision will hinge on the qualitative factors.

6.65
a. The first step is to rank-order the products per their contribution margin of the
scarce resource (binding constraint). For Sylvester’s, the cold rolling mill
(CRM) is the scarce resource. Thus, we need to calculate each product’s
contribution margin per minute of CRM usage. Doing so yields:

Steel
Alloy Coils Bars Wire
Contribution margin per pound $1.40 $0.45 $0.98 $0.75
Minutes per pound in CRM 0.10 0.03 0.35 0.30
Contribution per minute* $14.00 $15.00 $2.80 $2.50

* = (contribution margin per pound)/(minutes per pound in CRM)

Our analysis reveals that coils are the most profitable product, followed by alloy,
steel bars, and then wire. Coils are most profitable because they make the most
efficient (in the sense of contribution to profit) use of the resource that limits
Sylvester’s profit – the Cold Rolling Mill. Barring other constraints (see part [b]),
we would recommend that Sylvester’s use all of its available CRM capacity to
produce coils.

Since the Cold Rolling Mill can be operated for 24,000 minutes per month and
coils yield $15.00 per minute, Sylvester’s total contribution margin for the month
= 24,000 × $15.00 = $360,000. From this, we subtract Sylvester’s monthly fixed
costs of $200,000 (= $2,400,000/12) to arrive at a monthly profit of $160,000.

b. Based on our calculations in part [a], Sylvester’s should devote all available
capacity to coils. However, this assumes a perfectly competitive market, or a
fixed output price and unbounded demand at this price. Of course, there may
be market constraints that prohibit Sylvester’s from producing coils only. (In
operations, this is called a corner solution.) For example, our solution calls for
Sylvester to produce 24,000/.03 = 800,000 lbs. of coils per month, or
9,600,000 lbs. of coils per year. Given Sylvester’s overall size, it is not clear
that the demand for their coils (used in appliances) is this high, requiring
Sylvester’s to use CRM time to produce other products, as it currently does.

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More generally, Sylvester’s would devote as much time as possible to coils until
the contribution per minute in the CRM (due to market constraints) was lower
than alloys. It would then turn its attention to alloys and devote the maximum
attention to this product until its contribution margin per minute in the CRM was
just lower than steel bars. This process would be repeated until Sylvester’s “runs
out” of CRM time. Implementing this strategy, though, requires that we know the
market demand constraints for each of the products. This information is not
available in the problem, but clearly is necessary for optimal decision-making.

In addition to confirming price, we also would want to check the reliability of the
variable cost number in the computation of the contribution margin. For example,
Sylvester’s may classify direct labor cost as being variable. However, if, as is
typical for steel mills, the company is a union shop where employees have a
guaranteed contract, then Sylvester’s essentially is committed to paying its
employees regardless of output or product mix. Thus, the labor cost may be more
like a fixed cost than a variable cost.

Each product’s contribution margin might change if the amount of direct labor
cost that previously was included in the contribution margin differed across the
four products. In turn, this could change our rank ordering of products vis-à-vis
product profitability.

Note: This problem relates to the “Theory of Constraints” (TOC). The TOC
essentially argues that even variable selling and variable overhead costs are fixed
in the short run. Consequently, the contribution under TOC equals: sales –
materials cost. Again, if “variable” overhead and selling costs differ across
products, the ranking of products could change. Moreover, this problem
encourages students to think critically about what is “fixed” and what is
“variable.”

6.66
a. Crash faces a problem of excess demand. He only has 300 square feet of space
available.
To install the maximum desired number of each game, he would need:

Video games 5 × 50 square feet/game 250 square feet

Dance games 2 × 75 square feet/game 150 square feet
Simple games 6 × 10 square feet/game 60 square feet
Total space needed 460 square feet

Thus, Crash has to ration available space among the games. As detailed in the
text, he could determine the profit-maximizing mix by considering the
contribution margin per unit of the scarce resource. In our case, the scarce
resource is space. The following table shows the contribution margin for each
game per square foot.

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Video Dance Simple

Game Game Game
Revenue per hour $20 $40 $15
(fully occupied)
Occupancy rate 40% 30% 10%
Total hours available 100 100 100
per week
Revenue per week (= $800 $1,200 $150
revenue per hour ×
occupancy rate ×
hours available)
Maintenance costs $100 $300 $0
per week
Contribution margin $700 $900 $150
per week
Square feet 50 75 10
occupied/machine
Contribution per $14 $12 $15
square foot

Thus, a simple ranking would show Crash’s optimal allocation of space to be:

6 simple games 60 square feet

4 video games 200 square feet.
Unused space 40 square feet.

With this solution, we could compute Crash’s profit as:

6 simple games × $150/week $900 per week

4 video games × $700/week $2,800 per week
Total $3,700 per week.

b. Our solution from part [a] does not use all available capacity because our
three choices involve a minimum amount of space: that is, they are “lumpy.”
We need 10 square feet for a simple game, 50 square feet for a video game,
and 75 square feet for a dance game. The left over space of 40 square feet is
too small to accommodate a video game or a dance game, and we do not need
more space for the simple games.

c. Two features of the solution to part [a] are problematic. First, the solution
does not include any “dance” games and having at least one dance game
seems very important from a marketing perspective. Second, more than 10%
of the space is wasted. Let us therefore modify the solution a bit to see if we
could do better.

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First, let us consider putting in one dance game and then optimally allocate the
remaining space.
1 dance game 75 square feet
6 simple games 60 square feet
3 video games 150 square feet.
Unused space 15 square feet.

With this allocation, we could compute Crash’s profit as:

1 dance game × $900/week $900 per week

6 simple games × $150/week $900 per week
3 video games × $700/week $2,100 per week
Total profit $3,900 per week.

Another possible modification is to only install five simple games (saving 10

square feet) and installing five video games. With this, we have:

5 simple games 50 square feet

5 video games 250 square feet.
Unused space 0 square feet.

With this solution, we could compute Crash’s profit as:

5 simple games × $150/week $750 per week

5 video games × $700/week $3,500 per week
Total profit $4,250 per week.

d. This problem highlights a hidden assumption in the above-cited rule. In

particular, the rule implicitly assumes no constraints in how we use capacity
for available uses. In the context of Crash’s problem, this means that we could
install, for example, 2.54 video machines or 1.26 dance machines. In other
words, each of the games must be “smooth” in its use of the scarce resource,
space. This assumption is clearly not tenable in some situations.

How can we modify the rule for such situations? In classes on operations
management, we can formulate problems with constraints on use (e.g.,
“lumpy” uses) as integer programming problems and obtain optimal solutions.
The intuition for the solution methodology is to use the rule cited in the
question to identify an initial solution and then to improve on it via various
algorithms.

The overarching point is that the simple rule gives us an excellent starting
point to find the optimal solution even if it ignores some real world
constraints. The rule guarantees the optimal solution only when each resource
is “smooth” in its use of the scarce resource.

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6.67
a. Space is the binding constraint in this problem and, accordingly, Vidya needs
to allocate products according to their contribution per unit of space (e.g.,
cubic foot). Referring to newspaper sales per unit of space as x, we can make
this calculation as follows:

CM Sales per CM per unit of

($1 of sales) unit of space space
Newspapers 0.10 x $0.10x
Magazines 0.25 5x $1.25x
Snack foods 0.20 10x $2.00x

Thus, the maximum possible space should be devoted to snack food items and the
least amount of space should be devoted to newspapers. Subject to the other
constraints identified in the problem, this leaves Vidya with the following
allocation of her available space:

CM
per unit of space Space Allocated
Snack foods $2.00x 10% (limit)
Magazines $1.25x 40% (plug)
Newspapers $0.10x 50% (minimum)

Thus, Vidya would allocate:

300  .50 = 150 cubic feet to newspapers
300  .40 = 120 cubic feet to magazines, and
300  .10 = 30 cubic feet to snack foods

b. Let us use the multi-product CVP model with a weighted contribution margin
ratio (WCMR) formulation. Recall from Chapter 5:

Profit = (WCMR  Revenue) – Fixed costs.

Unfortunately, we do not know the sales prices of each item. As in part [a], we
assume that each cubic foot generates $x of sales in newspapers. Then, a cubic
foot devoted to magazines and candy will generate $5x and $10x of revenue
respectively. The following table uses these numbers to calculate the total
contribution margin ratio per average sales $

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Total Sales = cubic feet CM =CMR per sales $

Item Space × sales $ per cubic foot × total sales
Newspapers 150 cubic foot $150x (= 150 × $x) $15x
Magazines 120 cubic feet $600x (= 120 × $5x) $150x
Snacks 30 cubic feet $300x (= 30 × $10x) $60x
Total $1,050x $225x

Thus, Vidya expects to make a total contribution of $225x on sales of $1,050x,

where x is the sales in $ per cubic foot devoted to newspapers. Dividing, we
have:

WCMR = $225x/$1,050x = 21.4286%

Thus, the breakeven revenue = $2,700/0.214285 = $12,600.

We can divide the required sales volume ($12,600) by the amount of cubic feet
available (300 cubic feet) to get the sales as $42 per cubic foot.

Note: This problem assumes a continuous stocking model – that is, Vidya never
runs out of any product.

MINI CASES
6.68
a. Cody faces excess demand for his services; accordingly, Cody needs to
determine which group he is best off booking. To make this assessment, we
compute the incremental revenues and costs associated with booking each
group.

We begin by calculating the increase in Cody’s business income:

Trip
Item Detail Upper Keys Lower Keys
Fare Given $300 $500
Fuel and oil costsa 160miles  $.30; $48
400miles  $.30 $120
Maintenance costsa 160miles  $.15; $24
400miles  $.15 $60
Contribution margin $228 $320

a
: Although the trip is only one way, Cody will incur round-trip costs for fuel, oil,
and maintenance. Thus, the round-trip costs are relevant.

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Notice that the cost of the bus, office operating expenses, and advertising costs
are all fixed. These costs do not vary with respect to Cody’s decision and, thus,
are not relevant. For a similar reason, the fixed cost associated with insurance also
is excluded.

Based on our calculations, Cody’s business income will increase by $320 if he

books the trip to the Lower Keys and by $228 if he books the trip to the Upper
Keys.

Cody’s expected tip also is relevant to this decision. The expected tip for a trip to
the Lower Keys = $500  .15 = $75, while his expected tip for a trip to the Upper
Keys = $300  .15 = $45.

Thus, Cody’s overall (business + personal) income will increase by:

$320 + $75 = $395 if he books the trip to the Lower Keys, and
$228 + $45 = $273 if he books the trip to the Upper Keys.

In short, Cody’s overall income increases by $395 – $273 = $122 more by

booking the trip to the Lower Keys versus booking the trip to the Upper Keys.

Above and beyond the financial benefits, Cody would need to consider the
additional hours it will take to the complete the trip to the Lower Keys. By
booking the group going to the Lower Keys, it is likely that Cody will not return
home until late at night. If Cody has plans for the evening (e.g., a family event),
this could tip the scales in favor of booking the trip to the Upper Keys. Cody also
likely will consider whether each group has used his services in the past and is
likely to do so in the future (i.e., is the relationship ongoing or one time).

b. This piece of information changes the problem in a relatively straightforward

way – Cody will now earn a fare on the return trip from the Upper Keys but
(as assumed in part [a]) not on the return trip from the Lower Keys.
Additionally, Cody will earn a tip on the return trip from the Upper Keys.
Thus, Cody will be able to put the excess supply on the return trip from the
Upper Keys to profitable use.

The revised calculations are presented below:

Trip
Item Detail Upper Keys Lower Keys
$300  2; $600
Fare
$500  1 $500
$600  .15; $90
Tip
$500  .15 $75
160miles  $.30; ($48)
Fuel & oil costs
400miles  $.30 ($120)

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160miles  $.15; ($24)

Maintenance costs
400miles  $.15 ($60)
Increase in business +
$618 $395
personal income

We now see that Cody prefers the trip to the Upper Keys as his overall (business
+ personal) income increases by $618, or $618 – $395 = $223 relative to booking
the group traveling to the Lower Keys. The switch in Cody’s preference relative
to part [a] relates to the additional $300 fee + the $45 tip (= $300 × 0.15); in other
words, $300 + $45 – $122 = $223.

Here, we see the importance of the effective utilization of available capacity to

maximize income. In this particular setting, the benefit of Cody to making a trip
to the Upper Keys or Lower Keys depends crucially on whether he has a paid
return trip.

c. The following table re-classifies Cadillac Cody’s business and personal

income data by when the trip was made: peak season or off-peak season.

Peak Trips Off-Peak Trips Total

Revenuea $152,500 $67,500 $220,000
Tipsb $22,875 $10,125 $33,000
Fuel & oil costsc ($18,750) ($11,250) ($30,000)
Maintenance costsd ($9,375) ($5,625) ($15,000)
Contribution Margin $147,250 $60,750 $208,000
Cost of buse ($60,000)
Insurance costse ($10,000)
Office operating expensese ($45,000)
Brochures & advertisinge ($5,000)
Overall Income $88,000

a
: $152,500 = (275  $300) + (140  $500); $67,500 = (125  $300) + (60  $500).
b
: $22,875 = $152,500  .15; $10,125 = $67,500  .15.
c
: $18,750 = 62,500  .30; $11,250 = 37,500  .30.
d
: $9,375 = 62,500  .15; $5,625 = 37,500  .15.
e
: all of these costs are fixed and cannot be traced to the timing of the trip.

Since both the peak and the off-peak seasons last for 6 months (or roughly 26
weeks), Cody will lose $147,250/26 = $5,663 in overall income if he schedules the
trip for March and $60,750/26 = $2,337 in overall income if he schedules the trip for
July.

This information is likely to be very useful to Cody and his wife in planning their
vacation. Rightfully, this is part of the opportunity cost of going on vacation and

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should be added to the other vacation costs. In essence, we see that it costs Cody
substantially less to vacation during July (Cody’s off-peak business season) than
during March (Cody’s peak business season) – Cody loses less income by
scheduling his vacation in a period of excess supply.

This part of the problem also shows us the importance of taking aggregate data and
breaking it into smaller pieces. If Cody were to use his overall income to guide his
vacation decision, he might erroneously conclude that he would lose only $88,000/52
weeks = $1,692 by going on vacation. This calculation, however, ignores both fixed
costs and the timing of the trip. Cody might do a little better with the overall business
contribution margin data, calculating that he would lose $208,000/52 = $4,000 by
taking the trip. This number, however, still ignores the seasonal nature of Cody’s
business. Cody would underestimate the cost of taking a vacation in March and
overestimate the cost of taking a vacation in July. Moreover, Cody sacrifices the least
amount of income by taking the trip during the non-peak season.

d. Assuming the friend’s calculations are accurate, we calculate Cody’s incremental

income as follows:

Off-Peak Trips Off-Peak Trips

(normal fare) (25% discount)

a
Revenue $67,500 $81,000
Tipsb $10,125 $12,150
Fuel & oil costsc ($11,250) ($15,750)
Maintenance costsd ($5,625) ($7,875)
Contribution Margin
(business and personal income) $60,750 $69,525

a
: $67,500 = (125  $300) + (60  $500); $81,000 = [(125  1.60)  ($300  .75)]
+ [(60  1.60)  ($500  .75)].
b
: $10,125 = $67,500  .15; $12,150 = $81,000  .15.
c
: $11,250 = 37,500  .30; $15,750 = 37,500  1.40  .30.
d
: $5,625 = 37,500  .15; $7,875 = 37,500  1.40  .15.

Notice that the cost of the bus, office operating expenses, and advertising costs
are all fixed. Since these costs do not vary across Cody’s decision, they are not
relevant. For a similar reason, the fixed cost associated with insurance also is not
relevant. (Absent information to the contrary, we are assuming that the additional
mileage will not decrease the bus’s salvage value. Any such decrease would
diminish the attractiveness of slashing off-peak fares.)

Assuming the friend’s numbers are accurate, we see that Cody’s overall business
and personal income will increase to $69,525, which represents a $69,525 –

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$60,750 = $8,775 increase in overall income compared to his current pricing

strategy.

In terms of evaluating the advice, we would first need to consider whether Cody
actually would want to be this much busier during the off-peak season – perhaps
Cody enjoys the free time and having a more relaxed schedule for half of the year.

At another level, we see that such differential pricing strategies (also known as
peak-load pricing) are widely followed. Ready examples are utility firms that
offer different rates based on time-of-use, airlines offering summer specials,
hotels offering “deals” for weekend getaways, and golf courses offering reduced
rates for winter or mid-week play. The pricing strategy makes sense when fixed
costs are relatively high, implying that capacity utilization is key for maximizing
profit.

While this strategy may work well for airlines and hotels, it probably will not
work well for Cadillac Cody. Stated simply, the strategy works well for airlines,
hotels, and golf courses because the size of the overall market changes (it
increases) when these organizations cut prices. In other words, spurred by a low
airfare or a low green fee, more people will travel or play golf. The increase in the
market size is the source for the incremental revenue. For Cadillac Cody,
however, his actions are likely to have minimal impact on market size. After all,
people do not plan a vacation, costing thousands of dollars, based on the prices of
local transportation. The number of people traveling to the Keys will be the same
regardless of whether Cody keeps his prices the same or slashes them (similarly, a
relatively small change in shuttle-bus fees are unlikely to affect the number of car
rentals).

If Cody were to cut his prices, it also is likely that other shuttle-bus operators will
cut their prices. Since market size and market share are likely to stay the same,
everyone will make a lower profit. In other words, the friend’s calculation
assumes that all other persons would stay put, which is not a good assumption in
the real world. Given this insight and the fact that lowering prices will not affect
the overall size of the market, Cody would be well advised not to lower his off-
peak prices.

One may well ask what prevents Cody (and the other bus operators) from raising
prices to exorbitant amounts. Some amount of price-gouging no doubt takes
place. We must remember, however, that this is a market with relatively low entry
barriers. If shuttle-bus operators start making too much money, competition is
likely to intensify and exert downward pressure on prices. Price gouging is mostly
likely to occur in settings where the customer is not very price sensitive and non-
market forces prevent competitive entry (e.g., as for a professional or college
sports team).

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6.69
a. For all practical purposes, Hannah really has only two decision options:

 Option 1: Accept Piedmont’s business and reject Capelli’s offer. Thus, in

total, 192 suites (= 320 × 0.60; 75 to Piedmont and 117 to individuals) will
be booked for each of the three days at the end of February, with a daily
occupancy rate of 60%, which is close to the usual level.

 Option 2: Accept Capelli’s business and reject Piedmont’s offer. Thus, all
available suites or 320 suites (225 to Capelli and 95 to individuals) will be
booked for each of the three days.

Technically, Hannah has a third decision option. She could reject both Piedmont
and Capelli – this is the status quo. However, Hannah does not view this option to
be part of her opportunity set. As discussed in Chapter 2, Hannah has pruned her
opportunity set to focus on her two most viable choices.

b. The table below presents the total costs and total revenues associated with
each of Hannah’s decision options. In employing the gross approach, we only
included revenues and costs related to the three days in question. Thus, we
did not include Elegant Suite’s normal revenues or variable costs for the other
days in the month. We also did not include Elegant Suites’ overall fixed costs.
We could include any or all of these amounts under the gross approach as they
are the same across Hannah’s two options. Moreover, it is the difference in
profit that we ultimately are interested in.

The total revenues for each option comprise monies received from both corporate
and individual suite rentals. Corporate suite revenues equal the number of
corporate suites for the 3-day period  $120; individual suite revenues equal
number of individual suites for the 3-day period  $150; convention center
revenues are $5,000 per day, and food, telephone, and movie revenues equal the
total number of suites occupied  $25.

Variable costs comprise food, laundry, supplies, telephones, and movies (cost =
total number of suites  $30; $30 = $180,000/6,000), and labor related to cleaning
and cooking (for Piedmont, this is the total number of suites  $35; $35 =
$210,000/6,000; for Capelli, this cost is the total number of suites  $52.50 $35 ×
1.50), since Hannah will have to pay an overtime premium if she accepts the
Capelli offer). Finally, Elegant Suites will spend $3,000 to build the runway for
Capelli. (Note: as discussed earlier, the other remaining labor fixed costs for hotel
management and building and grounds are not controllable for this decision and,
thus, we did not include them as part of the total cost of each option).

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Accept Accept
Piedmont Capelli
Data:
Total suites – corporate 225 675
Total suites – individual 3511 2852
Price per suite – corporate $120.00 $120.00
Price per suite – individual $150.00 $150.00

Revenues:
Suites – corporate $27,000 $81,000
Suites – individual 52,650 42,750
Convention center 15,000 15,000
Food, telephone, & movies 14,4003 24,000
Total revenues $109,050 $162,750

Variable Costs:
Food, laundry, supplies, etc. $17,280 $28,800
Labor (kitchen help, maids) 20,1604 50,400
Contribution margin $71,610 $83,550

Additional Fixed Costs:

Build runway $3,000
“Profit” $71,610 $80,550
1
351 = [(320 × 3 days) × 0.60] – 225.
2
285 = [(320 × 3 days) - 675].
3
14,400 = ($25 × 960) × 0.60.
4
20,160 = ($30 × 960) × 0.60.

From a profit-maximizing perspective, we find the Cappelli Option to be the most

attractive. We also could verify this using the incremental approach, using either
controllable cost analysis or relevant cost analysis.

c. The new information would have a substantive effect on Hannah’s decision.

Let us begin by re-calculating the value of each decision option assuming
minimum possible demand.

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Accept Accept
Piedmont Capelli
Data:
Total suites – corporate 180 450
Total suites – individual 351 285
Price per suite – corporate $120.00 $120.00
Price per suite – individual $150.00 $150.00

Revenues:
Suites – corporate $21,600 $54,000
Suites – individual 52,650 42,750
Convention center 15,000 15,000
Food, telephone, & movies 13,275 18,375
Total revenues $102,525 $130,125

Variable Costs:
Food, laundry, supplies, etc. $15,930 $22,050
Labor (kitchen help, maids) 18,585 38,588
Contribution margin $68,010 $69,488

Additional Fixed Costs:

Build runway $3,000
“Profit” $68,010 $66,488

From a profit-maximizing perspective, we find the Cappelli option is no longer as

attractive. If Hannah were sure that demand would be at the low end, it is prudent
to go with the Piedmont option. However, as we learned earlier, the Capelli option
maximizes profit if demand were at the high end.

From a purely financial perspective, Hannah’s beliefs about possible demand

influence her decision. Many firms construct a “best case, most likely, worst
case” scenario to include uncertainty in their estimates. Sophisticated analyses
could include a demand distribution and simulations.

Hotels routinely buffer themselves against demand fluctuations such as these by

requiring a minimum number of occupied suite-days. Moreover, they might
release the “blocked” rooms 2-3 weeks prior to the conference to increase the
chance of filling any unused rooms.

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d. If Hannah accepts the Capelli deal, she will not be able to host Piedmont’s
meeting this year. By turning down Piedmont, a long-time client, Hannah may
indeed lose all future business with the company. Moreover, including the
possibility of uncertain demand reduces the financial attractiveness of Capelli,
although it is likely the better financial option. Thus, even though the
profitable short-term decision is to accept Capelli’s business, Hannah
probably will feel uncomfortable making this decision because it could mean
losing the Piedmont contract forever. Is the immediate incremental benefit of
$8,940 (= $80,550 – $71,610; see part b. above) worth losing a valued client?
It may be advisable for Hannah to go with decision option 1 and forgo this
short-term benefit.

6.70
a. Brenda’s decision deals with excess demand. There are competing demands
for Brenda’s time this coming Sunday, as she could either hold the open house
or show homes to some of her clients who are looking to buy a house. Brenda
cannot perform both activities on Sunday, giving rise to her dilemma.

b. Brenda’s expected profit is a function of the expected probability of sale, the

expected selling price, her commission rate, and the costs she incurs on the
open house. Formally, we have:

Expected probability of sale 10% given

Expected selling price $237,500 .95  asking price of 250,000
Expected commission $712.50 10%  3%  $237,500
Variable costs of open house $250
Expected profit (net commission) $462.50

c. Brenda’s expected profit is a function of the expected probability of sale, the

expected selling price, and her commission rate (the costs she incurs to show
homes are negligible). Formally, we have:

Expected selling price $209,000 0.95  $220,000

Expected commission (other’s listing) $250.80 4%  3%  $209,000

Expected commission (own listing) $125.40 1%  6%  $209,000
Expected profit (total commission) $376.20

d. Based on her expected profit (commission), Brenda should hold the open
house.

e. We know from part [c] that Brenda’s expected profit from showing homes to
potential buyers is $376.20. Additionally, we can model her profit from the
second open house as a function of the likelihood (chance) of selling the
home, or:

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Expected profit from second open house = (chance of selling  $237,500  .03) –
$250.

We find the probability that makes Brenda’s indifferent between the two options
by setting her expected profit from the second open house equal to $376.20. Thus,
we have:

$376.20 = (chance of selling  $237,500  .03) – $250, or chance of selling =

.0878. Thus, if the chance of selling the house on the second open house is less
than approximately 8.78% then Brenda should not hold the second open house.
Alternatively, if the chance of selling the house on the second open showing is
greater than approximately 8.79% then Brenda should hold the second open
house.

6.71
a. In solving this problem, it probably is best to set-up a profit model for each
option. Based on the information provided, we have:

Profit (outsource) = 0.20  whitewater rafting revenue.

Profit (operate internally) = (.60  whitewater rafting revenue) – $40,000.

These models allow us to calculate the profits under each option at the two
different revenue levels. Thus, we have:

Expected Revenue
Option $75,000 $125,000
Outsource $15,000 $25,000
Operate internally $5,000 $35,000

If revenues = $75,000 then Jackrabbit Trails should outsource as this

increases profit by $10,000; on the other hand, if revenues = $125,000 then
Jackrabbit Trails should operate the whitewater rafting tours internally as
this option leads to $10,000 higher profit than outsourcing.

b. Setting the two profit models equal to each other we have:

.20  gross whitewater rafting revenue = (.60  gross whitewater rafting revenue)
– $40,000.

Solving, we find gross whitewater rafting revenue = $100,000. Furthermore, for

revenue < $100,000, outsourcing is preferred. For revenue > $100,000, it is more
profitable to provide the service in house. More generally, the following graph
depicts whitewater rafting profit as a function of whitewater rafting revenue.

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Rafting Profit ($)

$80,000

$60,000 in-house

$40,000
outsource

$20,000

120,000

140,000

160,000
100,000
20,000

40,000

60,000

80,000

200,000
180,000
$0
0

-$20,000

-$40,000

Gross Whitewater Rafting Revenue

c. There are numerous other factors that Jackrabbit Trails might take into
consideration.

 Jackrabbit Trails should consider the quality of the service being offered –
will patrons’ whitewater rafting experience be more/less enjoyable and
safe with Tributary Tours or the in-house service? To this end, the
reliability and trustworthiness of Tributary Tours needs to be established.

 Jackrabbit Trails should consider the uncertainty in their estimate of gross

whitewater rafting revenues. They should also consider other sources of
risk such as the liability. By outsourcing, Jackrabbit trails shifts most, if
not all of the risk from themselves to Tributary Tours. Thus, increased
uncertainty would make contracting out the preferred option if
management were averse to risk. (Note: naturally, one could conceive of
this risk being priced out in the adventure tour market. That is, the price
charged would include a premium for the estimated value of risk in the
venture.)

 Jackrabbit Trails needs to consider how offering whitewater rafting will

affect their other activities – it is quite likely that the revenues on, for
example, sailing or canoeing will decrease – this opportunity cost would
need to be considered before any decision is made.

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6.72
From a purely monetary (quantitative) standpoint, the corporate donor is the better
deal. Robin and the museum net $2,000 + 10% of $15,000 less the $500 from the
charity by renting the atrium to the corporate donor. This is before counting any
“surprise” donation received from the corporate donor and any future events that
the corporate donor might hold.

Weighed against this, however, are the qualitative factors. First, there is the loss
of goodwill associated with moving the charitable event. It appears that a lot of
effort has been vested in the event, and canceling it is likely to lead to some
adverse publicity, perhaps with implications for future donations. Second, there is
the clear ethical obligation to the charity – after all, they reserved the atrium first.
There also is a legal obligation to the extent Robin has a contract with the charity.
There is an implicit long-term value that arises from these factors. The problem is
that the effects are difficult to quantify.

Most managers in this setting probably would call the charity to see if it is
possible to move the date and/or the location (with the museum or the corporate
donor picking up the cost). Some might even have the corporation call the
charity. If such a change is not feasible, then the right thing to do is honor the
commitment to the children’s charity. In addition to the ethical obligation, the
potential dilution of the Museum’s mission as well as the possibility of substantial
negative publicity are significant. (There also might be a legally binding
obligation, even if no written contract exists.)

Robin’s quandary reminds us that both quantitative and qualitative considerations

factor into most decisions. The quantitative analysis often is only a start, and it is
important to remember that better measurement does not necessarily make the
quantitative aspects more relevant than the qualitative aspects (i.e., issues with
greater measurement error). Ultimately, managerial talent lies in the ability to
estimate well the qualitative aspects and to reach a reasoned conclusion. In this
particular instance, the qualitative considerations are likely to receive the most
weight and guide Robin’s decision.

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 CHAPTER 7
Operating Budgets: Bridging Planning and Control
Solutions

REVIEW QUESTIONS

7.1 A plan for using limited resources.

7.2 Firms budget for (1) planning, (2) coordination, and (3) control (performance evaluation
and feedback).

7.3 Operating budgets reflect the collective expression of numerous short-term decisions that
conform to the direction set by long-term plans. Financial budgets quantify the outcomes
of operating budgets in summary financial statements.

7.4 The revenue budget. Organizations begin with the revenue budget because it is the first
line on the income statement. Additionally, organizations begin with the revenue budget
because revenues dictate the volume of operations which, in turn, drive many costs such
as those related to materials and labor.

7.5 The production budget.

7.6 The budgets for materials, labor, and overhead.

7.7 Cost of goods sold = Cost of beginning finished goods inventory + cost of goods
manufactured – cost of ending finished goods inventory.

7.8 The cash budget is important for managing a firm’s working capital. It allows companies
to determine whether they will have enough money on hand to sustain projected
operations.

7.9 (1) Inflows from operations, (2) outflows from operations, and (3) special items.

7.10 Because most businesses offer credit terms to their customers – as such, they receive cash
a few days, weeks, or months after the sale occurs. Moreover, a firm’s credit policy
affects the timing and amount of cash flows.

7.11 (1) Purchases of direct materials, (2) payments for labor, (3) expenditures on
manufacturing overhead, and (4) outflows for marketing and administration costs.

7.12 Some examples include the purchase or sale of equipment, the purchase or sale of stock,
and the payment of dividends.

7.13 A responsibility center is an organizational subunit. There are three types of

responsibility centers: (1) cost centers, (2) profit centers, and (3) investment centers.
7-2

7.14 Top-down is more of an authoritative approach, whereas a bottom-up approach is more

participative, encouraging organization-wide input into the budgeting process.

7.15 An incremental approach to budgeting can be useful as past trends may help with future
projections. It is pragmatic, as it focuses attention on making changes to the previous
year’s budget based on actual performance and new information. Finally, incremental
changes are easier to justify and communicate – it is human nature to compare
performance across people and periods.

DISCUSSION QUESTIONS

7.16 The span of the operation often determines the need for a formal budget. It is easier to
plan and keep track of what is happening if the operation is small enough. As the
business expands to a point where it is difficult for one person to oversee the whole
operation and multiple people have to make decisions with respect to different aspects of
the business, planning and coordination become necessary. Moreover, how can the owner
of this expanding business ensure that all other employees making the various decisions
are in fact making them as s/he would make them? Some control also becomes necessary.
Budgets serve these purposes.

7.17 Yes, this is in general a true statement. Having a formal written document that different
decision units commit to is the most efficient of ensuring that there is proper coordination
and there is goal congruence across these units.

7.18 It is true that there is always likely to some deviation from what is expected. But,
deviations can occur because of factors outside decision makers’ control, and there is not
much one can do to avoid these chance deviations. Deviations can also occur because the
organizational actions and decisions are not in line with what they were expected to do.
By providing a baseline for comparison, budgets allow us to measure and analyze these
deviations so that corrective actions can be taken when necessary.

7.19 If budgets can be used to create the right organizational incentives, and all decision
makers in the organizations are motivated to do the right thing, then close supervision
may not be necessary. However, as discussed in the chapter, budgets cannot be a perfect
substitute for supervision because they are susceptible to game-playing; no budget can be
perfect when it comes to setting the right incentives. Some supervision and monitoring is
beneficial.

7.20 Budgets play a limited role as a benchmark for performance evaluation in settings where
forecasting is difficult and there is a high level of inherent uncertainty. However, it is
better to have rough budgets than no budgets at all, and supplement budgets with other
monitoring mechanisms such as close supervision.

7.21 Depending on the size of the organization and the number of products it offers,
forecasting sales is a difficult exercise because it requires careful examination of market
conditions and trends. Inaccurate sales forecasts can throw the entire planning process out
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of gear. So, many organizations devote a lot of time developing dependable sales
forecasts. Estimating overhead is also difficult especially in large organizations because
there are multiple drivers of overhead. Identifying the right drivers and estimating the
precise relations between the overhead and its drivers is a difficult but an important step
in the budgeting process.

7.22 Just-in-systems are often referred to as “pull” systems because an order from a customer
leads to the production and procurement activities. The idea is to carry no inventory in
the system, but respond to demand quickly by coordinating all necessary activities
smoothly. To the extent a perfect pull system can be achieved there are minimal
inventory budgets that reconcile the difference between sales and production. Similarly,
there are minimal raw and work-in-process inventories that account for the difference
between material purchases and use.

7.23 The budgeting process is time consuming in most organizations. Some large
organizations are known to start their budgeting process six months ahead of time. The
benefit of going through several iterations is that budgets become more accurate, serve as
better benchmarks to evaluate performance, and there is better coordination across the
organization because everybody is aware of what is in the budget. The cost is that it takes
time and effort.

7.24 Both the cash budget and cash flow statement reconcile the cash position of a company at
the beginning of a period to the cash position at the end of the period. But there are many
differences. First, the cash flow statement is prepared at the end of the period, and reports
past cash inflows and outflows. Second, the cash flow statement reports cash flows
associated with investing, financing, and operating decisions of the firm. On the other
hand, a cash flow budget presents a plan of cash inflows and outflows at a more detailed
level, such as when and how much cash is expected from customers, when cash is to be
paid to suppliers, and working capital requirements.

7.25 Some believe that budgets promote a financial emphasis in organizations. It is true that
budgets are mostly financial plans of organizational activities. The reason for this is that
ultimately the performance of a company is judged in terms of the financial returns it
generates for its shareholders. But budgets need not necessarily be restricted to financial
measures. Many firms are now benchmarking key non-financial measures to ensure
organizational success.

7.26 Both lines of reasoning have merit. For growth companies, it is often difficult to develop
precise budgets because of the difficulty in forecasting outcomes from research and
development and other growth activities. Moreover, rigid budgets are often said to stifle
innovation and growth by not giving enough room to exercise discretion to seize
opportunities in a timely fashion. On the other hand, budgets that allow discretion are
also subject to misuse because formal control is difficult. Often more informal control
mechanisms and closer supervision are needed to achieve a measure of control in such
organizations.

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7.27 The advantages of participative budgeting include benefiting from the expertise and
knowledge of employees in all levels of the organization by involving them in the
budgeting process, promoting a sense of ownership and empowerment among all
employees, ensuring that everybody buys into the budget so that implementation is
smooth, and better communication and coordination. The disadvantages are that
participative budgeting is time consuming, and can lead to conflicts and disagreements
that are hard to resolve (as the adage goes -- “too many cooks spoil the broth”).

7.28 Top-down budgeting is preferable when decisions need to be taken quickly, and time is
of essence. Top-down budgeting is most suitable in smaller organizations with a narrow
and manageable range of products and services, and centralized decision making. In these
settings, top managers are likely to possess detailed enough information for budgeting
purposes.

7.29 Line-item budgeting is a term used to refer to budgets that are built line-item by line-
item. Usually, the budget for a line-item cannot be used for another line item even if there
is still some money left in it. In the government, for example, each line item in the budget
represents a certain use of public money such as road construction, maintenance of public
buildings, parks, medical care, public security, etc. The reason for not allowing
appropriation of funds set aside for one line-item for another purpose is to ensure that no
public good or service is left underfunded. Similar considerations apply to nonprofit
organizations. These considerations are not as applicable to commercial companies where
the whole purpose is to allocate funds in a way that generates the most profits.

7.30 A budget is said to lapse if any unspent amount in the budget is not carried over to the
next period. Yes, the criticism is valid. There are many documented instances of such
behavior. However, budget lapsing is a good way to force expenditures on some desirable
activities and causes. Research and development budgets are a good example in
commercial organizations.

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EXERCISES

7.31
In solving budgeting exercises, we repeatedly use the “inventory equation.” In its
simplest form, the inventory equation is:

Beginning balance + What we put in – What we take out = Ending balance.

We replace these terms with the appropriate account-specific terms when computing
specific revenue and cost budgets.

For Premium, we have:

Beginning inventory 1,750 Windows

+ Production 8,000
- Sales ?
= Ending inventory 2,500 windows

Thus, we find Sales for March = 7,250 windows.

Multiplying 7,250 windows by the $60 price per window gives budgeted March
revenue of $435,000.

7.32
Premium’s revenue budget for the year is as follows:

Month Quantity Revenue

January 2,500 $150,000
February 2,600 156,000
March 2,700 162,000
April 2,800 168,000
May 2,900 174,000
June 3,000 180,000
July 3,100 186,000
August 3,200 192,000
September 3,050 183,000
October 2,900 174,000
November 2,750 165,000
December 2,600 156,000
Totals 34,100 $2,046,000

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7.33
We can apply the inventory equation to find the missing data, as follows:

Number of Windows April September December

Desired ending inventory 1,800 2,000 3,200
+ Budgeted sales 10,000 15,000 20,000
= Total requirements 11,800 17,000 23,200
- Beginning inventory 1,200 3,000 2,200
= Budgeted production 10,600 14,000 21,000

In each instance, we perform the suitable arithmetic to rearrange the terms and solve for
the required item.

7.34
To begin, we know that:

Beginning inventory (March) = Ending inventory (February)

and,
Desired ending inventory (February) = 15% of March sales.

= 0.15 × 15,000 = 2,250.

With this step, we can fill in the table partially:

Number of Windows February March April

Desired ending inventory* 2,250 3,000 3,000
+ Budgeted sales 10,000 15,000 20,000
= Total requirements 12,250 18,000 23,000
- Beginning inventory** 1,500 2,250 3,000
= Budgeted production ? ? ?
* 2,250 = 0.15 × 15,000; 3,000 = 0.15 × 20,000
** Beginning inventory (March) = Ending inventory (February).

We then use the inventory equation to fill in the missing data, as follows:

Number of Windows February March April

Desired ending inventory 2,250 3,000 3,000
+ Budgeted sales 10,000 15,000 20,000
= Total requirements 12,250 18,000 23,000
- Beginning inventory 1,500 2,250 3,000
= Budgeted production 10,750 15,750 20,000

In each instance, we perform the suitable arithmetic to rearrange the terms and solve for
the required item. In particular, we first solve for February ending inventory and
February production. In turn, this gives us the Beginning inventory for March. We repeat
the process for March to get March production, and so on.

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7.35
a. The following table provides the required revenue budget, and income statement.
August September
Individuals 700 690
Family memberships 300 300
1
Revenue - Individual $ 70,000 $ 69,000
1
Revenue - Family $ 48,000 $ 48,000
Total Revenue $ 118,000 $ 117,000
Variable cost –
Individual $ 24,5001 $ 24,150
1
Variable cost - Family $ 18,000 $ 18,000
Contribution margin $ 75,500 $ 74,850
Fixed cost $ 40,000 $ 40,000
Profit before taxes $ 35,500 $ 34,850
1
$70,000 = 700 × 100; $48,000 = 300 × $160; $24,500 = 700 × $35; $18,000 = 300 × $60.

b. The following table provides the required revenue budget, and income statement.

August September
Individuals 710 700
Family memberships 305 305
Revenue - Individual $71,000 $70,000
Revenue - Family 48,800 48,800
Total Revenue $119,800 $118,800
Variable cost - Individual $24,850 $24,500
Variable cost - Family 18,300 18,300
Contribution margin $76,650 $76,000
Fixed cost 40,000 40,000
Ad campaign 10,000
Profit before taxes $26,650 $36,000

Based on the above, it would appear that profits have decreased. However, we cannot
conclude that the ad campaign is a bad idea. This is because the new members will
continue to benefit Hercules in the future as well (but not indefinitely). Suppose that the
average new membership is for 12 months. Then, the expected benefit from the campaign
is 12 months × [10 individuals × ($100-$35) + 5 families× ($160 –$60)] = $13,800,
which exceeds the cost of the ad campaign.

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Note: Firms develop “life-cycle” models to account for such future effects. Such models
are crucial in service firms such as cable operators and wireless providers who expect to
get a continuing stream of revenue from each new customer. Thus, these firms are willing
to take a “loss” in the first few months by spending a lot to get new customers.

7.36
The following table provides the required information. Notice the use of the inventory
equation to back out the amount of purchases.

August September October

Individuals 700 690 680
Family memberships 300 300 295
Supplies needed 13,6001 13,500 13,290
Ending inventory 5,000 4,500 4,500
=Total needed 18,600 18,000 17,790
-Beginning inventory 5,000 5,000 4,500
= Purchases $13,600 $13,000 $13,290
1
13,600 = 700 × 10 + 300 × 22.

Notice that the beginning inventory in September is the ending inventory in August. We
also calculate supplies needed as # of individual memberships × $10 + # of family
memberships × $22. Finally, notice that we cannot compute the purchases in November
because we do not know the required ending inventory.

7.37
Let us first calculate the expected production for finished vases:

Beginning inventory 75 vases

Production ? vases
- Sales 500 vases
= Ending inventory 50 vases

Thus, production = 475 vases.

Next, we know that each vase requires two pounds of material. Thus, 2 × 475 = 950
pounds of material will be used in production. So, we can solve for materials purchases
as:

Beginning inventory of materials 200 pounds

+ Materials purchases (in pounds) ?
-- Materials usage 950 pounds
= Ending inventory 160 pounds

Solving, we find budgeted purchases = 910 pounds

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7.38
Let us first calculate the expected production for finished vases:

Beginning inventory 75 vases

Production ? vases
- Sales 500 vases
= Ending inventory 50 vases

Thus, production = 475 vases.

Next, we know that each vase requires .50 hours of labor and labor costs $20 per hour.

So, budgeted direct labor cost = 475 × 0.50 × $20 = $4,750.

7.39
Let us begin by calculating the operating cash flow.

Item Detail September

Individual fees (690-180)× $100 $51,000
Family (300 – 60) × $160 38,400
Prepaid (individual) (180/12) * (12 × 100 × 90%) 16,200
Prepaid (family) (60/12) × (12 × 160 × 90%) 8,640
Total inflows $114,240

Purchase (current) 0.6 × $13,000 $ 7,800

Purchases (prior) 0.4 × $13,600 5,440
Variable costs (690 × $25) + (300 × $45) 30,750
Fixed costs $41,000 -$12,500 28,500
Total outflows $72,490

Operating cash flow $41,750

We can now prepare the cash budget.

Item September
Beginning balance $ 6,000
Operating cash flow 41,750
Special items - equipment (20,000)
Amount taken out (15,000)
Ending balance $12,750

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7.40
This exercise is “tricky” in the sense that we cannot directly apply the inventory equation
to the new sales projection for April. This is because we do not know the original or
revised sales for April. However, we know the original production for April. Using this
data, we can back out the original sales as 113,000 units (as shown in the table below).

The revised sales therefore = 90% of 113,000 = 101,700 units. We could then back out
the revised production for April as 106,500 units. Notice that there is no change in the
beginning inventory for April. This is because March is almost over and Gleason would
have already built up inventory as per the original budget. However, because May’s
estimates are down 10%, the desired ending inventory for April would be down 10%,
from 22,000 to 19,800.

April (old) April (new)

Desired ending inventory 22,000 0.9 × 22,000 = 19,800
+ Budgeted sales 113,0001 0.9 × 113,000 = 101,700
= Total requirements 135,000 121,500
- Beginning inventory 15,000 15,000
= Budgeted production 120,000 106,500
1
113,000 = 120,000 + 15,000 – 22,000.

7.41
The key point in this problem is that we have to perform the calculations separately for
each type of box (although we use the same inventory equation for all boxes).
Additionally, it’s important to remember that the ending inventory for any one month
equals the beginning inventory of the following month – thus, we can calculate the
beginning inventory for March as 20% of March’s sales (which is the ending inventory of
February).

Small boxes:

March April
Desired ending inventory
= (.20 × next month’s sales) 3,000 4,000
+ Budgeted sales 10,000 15,000
= Total Requirements 13,000 19,000
- Beginning inventory
= (.20 × current month’s sales) 2,000 3,000
= Budgeted production 11,000 16,000

Revenue budget (= Sales × $2.75) $27,500 $41,250

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Medium boxes:

March April
Desired ending inventory
= (.20 × next month’s sales) 6,000 8,000
+ Budgeted sales 25,000 30,000
= Total requirements 31,000 38,000
- Beginning inventory
= (.20 × current month’s sales) 5,000 6,000
= Budgeted production 26,000 32,000

Revenue Budget (= Sales × $3.75) $93,750 $112,500

Large boxes:

March April
Desired ending inventory
= (.20 × next month’s sales) 4,000 5,000
+ Budgeted sales 15,000 20,000
= Total requirements 19,000 25,000
- Beginning inventory
= (.20 × current month’s sales) 3,000 4,000
= Budgeted production 16,000 21,000

Revenue Budget (= Sales × $5.00) $75,000 $100,000

7.42
a. Once again, we apply the inventory equation to solve this problem. Using the
information provided, we have (units in linear feet):

March Detail
Desired ending inventory 75,840 40% of April needs =
(in linear feet) 0.40 × 15,800 boxes ×
12 feet/box.
+ Needed for production 144,000 12,000 boxes to be
produced × 12 feet/box.
= Total requirements 219,840
- Beginning inventory 50,000 Given
= Budgeted purchases 169,840
(linear feet)

Purchases budget =
budgeted purchases × $0.75 $127,380
per foot

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b. Boston would use 144,000 linear feet of cardboard strips to produce the boxes. The
total materials cost = 144,000 × $0.75 = $108,000. An inventory cost flow
assumption is not required in this instance because the entire inventory (beginning
inventory plus purchases) is valued at $0.75 per linear foot.

c. Because Boston has different layers of inventory with differing prices, the cost flow
assumption now becomes important. With FIFO, the firm will consume the oldest
layer first before consuming purchases.

Thus, we have:

From beginning inventory 50,000 linear feet @ $0.70/ft $35,000

From March purchases 94,000* linear feet @$0.75/ft $70,500
Total materials cost $105,500

* 94,000 = 144,000 – 50,000

Notice that the cost of materials usage has decreased. Why?

Under the FIFO cost flow assumption used by Boston, the materials in beginning
inventory will be used up first. Bosworth’s beginning inventory is valued at $35,000.
That difference of $2,500 (50,000 linear feet × 0.05/ft) causes the cost of material usage
to decrease.

Note: The usage budget for March would not change if Boston uses the LIFO method.
The firm would not be dipping into the layer of beginning inventory, meaning that all
144,000 linear feet used would be valued at $0.75 per foot.

7.43
We compute budgeted cash inflows using the following table:

November December
Revenues $135,000 $150,000
Cash collections from current revenues 40,500 45,000
Cash collected one month later 56,000 54,000
Cash collected two months later 33,750 35,000
Cash collected three months later 6,000 6,750
Total Cash Collections $136,250 $140,750

Notice that the collections for November include 30% of November sales (0.30 ×
$135,000), 40% of October sales (0.40 × $140,000), 25% of September sales (0.25 ×
$135,000), and 5% of August sales (0.05 × $120,000). We need to stagger sales in this
fashion because it takes Rena 3+ months to collect cash from her sales.

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7.44
As with the prior problem (which deals with receivables), it is most convenient to
calculate Rena’s cash outflows using a table such as the following:

October November December

Purchases 120,000 110,000 120,000
Cash payment for current purchases $72,000 $66,000 $72,000
Cash payment for prior month purchase 28,500 36,000 33,000
Cash payment for purchases made 2 months ago 9,000 9,500 12,000
Total Cash Outflow $109,500 $111,500 $117,000

Notice that the total cash outflow for December includes payments for December
purchases (0.60 × 120,000), for November purchases (0.30 × 110,000), and for October
purchases (0.10 × 120,000). We compute the cash outflows for October and November in
a similar fashion.

7.45
The following items pertain to October, and illustrate the logic for the cash budget.
1. Total cash available = beginning balance + receipts = $9,500 + $14,100 = $23,600.
2. Total disbursement = Sum of payments for materials, labor and overhead. Backing
out the numbers, for the payments for overhead we have $18,300 -$4,400 -$8,450 =
$5,450
3. Balance prior to financing = total available – total payments (or, disbursements).
Thus, $23,600 - $18,300 = $5,300.
4. Borrowing needed (if any) = Minimum balance – balance prior to financing.
5. Ending balance (October) = Beginning balance (November)

The following table provides the completed cash budget.

Cash Budget – Fourth Quarter

October November December
Beginning cash balance $9,500 $9,500 $9,500
Cash receipts 14,100 17,900 18,400
Total cash available $23,600 $27,400 $27,900
Cash disbursements
Payments for materials 4,400 3,630 4,100
Payments for labor 8,450 7,250 7,210
Payments for overhead 5,450 5,920 5,720
Total disbursements 18,300 16,800 17,030
Balance prior to financing 5,300 10,600 10,870
Minimum cash balance 9,500 9,500 9,500
Financing
Borrowing/(repayment) 4,200 (1,100) (1,370)
Ending cash balance $9,500 $9,500 $9,500

The firm’s ending loan balance is therefore $4,200 - $1,100 - $1,370 = $1,730.
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7.46
The following table provides Oliver’s cash budget for November and December.

November December
Opening balance of cash $16,000 $27,000
+ Receipts from current sales (70% of 35,000 42,000
current revenues)
+ Receipts from prior month sales (30% of 12,000 15,000
prior month revenues)
= Total available $63,000 $84,000
- Purchase cost
(= COGS = 60% of revenues) 30,000 36,000
- Marketing and admin. expenses 6,000 5,000
Ending balance of cash $27,000 $43,000

Notice that Oliver’s November collections include 70% of November sales ($35,000)
and 30% of October sales ($12,000). Based on our analysis, it appears that Oliver will
have plenty of cash on hand and, thus, will not need to borrow money.

7.47
a. We can do this problem in two ways. The short method is to recognize that Kris
would have collected all of her sales for March and April by May 31. She also would
have collected 50% of May sales in May. Thus, her accounts receivable would be
50% of May sales or $23,000 (= $46,000 × 0.50).

The longer method is to write down her accounts receivable, using a format similar to
that for inventory accounts. We have:

April May
Opening balance for receivables $25,000 $20,000
+ Current sales 40,000 46,000
= Total collectible $65,000 $66,000
- Collections for prior month 25,000 20,000
- Collections for current month 20,000 23,000
Closing balance for receivables $20,000 $23,000

b. Again, we can do this problem in two ways. The short method is to recognize that
Kris would have paid for all of her purchases in March and April by May 31. She also
would have paid for 80% of purchases in May. Thus, her accounts payable would be
20% of May purchases or 0.20 × $40,000 = $8,000.

The longer method is to write down her accounts payable, using a format similar to that
for inventory accounts. We have:

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April May
Opening balance for payables $6,000 $6,400
+ Current purchases 32,000 40,000
= Total payable 38,000 46,400
- Payments for prior month 6,000 6,400
- Payments for current month 25,600 32,000
Closing balance for payables $6,400 $8,000

7.48
This is an open-ended question with many possible views on the Wilma’s best course of
action. We summarize some possible arguments below.

Some might argue that Wilma should follow Scott Ford and Jake’s Lewis lead and pad
her budget as well. The problem appears to be very rigid standards and a formulaic
approach to incentive compensation. The founder’s approach, some may argue, leaves the
managers no choice, but to build in some cushion. Indeed, we might justify Jake’s actions
as beneficial in the long term, although we only have his word that the cushion is for
long-term improvements. Some might question Scott’s “excessive” low-balling, although
how much is “OK” and how much is “excessive” is not resolved easily.

At the other extreme, clearly the firm’s plans contain information known to be false.
Ethical standards for accounting professionals preclude Wilma from knowingly
compromising the integrity of information. Thus, she might have no choice but to try and
rectify the situation as much as possible. Doing so, however, might pit her against the
other managers, limiting her effectiveness.

Overall, a pragmatic approach might involve attempting to educate the owner about the
pitfalls of his methods. Indeed, Wilma might find that Roy is well aware of the padding
by his managers and that this is the ‘game’ that all in the firm agree to (implicitly). In this
case, Wilma’s conscience is clear and, in our opinion, she would comply with accounting
standards as well. Thus, our recommendation is for Wilma to speak with Roy and feel
him out on his views about budget padding before taking the next step.

7.49
This question is likely to provoke a range of answers. Clearly, the manager experienced
an unfavorable and uncontrollable event. Yet, should Sarah revise the budget? We see the
issue as two separate problems. The first is a planning problem in terms of scheduling
production, ordering materials, and so on. Naturally, the firm should take the latest
information into account for such decisions.

The second problem is whether the manager’s performance targets should be changed.
One could argue either for or against a change – we are inclined to not change the
performance targets in this instance. First, a change requires that she define a ‘big’ event,
and this is a slippery slope. It would not be long before any adverse event lead to a
request for a target reset. Second, good managers are supposed to deal with risk.

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Insulating them against risk defeats the purpose. Third, managers often are very
innovative when their back is against the wall. This event might spur management into
un-chartered territory. And, the final argument is “will the manager ask for a target reset
if the fire were in a competitor’s plant?”

PROBLEMS

7.50
a. BlueSteel appears to have enough capacity to meet its annual sales forecast. Annual
sales are 112,500 units (24,000 + 28,500 + 33,000 + 27,000) and the firm has
installed capacity for 120,000 units (12 months × 10,000 units per month).

b. Clearly, BlueSteel needs to build up inventory to meet the demand surge in Q3.
BlueSteel could do this by building up inventory in Q1 and Q2. The company would
need to begin in Q1 because there is limited excess capacity is Q2 – the excess
capacity in Q2 is not enough to make the extra units to meet the demand for Q3.

The following table illustrates one possible production schedule that enables the firm to
meet its sales forecast.

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Sales for quarter 24,000 28,500 33,000 27,000
Production for quarter 25,500 30,000 30,000 27,000
Inventory at end of quarter 1,500 3,000 0 0

In reality, the firm might wish to build up more inventory in Q1 so that the factory has
some slack in Q2 and Q3 to deal with unanticipated problems.

Another alternative is to produce something like 28,500; 28,500; 28,500, 27,000 cabinets
in the four quarters. This schedule smoothes out production (from a hiring standpoint),
leaves some additional capacity in Q2 and Q3 if needed, and lightens a bit in Q4, perhaps
for additional maintenance, and to secure desired year-end inventory.

c. The CEO’s basic approach appears to be sound. Modern management practice is to

limit the amount of inventory as much as possible. Such curtailing of capacity has
several advantages. First, it reduces the capital tied up. Second, it reduces
obsolescence. Third, a low inventory policy, if done in conjunction with suitable
changes to production processes, could help the firm improve quality and increase
responsiveness.

However, the low inventory policy comes with a cost. For BlueSteel, a zero inventory
policy would curtail Q3 sales to 30,000 units. Other than building inventory, the only
way to meet demand is by adding to capacity, which will increase capacity for all four
quarters.

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d. Inventory gives firms a way to “move” capacity across periods, as shown in part [b].
However, such movement is costly because of storage costs and the cost of capital
tied up in inventory, as well as intangible quality costs. The best solution is, of
course, situation specific, but the problem highlights that holding inventory has both
costs and benefits.

7.51
It is convenient to compute Mini’s expected cash inflows using a table such as the
following:

October November December

Sales $164,000 $175,000 $190,000
Cash from current sales $49,200 $52,500 $57,000
Credit sales (current month) 35,000 45,920 49,000
Credit (one month later) 33,250 43,750 57,400
Credit (two months later) 4,760 5,320 7,000
Total $122,210 $ 147,490 $170,400

Thirty percent of Mini’s sales are made for cash, so the collections for October include
30% of October sales (0.30 × $164,000). The remainder of 70% credit purchases for
October is calculated as follows: 40% of the credit sales in September (0.40 × 0.70 ×
$125,000), 50% of the credit sales in August (0.50 × 0.70 × $95,000) and 8% of the
credit sales in July (0.08 × 0.70 × 85,000). We need to stagger sales in this fashion
because Mini takes several months to collect cash from her sales. We compute the
collections for November and December in a similar fashion.

Notice that Mini writing off 2% of her credit sales has no impact on her expected cash
inflow. The write off would, however, reduce her balance of accounts receivable by
increasing the balance of allowance for doubtful accounts (The other side of the entry is
an expense in the income statement.)

7.52
a & b). The numerical answer to this question is relatively straightforward. Ashwini will
commit $150,000 in April, $185,000 in May and $210,000 in June. However, her bank
statement will record a cash outflow equal to received items: $150,000 in May, $185,000
in June, and $210,000 in July.

This discrepancy between committed outflows and actual outflows highlights two
observations. First, we might have to pay for some purchases before we receive the items.
Such arrangements are common in international settings, and in settings where the seller
has a great deal of bargaining power. Second, Ashwini’s actual cash outflow (in the sense
of an outflow from her bank account) would take place the same month she receives the
items. However, she needs to budget a bit differently because the bank would place a
“hold” on the money. This hold means that the money would not be available to Ashwini
for other purposes.

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Thus, the problem emphasizes that cash budgets must include the commitment of cash,
even if the actual outflow might take place later. We often see this in purchase budgets
that go into future months to show commitments triggered by current purchases. In cases
like the one Ashwini faces, firms would often have a separate line item for committed
funds that they would remove from available cash balances.

Note: Ashwini’s problem is similar, in principle, to depositing a check at a bank but not
having access to the funds until the check clears.

7.53
a. The following table provides Gary’s income statement for October through
December. In this statement, notice that the cost of purchases = 80% of sales. (Gary
marks up $1 of cost to $1.25 in sales. So, $1 in sales = $1/1.25 = $0.80 in cost.)

October November December

Revenues $475,000 $525,000 $562,500
Purchases cost 380,000 420,000 450,000
Contribution Margin $95,000 $105,000 $112,500
Cash fixed costs 85,000 85,000 85,000
Non cash fixed costs 10,000 10,000 10,000
Profit before taxes $0 $10,000 $17,500

Overall, Gary appears to be running a profitable business, with breakeven sales of

$475,000. (Check: $475,000 × CMR of 20% - $95,000 = 0). Thus, while Gary is at
breakeven in October, he is well past the required volume in November and December.

b. The following table provides Gary’s cash budget for October – December. In this
statement, Collections – 1 month are the collections from prior month sales (e.g.,
October = 0.30 of September sales) and Collections – 2 months are the collections
from sales 2 months ago (October = 0.70 × August sales). Likewise, purchases –
current month = 50% of current month purchases and purchases – 1 month are 50%
of the prior months purchases.

October November December

Collections - 1 month $140,625 $142,500 $157,500
Collections - 2 months 328,125 328,125 332,500
Total cash available $468,750 $470,625 $490,000
Purchase - current month 190,000 210,000 225,000

Purchase month ago 187,5001 190,0002 210,000

Cash fixed costs 85,000 85,000 85,000
Net cash from operations $6,250 ($14,375) ($30,000)
+opening balance 5,000 11,250 (3,125)

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= Ending balance $11,250 ($3,125) ($33,125)

1
$187,500 = (468,750/1.25) × 0.50.
2
$190,000 = (475,000/1.25) × 0.50.

Overall, Gary appears to be facing a cash crunch. Available cash dips from $11,250 in
October to an anticipated shortfall of ($33,125) in December. This occurs even though
sales have increased in this time period.

c. Gary’s problem is common among firms which experience growth. In essence, Gary
is pumping money into working capital because he is financing his customers’
purchases. He is paying his suppliers faster than his customers are paying him. Thus,
when his business grows, he has to put more money into the business. We can see this
by calculating that the accounts receivable at the start of October is $796,875 (= 70%
of August sales + September sales), whereas it is $930,000 (= 70% of November
sales + December sales) at the start of January next year.

Gary needs to find ways to manage this imbalance. One avenue is to borrow, but he
has to consider interest costs. The other avenue is to accelerate collections or defer
payments, but then customers might cut back on orders and suppliers might raise
prices. Both actions are costly to Gary. Gary would need to estimate his expected
profit to evaluate each option.

7.54
We know that the COGM is the outflow from the WIP inventory account. Direct
materials, direct labor, and overhead are the inflows into this account. Applying the
inventory equation then helps us fill in the required data.

Likewise, we know that the COGS is the cost of the items removed from finished goods
inventory. Thus, we can compute COGS by applying the inventory equation to the FG
inventory account.

Notice that COGM is the linking number between the two accounts. This amount is the
outflow from the WIP account and is the inflow into the FG account.

Let us begin with the WIP account. We have:

May June
Opening WIP $180,000 $275,500
+ Direct materials usage 250,000 280,000
+ Direct labor 265,500 345,000
+ Variable overhead 125,000 145,000
= Total inflow into WIP 820,500 1,045,500
- Variable cost of goods manufactured 545,000 574,000
= Ending WIP $275,500 $471,500

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Beginning with May, we apply the standard inventory equation to obtain ending
inventory as $275,500. The ending inventory in May is the beginning inventory for June.
This allows us to calculate the remaining “?’s” for June.

Next, let us apply the inventory equation to the FG inventory account.

May June
Opening FG $220,000 $150,000
+ Cost of goods manufactured 545,000 574,000
= Cost of goods available for sale 765,000 724,000
- Cost of goods sold 615,000 $499,000
= Ending FG inventory $150,000 $225,000

Once again, our computation uses the fact that the ending inventory in May = the
beginning inventory in June.

7.55
a. We have the following cash inflows for Molly during April

March Sales (discount) = $50 × 6,000 ×.60 × .96 = $172,800

+ March Sales (days 11-30) = $50 × 6,000 × .25 = $75,000
+ February Sales (days 31-60) = $50 × 5,800 × .10 = $29,000
Budgeted Cash Collections – April $276,800

b. Cash Disbursements during April

April Purchases = 5,550* × $30 $166,500

April selling = ($50 × 6,100 × .25 – $10,000) × .60 $39,750
March selling = ($50 × 6,000 × .25 – $10,000) × .40 $26,000
Budgeted Cash Disbursements – April $232,250

* We calculate April purchases as:

April Sales = 6,100

+ Ending Inventory = 5,600 (May sales) × 1.10 = 6,160
– Beginning Inventory = 6,100 (April sales) × 1.10 = 6,710
= Purchases 5,550

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7.56
This problem highlights the planning role for budgets. Let us first determine the variable
and fixed costs corresponding to Naomi’s operations.

Item Detail Current cost Expected cost

Direct materials $480,000/120,000 units $4/unit $4.40/unit
Direct labor $720,000/120,000 units $6/unit $6.30/unit
Selling & Adm. $120,000/$2.4 million 5% of sales $ 5% of sales $
Fixed costs $888,000 $888,000

With this data in hand, let us prepare a projected income statement if Naomi raises her
price to $22 per unit.

Price = $22 & Number of units sold = 120,000

Revenues (120,000 units × $22) $2,640,000
Variable costs
Direct materials $528,000
Direct labor 756,000
Selling and administration 132,000 $1,416,000
Contribution Margin $1,224,000
Fixed costs
Manufacturing 540,000
Marketing and sales 120,000
General administration 228,000 $888,000
Profit before taxes $336,000
Return on sales
($336,000/$2,640,000) 12.73%

Let us repeat the exercise with the lower-price, high-volume strategy.

Price = $19 & Number of units sold = 175,000

Revenues (175,000 units × $19) $3,325,000
Variable costs
Direct materials $770,000
Direct labor 1,102,500
Selling and administration 166,250 $2,038,750
Contribution Margin $1,286,250
Fixed costs
Manufacturing $540,000
Marketing and sales 120,000
General administration 228,000 $888,000
Profit before taxes $398,250
Return on sales 11.98%

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($398,250/$3,325,000)

Both strategies meet Naomi’s goals of increasing her profit and return on sales. However,
the two income statements conflict in terms of expected profit and expected profitability.
The higher-price, lower volume strategy has lower profit but higher profitability.

Naomi’s choice therefore depends on her goals and the nature of the product market. In
some instances, such as often occurs with premium products, it can make most sense to
go for a high margin strategy, sacrificing volume. In other instances, such as with
consumer goods, it might make more sense to lock up the market by going for sales
growth. Regardless, projecting future income statements under alternate formats help
firms put a number on the tradeoff and make a more informed choice.

In Naomi’s case, she does not appear to have a sustainable competitive advantage for the
types of products she offers (the barriers to entry are likely minimal) – thus, we would
argue for setting a lower price and getting a larger share of the market.

7.57
The participative budget described here seems participative in name only. The goal for
participative budgets is to take advantage of localized knowledge that operating
personnel possess. In virtually every instance, the participative input is subject to
oversight and discussion. Some amount of revision is also common. However, excessive
and arbitrary review that substitutes a top-down target for a bottom-up estimate makes a
mockery of the process, eliminating its value. This appears to be the case in Walter’s
firm. Melanie’s statement hints at a very autocratic style that essentially says, “My way
or the highway.”

The revision process also appears to be arbitrary and capricious. There is little incentive
for the salespersons to spend much time and effort in projecting the true expected sales
because they know that the target would be revised upwards and Walter’s estimate will
prevail.

This problem lays the foundation for an interesting discussion about the costs and
benefits of participative budgeting. While these budgets are useful, they also give rise to
game playing and slack. Reviews by top management cut down on slack, but also remove
some of the benefits. How best to manage the tradeoff is an open-ended problem with no
clear answer. Research has identified factors that increase game playing (excessive
reliance on incentives, uncertain environment, lack of management experience at the top,
lack of trust) but executing the tradeoff well remains an art.

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7.58
a. The following tables provide the required classifications. The classification into
manufacturing and selling depends is somewhat intuitive. The classification into fixed
versus variable costs is subjective to some degree. We gain confidence in this
estimate by computing unit costs (for manufacturing expenses) and the cost per sales
dollar (for selling expenses) – if these costs stay mostly the same as volume changes,
then we classify the expense as variable. If, however, these costs decrease markedly
as volume increases, then we classify the expense as fixed.

Manufacturing (M)/ Fixed (F)/

Selling (S) Variable (V)
Direct materials M V
Direct labor hours M V
Plant maintenance M F
Plant depreciation M F
Indirect labor M V
Engineering design M F
Utilities M V
Plant administration M F
Marketing administration S F
Sales force commissions S V
Plant supervision M F

Based on the above we conclude that:

(1) Variable manufacturing costs Direct materials, direct labor, indirect labor, utilities
(2) Variable selling costs Sales commissions
(3) Fixed manufacturing costs Plant maintenance, plant depreciation, engineering
design, plant administration, and plant supervision
(4) Fixed selling costs Marketing administration

b. Using the above table, we obtain the following estimates (averages of three years):

Unit price $56.00/unit

Variable manufacturing costs $27.67/unit (the average for 3 months)
Variable selling costs $0.03 per sales $
Total fixed costs $2,178,000 (the average for 3 months)

Thus, we could write the firm’s contribution margin statement as follows:

Units 150,000
Revenues $8,400,000
Variable manufacturing costs 4,150,500
Variable selling costs 252,000
Contribution Margin $3,997,500

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Total fixed costs 2,178,000

Profit before taxes $1,819,500

c. This problem illustrates a quick way to budget operations. In essence, the firm is
using the CVP relation to project its goals for the coming year. The parameters for the
CVP relation are the average of operations for the past three years. While this
approach has merit, there are potential concerns. First, given the significant change in
operations, it is likely that the demand projection falls outside the firm’s relevant
range of operations – thus, Essex may need to add additional capacity to manage the
additional demand. The simple CVP relation ignores these complications. A second
major problem is the omission of any kind of detailed breakdown or basis for the
sales forecast – this is particularly important given the optimistic nature of the
forecast – Essex could find itself in an awkward position if sales fall dramatically
short of projections.

7.59
a. With the given data, we could write the firm’s contribution margin statement as
follows:
Revised
Original Adjustment Budget
Units 150,000 150,000
Revenues $8,400,000 $8,400,000
Variable manufacturing costs 4,150,500 4,150,500
Variable selling costs 252,000 252,000
Contribution Margin $3,997,500 $3,997,500
Total fixed costs 2,178,000 $565,0001 $2,743,000
Profit before taxes $1,819,500 $565,000 $1,254,500
1
$565,000 = (225,000 + 125,000 + 100,000 + 40,000 + 75,000).

Notice that we have collapsed all of the increase in fixed costs into one line item. This
increase reflects the additional capacity costs that stem from increasing the firm’s
production capabilities – as we will learn in Chapters 9 and 10, cost allocations provide
us with a way to estimate such changes in capacity costs.

b. We could project the income statement for 125,000 units, using the estimates for
fixed and variable costs that we derived for the previous problem. We have:

Revised
Original Revenue/Cost per unit Budget
Units 150,000 125,000
Revenues $8,400,000 $56.00 $7,000,000
Variable manufacturing costs 4,150,500 $27.67 per unit 3,458,750
Variable selling costs 252,000 $0.03 per sales $ 210,000

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Contribution Margin $3,997,500 $3,331,250

Total fixed costs 2,178,000 2,178,000
Profit before taxes $1,819,500 $1,153,250

Notice that Essex’s profit decreases substantially, by 37%, if the firm produces 125,000
units.

c. Based on our analysis, Essex will more profitable situation if it produces 150,000
units and invests in additional capacity resources. However, if the company decides to
go ahead and make the investment to meet the budgeted volume of 150,000 and
demand falls short of expectations, either in the coming year or in future years, then
Essex will have to “eat” the additional fixed costs. This problem helps us see how
budgets enable firms to evaluate options in terms of their potential risks and rewards.

7.60
The following table provides the required income statement.

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

Sales $406,000 $529,250 $420,500 $594,500 $1,950,250
Discounts1 52,925 59,450 112,375
Net Sales $406,000 $476,325 $420,500 $535,050 $1,837,875
Cost of merchandise2 280,000 365,000 290,000 410,000 1,345,000
Credit card fees3 6,496 7,621 6,728 8,561 29,406
Fixed costs4 105,000 105,000 105,000 105,000 420,000
Profit $14,504 ($1,296) $18,772 $11,489 $43,469
Notes:
1. Discounts = Sales × .50 × .20 in Quarters 2 and 4.
2. Cost of merchandise = Sales/1.45.
3. Credit card fees = .02 × .80 × Net Sales.
4. Fixed costs = $35,000 × 3 months per quarter.

7.61

a. $100 in purchases generates $125 in sales ($100 × 1.25 = $125). Thus, $100 of revenue
requires purchases of $100/1.25 = $80. Per the inventory policy, the ending inventory for
August equals 30% of the cost of goods sold in September. Further, the beginning
inventory for August equals 30% of the cost of goods sold in August. With this
information, we have:

Cost of goods sold in August $1,200,000/1.25 $960,000

+ Desired ending inventory ($1,000,000/1.25) × 0.30 240,000
– Beginning inventory ($1,200,000/1.25) × 0.30 288,000
= Goods to be purchased $912,000

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b. The direct labor budget follows directly from the revenue budget. Bargain Mart budgets 60
hours of labor per $16,000 of revenue and plans to pay $12.50 per labor hour. Given the
revenue information for August, we have:
Labor hours required ($1,200,000/16,000) × 60 4,500
× Labor cost per hour $12.50
Direct labor cost $56,250

c. We have:

Bargain Mart
Budgeted Income Statement for August
Detail Amount
Revenue Given $ 1,200,000
Variable costs
Cost of goods sold Revenue/1.25 960,000
Hourly labor See part [b] 56,250
Contribution margin $183,750
Fixed costs
Supervisory salaries Given $28,000
Rent and utilities Given 35,000
Other expenses 5% of revenue 60,000
Profit before taxes $60,750

d. We have:
Bargain Mart
Cash Budget for August
Amount Amount Detail
Beginning balance $85,000
+ Cash inflows from operations
Collections—August Sales 960,000 80% of August sales
Collections—July sales 160,000 20% of July sales
– Cash outflows from operations
Purchases—August (547,200) 60% of August purchases*
Purchases—July (294,400) 40% of July purchases**
Hourly labor (56,250) See part [b]
Supervisory salaries (28,000) Given
Rent and utilities (35,000) Given
$60,000 – $10,000 in
Other expenses (50,000)
depreciation
+/- Special items

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Display units (40,000) For display units

Ending balance $154,150
* = .60 × 960,000 (from part a); ** = .40 × $736,000 (= July purchases, computed
using the same formula as in part a).

7.62
Not-for-profit organizations, which often operate multiple programs, face unique
planning, control, and reporting needs.

From the output side, I-Care needs to track budgets and actual results by program so that
it could assess the effectiveness of individual activities.

From the input side, I-Care also might need to track expenses and activities by specific
grants. For example, suppose USAID gives I-Care a grant of $1,000,000. I-Care would
need to submit periodic reports that show how it used these funds. Often, the money may
be spent for multiple programs, which complicates the reporting process.

From a regulatory view point, I-Care needs to submit reports to the IRS and other
agencies (e.g., Form 990). These forms have specific expense categories such as fund
raising expenses.

From a control perspective, a significant amount of cost is common across programs.

Such costs often pertain to personnel because the same set of people might work on
several programs simultaneously. Of course, I-Care also needs to have appropriate
expense approval and reporting policies in place because of the significant fiduciary
responsibility it bears towards donors. Often, charities will voluntarily undergo annual
audits (by suitably qualified accountants) to increase confidence among donors.

Thus, we see that not-for-profit institutions such as I-Care require sophisticated budgeting
and control systems to meet their various information needs. Usually, such organizations
prepare a program-centered budget, wherein they estimate costs for each of the many
programs they might execute during a year. In addition, the organization needs to budget
for common activities such as a fund-raising campaign or office administration.

Given the number of external constituents, the budgeting process at I-Care typically
would be more detailed and involved than the process for a for-profit organization
(whose primary goal is to make money). Indeed, for each program, I-Care needs to
estimate the activity volume and associated costs. Moreover, each program might
comprise several modules (such as the number of senior centers visited, with each visit
being a module) that might be scaled up or down based on the availability of funds and
actual expenses.

Overall, this problem looks at how budgeting needs might systematically differ across
organizations.

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7.63
To prepare an income statement, we need to be able to calculate the cost of goods sold
(COGS). This is the outflow from the finished goods (FG) inventory account. However,
we do not have the inflow into the FG account.

For Peterson, the inflows into the FG account comprise materials and labor (because all
overhead expenses are fixed). Once again, while we know labor costs, we do not know
the materials used in production. However, we do have information about the amount of
materials purchased and expected inventories.

Thus, we can back out the materials issued, as shown below:

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Opening balance for materials $400,000 $420,000 $415,000 $425,000
+ Purchases 235,000 211,200 222,300 207,500
= Total available $635,000 $631,200 $637,300 $632,500
- Ending balance 420,000 415,000 425,000 410,000
= Materials used for production $215,000 $216,200 $212,300 $222,500

In this table, notice that we link quarters by the fact that ending inventory in Q1 =
beginning inventory in Q2. Let us now compute Peterson’s COGM.

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Materials used for production $215,000 $216,200 $212,300 $222,500
+ Direct labor 240,000 244,500 238,500 248,600
= Cost of goods manufactured $455,000 $460,700 $450,800 $471,100

Next, we use the inventory equation for the FG inventory to determine COGS.

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Opening balance $380,000 $390,400 $385,600 $391,250
+ Cost of goods manufactured 455,000 460,700 450,800 471,100
= Total available $835,000 $851,100 $836,400 $862,350
- Ending balance 390,400 385,600 391,250 396,500
= Cost of goods sold $444,600 $465,500 $445,150 $465,850

Again, notice that ending balance in Q1 = opening balance in Q2.

We are finally ready to prepare the Peterson’s contribution margin income statement.

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Quarter 1 Quarter 2 Quarter 3 Quarter 4

Revenue $795,200 $834,200 $864,450 $856,250
- Variable cost of goods sold 444,600 465,500 445,150 465,850
= Contribution margin $350,600 $368,700 $419,300 $390,400
- Fixed manufacturing costs 150,000 172,250 169,250 174,300
- Fixed selling expenses 80,000 95,000 106,000 100,000
= Profit before taxes $120,600 $101,450 $144,050 $116,100

7.64
Let us begin by first constructing Peterson’s budgeted cash collections. We have:

Q1 Q2 Q3 Q4
Opening
receivables
balance $125,000 $106,027 $111,227 $115,260
+ Sales 795,200 834,200 864,450 856,250
= Total collectible $920,200 $940,227 $975,677 $971,510
- Collections 814,173 829,000 860,417 857,343
= Ending balance $106,027 $111,227 $115,260 $114,167

Notice that collections include all of the opening balance. They also include all sales for
the first two months of the quarter and 60% for the third month. Alternatively, we
compute the ending balance as 40% of the last month’s sales (all else would have been
collected) and back out the collections.

Next, we compute the cash outflow for purchases.

Q1 Q2 Q3 Q4
Opening payables
balance $126,500 $39,167 $35,200 $37,050
+ Purchases 235,000 211,200 222,300 207,500
= Total Payable $361,500 $250,367 $257,500 $244,550
- Payments 322,333 215,167 220,450 209,967
= Ending balance $39,167 $35,200 $37,050 $34,583

As with collections, payments include all of the opening balance. They also include all
purchases for the first two months of the quarter and 50% for the third month.
Alternatively, we compute the ending balance as 50% of the last month’s purchases
(Peterson’s would have paid all other bills.)

With these estimates in hand, we are now ready to construct the overall cash budget.

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Q1 Q2 Q3 Q4
Opening balance $75,000 111,840 $228,923 $370,140
+ Collections 814,173 829,000 860,417 857,343
= Total available $889,173 $940,840 $1,089,340 $1,227,483
Payments for purchases 322,333 215,167 220,450 209,967
Labor costs 240,000 244,500 238,500 248,600
Fixed manufacturing costs 135,000 157,250 154,250 159,300
Fixed selling costs 80,000 95,000 106,000 100,000
= Ending balance $111,840 $228,923 $370,140 $509,616

In our computations, notice that we have removed $15,000 each quarter for non-cash
manufacturing overhead expenses.

Notice that the cash balance is growing while income (see the prior problem) stays
relatively stable over the four quarters. Why is this? This occurs because we assumed that
Peterson hoards all of its cash – thus, the cash balance increases each quarter by the
amount of income (there also is a $15,000 difference due to the non-cash overhead
expense, which is accounted for in the income statement but not in the cash budget). In
reality, Peterson would not maintain such a large cash balance but would reinvest the
proceeds back in its own business or elsewhere.

MINI CASES
7.65

Contribution margin income statement

Let us first set up the format for the contribution margin income statement and, in turn, compute
each amount:

July August September

Revenues $250,000 $285,000 $300,000
Variable costs
COGS 121,250 136,800 144,000
Sales commissions 15,000 17,100 18,000
“Other” non-mfg. 10,000 11,400 12,000
Bad-debt expense 3,300 2,700 3,000
Contribution margin $100,450 $117,000 $123,000
Fixed costs
mfg. 48,000 48,000 48,000
non-mfg. salaries 3,000 3,000 3,000
Non-mfg. (office) rent 7,000 7,000 7,000
non-mfg. dep. 1,500 1,500 1,500
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Profit $40,950 $57,500 $63,500

Revenues
For each month, we calculate revenues as sales in units × $25 per unit.
So, July = $250,000 = 10,000 × $25
August = $285,000 = 11,400 × $25
September = $300,000 = 12,000 × $25

Let’s set COGS aside for the moment and calculate the remaining expenses

Sales commissions

Sales commission equal 6% of revenues

So, July = $15,000 = $250,000 × 0.06

August = $17,100 = $285,000 × 0.06
September = $18,000 = $300,000 × 0.06

Other non-manufacturing (e.g., distribution) expenses

Equal 4% of revenues

So, July = $10,000 = $250,000 × 0.04

August = $11,400 = $285,000 × 0.04
September = $12,000 = $300,000 × 0.04

Bad-debt expense

Occurs 2 months after sale and equal 2% of credit sales.

So, July = $3,300 = $275,000 (May sales) × 0.60 × 0.02

August = $2,700 = $225,000 (June sales) × 0.60 × 0.02
September = $3,000 = $250,000 (July sales) × 0.60 × 0.02
Fixed manufacturing costs = $48,000 per month

Non-mfg. salaries and wages = $3,000 per month

Non-mfg. (office) rent = $7,000 per month

Non-mfg. depreciation = $1,500 per month

Variable COGS

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Let’s first compute the production budget

July August September

sales in units 10,000 11,400 12,000
+ desired ending 2,850 3,000 3,900
inventory*
– beginning inventory** 2,500 2,850 3,000
= production in units 10,350 11,550 12,900

* = 25% of ensuing month’s sales

** = 25% of current month sales

Next, we compute the direct materials usage budget

July August September

Plastic ($)* $31,050 $34,650 438,700
Other materials ($)** 10,350 11,550 12,900
= Total materials used ($) $41,400 $46,200 $51,600

* = production in units × 1 pound per unit × $3 per pound

** = production in units × $1 per unit

Next, we add labor to get COGM (as there is no variable overhead)

July August September

Materials ($) $41,400 $46,200 $51,600
+ Labor ($)* 82,800 92,400 103,200
= COGM $124,200 $138,600 $154,800

* = production in units × 0.50 hours per unit × $16 per hour

Finally, we are in a position to compute COGS

July August September

Beginning FG inventory $31,250* $34,200 $36,000
+ COGM 124,200 138,600 154,800
– ending FG inventory** 34,200 36,000 46,800
= COGS $121,250 136,800 144,000

* = 2,500 units × $12.50 per unit (given)

** = 25% of next month’s sales × $12 per unit (= $3 for plastic + $1 for other materials + $8 for
labor)

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Cash Budget

There are many components to the cash budget. As with the contribution margin income
statement, let us set up the format and, in turn, compute each amount.

July August September

Beginning balance $16,0001 $15,725 $64,000
+ Cash sales
(current month)4 100,000 114,000 120,000
+ Cash from credit sales
(current month)5 15,000 17,100 18,000
+ Cash from credit sales
(prior month)6 94,500 105,000 119,700
+ Cash from credit sales
(2 months ago)7 29,700 24,300 27,000
= Cash available $255,200 $276,125 $348,700

– Fixed manufacturing3 26,000 26,000 26,000

– Fixed non-mfg salaries2 3,000 3,000 3,000
– Fixed non-mfg (office) 7,000 7,000 7,000
rent2
– Sales commissions2 15,000 17,100 18,000
– Variable “other” non- 10,000 11,400 12,000
mfg2
– Labor2 82,800 92,400 103,200

– Plastic9 32,325 36,675 43,650

– Other materials8 10,350 11,550 12,900

= balance b/f special items $68,725 $71,000 $122,950

– Equipment* 60,000 --- ---
– Dividend* --- --- 120,000

Balance b/f any loans $8,725 $71,000 $2,950

+/- Loans (PLUG) 7,000 -7,000 13,000

= Ending Balance $15,725 $64,000 $15,950

1 = Given

2 = As computed in part (a)

3 = $26,000 = total fixed manufacturing costs of $48,000 – $22,000 non-cash items

4 = current month revenues × 0.40

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5 = current month revenues × 0.60 × 0.10

6 = previous month revenues × 0.60 × 0.70

7 = current month revenues × 0.60 × 0.18

8 = other materials used, as calculated in the materials usage budget in part (a)

9 = we first need to calculate plastic purchases:

July August September

Production requirements 10,350 11,550 12,900
(lbs)
+ ending inventory (lbs)* 11,550 12,900 16,200
– beginning inventory 10,350 11,550 12,900
(lbs)**
= purchases (lbs) 11,550 12,900 16,200
× $3 = purchases ($) 34,650 38,700 48600

* next month’s production (September EI calculated in same fashion as in part (a))

** equals production for the current month

Once we have purchases, we know that half is paid in cash each month.

Thus, for July we add Accounts Payable of $15,000 + 0.50 × 34,650 = $32,325
For August we have: 0.50 × 34,650 + 0.50 × 38,700 = $36,675
For September we have: 0.50 × 38,700 + 0.50 × 48,600 = $43,650

7.66
Leslie’s problem is common. Firms have to trade off several factors when setting budget
targets and designing incentive schemes. First, sales personnel often possess superior
information about sales prospects for the next few months, quarters, or even years. They
obtain this information via their daily interactions with customers, other sales representatives,
and trade association meetings. Obviously, such information is of great value from a
planning perspective. The firm would like to have the most detailed and accurate information
about sales estimates because these estimates form the basis for the firm’s entire budget.

However, sales personnel have incentives not to divulge this information. This second
factor arises because of the agency conflict that we introduced in Chapter 1. As we
learned there, sales personnel are risk - and effort-averse. If they give out information,
then they have to work hard to meet the resulting target. There is no built-in slack to

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guard against unanticipated adverse events. Thus, sales personnel often build in a little
cushion (padding or slack) in their sales forecasts. Sales personnel must also be motivated
to work hard to meet the target. It is easier to get their private information if the data have
no effect on how they are rated.

Firms use incentive contracts to induce the sales personnel to reveal their private
information and to work hard at meeting the resulting target. However, because such
contracts are based on output targets and environmental factors affect the actual output,
such contracts impose risk on the sales person. A well performing, hard-working sales
person might not meet her target simply because of unfavorable economic circumstances
outside her control. Thus, the contract has to limit the risk imposed. However, imposing
some risk is critical to motivate the sales person to work hard. Inducing information is
also a two-edged sword. On the one hand, we can get good information if it will not
affect the sales compensation. But, we can set much better targets and incentive systems
if we have good information.

Leslie’s suggested schemes are all compromises that reflect tradeoffs among these
factors. Let us examine each in turn.

 A salary only scheme will induce the sales person to reveal private information
about sales targets. After all, their pay is fixed and there is no reason to build
cushions into the budget. However, once the target has been set, the sales
personnel have no incentive to work hard to meet the target. We have good
information, but we cannot use it to motivate the sales force!

Sales growth is unlikely with this compensation scheme. The incentive is not to
work hard by doing just enough to get by.

 Many firms follow this kind of a scheme (actual parameters will of course vary)
to balance the forces. Raising the budget, either by some arbitrary percentage or
via negotiation, helps to remove some of the slack. We prefer negotiation (ideally
based on data about macro conditions and prior experience) to a mechanical
adjustment. (Mechanical adjustments only induce the sales force to build the
adjustment into their initial forecast.) In a typical budget, there are several rounds
of negotiations before firms agree on targets.

A variable commission allows the incentive to operate after the target as well. In
contrast, the existing contract induces sales personnel to just meet the target and
stop; there is no benefit to exceeding the target by much. However, a variable
scale also accentuates the incentive to low ball the target. Firms often balance the
incentives by starting the bonus at 90% of the target (much like Leslie’s idea).
Firms also usually cap the maximum bonus payable to 120% (say) of the target.

Sales growth is likely under this system although it is not likely to vastly exceed
industry averages. The existence of a target-based pay system puts natural breaks

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on sales personnel’s incentives to set high targets (or provide information that
high targets are even achievable.)

 Adjusting based on an industry growth rate is a good idea and one that relies on
relative performance evaluation. This system ensures that Bartlett grows at the
same rate as the industry. The nature of the compensation contract, though,
ensures that sales personnel have no incentive to exceed the industry growth rate.

 The final incentive scheme takes the idea of relative performance evaluation to
the extreme and implements it within the firm. Such “rank and yank” systems
(popularized by the legendary CEO of General Electric, Jack Welch) force
managers to excel by pitting them against each other. While such systems have
much to recommend them, we note that they also dampen the incentives to
cooperate. Thus, they work well when we have multiple persons doing roughly
the same task (as in Bartlett’s case). They are ineffective when we require team
work and cooperative knowledge sharing.

Overall, we believe that Leslie should give active consideration to the rank and yank
system. The described environment seems ideally suited for relative performance
evaluation as many reps are selling the same drugs to essentially similar clientele. While
geographical differences surely exist, benchmarking against peers appears to be a winner
in this setting.

7.67
This is an open-ended question, with no obvious correct answer. Making a forecast of
future activity is, by nature, an imprecise activity. There could be, and often is, legitimate
disagreement about the feasible level of activity. Thus, this area is one where individuals
can “massage” the numbers to attain a desired result. From a control perspective,
managers therefore scrutinize these numbers carefully.

Eshe is caught between a rock and a hard place. Sticking to her guns would probably get
her fired or at least increase the chance of shutting off funding. The latter outcome also
adversely affects the many recipients of the charity’s efforts to distribute computing
equipment. A lot is riding on her estimate. However, accepting the CEO’s
recommendation is also problematic. The CEO’s estimate appears to be too rosy and is
designed to get this year’s funding approved. Knowingly submitting false estimates to
grantors compromises information integrity, putting her actions outside the ethical norms
expected of accounting professionals.

Our recommendation is for Eshe to collect more data that might support a rosier estimate,
or confirm a pessimistic estimate. She might also provide a range of possible outcomes
(best case, worst case) so that the grantor has complete information about the charity’s
prospects.

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7.68
There is no one correct answer to this question. On the one hand, not awarding a bonus is
justifiable. The firm has incurred a substantial loss and rewarding performance for this
result seems odd. Furthermore, revising budgets causes them to lose their “bite.” After
all, would the manager argue for a target reset if Florida experienced much nicer weather
than expected and tourism boomed? Because the manager has control over operations,
she should be held accountable for delivering results.

On the other hand, the forecast clearly did not account for the actual turn of events. It also
appears that the manager and staff worked hard to keep costs under control. Notice that
fixed costs have increased by $120,000 only even though hurricane related repair cost
$140,000. Further, the operations have also cut back on fixed marketing and selling
expenses. Fuel costs appear to account for the bulk of direct materials (the actual is 25%
of sales versus the budget of 17% of sales). The only item that seems out of line is direct
labor – there is an unexpected increase from 39% of sales to 46% of sales. Indeed, we
would expect the ratio to drop as the tourism industry dried up and more deck hands were
laid off.

We would also consider long-term effects of this decision. The owner, who may be
wealthy and have other sources of income, has a much greater ability to bear risk than do
the manager and staff. Awarding a bonus (albeit lower than last year) as a token of
appreciation would go a long way in building loyalty and employee morale. In the long
run, the success of the operations relies on staff attitude – interactions with staff are a
crucial part of the overall customer experience, which drives repeat business and word of
mouth.

Taking all of these arguments into account, one could reasonably argue for at least some
bonus. Usually, we would argue for holding the manager accountable for her choices – in
this instance, however, some budget revisions seem called for given the nature and
magnitude of the uncontrollable events.

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 CHAPTER 8
Budgetary Control and Variance Analysis
Solutions

REVIEW QUESTIONS

8.1 Many organizations use a budget as a benchmark for evaluating actual performance.

8.2 A plan that represents the expected revenues, costs, and profit corresponding to the
expected sales volume as of the beginning of the period.

8.3 The difference between an actual result and a budgeted amount is called a variance.

8.4 A favorable variance means that performance exceeded expectations – actual revenue
exceeded budgeted revenue or actual cost was less than budgeted cost. An unfavorable
variance means that performance fell short of expectations – actual revenue was less than
budgeted revenue or actual cost exceeded budgeted cost.

8.5 The total profit variance equals actual profit less master budget profit.

8.6 The sales volume variance and the flexible budget variance.

8.7 The budget at the actual level of sales.

8.8 The difference in profit between the flexible and master budgets.

8.9 The difference in profit between the actual results and the flexible budget. It is comprised
of the sales price variance, the fixed cost variance, and the variable cost variance.

8.10 The difference between actual revenues and flexible budget revenues.

8.11 The difference between budgeted and actual fixed costs.

8.12 A quantity variance and a price variance.

8.13 The difference between the “as if” budget and actual results for an input.

8.14 The difference between the flexible budget and the “as if” budget for an input.

8.15 It provides management with a summary that bridges actual and expected performance. It
helps pinpoint which areas to investigate in order to take appropriate corrective actions.

8.16 Variances could arise: (1) during the normal course of operations, (2) from a more
permanent change in the firm’s operating environment, and (3) because
budgets/standards are either too tight or too loose.

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8.17 (1) Investigate all significant variances, whether favorable or unfavorable, (2) Examine
trends, and (3) Consider the total picture.

8.18 (1) Timeliness, and (2) Specificity.

DISCUSSION QUESTIONS

8.19 Think of a budget you may have in any given month for eating out, for entertainment, and
for clothing. At the end of the month, you may realize that you have spent a lot more on
dining out than you had budgeted because you found a new favorite restaurant.

8.20 Both arguments are valid. Tight but achievable budgets are a way to motivate people in
the organization to become more careful and efficient. However, tight budgets could be
very demotivating if they are unachievable, and could lead to a loss in employee morale.
Tight budgets are especially effective when the tasks involved are specific, well-defined,
and routine. Loose budgets are more suitable when tasks are not well-specified and the
outcomes are uncertain. A good example is research and development efforts in, say, a
pharmaceutical company. These companies have to invest in R&D to stay ahead of the
competition, but it is difficult to specify a tight budget when it comes to the discovery of
new drugs. Planning and control for such activities have to be more informal and inter-
active.

8.21 Think about the mid-terms you take. You plan to spend a certain amount of time on each
subject based on your assessment of the difficulty of each subject. When you get your
grades back, you may not have done as well as you might have expected in some
subjects, and you may have done exceedingly well in others. This helps you in allocating
your time to study for the finals.

8.22 The sales volume variance will be unfavorable when the actual sales volume is less than
the planned sales volume underlying the master budget. The sales price variance will be
unfavorable when the actual sales price is less than the expected sales price at the time of
preparing the master budget. Yes, it is possible. Think of the reduced demand for trucks
and SUVs in response to steeply rising fuel price in the first six months of 2008. The auto
companies are reducing the prices on these vehicles to increase sales. Yet, despite such
price cuts, the sales of these vehicles decreased during this period.

8.23 Not necessarily. The sales volume variance has little to do with input quantities. It will be
favorable when the actual sales volume (i.e., output sold) is greater than the planned sales
volume underlying the master budget.

8.24 The materials price variance will be unfavorable if the actual price of materials is higher
than the budgeted price. It may not always indicate a control problem. Unexpected
shortages in the market can cause the price of materials to increase. The purchase
manager cannot be held responsible for such eventualities.

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8.25 The material quantity variance will be unfavorable if the actual quantity consumed is
more than the budgeted quantity for the actual output produced. A favorable materials
price may well be related to an unfavorable quantity variance if substandard materials are
bought (hence a favorable price variance) and used in the production process (use of
more materials than required because of low quality). For similar reasons, an unfavorable
labor quantity variance (use of more labor than budgeted) may be related to a favorable
quantity variance if inexperienced labor is used.

8.26 Some of the traditional variances lose their meanings in “lean” production environments
such as JIT. Entering into long-term contracts with suppliers ensures a stable supply of
critical inputs. However, firms often pay a premium for such arrangements. Budgets have
to reflect this philosophy so that traditional variances can serve a meaningful control role
(if at all). By the same token, new variances may have to be designed that can be useful
in such environments. Turning to the labor quantity variance, the focus in a JIT
environment is to achieve high quality levels with minimal defective production. Instead
of focusing on the traditional labor quantity variance in such settings, variances such as
the deviation of the output rate from an expected rate can be effective for control
purposes.

8.27 As we know, the sales volume variance will be favorable when the actual sales volume is
more than planned sales volume underlying the master budget. Unexpected demand
spurts can lead to a favorable variance. But when such a spurt occurs, capacity resources
get stretched, in which case the actual fixed costs are likely to increase (e.g., rental of
additional equipment, overtime paid for supervision)

8.28 We can think of the expected value as being similar to budgets. Any deviation within the
control limits is “acceptable” if it does not persist over time, or if it is just a chance
deviation. Persisting deviations even within control limits is often an indication of a shift
in the process that may worsen if not corrected. In principle, profit variance analysis is
very similar. If production costs go up, unfavorable variances will be generated.
Persisting variances may be indicative of a shift in cost structure or process efficiencies.

8.29 While non-financial measures are specific and timely, they are often numerous and they
interact with one another. Increasing customer satisfaction often requires spending more
time with the customer. Both customer satisfaction measures and mean time per call are
non-financial measures that are (typically) related to each other. Deciding how much time
to spend on each customer requires trading off the long-term financial benefit from
keeping customers satisfied against the cost of time and resources needed.

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EXERCISES

8.30
a.
The total profit variance = actual profit – master budget profit. With the information
provided, we have:

Master Actual
Budget Results
# of cupcakes 4,000 4,500
Revenue $10,000 $10,800
Variable costs 4,000 4,500
Contribution margin $6,000 $6,300
Fixed costs 2,000 2,000
Profit $4,000 $4,300

Thus, Clarissa’s total profit variance = $300 F = $4,300 – $4,000.

b. & c.

To arrive at the sales volume variance and the sales price variance, we need to calculate
Clarissa’s flexible budget. With the data provided, we have:

Flexible
Budget
# of cupcakes 4,500
Revenue1 $11,250
Variable costs2 4,5000
Contribution margin $6,750
Fixed costs 2,000
Profit $4,750
1
$11,250 = $2.50 × 4,500
2
$4,500 = $1 × 4,500

The sales volume variance equals the difference between flexible budget profit and
master budget profit. For Clarissa, we have $4,750 – $4,000 = $750 F sales volume
variance.

The sales price variance equals the difference between actual revenue and flexible budget
sales revenue. For Clarissa, we have $10,800 – $11,250 = ($450) or $450 U sales price
variance.

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NOTE: Clarissa’s total profit variance of $300 F = $450 U sales price variance + $750 F
sales volume variance. This occurs because actual fixed and variable costs equaled
budgeted fixed and variable costs (i.e., both the fixed cost spending variance and the
flexible budget variable cost variance = $0).

8.31
a.
The total profit variance = actual profit – master budget profit. With the information
provided, we have:

Master Actual
Budget Results
# of cars 60 70
Revenue $3,000,000 $3,150,000
Variable costs 2,400,000 2,800,000
Contribution margin $600,000 $350,000
Fixed costs 350,000 350,000
Profit $250,000 $0

Thus, Select Auto Imports’ total profit variance = $0 – $250,000 = ($250,000) or

$250,000 U.

That is, Select Auto Imports’ profit was $250,000 lower than budgeted.

b. & c.
To arrive at the sales volume variance and the sales price variance, we need to calculate
Select Auto Imports’ flexible budget. With the data provided, we have:

Flexible
Budget
# of cars 70
Revenue1 $3,500,000
Variable costs2 2,800,000
Contribution margin $700,000
Fixed costs 350,000
Profit $350,000
1
$3,500,000 = 70 × $50,000.
2
$2,800,000 = 70 × $40,000.

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The following table shows Select Auto Imports’ master budget, flexible budget, and
actual results for the most recent month.

Master Flexible Actual

Budget Budget Results
# of cars 60 70 70
Revenue $3,000,000 $3,500,000 $3,150,000
Variable costs 2,400,000 2,800,000 2,800,000
Contribution margin $600,000 $700,000 $350,000
Fixed costs 350,000 350,000 350,000
Profit $250,000 $350,000 $0

The sales volume variance equals the difference between flexible budget profit and
master budget profit. For Select Auto Imports, we have $350,000 – $250,000 = $100,000
or $100,000 F sales volume variance.

The sales price variance equals the difference between actual revenue and flexible budget
sales revenue. For Select Auto Imports, we have $3,150,000 – $3,500,000 = ($350,000)
or $350,000 U sales price variance.

NOTE: Select Auto Imports’ total profit variance of $250,000 U = $350,000 U sales
price variance + $100,000 F sales volume variance. This occurs because actual fixed and
variable costs equaled budgeted fixed and variable costs (i.e., both the fixed cost
spending variance and the flexible budget variable cost variance = $0).

8.32 Calculating and Interpreting Sales Variances (LO1, LO2, LO3).

a.
The total profit variance = actual profit – master budget profit. With the information
provided, we have:

Master Actual
Budget Results
Sales (seats sold) 480,000 500,000
Ticket Revenue $28,800,000 $31,000,000
Variable costs 1,440,000 1,600,000
Contribution margin $27,360,000 $29,400,000
Fixed costs 12,000,000 12,250,000
Profit $15,360,000 $17,150,000

Thus, BCS University’s total profit variance for football = $17,150,000 – $15,360,000
= $1,790,000 or $1,790,000 F.

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b. & c.
To arrive at the sales volume variance and the sales price variance, we need to calculate
BCS University’s football flexible budget. With the data provided, we have:

Flexible
Budget
Sales (seats sold) 500,000
Ticket Revenue1 $30,000,000
Variable costs2 1,500,000
Contribution margin $28,500,000
Fixed costs 12,000,000
Profit $16,500,000
1
$30,000,000 = 500,000 × $60.
2
$1,230,000 = 500,000 × $3.

The sales volume variance equals the difference between flexible budget profit and
master budget profit. Thus, we have $16,500,000 – $15,360,000 = $1,140,000 or
$1,140,000 F sales volume variance.

The sales price variance equals the difference between actual revenue and flexible budget
sales revenue. For BCS, we have $31,000,000 – $30,000,000 = $1,000,000 or $1,000,000
F sales price variance.

d.
BCS University’s total football profit variance does not equal the sum of the sales
revenue and sales price variances because actual fixed and variable costs did not equal
budgeted fixed and variable costs (i.e., both the fixed cost spending variance and the
flexible budget variable cost variances do not equal $0).

8.33
a.
The total profit variance = actual profit – master budget profit. With the information
provided, we have:

Master Actual
Budget Results
# of members 5,000 4,000
Revenue $2,500,000 $2,200,000
Variable costs 1,000,000 800,000
Contribution margin $1,500,000 $1,400,000
Fixed costs 1,200,000 1,200,000
Profit $300,000 $200,000

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Thus, Kamas’ total profit variance = $200,000 – $300,000 = ($100,000) or $100,000 U.

That is, Kamas’ profit was $100,000 lower than expected.

b.
To arrive at the sales volume variance and the sales price variance, we need to calculate
Kamas’ flexible budget. With the data provided, we have:

Flexible
Budget
# of members 4,000
Revenue1 $2,000,000
Variable costs2 800,000
Contribution margin $1,200,000
Fixed costs 1,200,000
Profit $0
1
$2,000,000 = 4,000 × $500.
2
$2,800,000 = 4,000 × $200.

The following table shows Kamas’ master budget, flexible budget, and actual results for
the most recent year.

Master Flexible Actual

Budget Budget Results
# of members 5,000 4,000 4,000
Revenue $2,500,000 $2,000,000 $2,200,000
Variable costs 1,000,000 800,000 800,000
Contribution margin $1,500,000 $1,200,000 $1,400,000
Fixed costs 1,200,000 1,200,000 1,200,000
Profit $300,000 $0 $200,000

The sales volume variance equals the difference between flexible budget profit and
master budget profit. For Kamas’ Gym, we have $0 – $300,000 = ($300,000) or $300,000
U sales volume variance.

The sales price variance equals the difference between actual revenue and flexible budget
revenue. For Kamas’ Gym, we have $2,200,000 – $2,000,000 = $200,000 F sales price
variance.

NOTE: Kamas’ total profit variance of $100,000 U = $300,000 U sales volume variance
+ $200,000 F sales price variance. This occurs because actual fixed and variable costs
equaled budgeted fixed and variable costs (i.e., both the fixed cost spending variance and
the flexible budget variable cost variance = $0).

Based on the sales variances, it appears that raising the membership fee was not a good
idea as it reduced Kamas’ profit by $100,000. In essence, the increased revenue generated
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from raising the membership fee (i.e., the favorable sales price variance) did not
compensate for the reduction in members from raising the membership fee (i.e., the
unfavorable sales volume variance).

c.
This question links back to the material covered in Chapters 5 and 6. At the time the
decision was made, raising the membership fee to $550 was expected to increase profit
by $75,000. This can be seen by comparing expected profit with and without the increase
in the membership fee:

Budgeted Profit Expected Profit

(without fee increase) (with fee increase)
# of members 5,000 4,500
Revenue1 $2,500,000 $2,475,000
Variable costs2 1,000,000 900,000
Contribution margin $1,500,000 $1,575,000
Fixed costs 1,200,000 1,200,000
Profit $300,000 $375,000
1
: $2,500,000 = 5,000 × $500; $2,475,000 = 4,500 × $450.
2
: $1,000,000 = 5,000 × $200; $900,000 = 4,500 × $200.

Alternatively, we could calculate the benefit of increasing the membership fee as 4,500 
$50 = $225,000 and the cost (lost contribution margin due to 500 fewer members) as 500
 ($500 – $200) = $150,000, again netting to a $75,000 increase in profit. Either way, the
decision appeared to be a good one based on the data available at the time the decision
was made. Unfortunately, the actual decrease in membership was double that expected
(1,000 vs. 500), leading to a $100,000 reduction in profit, as documented earlier.

This problem underscores the importance of conducting variance analysis – what

appeared to be a good decision turned out to be a poor decision (in terms of the bottom
line, anyway). Had we not undertaken a retrospective examination of the owner’s
decision to increase the membership fee (i.e., by calculating the sales price and sales
volume variances) the negative effect on profit might have gone unnoticed. With variance
analysis, the owners are in a position to correct the decision they previously made – based
on our calculations, the owners should seriously consider going back to a $500 annual
membership fee in the coming year.

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8.34
The following table shows Hercules’ master budget, flexible budget, and actual results
for April.

Master Flexible Actual

Budget Budget Results
# of members 950 975 975
Revenue $95,000 $97,500 $98,100
Variable costs 33,250 34,125 34,125
Contribution margin $61,750 $63,375 $63,975
Fixed costs 42,000 42,000 43,000
Profit $19,750 $21,375 $20,975

We therefore have:

(1) Sales volume variance = $21,375 - $19,750 = $1,625 F

(2) Sales price variance, = $98,100 - $97,500 = $600 F
(3) Variable cost variance = $34,125 - $34,125 = $0
(4) Fixed cost variances = $42,000 -$43,000 = $1,000 U

Of course, the sum of these variances is $1,225F, which is the difference between the
actual and budgeted profit.

8.35
To calculate the chlorine price and quantity variances, we need to know: (1) the flexible
budget for chlorine; (2) the “as if” budget for chlorine with actual efficiencies; and (3) the
actual results. The table below provides the required computations and accompanying
variances.

Flexible Quantity “As if” Price Actual

Budget1 Variance budget2 Variance Results3
Chlorine $2,000 $240 U $2,240 $140 F $2,100
1
$2,000= 500 pools × .50 gallons per pool × $8.00 budgeted cost per gallon.
2
$2,240 = 280 gallons actually used × $8.00 budgeted cost per gallon.
3
$2,100 = 280 gallons actually used × $7.50 actual cost per gallon.

Thus, Crystal’s chlorine price and quantity variances were $140 F and $240 U,
respectively, for the most recent week.

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8.36
a.
To calculate the materials price and quantity variances, we need to know: (1) the flexible
budget for materials; (2) the “as if” budget for materials with actual efficiencies; and (3)
the actual results. The table below provides the required computations and accompanying
variances.

Flexible Quantity “As if” Price Actual

Budget1 Variance budget2 Variance Results3
Materials $750 $62.50 U $812.50 $32.50 U $845
1
$750 = 300 vases actually produced × 2 pounds of materials budgeted per vase ×
$1.25 budgeted cost per pound.
2
$812.50 = 650 pounds of materials actually used × $1.25 budgeted cost per
pound.
3
Given.

Thus, Glass Vessel’s materials price and quantity variances were $32.50 U and
$62.50U, respectively, for March.

b.
As in part [a], to calculate the labor price and quantity variances, we need to know: (1)
the flexible budget for labor; (2) the “as if” budget; and (3) the actual results. The table
below provides the required computations and accompanying variances.

Flexible Quantity “As if” Price Actual

Budget1 Variance budget2 Variance Results3
Labor $6,750 $450 U $7,200 $0 $7,200
1
$6,750 = 300 vases actually produced × 1.5 hours of labor budgeted per vase ×
$15.00 budgeted cost per labor hour.
2
$7,200 = 480 hours actually worked × $15 budgeted cost per labor hour.
3
Given.

Thus, Glass Vessel’s labor price and quantity variances were $0 and $450 U,
respectively, for March.

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8.37
a.
From Appendix A, we know:

Purchase price variance = (Budgeted input price – Actual input price) × Actual quantity
purchased.

Moreover, we know that the unit cost is $1.30 ($910/700) for the amount of materials
purchased.

Applying the formula, we have:

($35) = (1.25 – 1.30) × 700 pounds.

Thus, the purchase price variance for March is $35 U.

b.
As discussed in Appendix A, some argue that the purchase price variance is a better
measure for evaluating the purchasing function since these individuals are responsible for
the amount of materials purchased. On the flip side, using the purchase price variance can
provide managers with incentives to take advantage of quantity discounts, which can
ultimately lead to undesirable inventory build-ups. Additionally, using the purchase price
variance will not lead to a full reconciliation of the total profit variance (i.e., the budget-
reconciliation report will not tie out) because the variance is computed using materials
purchased and not materials used in production (i.e., it is not based on actual output).
Finally, it is often the case that the difference between the purchase price variance and the
materials price variance is negligible, rendering the choice of which variance to compute
moot. In the end, organizations must balance the benefits and costs associated with using
each variance and choose the one that best meets their needs – because of the incentive
issues and simplicity and completeness (in the sense of reconciling actual profit with
master budget profit), we emphasize the materials price variance.

8.38
a.
To calculate the ground beef price and quantity variances, we need to know: (1) the
flexible budget for ground beef; (2) the “as if” budget for ground beef; and (3) the actual
results. The table below provides the required computations and accompanying variances.

Flexible Quantity “As if” Price Actual

Budget1 Variance Budget2 Variance Results3
Ground Beef $4,050 $300 F $3,750 $250 U $4,000
1
$4,050 = 1,200 hamburgers actually served × (225/200) pounds of ground beef
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budgeted per hamburger × $3.00 budgeted cost per pound.

2
$3,750 = 1,250 pounds of ground beef actually used × $3.00 budgeted cost per
pound.
3
$4,000 = 1,250 pounds actually used × $3.20 per pound.

Thus, J&M’s ground beef price and quantity variances were $250 U and $300 F,
respectively, for the most recent week.

b.
The ground beef price variance is unfavorable because Juhee and Michael actually paid
$3.20 per pound while it only budgets to pay $3.00 per pound. The ground beef quantity
variance is favorable because J&M’s actually used 1,250/1,200 = 1.04 pounds of ground
beef per hamburger rather than the budgeted 225/200 = 1.125 pounds of ground beef per
hamburger.

One explanation for this pattern of results is that Juhee and Michael purchased higher
quality ground beef than usual and this resulted in less overcooking and, in turn, less
waste.

Another explanation is that since J&M averaged 171 hamburgers per day (i.e., 1,200/7)
rather than the “usual” 200, staff generated less ground beef waste because they were less
busy (i.e., they were able to watch the hamburgers more closely).

Finally, it is possible that J&M’s standards simply need to be revised to reflect, for
example, the increase in the price of ground beef or a new grill that allows employees to
generate less waste.

8.39
To calculate the towel price and quantity variances, we need to know: (1) the flexible
budget for towels; (2) the “as if” budget for towels; and (3) the actual results. The table
below provides the required computations and accompanying variances.

Flexible Quantity “As if” Price Actual

Budget1 Variance Budget2 Variance Results3
Towels $726.25 $83.25 U $810 $27 U $837
1
$726.75 = (969 members / 4) × $3.00 budgeted cost per towel.
2
$810 = 270 towels actually used × $3.00 budgeted cost per pound.
3
$837= Given

Thus, Hercules’ towel price and quantity variances were $27U and $83.25U,
respectively.

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8.40
a.
To calculate the labor price and quantity variances, we need to know: (1) the flexible
budget for labor; (2) the “as if” budget for labor; and (3) the actual results. The table
below provides the required computations and accompanying variances.

Flexible Quantity “As if” Price Actual

Budget1 Variance Budget2 Variance Results3
Labor costs $1,312.50 $437.50 U $1,750 $280 F $1,470
1
$1,312.50 = 210 cars actually service × 0.50 hours of labor budgeted per car ×
$12.50 budgeted cost of labor per hour.
2
$1,750 = 140 hours worked × $12.50 budgeted cost of labor per hour.
3
Given.

Thus, QuickyLube’s labor price and quantity variances were $280 F and $437.50 U,
respectively, for the most recent week.

b.
QuickyLube’s labor price variance is favorable because the actual wage rate per hour of
$10.50 was less than the budgeted wage rate of $12.50 per hour. The labor quantity
variance is unfavorable because QuickyLube’s technicians actually spent 140/210 = .67
hours per car serviced (40 minutes) rather than the budgeted 30 minutes per car serviced.

One explanation for this pattern of results is that, because QuickyLube had a slower than
average week (i.e., they serviced 65 fewer cars than budgeted), management scheduled
newer and relatively less experienced technicians. In turn, this lead to a favorable
technician price variance (because newer technicians are likely to receive a lower wage
rate than more experienced technicians) and an unfavorable technician quantity variance
(because newer technicians are likely to take more time per car serviced than experienced
technicians).

As with any variance, it is also possible that QuickyLube’s standards are out of date and
need to be revised to reflect changes in market or operating conditions.

8.41
To calculate the flour price and quantity variances, we need to know: (1) the flexible
budget for flour; (2) the “as if” budget for flour with actual efficiencies; and (3) the actual
results. The table below provides the required computations and accompanying variances.

Flexible Quantity “As if” Price Actual

Budget1 Variance budget2 Variance Results3
Flour $202.50 $22.50 F $180 $21.60 F $158.40
1
$202.50 = 3,240 doughnuts in actual output × .25 (= 625/2,500) pounds of flour
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budgeted per doughnut × $0.25 budgeted cost per pound.

2
$180 = 720 pounds of flour actually used × $0.25 budgeted cost per pound.
3
$158.40 = 720 pounds of flour actually used × $0.22 actual cost per pound.

Thus, Homer’s flour price and quantity variances were $21.60 F and $22.50 F,
respectively, for the most recent week.

The flour quantity variance is favorable because Homer actually made 3,240/720 = 4.5
doughnuts per pound of flour rather than the budgeted 4.0 doughnuts per pound of flour.

Note: To calculate the flexible budget amount, we need to start with actual output, which
equals 3,240 chocolate-glazed doughnuts. Since Homer budgets to make 4 doughnuts per
pound of flour, the flexible budget quantity for flour = 3,240/4 = 810 pounds of flour.

These variances are relatively small and it is likely that Homer will not pursue them
further. One explanation for the pattern of variances observed is that Homer’s employees
did an excellent job in beating their budgets – e.g., Homer’s employees found a better
supplier for the flour they use and also manufactured the doughnuts using less flour than
expected (i.e., they were less “wasteful”). Moreover, while the variances are small, a
continued trend of favorable flour price and quantity variances do add up and may lead
Homer to reward the employees responsible. Finally, it is always possible that Homer’s
standards are out of date and need to be revised.

8.42
The table below provides the required

Flexible Quantity “As if” Price Actual

Budget1 Variance budget2 Variance Results3
Polymer $27,000 $4,500 F $22,500 $3,150 U $25,650
1
$27,000 = 18,000 pounds × $1.50 per pound.
2
$22,500 = $27,000 – $4,500.
3
$25,650 = $22,500 + $3,150.

Because we know the budgeted price is $1.50 per pound, we can use the “as if” budget to
calculate the actual quantity of the polymer material used in production. Specifically,
because the “as if” budget = the actual input quantity × budgeted input price, we know
that $22,500 = actual input quantity × $1.50, or $22,500/$1.50 = 15,000 actual pounds
used.

We can then use this number, coupled with the actual results, to find the actual price per
pound because we know: actual results = actual input quantity × actual price. Thus,
$25,650 = 15,000 × actual price, or $25,650/15,000 = $1.71 actual price.

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One explanation for this pattern of results is that GripRite purchased a higher quality
polymer material and, in turn, incurred less waste and spoilage during the production
process.

8.43
a.
The alertness of security officers is very important – simply having someone awake and
visible is enough to deter many crimes. Thus, the challenge Guardian Services faces is to
ensure that their security officers are providing the appropriate input, alertness.

Controls that require some physical action on the part of the security officer are likely to
be particularly effective. For example, Guardian Services may require that their security
officers enter a code in a computer window that pops up at random intervals (say 20
minutes). The system could then dial a central number if the security officer does not
respond within a pre-set interval (say 5 minutes). Monitoring the delay in response (i.e.,
counting the number of delays) is a way to figure out who is “sleeping on the job.”

Guardian also may “monitor the monitor” by videotaping their security officers and
having someone review random segments of each videotape. Naturally, this would entail
hiring another individual and is likely to be more costly than the previous option.

b.
With police officers, there probably is little opportunity to doze off. There is constant
communication between the police dispatcher/control center and the officers.
Furthermore, the amount of miles driven by each officer is measured on a regular basis.

Rather than monitoring alertness, it would seem to be more important to measure output
statistics such as the number of arrests or citations. Moreover, the concern with the police
officers probably does not rest on whether they are awake but, rather, whether they are
spending their waking hours keeping the peace. Such output statistics can then be
compared against historical averages and against the statistics generated by other officers.
Thus, there probably is some merit to the age-old argument that officers have a “quota” –
such tracking ensures that the officers are doing their job.

c.
The control mechanisms differ because of differences in the nature of each job. With the
security officers, both the preferred and expected outcome is for nothing to happen. There
also is potential for slacking, implying that controls are necessary to obtain the desired
behavior. In this case, given the lack of an appropriate output-based measure (since we
expect little activity), input-based controls and performance measures are needed.

With the police officers, the preferred outcome is for nothing to happen but,
unfortunately, we expect that people actually will violate the law, resulting in citations
and other interventions by the officers. There still is the potential for slacking since the
officers are on their own (or with one partner). Thus, we are again faced with the
challenge of ensuring that the officers are being vigilant in their duties. In this case,
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however, we have an appropriate outcome measure – the number of citations or arrests.

This measure ensures the police officers are patrolling the street and enforcing the law.

8.44
a.
As the franchisee, you need to monitor both financial measures (for assessing business
profit) and non-financial metrics (for ensuring adherence to policies and to identify future
problems and opportunities).

Financial Performance Measures:

On a short-term (daily and/or weekly) basis, you probably will monitor total sales (as per
the register) and receipts (as per the cash drawer). This informs you of what is coming
into the business and whether it differs from the prior week or budget. Further, a
reconciliation between total sales (per the register) and receipts informs you of whether
you have problems with regard to employee theft.

You also probably would track total purchases and total labor costs. In this business,
purchases of food items and supplies and labor represents the bulk of your variable costs.
Similar to sales, these items can be compared to the budget, with any significant
deviations being followed up. Finally, by tracking sales, purchases, and labor costs, you
monitor your weekly contribution margin; again, this enables you to assess any increases
or decreases relative to the budget.

Non-Financial Performance Measures:

Here, you probably would track things like customer complaints and employee
absenteeism/turnover (complaints and absent employees are early warning signs that
something is wrong). You also might track materials usage, which is important both to
ensure that customers are not getting short-changed in the amount of food served and to
prevent pilferage. Finally, you would track the cleanliness of the restaurant and facilities
and assure general adherence to daily procedures.

b.
Non-financial measures are more immediate (timely) and actionable (specific); they
ensure that people are doing what they are supposed to be doing and that processes are
performing as expected. Such measures can help identify and correct problems before
they become severe (e.g., for a sports analogy, if players are not showing up for practice,
this decreases the chances of doing well).

Financial measures tend to be more aggregate in nature; they are excellent summary
measures showing how a business has performed for a given period of time. These
measures allow us to quickly assess whether the business is on track or in need of help
(similar to the win-loss record of a sports team).

The two types of measures clearly are related. For example, employee absenteeism would
show up eventually in the financial statements both in the form of reduced sales and

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increased staffing cost. Tracking absenteeism directly allows for immediate identification
of problem employees with a ready-made solution.

8.45
The performance measures at Darjeeling Tea are non-financial and output-based for
pickers because there is a strong relation between input and output; more time spent
picking translates to more tea leaves picked. Additionally, output is easily measured at
the individual level since pickers work alone.

There is no need to specify start and stop times or output quotas because workers have
incentives to maximize their productivity (output) – doing so maximizes their income.
Thus, Darjeeling can let workers decide how much they wish to make; if Darjeeling
wishes to increase output, they can simply hire more workers. Finally, pickers have
incentives to maintain the long-term viability of the business (e.g., be gentle when
picking, not tread on young shrubs, and so on) because they will be returning to the same
estate each day for work. In other words, if they damage a tea shrub, they jeopardize their
future income. On the flip side, the estate’s output relies crucially on worker morale and
output, ensuring humane and equitable treatment.

Financial measures are not useful because the workers have no control over the price of
tea leaves – they only have control over the quantity and quality of leaves they pick.

8.46

To compute the market size and share variances, we need data on budgeted market size
and actual market share. Because the problem does not provide these numbers, we need
to compute them:

Budgeted market size. The budget called for sales of 950 members and this volume was
estimated to be 15% of the market. Consequently, the budgeted market size must have
been 6,333 units = 950/0.15.

Actual market share. The actual market size was 6,075 members, and the actual sales
volume was 975. Consequently, the actual market share = 975/6,075 = 16.05%.

We now have all of the data necessary to compute the market size and market share
variances. From Appendix B, we know that:

Market Share Variance = Actual Market Size × (Actual Market Share – Budgeted Market
Share) × Budgeted Unit Contribution Margin.

Market Size Variance = (Actual Market Size – Budgeted Market Size)

× Budgeted Market Share × Budgeted Unit Contribution Margin.

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From the earlier problem, we know that Budgeted Unit Contribution Margin = $20 per
rocket ship. Thus, we have:

Market Share Variance = 6,075 × (0.1605 – 0.15) × $65 = $4,147 F.

Market Size Variance = (6,075 – 6,333) × 0.15 × $65 = $2,516 U.

Of course, the sum of the market size and share variances is $1,631 U. We can verify
that this is the sales volume variance: (975 members – 950 members) × $65 per
member = $1,625 U (the difference is due to rounding off errors).

Notice that we do not use data on actual contribution margin. That information is relevant
for calculating the flexible budget variance. The market size and share variances
decompose the sales volume variance, which is a function of budgeted unit contribution
margin.

8.47
a.
Using the information provided, we have:

Master Budget Flexible Budget

Individuals 700 750
Families 300 250
Revenue – Individual $70,000 $75,000
Revenue – Family 45,000 37,500
Variable costs - Individual 24,500 26,250
Variable costs - Family 18,000 15,000
Contribution margin $72,500 $71,250

Notice that we can stop after contribution margin because the fixed cost will be the same
for both the master and the flexible budget.

Thus:

Sales volume variance = flexible budget profit – master budget profit = $71,250 –
$72,500 = $1,250 U.

b. & c.
We gain intuition into the operating results by recasting the above data using a Weighted
Unit Contribution Margin (WUCM). We have the

WUCMmaster = $72,500 / (700 + 300 memberships) = $72.50 / membership.

WUCMflexible = $71,250 / (750 + 250 memberships) = $71.25 / membership.

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We could compute the answers using the formulae provided in Appendix C.

Sales Mix Variance = Actual Total Sales × (WUCMflexible budget – WUCMmaster budget).

Sales Quantity Variance = (Actual Total Sales – Budgeted Total Sales)

× WUCMmaster budget.
Plugging in the numbers we have:

Sales Mix Variance = 1,000 × ($72.5 - $71.25) = ($1,250) or $1,250 U.

Sales Quantity Variance = (1,000 – 1,000) × $72.50 = $0.

8.48
a.
Using the information provided, we have:

Master Budget Flexible budget Actual results

Revenue – F1 $3,750,000 $4,500,000 4,500,000
Revenue – F2 3,000,000 2,000,000 2,000,000
Revenue – F3 4,000,000 4,000,000 4,000,000
Variable costs - F1 1,875,000 2,250,000 2,250,000
Variable costs - F2 1,650,000 1,100,000 1,100,000
Variable costs - F3 2,400,000 2,400,000 2,400,000
Contribution margin $4,825,000 $4,750,000 $ 4,750,000
Fixed costs 3,860,000 3,860,000 3,860,000
Profit $965,000 $890,000 $890,000

Thus:

Sales volume variance = flexible budget profit – master budget profit = $890,000 –
$965,000 = ($75,000) or $75,000 U.

Flexible budget variance = actual profit – flexible budget profit = $890,000 – $890,000
= $0.

We expect the flexible budget variance to be zero because the unit selling prices, variable
costs and fixed costs were all as budgeted. The sales volume variance is a bit puzzling,
though. Tornado budgeted to sell a total of 50,000 units and actually sold this amount.
Yet, the company has a sales volume variance of $75,000 U. How could this be? Parts (b)
and (c) help us understand this result.

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b. & c.
We gain intuition into Tornado’s operating results by recasting the above data using a
Weighted Unit Contribution Margin (WUCM). We have:

Master budget Flexible budget Actual results

Total units 50,000 50,000 50,000
Weighted Unit
Contribution
Margin1 $96.50 $95.00 $95.00
Contribution margin $4,825,000 $4,750,000 $ 4,750,000
Fixed costs 3,860,000 3,860,000 3,860,000
Profit before taxes $965,000 $890,000 $890,000
1
: $96.50 in master budget = 25,000/50,000 × $75 + 15,000/50,000 × $90 + 10,000/50,000 × $160; $95.00
in flexible budget = 30,000/50,000 × $75 + 10,000/50,000 × $90 + 10,000/50,000 × $160. The flexible
budget and actual WUCM are both $95 because the budgeted selling prices and variable costs for all three
products were the same as the actual selling prices and variable costs.

NOTE: We also could compute the WUCM for the master budget as $96.50 (=
$4,825,000/50,000 units). Similar computations apply to the other columns.

This table informs us that the flexible budget variance is a direct consequence of the
WUCM being different for the master budget and the flexible budget. This occurs even
though both budgets use the same unit selling prices and variable costs. Why? Because
the two budgets could have a different sales mix – the master budget employs the original
sales mix and sales volume, while the flexible budget uses the actual sales mix and
volume.

Thus, the sales volume variance mingles two effects – changes in the total number of
units sold and changes in the mix of units sold. We could decompose the two factors as
below:

“As if” budget

with budgeted Flexible
Master Budget sales mix budget
Total units 50,000 50,000 50,000
Weighted Unit
Contribution Margin $96.50 $96.50 $95.00
Contribution margin $4,825,000 $4,825,000 $ 4,750,000
Fixed costs 3,860,000 3,860,000 3,860,000
Profit before taxes $965,000 $965,000 $890,000

The profit difference between the first two columns is purely due to changes in sales
quantity, holding sales mix constant. For Tornado, the sales quantity variance is $0 =
$965,000 – $965,000. The sales mix variance is the profit difference between the “as if”
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budget and the flexible budget. For Tornado, the sales mix variance = ($75,000) U =
$890,000 – $965,000.

Alternatively, We could compute the answers using the formulae provided in Appendix
C.

Sales Mix Variance = Actual Total Sales × (WUCMflexible budget – WUCMmaster budget).

Sales Quantity Variance = (Actual Total Sales – Budgeted Total Sales)

× WUCMmaster budget.
Plugging in the numbers we have:

Sales Mix Variance = 50,000 × ($95 - $96.50) = ($75,000) or $75,000 U.

Sales Quantity Variance = (50,000 – 50,000) × $95 = $0.

d.
The change in the sales mix is the reason for the unexpected drop in profit. The sales mix
has shifted toward the less profitable (on a per unit basis) F1 and away from the more
profitable F2. Consequently, the average vacuum cleaner now only yields $95 in
contribution margin rather than the budgeted amount of $96.50. This change in mix over
50,000 units leads to a net drop of $75,000 in profit ($75,000 = 50,000 × $1.50).

PROBLEMS

8.49
a.
With the information provided, Space Toys’ flexible budget for the most recent quarter of
operations is:

Flexible Budget Detail

Rocket ship sales 12,000 units Actual sales

Revenue $300,000 12,000  $25;

$25 = $375,000/15,000
Variable costs 60,000 12,000  $5;
$5 = $75,000/15,000
Contribution margin $240,000
Fixed costs 150,000 from the master budget
Profit $90,000

b.
The sales volume variance = flexible budget profit – master budget profit, or $90,000 –
$150,000 = ($60,000) or $60,000 U.

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The sales price variance = actual revenue – flexible budget revenue, or $300,000 –
$300,000 = $0.

c.
The variable cost variance = flexible budget variable costs – actual variable costs, or
$60,000 – $54,000 = $6,000 or $6,000 F.

The fixed cost variance = budgeted fixed costs – actual fixed costs, or $150,000 –
$141,000 = $9,000 or $9,000 F.

Note: We do not have enough information to decompose the flexible budget variable cost
variance into price and quantity components.

d.
Based on the variances we calculated, it appears that the Marketing Director is
responsible. Sales are 3,000 units lower than expected; this alone reduced Space Toys’
profit by $60,000, as shown by the unfavorable sales volume variance. Moreover, actual
profit would have been $90,000, or 40% lower than expected had the production manager
not done an excellent job controlling costs (as evidenced by the total $15,000 favorable
cost variances). A focus on sales and income masks the Production Manager’s good
performance, and mutes the Marketing Director’s poor performance.

There are, of course, caveats to this story. For example, the decrease in sales may actually
be related to the Production Manager’s excellent performance. For example, it is possible
that the Production Manager’s cost-cutting efforts reduced the quality of the product
which, in turn, reduced the demand for the product.

It also is possible that the decrease in sales volume is outside the Marketing Manager’s
control; for example, consumer tastes and preferences may have changed (perhaps rocket
ships were “hot” last year and not the trend this year). Alternatively, perhaps a competitor
has entered the market and captured some of Space Toys’ market share. Such reasons
underscore the importance of examining market size and market share variances, issues
that are addressed in Appendix B and the next problem.

8.50
To compute the market size and share variances, we need data on budgeted market size
and actual market share. Because the problem does not provide these numbers, we need
to compute them:

Budgeted market size. The budget called for sales of 15,000 rocket ships, and this volume
was estimated to be 10% of the market. Consequently, the budgeted market size must
have been 150,000 units = 15,000/0.10.

Actual market share. The actual market size was 100,000 rocket ships, and the actual
sales volume was 12,000 rocket ships. Consequently, the actual market share =
12,000/100,000 = 12%.
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We now have all of the data necessary to compute the market size and market share
variances. From appendix B, we know that:

Market Share Variance = Actual Market Size × (Actual Market Share – Budgeted Market
Share) × Budgeted Unit Contribution Margin.

Market Size Variance = (Actual Market Size – Budgeted Market Size)

× Budgeted Market Share × Budgeted Unit Contribution Margin.

From the earlier problem, we know that Budgeted Unit Contribution Margin = $20 per
rocket ship. Thus, we have:

Market Share Variance = 100,000 × (0.12 – 0.10) × $20 = $40,000 F.

Market Size Variance = (100,000 – 150,000) × 0.10 × $20 = $100,000 U.

Of course, the sum of the market size and share variances is $60,000 U, which is exactly
what we determined to be the sales volume variance in the earlier problem.

The market-size and market-share variances inform us that the decrease in revenue is
attributable to the substantial reduction in the overall size of the market and not Space
Toys’ share of the market. Because of this, we probably would re-evaluate our
assessment of the Marketing Manager’s performance. The marketing manager cannot
control consumer tastes and preferences (market size) – in this regard, it is possible that a
new toy is “hot” – i.e., perhaps rocket ships were big last year and a different toy is hot
this year. Because of this, we naturally would expect Space Toys sales to decrease, at no
fault of the Marketing Manager.

Holding the size of the market constant, Space Toys’ share has increased from 10% to
12% – this implies that the Space Toys has improved their position in the market vis-à-
vis their competition. Because this is part of the job of the Marketing Manager, we would
conclude that s/he has done well, although we may still wish to examine whether market
share has increased simply because a competitor has exited the market.

8.51
a.
The following table shows Ajay’s master budget profit and actual profit for the month of
December:

Master
Budget Actual
Profit* Profit
Packages wrapped 1,250 1,500
Revenue $3,750 $4,500
Variable costs 1,250 1,600
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Contribution margin $2,500 $2,900

Fixed costs 600 700
Profit $1,900 $2,200

* Ajay’s budgeted selling price is $3.00 per package and his budgeted variable cost is
$1.00 per package. Thus, Ajay’s master budget revenue = 1,250 × $3.00 = $3,750 and his
master budget variable costs = 1,250 × $1.00 = $1,250.

From this table, we see that Ajay’s actual profit for December was $300 higher ($2,200 –
$1,900) than his master budget profit. That is, Ajay’s total profit variance is $300 F.

b.
Ajay’s sales volume variance equals the difference between his flexible budget profit and
master budget profit for the month of December. We calculated Ajay’s master budget
profit in part [a]. Thus, we need to calculate Ajay’s flexible budget profit. With the data
provided, we have:

Flexible
Detail Budget
Packages wrapped 1,500
Revenue # packages  $3.00 $4,500
Variable costs # packages  $1.00 1,500
Contribution margin $3,000
Fixed costs $600 (given) 600
Profit $2,400
Thus, Ajay’s sales the sales volume variance is $2,400 – $1,900 = $500 or $500 F. This
can be intuitively explained as follows – Each package is budgeted to contribute $2.00
toward profit; since Ajay wrapped 250 more packages than budgeted, the increase in
volume should have contributed $500 = 250 × $2.00 to actual profit.

c.
Using our answers from parts [a] and [b], we can construct the following table
delineating master budget profit, flexible budget profit, and actual profit:

Master Flexible
Budget Budget Actual
Packages wrapped 1,250 1,500 1,500
Revenue $3,750 $4,500 $4,500
Variable costs 1,250 1,500 1,600
Contribution margin $2,500 $3,000 $2,900
Fixed costs 600 600 700
Profit $1,900 $2,400 $2,200

Ajay’s overall variable cost variance equals the difference between his flexible variable
costs and his actual variable costs, or $1,500 – $1,600 = ($100) or $100 U.
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Ajay’s fixed cost spending variance equals the difference between budgeted and actual
fixed costs, or $600 – $700 = ($100) or $100 U.

Unfortunately, we do not have enough information to decompose Ajay’s variable cost

variance into price and quantity components. To calculate these variances we would need
to the amount of supplies Ajay budgets to use per package wrapped and the actual and
budgeted price of each supply (i.e., an unfavorable variable cost variance can arise
because Ajay used more supplies per package wrapped and/or he paid more than
budgeted for the supplies used). While the problem seems to suggest that Ajay’s
unfavorable variable cost variance arose due to spending more on bows than planned, it is
not clear that the entire $100 variance is attributable to this. Indeed, it is possible that the
bow price variance was greater than $100 U and that Ajay had a favorable supply
quantity variance to offset this. Ajay would likely wish to gather this additional
information to pinpoint the cause of the flexible budget cost variance.

d.
We can now prepare the following budget reconciliation report:

Item Amount Detail

Master budget profit $1,900 From the master budget
Favorable sales volume
variance 500 From part [b]
Unfavorable variable cost
variance ($100) From part [c]
Unfavorable fixed cost
spending variance ($100) From part [c]
Actual profit $2,200

In essence, Ajay spent $100 more in variable costs and $100 more in fixed costs than
budgeted; coupled with the sales volume variance, these two factors explain the
difference between Ajay’s master budget and actual profit.

8.52
a.
We need to complete a table like the one below to arrive at Pizzeria Paradise’s dough
price and quantity variances:

Flexible Budget “As if” budget Actual

? ? ?

In terms of calculating the actual dough cost, we know that Pizzeria Paradise used 6,800
pounds of dough and paid $1.90 per pound. Thus, we have:

Actual cost = 6,800  $1.90 = $12,920.

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To calculate the flexible budget amount, we need to start with actual output – for Pizzeria
Paradise, this is 12,000 pizzas. Since Pizzeria Paradise budgets to use ½ pound of dough
per pizza, the flexible budget quantity in pounds equals 12,000  0.50 = 6,000 pounds of
dough. To arrive at the flexible budget cost, we need to multiply this amount by the
planned cost of $2.00 per pound. Thus, we have:

Flexible budget cost = 12,000 pizzas  0.50 pounds of dough per pizza  $2.00/lb. =
$12,000

Moving on to “as if” budget, Pizzeria Paradise actually used 6,800 pounds of dough and
the planned cost per pound is $2.00. Thus, we have:

“As if” budget = 6,800  $2.00 = $13,600.

We now have the information necessary to complete our table and, in turn, compute the
dough price and quantity variances:

Flexible Budget “As if” budget Actual

12,000  0.50  6,800  $2.00 6,800  $1.90
$2.00
$12,000 $13,600 $12,920

Dough price variance = $13,600 – $12,920 = $680 or $680 F.

Dough quantity variance = $12,000 – $13,600 = ($1,600) or $1,600 U.

b.
Performing calculations analogous to those for dough, we arrive at the following for
Pizzeria Paradise’s labor variances for June:

We can complete a table similar to the one we completed for dough. Doing so yields:

Flexible Budget “As if” budget Actual

12,000  0.25  3,200  $8.00 Given
$8.00
$24,000 $25,600 $26,400

Labor price variance = $25,600 – $26,400 = ($800) or $800 U.

Labor quantity variance = $24,000 – $25,600 = ($1,600) or $1,600 U.

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c.
One explanation for this pattern of results is that Pizzeria Paradise purchased lower
quality dough at a lower price. This results in a favorable dough price variance, but could
lead to both unfavorable dough and labor quantity variances as a result of more waste or
spoilage in the making of the pizzas.

A second explanation relates to labor scheduling. The unfavorable labor quantity variance
may be the result of scheduling more people than necessary for a particular shift. The
unfavorable labor price variance may be the result of scheduling more and higher paid
employees (e.g., assistant managers) than was planned.

Finally, it is always possible that Pizzeria Paradise’s plan assumptions and targets are out
of date and need to be revised to reflect current economic conditions (such as a switch in
dough suppliers and/or an increase in the hourly wage rate).

8.53
a.
24,000 transactions are predicted for an average month. For this volume of transactions,
Alvin would budget 24,000/20 = 1,200 hours of work. In turn, the budgeted cost = 1,200
 $12.50 = $15,000 for an average month.

This past November, there were 32,000 transactions. For this volume of transactions,
Alvin would budget 32,000/20 = 1,600 hours of work. In turn, the budgeted cost = 1,600
 $12.50 = $20,000 for this past November.

b.
The actual cost of the tellers for November was $19,000. Comparing this to the budgeted
teller costs for an average month (calculated in part [a]) yields an unfavorable variance
of $4,000 = $15,000 – $19,000.

It probably is not appropriate to evaluate Alvin’s performance for the month of

November using this variance. Relative to the budgeted teller cost for an average month,
the actual teller cost for any particular month can vary for three reasons: (1) changes in
transaction volume, (2) changes in teller efficiency, and/or (3) changes in the hourly
wage rate (price). The first reason, or changes in transaction volume, is not something
that Alvin can control – rather, it is something that Alvin needs to respond to – Alvin’s
job is to manage teller cost for a given level of transaction volume and not to control
transaction volume itself. Accordingly, it is most appropriate to evaluate Alvin’s
performance vis-à-vis the flexible budget for the month of November.

c.
From part [a], we know the flexible budget cost for November = $20,000. Additionally,
from part [b] we know that the actual cost for November = $19,000. Thus, we need only
calculate the “as if” budget to arrive at the teller price and quantity variances. Given that
there 1,520 actual hours worked and the budgeted wage rate is $12.50 per hour, we have:
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“As if” budget = 1,520  $12.50 = $19,000.

We now have the information necessary to compute the teller price and quantity
variances:

Flexible Budget “As if” budget Actual

(32,000/20)  1,520  $12.50 Given
$12.50
$20,000 $19,000 $19,000

Teller price variance = $19,000 – $19,000 = $0

Teller quantity variance = $20,000 – $19,000 = $1,000 or $1,000 F

There is no teller price variance because the actual hourly wage rate of $12.50 (= $19,000
in actual wages divided by 1,520 actual hours) exactly equaled the budgeted hourly rate
of $12.50. The teller quantity variance is favorable because the actual transactions
processed per hour of 21.05 (= 32,000 transactions divided by 1,520 hours worked)
exceeded the budgeted transactions per hour of 20.

Overall, it appears that Alvin has done an excellent job responding to the increased
volume of transactions during the month of November. Oftentimes, such wide
fluctuations in volume can catch people “off guard.” In this case, Alvin seems to have
well anticipated the increased volume and staffed tellers so that he did not have to pay
any overtime premiums. Further, the number of actual transactions processed per hour is
very close to the budgeted transactions per hour – this is good because a significant
deviation in either direction could be interpreted as being “unfavorable.” That is, if tellers
processed too few transactions per hour, we might interpret this as Alvin overestimating
demand and staffing too many tellers. On the other hand, if tellers processed a vast
number of transactions per hour (say over 25), we might interpret this as Alvin
underestimating demand and staffing too few tellers – i.e., customers might be waiting in
long lines and becoming upset. This may have negative long-run repercussions such as
customers switching banks.

8.54
a.
We can calculate Laureen’s budgeted and actual profit from this job as follows:

Master
Budget Profit Actual Profit
Revenue Given $9,000 $9,000
Shari’s time 50  $50; 70  $50 (2,500) (3,500)
Assistant’s time 100  $20; 65  $20 (2,000) (1,300)

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Profit $4,500 $4,200

Thus, Laureen’s actual profit was $300 lower than expected. In other words, there is a
total profit variance of $300 U from this job.

Note: In this problem, Laureen submitted a fixed price bid. Thus, she has to “eat” the
variance. Oftentimes, these types of jobs are billed out based on the actual time spent
because such jobs tend to “change” as the system is installed. That is, as the job evolves,
the consultant discovers new problems, the owner wants more work done, etc. For
example, think about how a “simple” kitchen remodeling job can expand into a total
kitchen renovation.

From the buyer’s standpoint, fixed fee arrangements provide protection against cost over-
runs and/or hidden charges. The downside is that workers have an incentive to take
shortcuts (in Shari’s example, the fewer hours spent on the job, the greater the profit). On
the other hand, jobs billed out on an actual time basis impose risk of cost over-runs and
hidden charges, although workers incentives to take shortcuts are muted. This particular
problem provides a nice venue for instructors to discuss the advantages/disadvantages of
fixed fee contracts.

b.
The tables below provide the required information to calculate the variances.

Laureen’s labor:

Flexible Budget “As if” budget Actual

1  50*  $50 70  $50 70  $50
$2,500 $3,500 $3,500

* The flexible budget quantity = 50 hours because there is only 1 job and Laureen
planned for 50 hours to complete the job. Moreover, it is important to remember that the
flexible budget quantity is based on output (and not input) which, in this case, is the
number of jobs completed. A similar rationale applies for Laureen’s assistant.

Assistant’s Labor:

Flexible Budget “As if” budget Actual

1  100  $20 65  $20 65  $20
$2,000 $1,300 $1,300

Thus, both labor price variances are $0 (since the budgeted input price equaled the
actual input price).

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Thus, Laureen’s labor quantity variance = $3,500 – $2,500 = $1,000 U.

For Laureen’s assistant, the labor quantity variance = $1,300 – $2,000 = $700 F.

c.
The total labor quantity variance is $300 U = ($1,000 U + 700 F). There are no other
costs (e.g., materials), there are no revenue variances, and the actual wage rate equals the
budgeted rate. This number indeed explains the difference between Laureen’s actual
profit and master budget profit for this job.

The fact that the total labor quantity variance is unfavorable seems odd because the actual
total number of hours worked (70 + 65 = 135) is less than the budgeted number of total
labor hours to be worked (100 + 50 = 150 hours). How can we say that the firm was not
as efficient even though fewer total hours were worked? The answer lies in the mix of
hours. While fewer total hours were worked, a greater proportion of these hours were
worked by Laureen (the more skilled and more highly compensated employee). Thus, it
is not appropriate to consider the two types of labor hours as substitutes. Because of this,
it is most appropriate to calculate the labor variances separately. Moreover, combining all
of the variances can obscure differences between employees of differing skill or ability
levels (e.g., a really productive employee and a non-productive employee).

8.55
a.
To calculate the actual quantity of materials used, we use the quantity variance that
compares the flexible budget to the “as if” budget. We cannot use the price variance since
there are two unknowns, the actual price and quantity.

We know that the quantity variance equals the difference between the flexible budget
quantity and the actual quantity multiplied by the budgeted price. Plugging in the data
provided, we have:

($1,875) = (2,500 × 52,500 – actual quantity of materials) × $0.0001.

Or, actual quantity of materials = 150,000,000 mgs.

b.
To calculate the actual price paid for materials, we use the price variance and our answer
from part (a):

Price variance = (budgeted price – actual price) × actual quantity.

With the data provided, we have:

$3,000 = ($0.0001 – actual price) × 150,000,000.

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Or, actual price = $0.00008 per mg.

c.
Following the same setup that we used for materials, we have:

Using the quantity variance and the other data provided, we have:

$180 = (2,500 × (6/60 hours per bottle) – actual quantity of labor) × $12.00.

Or, actual quantity of labor = 235 hours.

d.
To calculate the actual price paid for labor, we use the price variance:

Using the price variance and the other data provided, we have:

($188) = [$12.00 – actual price] × 235.

Or, actual price = $12.80 per hour.

8.56
a.
This problem requires students to understand the relations among the various variances,
as shown in the chapter.

To calculate master budget profit, recall that:

Total profit variance = actual profit – master budget profit

With the data provided, we have:

$5,000 = $100,000 – master budget profit.

Thus, master budget profit = $95,000.

b.
The sales volume variance = flexible budget profit – master budget profit. While we
know master budget profit, we do not know flexible budget profit. Thus, we have one
equation with two unknowns.

Fortunately, we recall that the total profit variance can be written as follows:

Total profit variance = actual profit – master budget profit

= (actual profit – flexible budget profit)
+ (flexible budget profit – master budget profit)
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= sales price variance + variable cost variance

+ fixed costs spending variance + sales volume variance.

Using the information provided, we have:

$5,000 = ($4,000) + $4,000 + ($2,000) + sales volume variance.

Thus, the sales volume variance = $7,000 F.

c.
We know that: sales volume variance = flexible budget profit – master budget profit.

Thus, $7,000 = flexible budget profit – $95,000.

Thus, flexible budget profit = $102,000.

d.
We know that:

Variable cost variance = materials price variance + materials quantity variance + labor
price variance + labor quantity variance.

Plugging in the data provided:

$4,000 = ($1,500) + $2,500 + ($500) + labor quantity variance.

Thus, the labor quantity variance = $3,500 F.

8.57
a.
With the information provided, we calculate Shari’s master budget profit for May as:

Revenue $16,000
Variable costs 4,000 = $16,000 × .25
Contribution margin $12,000
Fixed costs 6,000
Profit $6,000

Alternatively, we can use the CVP model (employing the contribution margin ratio
approach) to compute Shari’s master budget profit for May. We begin by noting that
Shari’s contribution margin ratio is 75% = (1 – the variable cost ratio) = 1 – 0.25 = 0.75.

Accordingly, we have:

Profit before taxes = Contribution margin ratio × Revenue – fixed costs.

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OR, 0.75 × $16,000 – $6,000 = $6,000 of budgeted profit for May.

Shari’s actual profit for May was:

Revenue $21,000
Variable costs 5,800 = total costs – fixed costs
Contribution margin $15,200
Fixed costs 6,300
Profit $8,900

Thus, Shari’s total profit variance for May = $8,900 – $6,000 = $2,900 or $2,900 F.

b.
The challenging aspect of this problem is determining what to use for the flexible budget
computations. The given actual volume of operations is total revenue (not sales quantity),
which is comprised of sales quantity and sales price. As we know, actual revenue can
differ from budgeted sales revenue for two reasons: (1) changes in sales volume (in
units), and (2) changes in sales price.

We can disentangle the sales volume and sales price variances in the following way:
For Shari, actual revenue was $21,000. This included a 5% price increase relative to
normal prices. Thus, at normal prices, she would have recorded revenue of $20,000 =
$21,000/(1 + 0.05) in May.

Next, we need to determine whether expected costs for actual operations should be
defined at the actual revenue of $21,000 or revenue adjusted for changes in the selling
price (i.e., the $20,000). $21,000 would be appropriate if Shari’s variable costs were
something like sales commissions, which vary directly with actual revenue. However,
most of Shari’s costs (flowers) are not related to actual revenue. These costs are
expressed as a function of sales only for convenience. (Consider the difficulty of
computing the cost of each type of flower, estimating the sales mix and so on, if we had
to specify costs in terms of the number of flowers sold.).

Thus, Shari’s flexible budget cost is appropriately expressed in terms of the revenue
adjusted for price changes, or the $20,000. This implies that her flexible budget variable
cost is $20,000 × 0.25 = $5,000.

We are now in a position to compute Shari’s flexible budget and determine the
components of her total profit variance.

Master Flexible Actual

Item Budget Budget results
Revenue $16,000 $20,000 $21,000
Variable costs 4,000 5,000 5,800
Contribution margin $12,000 $15,000 $15,250
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Fixed costs 6,000 6,000 6,300

Profit $6,000 $9,000 $8,900

In turn, we can prepare the following budget reconciliation report:

Item Amount Detail

Master budget profit $6,000 From budget in part [a]
+ Favorable sales price $1,000 $21,000 (actual) – $20,000
variance (flexible budget)
+ Favorable sales $3,000 $9,000 (flexible budget profit)
volume variance – $6,000 (master budget
profit)
– Unfavorable variable ($800) $5,000 (flexible budget
cost variance variable costs) – $5,800
(actual variable costs)
– Unfavorable fixed ($300) $6,000 (budgeted fixed costs)
cost spending variance – $6,300 (actual fixed costs)
= Actual profit $8,900 Calculated in part [a]

The difference between Shari’s actual and budgeted profit for May is now fully
reconciled.

8.58
From Appendix B, we know that:

Market Share Variance = Actual Market Size × (Actual Market Share – Budgeted Market
Share) × Budgeted Unit Contribution Margin.

Market Size Variance = (Actual Market Size – Budgeted Market Size)

× Budgeted Market Share × Budgeted Unit Contribution Margin.

Unfortunately, we do not have Shari’s Budgeted unit contribution margin. However, we

can substitute this with the Contribution Margin Ratio (CMR), if we also define market
size in terms of revenue. Moreover, notice that Shari’s budgeted market share of 2%
corresponds to a budgeted market size of $800,000 = $16,000/0.02. Additionally, Shari’s
actual market share is 1.6% ($20,000/$1,250,000). Notice that we calculate actual market
share based on the revenue with budgeted prices (i.e., actual revenue – the price variance
of $1,000 F.)

Thus, we have:

Market Share Variance = $1,250,000 × (0.016 – 0.020) × 0.75 = $3,750 U.

Market Size Variance = ($1,250,000 – $800,000) × 0.02 × 0.75 = $6,750 F.

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The sum of the market size and share variances is $3,000 F, which equals the sales
volume variance we calculated in the earlier problem.

The additional detail provided by this analysis should give Shari cause for concern. The
market for flowers has experienced a boom. This boom should have increased her profit
by $6,750 relative to budget. However, because she has lost ground in terms of share, she
could only increase profit by $3,000. She needs to figure out why she lost share and find
strategies to regain the lost share. One explanation may relate to the fact that, as
discussed in the previous problem, Shari raised her selling prices by 5 percent.

Note: It is likely that the unfavorable effect of the market share variance is over-stated.
This is because the actual market size would be at actual market prices. Presumably, the
other florists also raised prices, meaning that the market size at budgeted prices would be
lower than $1,250,000. The calculations, however, implicitly assume that Shari’s and the
market sales are at budgeted prices. Because we do the correction for Shari (notice her
sales are $20,000 and not $21,000 for the market share calculation) but not the market,
we calculate the market share to be lower than what it truly is.

8.59
a.
The problem provides us with the actual costs for materials and labor; thus, to calculate
the flexible budget cost variances, we need only determine the flexible budget amounts
for materials and labor. To calculate the flexible budget amounts, we need actual output –
for SpringFresh, it is 60,000 pounds laundered. Next, because materials and labor costs
are expressed in terms of pounds laundered, we can take the respective budgeted amounts
per pound and multiply it by the actual pounds laundered. Thus, we have:

Flexible Budget Actual Variance

Materials 60,000  $0.10 = $6,000 $4,000 $2,000 F
Labor 60,000  $0.40 = $24,000 $20,000 $4,000 F

Notice that because materials and labor costs are directly expressed (budgeted) in terms
of pounds laundered and not, for example, in terms of labor hours or detergent usage, we
are precluded from calculating the materials and labor price and quantity variances.

b.
Absolutely. Without any other information, we would have to conclude that management
indeed has done an excellent job controlling materials and labor costs. At a volume of
60,000 pounds SpringFresh would have budgeted to spend a total of $30,000 ($6,000 +
$24,000) on materials and labor. However, they only spent $24,000 ($4,000 + $20,000), a
savings of $6,000, which is 20% lower than budgeted.

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c.
Indeed it does. In light of this new information, we would conclude that management is
“cutting corners,” using less detergent than quality standards call for, mixing items of
different colors and types, and loading the washers with as much as they can hold. Such
actions can make employees look good in the short term because they are spending less
than budgeted on materials and labor – that is, they are generating favorable cost
variances for the company.

However, such actions can lead to quality problems and customer dissatisfaction, as
indicated by the customer complaints. Such actions may lead customers to switch laundry
service providers – for example, it is possible that SpringFresh only laundered 60,000
pounds in the most recent month, rather than the budgeted 70,000 pounds, because
customers are going elsewhere. The lost contribution margin on this volume of business
(or sales volume variance) = 10,000  ($1.50 – $0.10 – $0.40) = $10,000, which exceeds
the $6,000 “savings” on materials and labor.

A key insight from this problem is that “favorable” variances are not necessarily “good”
(and, as a corollary, “unfavorable” variances are not necessarily “bad”). Sometimes, as in
the current example, quality and future profitability are being sacrificed to generate
favorable variances and short-term profits. Indeed, it is likely that the owners of
SpringFresh would look as negatively upon a large favorable cost variance as they would
a large unfavorable cost variance because the large favorable variance likely indicates
that employees are cutting corners and not adhering to quality standards.

8.60
a.
With the information provided, we calculate the Locker Room’s master budget and
flexible budget profit for October as:
Master Flexible
Budget Budget
Data
Units (pairs of shoes) 4,000 4,250
Price per pair of shoes $80.00 $80.00
Cost per pair of shoes $44.00 $44.00
Commission rate 5% 5%

Results
Revenue $320,000 $340,000
Cost of shoes 176,000 187,000
Labor – commissions 16,000 17,000
Labor – base wages 3,500 3,500
Profit $124,500 $132,500

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Thus, the Locker Room’s total profit variance for October = $133,850 – $124,500 =
$9,350 F.

Note that the “wrinkle” in this problem is to recognize that labor is a step-fixed cost – in
many settings, labor is classified as a variable cost.

b.
The sales volume variance = flexible budget profit – actual profit. For the Locker Room,
we have for October:

Sales volume variance = $132,500 – $124,500 = $8,000 F.

The sales price variance = actual revenue – flexible budget revenue. For the Locker
Room, we have for October:

Sales price variance = $323,000 – $340,000 = $17,000 U.

The flexible budget cost variance for both shoes and labor equals the difference between
the flexible budget cost of shoes and labor and the actual cost of shoes and labor. Thus,
we have:

Flexible budget shoe cost variance = $187,000 – $170,000 = $17,000 F.

Flexible budget labor cost variance = ($17,000 + $3,500) – ($16,150 + $3,000) =

$1,350 F.

c.
Using the variances computed above, we can prepare the required budget reconciliation
report.

Master budget profit $124,500

+ Favorable sales volume variance 8,000
- Unfavorable sales price variance (17,000)
+ Favorable flexible budget shoe
cost variance 17,000
+ Favorable flexible budget labor
cost variance 1,350
= Actual profit $133,850

The performance looks good. It appears that the manager of the Locker Room passed on
a 10% decrease in shoe cost to consumers (notice that the price variance and shoe cost
variance are perfectly offsetting). That is, shoe costs decreased by $4 per pair, from a
budgeted cost of $44 per pair to an actual cost $40 per pair ($40 per pair actual cost =
$170,000/4,250). Additionally, the selling price decreased by $4 per pair, from a
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budgeted price of $80 per pair to an actual price of $76 per pair ($76 = $323,000/4,250).
In turn, the reduction in the selling price appeared to generate a favorable sales volume
variance and a modest increase in profit.

Because of the reduction in the selling price, labor commissions also were lower than
budgeted. Moreover, the $17,000 reduction in revenue led to $17,000 × .05 = $850 less in
commission costs ($850 = $17,000 – $16,150). Finally, labor staffing was 100 hours
under budget, leading to a savings of 100 × $5 = $500 (budgeted labor hours = 700;
actual labor hours = 3,000/$5 = 600; also, $500 = $3,500 – $3,000). Thus, the manager
achieved an increase in sales with fewer labor hours. All in all, it appears that the
manager has done a good job generating revenue and controlling costs.

8.61
a.
The differences in the use of time controls exist because of the nature of job performed
by each type of worker.

It is important for factory workers to show up on time because it is difficult to trace the
assembly line’s output to a specific worker. More importantly, there is a strong need to
coordinate the actions of many workers; each of the stations in the line must be manned
adequately for output to be effectively and efficiently produced.

At the other extreme, faculty members do not need to coordinate their work on a daily (or
even weekly) basis. Periodic updates (sometimes measured in months) are enough to
ensure that faculty members are fulfilling their teaching, research, and service
obligations. Additionally, there are clear links between outputs (number of courses
taught, number of committees served on, conferences attended, number of research
papers published) and the input. Thus, there is no need for strict time controls.

Office workers fall somewhere between these two extremes. There is some need for daily
coordination (e.g., for meetings) but there is a lot of individual work as well. Thus, flex-
time policies seem appropriate. They serve the employer’s purpose and provide some
flexibility (which is valuable) to the employee.

b.
Again, the difference arises due to the nature of the job being performed. The job being
performed by the production worker typically is well understood – the worker knows
exactly what the firm expects him/her to do on the job and how the job is to be
performed. Thus, barring any unexpected events (e.g., machine breakdown), there is a
clear relation between the time spent at the work station and output. Since the use of
input measures imposes less risk on workers than output measures (e.g., an employee
cannot control a machine breakdown), they are preferred.

In contrast, the relation between inputs and outputs is not well understood for faculty
members. While faculty are expected to teach well, perform service to their university
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and profession, and produce research, it is unclear how much time needs to be spent on
each activity and, for a given amount of time, how to go about best performing each
activity. For example, two different faculty members can spend the same amount of time
preparing for a class, yet their effectiveness may differ. Thus, measuring the time spent
preparing to teach is not adequate to evaluate performance. We need to look at output,
even though it imposes risk on the faculty member (this is a cost of using output
measures).

A key point to emphasize in this problem is the importance of tailoring the control system
and performance measures to the type of work being performed.

8.62
a.
There are several measures that you might track on a daily basis. Most of these measures
ensure that employees are adhering to the operating plans of the business and that the
quality of the product and the shop’s atmosphere is good. These measures include the
following:

Cleanliness of the shop and employees. You probably would ensure that the counters are
cleaned on a regular basis, employees show up to work on time in appropriate attire, the
tables and restrooms are clean, the floors are clean, and the trash is removed regularly.
These measures help ensure a quality product and a pleasant atmosphere.

Cups of yogurt sold and sales. You probably would track the number of cups of yogurt
sold each day and reconcile the money in the cash drawer with total sales (as per the
register’s receipt). These measures ensure that employees are not stealing from the
business and that employees are not giving away free yogurt (e.g., if daily sales are really
low).

Quality. You would attend to customer complaints or inquiries. You would make sure
that the yogurt is fresh and tastes good, that serving sizes are appropriate, and that the
product is appealing (e.g., has a nice swirl). These measures ensure the delivery of a
quality product.

b.
There are several measures that you might track on a monthly basis. Most of these
measures check how the company is doing vis-à-vis the budget. These measures include
the following:

Revenues: You would track total cups of yogurt sold for the month and total sales in
dollars. Both of these numbers could be compared to the monthly budget to check for any
significant deviations between quantity and price.

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Costs: You would track staffing costs, yogurt (raw materials) costs, supply (cups, spoons,
napkins) costs, and fixed costs related to rent and utilities. These numbers also would be
compared against budgeted amounts to check for any significant deviations.

In addition to reviewing monthly revenue and cost data, you probably also would review
any customer complaints, employees’ attendance and tardiness records, and whether any
unexpected events occurred in the previous month (e.g., such as a power outage).

c.
The daily measures are in place to ensure that people are doing what they are supposed to
be doing. As a result, these measures tend to be very input-oriented and non-financial in
nature. Such measures ensure the daily quality of the product, the cleanliness of the shop,
and the atmosphere.

As the time horizon expands, however, the measures tend to reflect the state of the
business as it pertains to the current budget. These measures tend to be more output-
oriented and financial in nature. Such measures are aggregate, summary measures of how
the business has performed for a period of time.

8.63
a.
Your primary task is to ensure that workers are fully utilized and that adequate quality
control is maintained. Thus, measuring the number of calls per hour staffed would seem
crucial. This metric measures the demand for services, holding the supply constant.
Another important measure to ensure adequate staffing is the average wait time before a
call is answered. This tracks the supply of staff and ensures that there is a match between
demand and supply.

Another key attribute is quality. Quality could be measured by a random monitoring of

calls and also by tracking the number of customer complaints and the number of calls
transferred to the supervisor.

b.
One benefit is that this is a direct measure of productivity. We ensure that available staff
are fully utilized and not engaging in extended personal conversations with callers. The
cost of this measure is that staff may become intolerant of callers who have complex and
time-consuming issues. The operator has incentives to hang-up on such customers (“I
will transfer you to the right department”) or to put them on indefinite hold (“we will be
right back with you”). Such behaviors breed customer ill will and can be very costly to
the firm.

c.
Call centers do this to monitor quality. While it is relatively straightforward to devise
measures that ensure productivity, measuring quality is much more difficult. A popular
solution to this problem is to use third-party monitoring – not knowing if and when their
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supervisor may “listen in,” employees have an incentive to be courteous and responsive
to each caller. This practice is somewhat akin to the “mystery shopper” program that
many retail firms employ to assess the customer experience in their stores.

8.64
a.
This is a sizeable loan, and it will be very important that the bank keep close tabs on Dan
to ensure that he does not default on the loan. There are several measures that you might
use to ensure repayment.

First, you probably will track whether repayments are being made according to schedule
(e.g., monthly or quarterly). One missed (or even late) payment is likely to generate a
follow-up investigation.

Second, large business loans almost always contain clauses that impose restrictions
(called “covenants”) on financial ratios such as the current ratio (current assets/current
liabilities), debt to equity ratio (debt/equity), and dividend payout (e.g., no dividends can
be paid if loan payments are in arrears). These ratios (covenants), which will be
monitored by the bank on a regular basis, help safeguard the loan by restricting the
amount of additional borrowing & spending Steve and his company can do.

Finally, you also might monitor Steve’s business growth and profits to ensure the
continued viability of his business. Such measures would be particularly important for
line-of-credit loans.

b.
The performance measures would change significantly because both the amount of the
loan and the type of loan have changed (even though the parties involved have not
changed). For a “garden-variety” home mortgage, the bank likely would check Steve’s
credit status and employment history at the time of making the loan. Once the loan has
“closed,” no action will be taken by the bank unless there is a default (i.e., Steve does not
make a payment). If and when a default occurs, the bank has established procedures for
penalties and loan recovery. Other than this, however, banks typically do not use any
additional performance measures for home loans. Unlike a business loan, there are no
monthly, quarterly, or annual updates of Steve’s financial status and there are no
covenants.

c.
The measures differ because of the nature and, especially, the size of the loan. With a
large business loan, an individual loan officer is likely responsible for negotiating and
monitoring the loan. Because business conditions frequently change and numerous
businesses fail, constant monitoring is necessary to detect any unfavorable developments
and ensure loan repayment.

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On the other hand, home mortgages are relatively small from the bank’s perspective and
each loan, by itself, is not that important. The product also is standardized; there is very
little customization of loan terms. Further, the loan is secured with a lien on the property,
which almost surely assures that the majority of the loan amount will be recovered even
if there is a default. Thus, an overall monitoring strategy of management by exception
(assume all is well until a payment is late or is missed) is adequate.

A fundamental point of this problem is that we need to tailor performance measures to

the specific task at hand and to the specific risks we face.

8.65
a.
The materials price variance = (Budgeted price – Actual price) × Actual quantity, where
the term “actual quantity” refers to the actual quantity of materials used in operations.
With respect to the carbon-composite material used in Armstrong’s bicycle frames for
December, we have:

Budgeted price = $40.00 per pound.

Actual price = $37.50 per pound ($37.50 = $56,250/1,500).
Actual quantity = 1,125 pounds.

Thus, Armstrong’s materials price variance for December = ($40.00 – $37.50) ×

1,125 = $2,812.50 or $2,812.50 F.

The purchase price variance = (Budgeted price – Actual price) × Actual quantity of
materials purchased. With respect to the carbon-composite material, we have:

Budgeted price = $40.00 per pound.

Actual price = $37.50 per pound ($37.50 = $56,250/1,500).
Actual quantity of materials purchased = 1,500 pounds.

Thus, Armstrong’s purchase price variance for December = ($40.00 – $37.50) ×

1,500 = $3,750 or $3,750 F.

b.
Notice that the materials price variance and the purchase price variance move in the same
direction – that is, for Armstrong both variances are favorable. This typically will be the
case – i.e., both variances will either be favorable or unfavorable. The two variances can
differ in direction when substantial amounts of prior-period inventory are used in
operations and the price paid for inventoried materials differs from the price paid for
current-period purchases.

While both the materials price variance and the purchase price variance are favorable,
they do differ in magnitude – for Armstrong, the purchase price variance is $937.50
larger than the materials price variance.
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As discussed in Appendix A, some argue that the purchase price variance is a better
measure for evaluating the purchasing function since these individuals are responsible for
the amount of materials purchased. On the flip side, using the purchase price variance can
provide managers with incentives to take advantage of quantity discounts (as in the case
of Armstrong), which can ultimately lead to undesirable inventory build-ups.
Additionally, using the purchase price variance will not lead to a full reconciliation of the
total profit variance (i.e., the budget-reconciliation report will not tie out) because the
variance is computed using materials purchased and not materials used in production
(i.e., it is not based on actual output). Finally, it is often the case that the difference
between the purchase price variance and the materials price variance is negligible,
rendering the choice of which variance to compute moot. In the end, organizations must
balance the benefits and costs associated with using each variance and choose the one
that best meets their needs – because of the incentive issues and simplicity and
completeness (in the sense of reconciling actual profit with master budget profit), we
emphasize the materials price variance.

8.66
a.
Let us first examine the flow of materials through the inventory account to determine the
amount of materials issued out and the amount in ending inventory.

Beginning inventory 4,000 kg.

+ Purchases 1,800 kg.
- Issued out 3,000 kg.
= Ending inventory 2,800 kg.

We also know that the standard cost is $2 for each kg. of chromic acid ($2.00 =
$8,000/4,000). Moreover, we know that Rush uses standard costs to value materials
issued out and inventories. (That is, Rush isolates the purchase price variance when items
are purchased.) Thus, ending inventory would be valued at $5,600 (2,800 × $2) and the
value of materials issued out equals $6,000 (3,000 × $2).

b.
From Appendix A, we have:

Purchase price variance = (Budgeted price – Actual price) × Actual quantity purchased.

Moreover, we know that the unit cost is $2.15 (= $2,150/1,000 kg) and $2.04 (=
$1,632/800) for the purchases on August 10 and 22nd, respectively. Applying the formula,
we have:

($182) = (2.00 – 2.15) × 1,000 kg + (2.00 – 2.04) × 800 kg.

Thus, the purchase price variance for August is $182 U.

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c.
We use the data from parts [a] and [b] to complete the table, as shown below.

Item Kgs. Value

Opening Inventory 4,000 $8,000
+ Purchases 1,800 3,782
- Issued out 3,000 (6,000)
+/- Purchase price variance 0 (182)
= Closing inventory 2,800 5,600

Notice that the purchase price variance removes the effect of price fluctuations, allowing us
to use the budgeted cost (also known as the standard cost) of $2 per kg. to value all
inventories and cost flows.

8.67
a.
We use the columnar format discussed in the text to determine the total profit variance.
We have:

Master budget Actual results

Revenue – B $160,000 $147,000
Revenue – M 160,000 178,500
Variable costs – B 80,000 84,000
Variable costs – M 80,000 93,500
Contribution margin $160,000 $148,000
Fixed costs 75,000 76,000
Profit $85,000 $72,000

Total profit variance = $72,000 – $85,000 = ($13,000) or $13,000 U.

This large drop in profit is somewhat surprising because Mountain Maples sold the same
total number of trees, 2,400, as planned. Let us dig deeper.

b.
We need Mountain Maples’ flexible budget to perform the decomposition. Notice that the
flexible budget, shown below, is formulated using the actual mix of trees sold.

Flexible
Master Budget budget Actual results
Butterfly sales 800 700 700
Moonfire sales 1,600 1,700 1,700
Revenue – B $160,000 $140,000 $147,000
Revenue – M 160,000 170,000 178,500
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Variable costs – B 80,000 70,000 84,000

Variable costs – M 80,000 85,000 93,500
Contribution margin $160,000 $155,000 $148,000
Fixed costs 75,000 75,000 76,000
Profit $85,000 $80,000 $72,000

Sales volume variance = $80,000 – $85,000 = ($5,000) or $5,000 U

Flexible budget variance = $72,000 – $80,000 = ($8,000) or $8,000 U.

This analysis informs us that about 40% of the profit drop is related to changes in sales
volume or mix. The remainder has to do with changes in sales prices, variable costs, and
fixed costs.

c.
We can perform the required analysis by comparing the line items in the flexible budget
and actual results. We have:

Sales price variance = ($147,000 – $140,000) + ($178,500 – $170,000) = 15,500 F

Variable cost variance = ($84,000 – $70,000) + ($93,500 – $85,000) = ($22,500) U
Fixed cost variance = $75,000 – $76,000 = ($1,000) U
Total = ($8,000)

This analysis informs us that unexpected increases in variable costs are the primary
reason for the drop in profit. Mountain Maples appears to have tried to recoup some of
the cost increase via price increases. However, the gain from increasing prices has not
offset the increased cost. Fixed costs have increased a little as well.

d.
As explained in Appendix C, the sales volume variance mingles two effects – changes in
the total number of units sold and changes in the mix of units sold. We could decompose
the two factors as below:

“As if” budget

with budgeted Flexible
Master Budget sales mix Budget
Total sales in units 2,400 2,400 2,400
Weighted Unit
Contribution Margin $66.67 $66.67 $64.5833
Contribution margin $160,000 $160,000 $155,000
Fixed costs 75,000 75,000 75,000
Profit before taxes $85,000 $85,000 $80,000

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In constructing this table, notice that the WUCM for the master budget is $66.67 =
$160,000/2,400 trees. Similar computations apply for the other two columns.

The profit difference between the first two columns is purely due to changes in sales
quantity, holding the sales mix constant. Thus, the sales quantity variance is $0 =
$85,000 – $85,000. This is expected because Mountain Maples’ overall sales quantity is
the same as budgeted (2,400 trees in total). The sales mix variance is the profit difference
between the flexible budget and the “as if” budget. Thus, the sales mix variance =
$5,000 U = $80,000 – $85,000.

e.
The budget reconciliation report is as follows:

Butterfly Moonfire Total

Master budget profit $85,000
Sales mix variance (5,000)
Sales quantity variance 0
Sales price variance $7,000 8,500) 15,500
Variable cost variance (14,000) (8,500) (22,500)
Fixed cost variance (1,000)
Actual profit $72,000

This report provides a rather sobering picture to the management of Mountain Maples. It
appears that variable costs are considerably higher than anticipated. They tried to recover
the cost increase by raising the price of trees. Indeed, anticipating resistance, the price
increase for Butterfly is less than the cost increase. Yet, the product mix deteriorated with
less of the more profitable Butterfly trees being sold. This change in mix does not bode
well. Management should investigate if there is a significant change in customer
preferences. It also seems prudent to investigate the cause for the significant rise in unit
variable costs.

8.68
a.
Let us use the columnar format discussed in the text to determine the total profit variance.
We compute the revenue from each kind of bike as the total sales times the revenue
share. For each bike, we compute variable costs as (1 – contribution margin ratio) ×
revenue.

We have:

Master budget Actual results

Revenue – Deluxe $40,000 $36,000
Revenue – Standard 60,000 84,000
Variable costs – Deluxe 24,000 21,600
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Variable costs – Standard 42,000 58,800

Contribution margin $34,000 $39,600
Fixed costs 27,000 27,000
Profit before taxes $7,000 $12,600

Thus, we have:

Total profit variance = $12,600 – $7,000 = $5,600 U.

This large drop is surprising because Tom realized sales that were 20% higher than
expected, and his costs are well under control.

b.
Let us introduce the flexible budget to perform the decomposition. Notice that the
flexible budget includes the actual mix of bikes sold.

Flexible
Master budget budget Actual results
Total Revenue $100,000 $120,000 $120,000
Deluxe 40% 30% 30%
Standard 60% 70% 70%
Revenue – Deluxe $40,000 $36,000 $36,000
Revenue – Standard 60,000 84,000 84,000
Variable costs – Deluxe 24,000 21,600 21,600
Variable costs – Standard 42,000 58,800 58,800
Contribution margin $34,000 39,600 $39,600
Fixed costs 27,000 27,000 27,000
Profit $7,000 $12,600 $12,600

Sales volume variance = $12,600 – $7,000 = $5,600 F

Flexible budget variance = $12,600 – $12,600 = $0.

This analysis informs us that the profit drop relates to a change in sales volume and/or a
change in sales mix. There is no effect due to changes in sales prices, variable costs, and
fixed costs.

c.
As explained in Appendix C, the sales volume variance mingles two effects – changes in
the total number of units sold and changes in the mix of units sold. Unfortunately, we
cannot employ a weighted unit contribution margin approach because we do not know
individual selling prices or costs. However, we can employ the weighted contribution
margin ratio approach to address this issue.

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First, notice that the weighted contribution margin ratio at the budgeted sales mix is
$34,000/$100,000 = 34%. Likewise, the flexible budget has a weighted contribution
margin ratio of 33% = $39,600/$120,000. Using this data, we could decompose the two
factors as below:

As if budget
with budgeted Flexible
Master Budget sales mix budget
Total units sold $100,000 $120,000 $120,000
Weighted
Contribution Margin
Ratio 34% 34% 33%
Contribution margin $34,000 $40,800 $39,600
Fixed costs 27,000 27,000 27,000
Profit before taxes $7,000 $13,800 $12,600

The profit difference between the first two columns is purely due to changes in sales
quantity, holding sales mix constant. Thus, the sales quantity variance is $6,800 F =
$13,800 – $7,000. This is as expected. If Tom’s sales mix did not change, his overall
profit would have increased at the rate of 34 percent of revenue. An increase of $20,000
in revenue, therefore, should have increased profit by $6,800. However, Tom’s sales mix
deteriorated. He now sells more of the less profitable standard bikes. The sales mix
variance is the profit difference between the flexible budget and the as if budget. Thus,
the sales mix variance = $1,200 U = $12,600 – $13,800. Of course, the sales mix and
quantity variances sum to the sales volume variance we computed earlier.
d.
There appears to be both good news and bad news. On the one hand, revenue has
increased dramatically, by 20%. On the other hand, the mix of sales has worsened. The
net effect of these two factors is positive. Tom must seriously consider whether his
business strategy is to sell more of high margin products (the deluxe bikes) or more of the
lower margin product (the standard bike). The budget indicates the former but actual
results indicate the latter. Because actual results likely reflect customer tastes, Tom may
be well advised to revise his plans.

MINI-CASES

8.69
a.
The following table shows Jason’s expected profit using the information contained in the
master budget:

Master Budget
(Amazing Grace Putter)
Putters sales 5,000
Revenue 5,000  $280 $1,400,000
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Variable costs
Material costs:
Aluminum & weights
(for putter head) 5,000  $60 $300,000
Shaft (steel) 5,000  $8 40,000
Grip 5,000  $10 50,000
Labor costs 5,000  $60 300,000
Contribution margin $710,000
Fixed costs Given 250,000
Profit $460,000

Alternatively, we could calculate Jason’s master budget profit using the cost-volume-
profit (CVP) equation.

We have:

Profit before taxes = unit contribution margin × sales in units – fixed costs.

The budgeted contribution margin on each Amazing Grace putter = $280 – $60 – $8 –
$10 – $60 = $142. Additionally, Jason’s fixed costs are expected to be $250,000. Finally,
Jason’s master budget calls for sales of 5,000 putters.

Thus, we have: ($142 × 5,000) – $250,000 = $460,000 in master budget profit.

b.
Using the data provided, the following table presents Jason’s actual profit from his
Amazing Grace putter:

Actual Profit
(Amazing Grace Putter)
Putters sales 5,600
Revenue 5,600  $245 $1,372,000
Variable costs
Material costs:
Aluminum & weights
(for putter head) 5,600  $42 $235,200
Shaft (steel) 5,600  $8 44,800
Grip 5,600  $12 67,200
Labor costs 5,600  $50 280,000
Contribution margin $744,800
Fixed costs 300,000
Profit $444,800

Thus, Jason’s total profit variance = $444,800 – $460,000 = ($15,200) or $15,200 U.

That is, Jason’s actual profit is $15,200 lower than his master budget profit.
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c.
Using the assumptions contained in the master budget and adjusting for the actual sales
level of 5,600 putters, we have:

Flexible Budget Profit

(Amazing Grace Putter)
Putters sales 5,600
Revenue 5,600  $280 $1,568,000
Variable costs
Material costs:
Aluminum & weights 5,600  $60 $336,000
(for putter head)
Shaft (steel) 5,600  $8 44,800
Grip 5,600  $10 56,000
Labor costs 5,600  $60 336,000
Contribution margin $795,200
Fixed costs 250,000
Profit $545,200

Alternatively, we could use Jason’s CVP model to answer this question. Using the
equation we developed in part [a] and plugging in an actual sales volume of 5,600 putters
yields:

Flexible budget profit = ($142 × 5,600) – $250,000 = $545,200.

d.
To answer this question, we need to look at the sales volume variance and the sales price
variance. After all, the decision to reduce the sales price affects the quantity of putters
sold (sales volume) and the price at which the putters are sold (sales price). The net effect
of these two variances gives us the profit impact associated with a change in the sales
price.

We can use our answers from parts [a] – [c] to assist us in calculating the sales volume
variance and the sales price variance.

We have:

Master Flexible Actual

Budget Budget Results
# of putters sold 5,000 5,600 5,600
Revenue $1,400,000 $1,568,000 $1,372,000
Variable costs (total) 690,000 772,800 627,200
Contribution margin $710,000 $795,200 $744,800
Fixed costs 250,000 250,000 300,000

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Profit $460,000 $545,200 $444,800

The sales price variance equals the difference between actual revenue and flexible budget
revenue. For Jason’s Amazing Grace putter, we have $1,372,000 – $1,568,000 =
($196,000) or $196,000 U sales price variance.

The sales volume variance equals the difference between flexible budget profit and
master budget profit. For Jason’s Amazing Grace putter, we have $545,200 – $460,000 =
$85,200 F sales volume variance.

Based on the sales variances, it appears that reducing the selling price by $35 was not
a good idea since it reduced Jason’s profit by $196,000 – $85,200 = $110,800. In
essence, the increased volume associated with reducing the selling price (i.e., the
favorable sales volume variance) did not compensate for the reduction in sales revenue
associated with reducing the selling price (i.e., the unfavorable sales price variance).

One explanation is that Jason’s customers are not very price sensitive (i.e., demand is
relatively inelastic). Avid golfers may recognize that a selling price of over $200 for a
putter, while not uncommon, is at the high end of the putter market. Thus, Jason’s
customers are likely to be individuals with a fair amount of discretionary income who
like to have the latest equipment that the pros are playing with and will spend a lot of
money to have what they view as the “best” equipment. Reducing the selling price by
$35, or 12.5%, is unlikely to attract that much additional business because the putter is
still “pricey” at $245. Because of the relatively inelastic demand for Jason’s putters, he
may even wish to consider raising the selling price to $299 or the low $300s.

e.
To answer this question, we need to look at the fixed cost spending variance, the
materials (aluminum & weight) quantity variance, and the labor quantity variance. As
mentioned in the body of the problem, the decision to rent the machine was expected to
positively affect materials and labor quantity variances (the decision is not expected to
affect Jason’s other costs). Of course, the decision to rent the machine also increases
Jason’s fixed costs for the year.

The fixed cost spending variance equals the difference between budgeted and actual fixed
costs. Jason’s budgeted fixed costs were $250,000 and his actual fixed costs were
$300,000; Thus, Jason’s fixed cost spending variance = $250,000 – $300,000 =
($50,000) or $50,000 U.

The materials and labor quantity variances represent the difference between the
respective flexible and “as if” budgets. Thus, we can calculate these variances as the
difference between the flexible budget quantity and actual quantity for each input,
multiplied by the budgeted price.

For materials, we have:

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Flexible budget quantity = 5,600 putters actually sold × 1,000 grams budgeted per putter
= 5,600,000 grams.
Actual quantity = 5,600 putters actually sold × 700 grams actually used per putter =
3,920,000 grams.
Budgeted price = $0.06 per gram.

Thus, the materials quantity variance = (5,600,000 – 3,920,000) × $0.06 = $100,800 or

$100,800 F.

For labor, we have:

Flexible budget quantity = 5,600 putters actually sold × 3 hours per putter = 16,800
hours.
Actual quantity = 5,600 putters actually sold × 2.50 hours per putter = 14,000 hours.
Budgeted price = $20 per hour.

Thus, the labor quantity variance = (16,800 – 14,000) × $20 = $56,000 or $56,000 F.

Thus, it appears that the rental fee of $50,000 (which explains the unfavorable fixed cost
spending variance) was well worth it, as overall profit increased by $100,800 (the
favorable materials quantity variance) + $56,000 (the favorable labor quantity variance) –
$50,000 (the unfavorable fixed cost spending variance) = $106,800 from renting the
machine.

NOTE: The five variances calculated in parts [d] and [e] do not explain Jason’s total
profit variance of $15,200 U because of the unfavorable grip price variance of $11,200
($11,200 U = [$10.00 – $12.00] × 5,600). We did not include the grip price variance in
our calculations because it is unlikely that Jason’s two decisions affected the price paid
for grips (this is likely the result of market conditions and/or Jason switching suppliers).

Moreover, Jason’s budget reconciliation report looks as follows:

Master budget profit $460,000

Favorable sales volume variance 85,200
Unfavorable sales price variance (196,000)
Favorable materials quantity variance 100,800
Favorable labor quantity variance 56,000
Unfavorable fixed cost spending variance (50,000)
Unfavorable grip price variance (11,200)
Actual profit $444,800

f.
This problem underscores the importance of conducting variance analysis. Similar to
every business, Jason made multiple business decisions after the master budget had been
released. Variance analysis helps us disentangle the effects of these decisions and see
which ones worked and which ones did not work.
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Had we just compared actual to master budget profit, we would have found an overall
variance of $15,200, or approximately 3% of profit. By itself, this variance probably is
not worth pursuing since it is relatively small. The overall profit variance, though, masks
the good decision to rent the milling machine and the poor decision to reduce the selling
price. While the decision to rent the machine increased profit by $106,800, the decision
to reduce the selling price decreased profit by $110,800 (this, coupled with the $11,200
unfavorable grip price variance led to the $15,200 reduction in profit).

In terms of moving forward, we probably would recommend raising the selling price (to
at least its “old” level of $280) and continue renting, if not buying, the milling machine.
If all else stays the same, this decision will increase Jason’s profit next year by $110,800
(the loss incurred this year from reducing the selling price). This significant increase in
profit would be directly attributable to our use of variance analysis.

8.70
a.
The following table shows College Painters’ master budget profit and actual profit for the
month of August:

Master Budget
Profit Actual Profit
Square feet painted 25,000 24,000
Revenue $27,5001 $25,333
Paint costs $2,0002 $2,160
Supplies costs $5003 $480
Labor costs $12,0004 $11,475
Contribution margin $13,000 $11,218
Fixed costs $2,000 $2,250
Profit $11,000 $8,968
1
25,000/500 = 50 budgeted jobs. Further, each job is budgeted to bring in $550 in
revenue. Thus, $27,500 = 50 × $550. Alternatively, one can calculate the average revenue
per square foot painted as $550/500 = 1.1; thus, $27,500 = 25,000 × $1.1.
2
$2,000 = 50 budgeted jobs × 1.6 gallons per job × $25 per gallon. Alternatively, one can
calculate the average paint cost per square foot painted as (1.6 × $25)/500 = $0.08; Thus,
$2,000 = 25,000 × $0.08.
3
$500 = 50 budgeted jobs × $10 per job. Alternatively, one can calculate the average
supplies cost per square foot painted as $10/500 = $0.02; Thus, $500 = 25,000 × $0.02.
4
$12,000 = 50 budgeted jobs × 16 hours per job × $15 per hour. Alternatively, one can
calculate the average labor cost per square foot painted as (16 × $15)/500 = $0.48; Thus,
$12,000 = 25,000 × $0.48.

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The total profit variance = actual profit – master budget profit. Thus, College Painters’
total profit variance = $8,968 – $11,000 = ($2,032) or $2,032 U. That is, College
Painters’ profit during August was $2,032 lower than expected.

b.
We need to calculate:

(1) The sales volume variance

(2) The sales price variance
(3) Paint price variance.
(4) Paint quantity variance.
(5) Labor quantity variance.
(6) The fixed cost spending variance
(7) The labor price variance, and
(8) The supplies flexible budget cost variance

(NOTE: We cannot decompose variance (8) into price and quantity components because
we are not provided with detailed price and quantity information regarding supplies – that
is, we only have the total amount spent on supplies and the $10 budgeted amount to be
spent per 500 square feet painted – i.e., we do not have enough information to calculate
the actual quantity.

Preparing College Painters’ flexible budget for August will assist us in making the
additional variance computations. The following table shows College Painters’ flexible
budget profit for the month of August:

Flexible Budget
Profit
Square feet painted 24,000
Revenue $26,4001
Paint costs $1,9202
Supplies costs $4803
Labor costs $11,5204
Contribution margin $12,480
Fixed costs $2,000
Profit $10,480
1
24,000/500 = 48 budgeted jobs. Further, each job is budgeted to bring in $550 in
revenue. Thus, $26,400 = 48 × $550.
2
$1,920 = 48 budgeted jobs × 1.6 gallons per job × $25 per gallon.
3
$480 = 48 budgeted jobs × $10 per job.
4
$11,520 = 48 budgeted jobs × 16 hours per job × $15 per hour.

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The sales volume variance = flexible budget profit – master budget profit. For College
Painters, we have: $10,480 – $11,000 = ($520) or $520 U.

The sales price variance = actual revenue – flexible budget revenue. For College
Painters, we have: $25,333 – $26,400 = ($1,067) or $1,067 U.

(1) Paint price variance = the difference between the budgeted price and the actual price,
multiplied by the actual quantity.

We know the following:

Budgeted price = $25 per gallon.

Actual price = $30 per gallon ($30 = $2,160 spent on paint/72 gallons purchased).
Actual quantity = 72 gallons.

Thus, College Painters’ paint price variance for August = ($25 – $30) × 72 = ($360) or
$360 U.
(2) Paint quantity variance = the difference between the flexible budget quantity and the
actual quantity, multiplied by the budgeted price.

We know the following:

Flexible budget quantity = 76.8 gallons; 76.8 = 24,000 square feet actually painted ×
(1.6/500 budgeted gallons of paint per square foot painted).
Actual quantity = 72 gallons.
Budgeted price = $25 per gallon.

Thus, College Painter’s paint quantity variance for August = (76.8 – 72) × $25 = $120 or
$120 F.

(3) Labor quantity variance = the flexible budget quantity less the actual quantity,
multiplied by the budgeted price.

We have:

Flexible budget quantity = 768 hours; 768 = 24,000 square feet actually painted ×
(16/500 budgeted hours per square foot painted).
Actual quantity = 765 hours.
Budgeted price = $15 per hour.

Thus, College Painter’s labor quantity variance for August = (768 – 765) × $15 = $45 or
$45 F.

The fixed cost spending variance = actual fixed costs – budgeted fixed costs = $2,250 –
$2,000 = ($250) or $250 U.

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The labor price variance = the budgeted price less the actual price, multiplied by the
actual quantity.

We know:

Budgeted price = $15 per hour.

Actual price = $15 per hour ($15 = $11,475 spent on labor/765 hours of labor).
Actual quantity = 765 hours.

Thus, College Painters’ labor price variance for August = ($15 – $15) × 765 = $0.

Finally, the supplies flexible budget cost variance = $0 because the flexible budget cost
and the actual cost both equal $480.

We can now prepare the following budget reconciliation report for College Painters for
August:

Item Amount Detail

Master budget profit $11,000 From part [a]
Unfavorable sales volume
variance ($520) From part [d]
Unfavorable sales price
variance ($1,067) From part [d]
Unfavorable fixed cost
spending variance ($250) From part [d]
Unfavorable paint price
variance ($360) From part [c]
Favorable paint quantity
variance $120 From part [c]
Favorable labor quantity
variance $45 From part [c]
Actual profit $8,968 From part [a]

c.
The following table provides a possible estimate of the cost of the accident.

Item Amount Accident Cost type Detail

Amount
sales volume ($520) $520 Opportunity Could have made $16.25
variance cost per hour on 32 lost hours
sales price ($1,067) $1,000? Out-of- Possible price break
variance pocket given to home owner
fixed cost ($250) 0 From part [d]
spending
paint price ($360) 0 From part [c]
variance
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paint quantity $120 $30 Out-of- Cost of spilled paint

variance pocket
labor quantity $45 $480 Out of Cost of additional labor
variance pocket used
Total ($2,032) $2,030 From part [a]

In terms of out of pocket costs, Kim and Tim incurred the cost to replace the can of paint
and the cost of the 32 labor hours. The actual cost associated with each of these items is:

Paint (1 gallon) $30 ($30 = $2,160 spent on paint/72 gallons purchased)

Labor (32 hours) $480 ($480 = $11,475/765 wage rate per hour × 32 hours)
Out of pocket costs $510

The lost labor has an opportunity cost – after all, if the accident had not taken place, it is
likely that Kim and Tim could have put the labor to productive use. For example, per
their budget Kim and Tim could have used the 32 hours of labor to complete two
additional jobs.

Computing the opportunity cost associated with the lost labor time is somewhat
challenging. Using the master budget to calculate the opportunity cost, we find:
Contribution margin per hour of labor = $13,000 of master budget contribution
margin/800 hours of labor in the master budget = $16.25 (note: 800 hours of labor = 50
jobs × 16 hours per job). Since there were 32 hours that were lost in the accident, we
would compute the opportunity cost as 32 × $16.25 = $520.

Finally, the accident might lead to other costs. For example, to make amends for the
inconveniences the customer experienced as a result of the accident, Kim and Tim may
not have charged the homeowner for any work done (i.e., they may have provided all of
the work for “free”). This could lead to an unfavorable sales price variance for the month.
Additionally, it is possible that the accident could lead to negative goodwill and a loss of
future business if the homeowner was sufficiently upset by the accident and chose to
“badmouth” College Painters to other potential customers.

d.
As alluded to in the problem, switching the paint used is likely to affect 3 variances: (1)
the paint price variance, (2) the paint quantity variance, and (3) the labor quantity
variance.

One might be tempted to conclude that switching paint decreased College Painters’ profit
by $360 U + $120 F + $45 F = $195 U. This, though, does not tell the whole story
because of the accident. That is, the one can of pain lost in the accident plus the 32 hours
of labor time devoted to cleaning up the accident affected College Painters’ paint price
variance, paint quantity variance, and labor quantity variance. The effect of the accident
on each of these variances can be calculated as follows:

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First, the extra can of paint increased the unfavorable paint price variance by $5, or the
difference between the budgeted price of $25 and the actual price of $30. Second, the
extra can of paint used decreased the favorable paint quantity variance by $25 since the
actual quantity would have been 1 can fewer had the accident not occurred. Finally, the
accident decreased the favorable labor quantity variance by 32 × $15 = $480, since the
actual quantity would have been 32 hours fewer had the accident not occurred. Notice
that the total of these amounts, or $510 = $480 + $25 + $5 corresponds exactly to our
calculation in part [b] of the out-of-pocket costs associated with the accident.

With these adjustments, we would re-compute the variances attributable to the decision to
switch paint as:

Paint price variance = $360 – $5 = $355 U.

Paint quantity variance = $120 + $25 = $145 F.
Labor quantity variance = $45 + $480 = $525 F.

Thus, the decision to change paint appeared to increase College Painters’ August
profit by $525 + $145 – $355 = $315.

This aspect of the problem reminds us that a single variance oftentimes is the result of
numerous actions and decisions – in this case, the paint price variance, the paint quantity
variance, and the labor quantity variance co-mingle the effect on profit of the paint
accident and the decision to switch paints.

e.
Overall, College Painters’ appears to be pretty much on track. While there is a profit
shortfall of $2,032, half of this amount appears to be, as shown in part [c], due to the
accident involving the spilled can of paint. To this end, notice that the unfavorable sales
volume variance of $520 corresponds exactly to our estimate of the opportunity cost of
the lost labor time when basing the estimate on information contained in the master
budget. While not conclusive, it appears that losing 32 hours of labor time likely led to
the unfavorable sales volume variance. In other words, the unfavorable sales volume
variance probably was not demand related.

The accident also may have affected Kim and Tim’s business in other ways. For example,
the unfavorable sales price variance may be related to the accident – it is possible that, as
a result of the accident, Kim and Tim did not charge the involved homeowner for the
work performed. If the job was around 1,000 square feet, then this would lead to $1,100
less revenue than expected ($1,100 = $550 × 2). To the extent this is true, Kim and Tim
should include the lost revenues as part of the cost of the accident in part [b]. If this is not
true, then Kim and Tim likely will need to dig deeper into their operations to uncover the
reason underlying the unfavorable sales price variance – is it related to new competition,
a decline in the local demand for faux painting, macroeconomic conditions, or some other
reason.

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Kim and Tim should further pursue the unfavorable fixed cost spending variance of $250
– given that it was August, the unfavorable variance may relate to utilities being higher
than normal. It also may relate to some other factor, such as additional advertising.
Moreover, Kim and Tim should check to see whether this variance will be ongoing (in
which case they should revise their fixed cost estimate) or a one-off deviation. Finally,
the decision to switch paint appears to be a good one – as calculated in part [b], College
Painter’s monthly profit increased by $315 as a result of this decision.

In sum, assuming the sales volume and sales price variances related to the accident
involving the spilled paint, we would expect College Painters’ actual profit to more
closely mirror budgeted profit in the coming months (barring future accidents, of course).

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 CHAPTER 9
Cost Allocations: Theory and Applications
Solutions

REVIEW QUESTIONS

9.1 Profit margin.

9.2 Contribution margin equals revenues less variable costs, and profit margin equals
contribution margin less allocated capacity costs.

9.3 Direct estimation, and cost allocations.

9.4 The direct estimation approach involves systematically examining each cost account to
evaluate whether (and how much) a decision would change a capacity cost. An advantage
of this approach is that it can be very accurate. However, it is tedious and time-
consuming, and is subject to the biases and incentives of the decision maker.

9.5 To calculate income in accordance with GAAP, and to influence behavior.

9.6 Absorption costing.

9.7 All product costs – direct materials, direct labor, as well as variable and fixed
manufacturing overhead.

9.8 Sales volume does not affect the fixed manufacturing overhead expensed on the income
statement. Under variable costing, the entire amount of fixed overhead is expensed,
regardless of sales volume.

9.9 As sales volume increases, the amount of fixed manufacturing overhead expensed on the
income statement also increases (and vice-versa). This occurs because, under absorption
costing, fixed manufacturing overhead “travels” with the units produced and sold.

9.10 When inventory levels do not change – that is, when sales = production.
They might do this when there is uncertainty about the final cost – e.g., it allows the
government and the supplier to share the risk of cost overruns.

9.11 To protect its suppliers from the risk of cost over-runs, so that they make the necessary
investments and supply DoD’s requirements.

9.12 To increase profits, as the Ryan Supply Systems example illustrates.

9.13 Allocations can act like a tax – for example, organizations might allocate costs based on
labor hours to encourage divisions to automate.

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9.14 Controllability and incentives.

9.15 Income reported under absorption costing = income reported under variable costing +
fixed manufacturing costs in ending inventory – fixed manufacturing costs in beginning
inventory.

DISCUSSION QUESTIONS

9.16 In such production facilities, all costs that are traceable directly to each product line need
not be allocated among products. In other words, many indirect costs become direct costs,
and costing a product become simpler and more accurate. The disadvantage is that when
a production line is idle because of temporary lull in demand, it cannot be used to make
other products. That is, dedicating production lines can often lead inefficient utilization of
capacity.

9.17 Supplying a product with a negative profit margin product may be necessary to keep a
large customer of the profitable products from going elsewhere. Making a negative profit
margin product may also be good for business if it brings good reputation in the market
place. For example, a restaurant can establish reputation in a community by catering to
large not-for-profit charity events at or below cost so as to develop a clientele.

9.18 Eight to ten years for the automobile industry, two to three years for the toy industry,
three to five years for the computer industry, and ten to fifteen years for the computer
industry would be reasonable estimates.

9.19 To validate this assumption, the company would have to keep track of the consumption
of the capacity resource and the activity volume as measured in units of the cost driver
for a number of periods (say, a week or a month), and then use the High-Low or
regression techniques that we learned in Chapter 4 to evaluate the association.

9.20 There are costs and benefits. As a shareholder, you can get a better idea of a firm’s cost
structure and its operating leverage if GAAP allows variable costing for financial
reporting. On the other hand, firms may not choose to follow variable costing because
they may lose a competitive edge by revealing their cost structure to the competition
(from this perspective it is not in the shareholders’ best interests as well).

9.21 Research and development expenditures are typically not unit level costs. They are either
firm-level costs or product-level costs. Moreover, benefits from research and
development are uncertain both in terms of timing and magnitude. Finally, research and
development costs are not readily identifiable with current production, just as material
and labor costs are. So it does not make sense to “inventory” these costs.

9.22 Yes. The cost pool is the original cost of the machine less salvage value. The cost object
is either the product(s) or the division(s) whose profitability is being measured. The cost
driver is the useful life of the asset being depreciated. The denominator volume is the
expected number of years of useful life.

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9.23 Yes. Reported income under absorption costing will exceed the income under variable
costing if the amount of manufacturing overhead contained in inventory increases over
the year. In multi-product firms, it is possible that the gross value of inventory increases
but the amount of overhead decreases. This seeming anomaly can occur because the
percent of overhead costs can vary across products.

9.24 If cost uncertainty is high and there is no assurance of cost recovery through cost
reimbursement contracts, the risk has to be borne by the producer or the service provider.
In this case, it will be difficult to induce the producer or the service provider to undertake
the necessary investment. On the other hand, once there is assurance of cost
reimbursement there is a natural incentive to overstate the costs. This is a “necessary
evil” that must be tolerated to ensure socially desirable projects (such as key defense
initiatives) are undertaken.

9.25 The charity might wish to choose procedure that would allocate more costs against non-
charity related taxable revenues so as to save on taxes, and use these tax savings for other
presumably charitable causes.

9.26 Not really. Strictly speaking, in competitive markets the prices are set by the market
forces. It is the firm’s overall profitability that matters. As long as the two products are
earning positive contribution margins and more capacity is allocated to the product that
makes the more profitable use of capacity, allocation of capacity costs is not necessary.

9.27 In many firms (especially service and IT firms), people are the most valuable resource.
Getting rid of good talent and people with valuable firm-specific experience just because
of incentives arising from a cost allocation procedure can hurt the company in the long
run. Should the need arise in the future for similar work force in the future it is a lot more
costly to recruit and train new people to the level where they become as efficient as those
who occupied their jobs previously.

9.28 To avoid being allocated overhead costs based on labor consumption, the product line
manager’s natural incentive would be to “outsource” labor intensive activities, even if
outsourcing may be costlier from the firm’s perspective. For example, the manager might
prefer outsourcing parts with high labor content. Outsourcing reduces labor costs as well
as the overhead that is allocated based on labor costs, but it might increase “material”
costs because of the higher prices to be paid for the parts. However, the net result on the
line profit may be positive.

9.29 Yes. From a performance evaluation perspective, the allocated costs will be treated by the
manager as if they are variable costs. By finding ways in which to reduce the costs
allocated to his/her unit, the manager can paint a better picture of his/her performance.
Thus, in making short-term decisions, the manager’s natural incentive would be to not
treat allocated costs as fixed costs even if they are truly fixed.

9.30 Most governments permit some form of accelerated depreciation of long-term assets to
allow higher tax deductions in the initial years of the assets’ lives to induce investment
and growth in their economies. As we know, depreciation is, in essence, allocation of an

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assets cost over its useful life. Some governments levy taxes on imported foreign goods
to protect local industries from foreign competition. This is much like taxing labor via
cost allocation to promote automation. Even arbitrary allocations can induced desired
behavior so long as these allocations are not used for planning and decision making.

EXERCISES

9.31
a. The rate per labor hour is $2,000,000/100,000 hours = $20 per labor hour.

b. If AJ increases its operations to 150,000 labor hours, it might reasonably expect

its overhead costs to be 150,000 hours × $20 per hour = $3 million.

9.32
Molly’s estimated capacity costs for the next year are as follows:

Estimate of overhead
Item Overhead rate Expected volume Expected
(current year) (next year) overhead cost
Machine related $10 per machine 132,000 = 120,000 * 1.1 $1,320,000
costs hour
Labor related $6 per labor hour 86,250 = 75,000 * 1.15 $517,500
costs
Selling 10% per sales $ $1,792,000 = $1,600,000 179,200
expenses * 1.12
Total estimated $2,016,700
cost

9.33
a. The following table provides the required income statements.

Contribution Margin Statement

Item Amount Amount (next year)
(current year)
Revenue $1,500,000 $1,700,000
Cost of Goods sold (25% of sales) 375,000 425,000
Contribution $1,125,000 $1,275,000
Fixed costs 900,000 900,000
Profit before taxes $ 225,000 $ 375,000

Notice that fixed costs remain at $900,000 even though the volume of operations has
increased. This is a reasonable assumption – while fixed costs might increase some, they

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are not likely to increase dramatically because of a modest increase in sales. Further, the
recent hire implies that David has just crossed a step.

b. The following table provides the required statement.

Contribution Margin Statement

Item Amount Amount (next year)
(current year)
Revenue $1,500,000 $2,800,000
Cost of Goods sold (25% of sales) 375,000 700,000
Contribution $1,125,000 $2,100,000
Fixed costs 900,000 1,600,000
Profit before taxes $ 225,000 $ 500,000

Our view of “fixed” costs changes based on the volume of operation. David seems to have
a normal range of operations of about $1.5 million. His fixed costs of $900,000 support
operations at this level. However, the capacity provided by this expenditure is unlikely to
support a much higher volume of sales. For instance, David might need to make more trips,
spend more on stocking and tracking inventory, hire additional sales persons, open a branch
outlet, and so on. All of these actions contribute to higher fixed costs.

This problem reinforces that “fixed” costs are fixed only for a given volume of operations
and for a given time frame. These costs do become controllable if we significantly change
the volume of operations or consider a long time frame. In David’s case, estimating the
higher fixed cost might be hard. One reasonable approach is to say that fixed costs are 60%
of sales revenue ($900,000/$1,500,000). Then, at a volume of $2.8 million in sales, David
would estimate fixed costs at $1,680,000.

Note: Part (b) provides an estimate of $1.6 million toward fixed costs. The difference
underscores that using an allocation to project capacity costs assumes that the underlying
relation would be the same. In David’s case, it is likely that, because of scale economies,
fixed costs do not increase proportionately with sales volume. Methods such as direct
estimation are better equipped to deal with such effects, but require more effort and
expertise.

9.34
a.
Let us begin by calculating the current overhead rate. To do so, we first calculate the total
number of labor hours used as 140,000 = 20,000 small * 4 hours per small + 10,000 large *
6 hours per large. Dividing this volume into the total cost of $2,100,000 yields a rate of $15
per labor hour.

With the changed product mix, the number of labor hours needed increases to 150,000 =
15,000 small * 4 hours per small + 15,000 large * 6 hours per large. Thus, we expect the
overhead cost to be $15 per hour * 150,000 hours = $2,250,000.

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b.
We expect no change in overhead costs if we use units as the cost driver to allocate costs
and to estimate changes. The current rate is $70 per unit = $2.1million / 30,000 units. The
expected cost is also 30,000 units * $70 per unit = $2.1 million. There is no change
because the allocation models cost as being proportional to the total volume of units,
without considering any change in the mix of units.

9.35
a.

Let us begin by constructing the income statement. The allocation rate is

$1,400,000/300,000 units = $4.67 per unit. We have (rounding numbers to the nearest $):

Standard Deluxe Total

Number of 250,000 50,000 300,000
units

Revenue $3,500,000 $900,000 $4,400,000

($14 ×
250,000; $18
× 50,000)
Variable costs 2,000,000 450,000 2,450,000
($8 × 250,000;
$9 × 50,000)
Contribution $1,500,000 $450,000 1,950,000
margin
Common 1,167,500 233,500 1,401,000
fixed costs
($4.67 per
unit)
Profit before $ 332,500 $ 216,500 $549,000
taxes

Let us repeat the exercise with the new product mix. Notice that the common cost for each
segment now is the new product volume × the allocation rate of $4.67 per unit. We have:

Standard Deluxe Total

Number of 150,000 150,000 300,000
units

Revenue $2,100,000 $2,700,000 $4,800,000

Variable 1,200,000 1,350,000 2,550,000
costs
Contribution $900,000 $1,350,000 2,250,000
margin

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Common 700,000 700,000 1,400,000

fixed costs*
Profit before $ 200,000 $ 650,000 $850,000
taxes
* The new product mix consists of 50% Standard and 50% Deluxe. To avoid
rounding errors, we can simply allocate 50% of the common fixed costs to each
product (50% × $1,400,000 = $700,000)

b.
Let us repeat the exercise with the new product mix. We have to compute the allocation
rate for labor hours though. Using the data for the current year, we have total cost =
$1,400,000 and total labor hours = (2 hrs × 250,000 units) + (50,000 units × 4 hours per
unit) = 700,000. Thus, the rate is $2 per labor hour ($1,400,000/700,000). With this rate,
the following table provides the projected income statement. Notice that the common cost
for each segment now is the new product volume × number of labor hours per product ×
the allocation rate of $2 per labor hour.

Standard Deluxe Total

Number of 150,000 150,000 300,000
units

Revenue $2,100,000 $2,700,000 $4,800,000

Variable 1,200,000 1,350,000 2,550,000
costs
Contribution $900,000 $1,350,000 2,250,000
margin
Common 600,000 1,200,000 1,800,000
fixed costs
($2 × 2 ×
150,000; $2
×4×
150,000)
Profit before $ 300,000 $ 150,00 $450,000
taxes

c.
We believe that the pessimistic estimate in part (b) is likely more accurate than the
optimistic estimate in part (a). This is because the allocation in part (a) assumes that each
product, whether it is standard or deluxe, consumes the same amount of capacity resource.
This is not likely a good assumption because the deluxe product takes twice the amount of
labor taken to make a standard product. While some costs surely vary by units, other costs
(perhaps the majority of costs) bear a closer relation to labor hours. Thus, neither the
estimate in part (a) nor the estimate in part (b) is likely to be accurate. However, the
estimate in part b (using labor hours as the basis) is likely more accurate. Based on
this analysis, Bradshaw might rethink its decision to alter its product mix.

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9.36
a.
Each additional member from Acme pays $60 but would lead to additional variable costs of
$35 per month. Thus, each “Acme” member would generate a contribution of $60 -$35 =
$25 per month. The 200 additional members therefore increase Hercules’ contribution
margin by 200 members × $25 per member per month = $5,000 per month.

b.
No, the answer in (a) is not a preferred way for Tom and Lynda to evaluate the
proposal. The method would be correct if the costs and benefits associated with the
proposal would be realized in the short-term. That is, accepting or denying the proposal
would not change the magnitude of ‘capacity’ or fixed costs. However, accepting the
proposal will almost surely change “fixed” costs. The proposal would increase membership
by 20% (1,000 to 1,200 members) which means considerably more usage of the facilities.
For example, cardio and strength training equipment would see more wear and tear, and
more yoga classes might need to be scheduled. This means that costs associated with
machine repair and replacement, as well as instructor salaries (fixed costs) would increase.
Tom and Lynda must consider this change to make an effective decision.

In this context, allocating the fixed costs over members might provide a better estimate
of the long-term cost per member. The allocation is $40,000/1,000 = $40 per member per
month. Added to the $35 in variable costs, the “total cost” of servicing is $75 per member
per month. This estimate is a better approximation of the long-run cost of a member. With
this estimate, Hercules would actually lose $15 per “Acme” member, of $3,000 per month
if it accepts the proposal.

Note: The $75 is just an estimate. It is likely that not all costs (e.g., rental for building)
would increase proportionately with membership, even in the long run. Such factors (which
loosely correspond to scale economies) would lower the actual cost below $75 per member.
However, research shows that operating close to capacity increases both fixed and variable
costs more than proportionately when facilities operate close to capacity. Thus, the “true”
cost might well exceed $75 per member per month. Tom and Lynda would do well to make
the decision as if the cost were “about $75 per month” but could be lower (maybe $70) or
higher (maybe $80). Note that the decision does not change within this qualitatively
estimated range.

9.37

a.
Under variable costing, inventoriable costs only include variable manufacturing costs. In
particular, the value does not contain any allocation for fixed manufacturing overhead.
Thus, the inventoriable cost is $200 + $350 = $550 per unit. Notice that selling expenses
are not included because they only pertain to units sold.

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b.
Under absorption costing, inventoriable costs includes variable manufacturing costs PLUS
any allocation for fixed manufacturing overhead. Thus, the inventoriable cost is $200 +
$350 + $500 = $1,050 per unit.

c.
The ending inventory of 50 units contains $25,000 = 50 units * $500 per unit in fixed
manufacturing cost. Because Tip-top began with zero inventories, this amount is also the
change in the fixed overhead contained in the inventory. Thus, absorption costing income
will be higher by $25,000 relative to variable costing income.

9.38
a.
As reported in the following table, the value of Charlie’s ending inventory equals the sum
of the materials cost, the labor cost, and the allocated overhead cost.

Materials cost Given $5,000

Labor cost Given 7,500
Overhead cost 100% of labor cost 7,500
Total cost of ending inventory $20,000

b.
The change in the allocation basis will lead to a change in the amount of overhead cost
allocated to the inventory account. However, to determine the revised inventory value,
we first need to figure out Charlie’s overhead rate using materials $.

The overhead cost is given. If this value is not provided, we can compute the value
because the rate = total overhead cost/total material $. We can use the fact that the labor $
based overhead rate is 100% of labor cost and the fact that labor cost is $30,000 to
determine that Charlie’s overhead cost is $30,000. Using this estimate, we can compute:

Step 1: Overhead rate per materials $ = $30,000/$24,000 = $1.25 per materials $.

Step 2: In turn, we can use this rate to compute the value of Charlie’s ending inventory.

Materials cost Given $5,000

Labor cost Given 7,500
Overhead cost 125% of materials cost 6,250
Total cost of ending inventory $18,750

c.
Charlie will report $1,250 more in income if he uses labor $ as the allocation basis.
To see why, notice that the allocation serves to partition the total overhead cost of
$30,000 between inventory and the cost of goods sold. Changing the allocation basis

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from labor $ to materials $ reduces the portion allocated to inventory from $7,500 to
$6,250. Thus, the change must increase the portion allocated to the cost of goods sold
from $22,500 (= $30,000 - $2,500) to $23,750 (= $30,000 - $6,250). Because the change
does not affect any other item in the income statement, using materials $ as the allocation
basis reduces Charlie’s reported income by $1,250.

9.39
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.

Precision 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 costs in the cost pool by the
denominator volume. Plugging in the numbers from the problem:

$11,750,000/5,875,000 units = $2.00 per unit.

Step 2: With this rate in hand, we can determine inventoriable cost for each kind of
bearing:

Model Model Model

6203 6210 30207
Materials cost $1.00 $1.75 $3.00
Labor cost 3.00 4.00 7.00
Allocated overhead 2.00 2.00 2.00
Inventoriable cost $6.00 $7.75 $12.00

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 bearing:

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Model Model Model

6203 6210 30207
Materials cost $1.00 $1.75 $3.00
Labor cost 3.00 4.00 7.00
Allocated overhead 1.50 2.00 3.501
Inventoriable cost $5.50 $7.75 $13.50
1
$1.50 = $3.00 × $0.50/ labor $; $2.00 = $4.00 × $0.50/ labor $; $3.50 = $7.00 × $0.50/ labor $.
In each case, we compute the allocated overhead as the labor cost of each bearing × rate
per labor $. Notice again that we do not allocate fixed SG&A costs to determine
inventoriable costs.

c.
We find that the inventoriable cost for 6203 has decreased, the cost for 30207 has
increased, and there is no change in the cost for 6210. To understand the difference,
notice that when Precision allocates fixed manufacturing costs using units, each bearing
gets an equal share of overhead. However, when Precision allocates by labor cost,
allocated overhead is proportional to each bearings’ labor cost.

The “average bearing” consumes $4 of labor (= $23,500,000/5,875,000 bearings). There

will be no change due to the change in the allocation basis only if each kind of bearing
actually did consume $4 per bearing in labor costs. However, this equivalence is not true.
Thus, bearings with lower than average labor cost (e.g., 6203) will experience a
reduction in reported cost if Precision changes it allocation basis from units to labor cost.
Conversely, bearings with higher than average labor cost (e.g., 30207) will
experience an increase in reported cost.

Note: While the inventoriable cost of each individual bearing changes depending on the
allocation basis chosen, the total fixed manufacturing costs allocated to all bearings will
be $11,750,000 regardless of the allocation basis chosen.

9.40
a.
Horizon would report the following income and inventory numbers under variable
costing:

Revenue 1,600 × $50 $80,000

Variable costs
Manufacturing 1,600 × $16/unit $25,600
Selling and administrative 1,600 × $6/unit 9,600
Contribution Margin $44,800
Fixed Costs
Manufacturing Given $24,000
Selling and administrative Given 10,000
Profit before taxes $10,800

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Cost of Ending Inventory = $6,400

(400 units (=2,000-1,600) × $16 variable manufacturing cost per unit)

b.
Horizon would report the following income and inventory numbers under absorption
costing:

Revenue 1,600 × $50 $80,000

Cost of Goods Sold
Variable manufacturing 1,600 × $16 $25,600
Fixed manufacturing 1,600 × $121 19,200
Gross Margin $35,200
Period Costs
Variable selling and administrative 1,600 × $6 9,600
Fixed selling and administrative Given 10,000
Profit before Taxes $15,600

Cost of Ending Inventory = $11,200

(400 units × ($16 variable manufacturing cost per unit + $12 allocated fixed
manufacturing cost per unit)).
1
: $12 = $24,000 total fixed costs/2,000 units produced.

c.
We reconcile the income reported under the two formats as follows:

Income reported under variable costing $10,800

+ fixed overhead in ending inventory 400 units × $12 allocated fixed 4,800
manufacturing cost per unit
- fixed overhead in opening inventory Given 0
= Income reported under absorption $15,600
costing

Notice that the difference in income under the two approaches corresponds to the
difference in ending inventory ($4,800 = $11,200 – $6,400).

9.41
a.
The following table provides Creative Tiles’ contribution margin statement and ending
inventory value under variable costing:

Creative Tiles
Contribution Margin Statement & Ending Inventory Value
Revenue/Cost
per unit

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Sales volume (in units) 13,500

Production volume (in units) 15,000

Revenue $450 $6,075,000

Variable costs
Direct materials $70 $945,000
Direct labor $140 1,890,000
Marketing & sales $50 675,000
Contribution Margin $190 $2,565,000
Fixed costs
Manufacturing $1,500,000
Marketing & sales 625,000
Profit before taxes $440,000
Inventory:
Units in ending inventory 1,500
Value per unit $70 + $140 $210
Value of ending inventory $315,000

b.
Under absorption costing, we must allocate fixed manufacturing costs. Creative uses
batches as the allocation basis to perform this allocation. Given total fixed manufacturing
costs of $1,500,000 and 15,000 batches produced, we have the overhead rate as:

$1,500,000/15,000 batches = $100 per batch.

Creative Tiles
Gross Margin Statement & Ending Inventory Value
Revenue/Cost
per unit
Sales volume (in units) 13,500
Production volume (in units) 15,000
Revenue $450 $6,075,000
Cost of Goods Sold
Direct materials $70 $945,000
Direct labor $140 1,890,000
Allocated fixed manufacturing costs $100 1,350,000
Total Cost of Goods Sold $310 $4,185,000
Gross Margin $140 $1,890,000
Period Costs
Variable marketing and sales $50 $675,000
Fixed marketing and sales 625,000
Profit before Taxes $590,000
Units in ending inventory 1,500
Inventoriable cost per unit $70+$140+$100 $310

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Value of Ending Inventory $465,000

c.
As detailed in the text, the income reported under the two formats differs because of their
differing treatment of fixed manufacturing costs. We expense these costs under variable
costing, whereas we allocate them under absorption costing. Moreover, under absorption
costing, fixed overhead travels with the units produced, first passing through inventory
and then to cost of goods sold. If any units stay in inventory, the associated overhead cost
also stays in inventory, temporarily boosting reported income.

We can reconcile the income reported under the two formats as follows:

Item Calculation Amount

Income reported under variable costing $440,000
+ fixed overhead in ending inventory 1,500 units × $100 per $150,000
unit
- fixed overhead in opening inventory 0 units × $100 per unit 0
= Income reported under absorption costing $590,000

9.42
a.
Under GAAP, inventoriable costs include both variable and fixed manufacturing costs,
but exclude variable and fixed selling and administrative costs. While we have
information about the variable manufacturing costs per unit, we need to allocate fixed
manufacturing costs.

Step 1: First, let us compute the overhead rates in the two departments.

Fabrication = $66,000 / 12,000 machine hours = $5.50 per machine hour.

Assembly = $39,000 / 6,000 labor hours = $6.50 per labor hour.

Step 2: With the information from step 1, we can compute the cost of the product:

Materials cost $50.00 given

Labor cost 42.00 given
Fabrication Overhead 5.50 1 machine hour × $5.50 / machine hour
Assembly Overhead 13.00 2 labor hours × $6.50 / labor hour
Inventoriable cost $110.50

Again, we note that the SG&A costs, whether variable or fixed, are not included in
inventoriable costs. In addition, observe that we could perform the allocation even though
we only have data pertaining to one product.

b.

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The inventoriable cost computed under absorption costing will understate the true
long-term cost of a product as it ignores SG&A costs. To determine the long-term
profitability of a product, we need to include all controllable costs. For the product in
question, this means that we should probably add $11 ($5 of variable selling costs + $6 of
fixed selling costs), as both the variable and fixed selling and administrative expenses are
controllable over an extended horizon. For example, if Boston drops the product in
question, it will no longer incur the shipping costs, sales commissions, and advertising
costs associated with selling and marketing the product.

9.43
a.
As per GAAP, Atsuko should value her inventory as the total of materials cost, labor
cost, and allocated manufacturing overhead. Selling and administrative expenses are
treated as period costs and, thus, are not included in the value of ending inventory.

We determine the allocated overhead in two steps;

1. Calculate the overhead rate. For Atsuko, dividing total manufacturing overhead of
$525,000 by total labor cost of $1,050,000 means that her overhead rate is $0.50
per labor dollar.

2. Determine the portion allocated to inventory. Atsuko’s inventory has $62,500 of

labor content. Multiplying this amount by $0.50 per labor dollar, she will allocate
$31,250 to the inventory.

Thus, combining $50,000 materials + $62,500 labor + $31,250 allocated overhead,

Atsuko will value her inventory at $143,750.

b.
The following table computes Atsuko’s reported income.

Revenue 3,300 pairs  $750 per pair $2,475,000

- Materials ($700,000 - $50,000) 650,000
- Labor cost ($1,050,000 - $62,500) 987,500
- Overhead cost ($525,000 - $31,250) 493,750
= Gross Margin $343,750
- Selling and administrative costs Given 250,000
= Profit before taxes $93,750

Notice that the total cost of materials and labor is split between cost of goods sold (in the
income statement) and the inventory account (in the balance sheet). The manufacturing
overhead cost is split in a like fashion.

c.
The key to answering this question lies in recognizing that the manufacturing overhead
has a large fixed component, which does not change in response to volume. However,

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the cost will be split between inventory (a balance sheet account) and cost of goods sold
(an income statement account) in proportion to the number of units. (For simplicity, we
use units as the allocation basis – the argument holds for other allocation bases as well).
Thus, if Atsuko increases her production, she will have more units in inventory. In turn,
the greater number of units in inventory will attract a greater share of the fixed
overhead cost. By arithmetic, the amount recorded in the cost of goods sold for
overhead expenses will decrease, causing reported income to increase. Thus, Atsuko
can increase reported income by increasing production. More generally, including
allocated manufacturing overhead when valuing inventory provides an incentive to
over-produce because such over production temporarily boosts reported income.

9.44
a.
Contribution margin is price less all variable costs. For Xenon, variable costs include
materials, labor, and variable overhead. We know the cost of materials and labor but need
allocations to determine the cost of variable overhead.

Total variable overhead costs = 1/3 of total overhead = 1/3 × $1,500,000 = $500,000.

Dividing through by the total labor cost, we have:

Variable overhead per labor $ = $500,000/$1,000,000 = $0.50/labor $.

Because the pump has $30 of labor cost, Xenon will allocate $30 × $0.50 = $15 toward
variable overhead.

Collecting this information, we have:

Sales Price $90.00 per unit Given

Less: Materials 12.00 Given
Labor 30.00 Given
Variable overhead 15.00 $30.00 × $0.50 / labor $
Equals: Contribution margin 33.00 per unit

b.
Gross Margin is price less all manufacturing related costs, including variable and fixed
overhead. We know the cost of materials and labor but need allocations to determine the
cost of variable and fixed overhead.

From part [a], we know that variable overhead rate is $0.50 per labor $.

Additionally, total fixed overhead costs = 2/3 of total overhead = 2/3 × $1,500,000 =
$1,000,000.
Dividing through by the total labor cost, we have:

Fixed overhead per labor $ = $1,000,000/$1,000,000 = $1.00/labor $.

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Because the pump has $30 of labor cost, Xenon will allocate $30 × $1.00 = $30 per pump
toward fixed overhead.

Collecting this information, we have:

Per Pump
Sales Price $90.00 Given
Less: Materials 12.00 Given
Labor 30.00 Given
Variable overhead 15.00 $30.00 × $0.50/labor $
Fixed overhead 30.00 $30.00 × $1.00/labor $
= Inventoriable cost 87.00
Equals: Gross Margin $3.00

Note: While the gross margin on Xenon’s pump is lower than its contribution margin,
this is not always the case. For example, the gross margin could exceed the contribution
margin if allocated fixed manufacturing costs are less than variable selling costs.

c.
Now, Xenon has to compute two separate fixed overhead rates, corresponding to the two
cost pools. We have:
Costs Denominator Rate
Volume
Materials related pool $240,000 $600,000 $0.40 / materials $
Labor related pool $760,000 $1,000,000 $0.76 / labor $

Using these rates, we compute:

Per Pump
Sales Price $90.00 Given
Less: Materials & components 12.00 Given
Labor 30.00 Given
Variable overhead 15.00 $30.00 × $0.50 / labor $
Fixed overhead (materials) 4.80 $12.00 × $0.40 / material $
Fixed overhead (labor) 22.80 $30.00 × $0.76 / labor $
= Inventoriable cost 84.60
Equals: Gross Margin $5.40

We can understand the difference in gross margins (inventoriable costs) by appealing to the
property that the allocated cost is proportional to the driver volume in a cost object. When
Xenon allocates cost using labor $, the overhead allocated to the pump is a multiple of the
labor $ in the pump. The percent of overhead allocated to the pump equals the percent labor
contained in the pump.

Globally, materials cost is 60% of labor cost (60% = $600,000/$1,000,000), meaning that
an average product has $0.60 of materials cost for each $1 of labor cost. However, the

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pumps only have $12 of materials for $30 of labor, meaning that pumps use
proportionately less materials than the average product ($12/$30 = 40%). The ratio of
the pumps’ materials cost to total materials cost is therefore smaller than the ratio
of the pumps’ labor cost to total labor cost. Thus, when Xenon breaks out some
overhead (in this case $240,000) and allocates this amount using materials $, the amount
allocated to the pumps will decrease. Naturally, inventoriable cost also decreases, thereby
increasing gross margin.

9.45

Putting units into inventory instead of selling them has two effects. First, we would lose the
revenue and second, we would avoid the associated COGS and variable selling expenses.
Thus, if a product has a negative profit margin (or equivalently, if the allocated fixed
overhead cost > contribution margin), then inventorying the unit will increase profit.

9.46
Let’s compute the taxes paid if Shah uses garments as the allocation basis:

Cost per garment = $660,000 / (20,000 + 20,000) = $16.50 per garment.

Costs allocated to Europe = 20,000 garments × $16.50 / garment = $330,000.

Costs allocated to India = 20,000 garments × $16.50 / garment = $330,000.

We cannot compute the tax directly as we do not have data relating to income. However,
we can calculate the tax savings as the overhead cost is an allowable deduction to
income.

Thus, the allocation scheme will result in a tax shield of ($330,000 × 40%) + ($330,000 ×
30%) = $231,000.

Next, let us compute the tax shield if Shah were to allocate overhead cost using labor
hours as the allocation basis.

Denominator volume = (20,000 garments × 7 hours) + (20,000 garments × 4 hours)

= 220,000 hours.

Cost rate per hour = $660,000 / 220,000 hours = $3 per hour.

Costs allocated to Europe = 20,000 garments × 7 hours / garment × $3 / hour = $420,000.

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Costs allocated to India = 20,000 garments × 4 hours / garment × $3 / hour = $240,000.

Thus, the allocation scheme will result in a tax shield of ($420,000 × 40%) + ($240,000 ×
30%) = $240,000.

Changing the allocation basis from garments to labor hours would therefore save Shah
Company, $240,000 - $231,000 = $9,000 in taxes paid.

9.47
a.
If David outsources the product, the firm will pay $90,000 but save $60,000 in materials
and labor costs. There is no change in capacity costs (as stated in the problem). Thus, the
firm’s profit would decline by $30,000 if David were to outsource this product.
b.
From David’s perspective, the cost of outsourcing the product is still $90,000. But, he will
avoid (in his profit and loss statement), the allocation for labor costs. The cost of the
component is now part of materials costs, which does not attract a overhead charge. How
much will David save in allocated overhead? We know that materials plus labor is $60,000
and that labor is usually twice the cost of materials for the average product. Thus, labor
cost is $40,000. We also know that overhead is allocated at 100% of labor cost. Thus, the
current internal cost (from David’s perspective) is $100,000 = $20,000 (materials) +
$40,000 (labor) +$40,000 (allocated overhead). Thus, the profit of his product line will
increase by $10,000 if he outsources the product.

c.
This problem illustrates the classic tension between the firm wide and the local
perspective. For the firm, capacity costs are fixed relative to this decision. If the costs were
not allocated to David, they would be allocated elsewhere. However, the allocation
process makes the fixed cost appear to be a variable cost – David’s allocation reduces
by $1 for each dollar reduction in labor costs. This change in the perception of cost
behavior is why divisions might (often unknowingly) make decisions that are not
beneficial to the entire firm.

9.48

a.
Let us consider the problem from the firm’s perspective.

Item Product A Product B

Cost to buy (outsource) $60,000 $45,000
Cost to make internally:
Materials $20,000 $40,000
Labor costs $30,000 $10,000
Total cost (internal) $50,000 $50.000

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Outsource? NO YES
Profit from outsourcing ($10,000) $5,000

b.
Let us consider the problem from Samantha’s perspective.

Item Product A Product B

Cost to buy (outsource) $60,000 $45,000
Cost to make internally:
Materials $20,000 $40,000
Labor costs $30,000 $10,000
Allocated overhead $45,000 $20,000
Total cost (internal) $95,000 $70.000

Outsource? YES YES

Profit from outsourcing $35,000 $25,000

Samantha would prefer to outsource product A rather than product B as his income
increases more.

c.
This problem illustrates the classic tension between the firm wide and the local
perspective. For the firm, capacity costs are fixed relative to this decision. If the costs were
not allocated to Tim, they would be allocated elsewhere. However, the allocation process
makes the fixed cost appear to be a variable cost – Tim’s allocation reduces by $1.50 for
each dollar reduction in labor costs. This change in the perception of cost behavior is why
divisions might (often unknowingly) make decisions that are not beneficial to the entire
firm.

9.49 This problem demonstrates the arbitrary nature of allocations for some common costs. In
this case, the demand for the allocation is driven by a reimbursement consideration. There
is no underlying economics of the production process that can help guide the decision, nor
is there is a control role. Thus, because the sole objective is to split the cost between two
cost objects, Shibin must subjectively choose the allocation basis.

The following schemes come to mind:

1. Equal split of cost because both schools derive the same benefit. Under this scheme,
Shibin will seek a reimbursement for $250 from each of the two schools.
2. Allocate $400 to State University and $100 to Prestige, arguing that State
University would have paid $400, if Prestige had not invited Shibin for an
interview. Prestige is only responsible for the incremental cost.
3. Split the cost as per perceived ability to pay. Arguably, as a private Ivy League
school, Prestige has greater financial resources relative to State University, a state-

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supported school. Thus, Shibin may submit expenses of, for example, $350 to
Prestige and $150 to State University.

Overall, there is no clear winner among the candidate mechanisms. The choice
depends on perceptions of fairness, equity, and ability to bear.

9.50
a.
The following table provides the required computations.

Allocation Allocation Using Allocation

Using Pam’s Sales Using
Budgeted Client’s Sales
hours
Step 1: Determine the allocation rate

Total cost in cost pool $6,000 $6,000 $6,000

Denominator volume 80 hours $125,000 $250 million
(40+40) (100,000+25,000) (50m + 200m)
Rate per unit of cost driver $75 per $0.048/$ of Pam‘s $24/million of
hour sales to client client sales

Step 2: Determine the cost allocated to each client

Apollo $3,000 $4,800 $1,200
Troy $3,000 $1,200 $4,800
Total allocated $6,000 $6,000 $6,000

Notice that the cost allocated to each client differs markedly depending on the allocation
basis chosen.

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b.
Pam faces a sticky problem, with no obvious solution. The one thing that is clear is that
she cannot double-bill her clients. That is, it would be unethical for Pam to charge both
clients for the entire $6,000 cost of the common work. She must allocate this cost among
the two clients.

However, there is no obvious allocation basis. All else being the same, Pam prefers to
allocate more to Apollo as the choice increases her reimbursement. Pam’s likely goal of
increasing her wealth and building a longer client list also push her in this direction.
However, this action penalizes an existing client for a new one.

The “ability to bear” criterion suggests a greater allocation to Troy. Ultimately, Pam has
to make a subjective decision about the choice for an allocation basis. An equal split
seems as good as any other choice. Moreover, such a split is easy to explain and is a
defensible action, should a client challenge the cost.

PROBLEMS

9.51
a.
We can understand the rationale for Brian’s actions. As we learned in Module II, firms
cannot control capacity costs in the short-term. That is, these costs are not relevant for
short-term decisions. Moreover, Brian’s firm is a setting of excess capacity, meaning that
capacity has zero opportunity cost. With these facts, contribution margin is the right
measure to maximize profit in the short-term. However, the italicized “short-term” is
crucial, as we will see next.

b.
We also can understand the rationale for the VP’s actions. The VP might be considering
longer-term effects in nixing the deal. For instance, reducing the price now might make it
much harder to raise prices once demand picks up. Likewise, knowledge of a price cut for
this customer might lead other customers to demand similar concession, leading to lower
profitability. Finally, perhaps the VP knows that capacity is likely to become more fully
utilized in the near future (i.e., she knows the deals in works by ALL sales persons, unlike
Brian, who only knows the deals he is working on), meaning that she might have a finer
estimate of the opportunity cost of capacity. Thus, we can justify the VP’s actions if we
adopt a long-term view.

Note: This problem links back to the big-picture presented in the part opener.

9.52

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a.
Let us begin by calculating the total number of machine hours that Catlow uses. We have:

(2,900 units × 2 hours / unit) + (1,400 units × 3 hours / unit) = 10,000 hours.

Given the overhead rates:

Expected variable costs for the year = 10,000 hours × $20 / hour = $200,000
Expected fixed costs for the year = 10,000 hours × $30 per hour = $300,000

Thus, during the current year, total expected overhead = $500,000.

We can also use the rates to project capacity costs (overhead) for the new product mix.
Under this mix, we have:

(3,400 Alpha units × 2 hours /unit) + (2000 Beta units × 3 hours/unit) = 12,800 hours

The expected overhead is (12,800 hours × $20 / hour) - $256,000 for variable overhead,
and $384,000 (= 30 × 12,800) for fixed overhead, or $640,000 in total.

b.
The estimate in part (a) is likely understated. This is because we need 12,800 hours and
each machine could only provide 2,000 hours. Thus, we need to expand capacity from 5 to
7 machines. This change would not affect the variable overhead (which is only proportional
to actual machine hours consumed). However, the purchase of 2 additional machines would
substantially increase fixed overhead costs. Currently, each machine costs 2,000 hours ×
$30 per hour = $60,000 in fixed overhead. With 7 machines, we will have $420,000 of
overhead. Thus, total overhead is more likely to be $256,000 + $420,000 = $676,000.

Why does expected overhead increase? We will need to buy 7 machines or 14,000 hours of
capacity even though we only need 12,800 hours. The additional purchase occurs because
we can only buy capacity in increments of 2,000 hours. The fixed overhead relates to the
cost of capacity supplied in the form of machine hours. The machine cost would not
decrease because we do not plan to fully use the machine.

Such fine-tuning of capacity cost estimation is possible only if we perform direct

estimation. In this case, we analyzed the individual nature of the machines to determine the
increase in costs. While refining the analysis this way leads to greater accuracy, doing so is
costly. In particular, we need to collect data on more drivers and perform more analysis to
assign costs to drivers. This is a difficult and subjective exercise. We trade off accuracy in
estimation with the ease in obtaining the estimate.

9.53
a.
Let us begin by calculating unit contribution and profit margins.

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Item Standard Custom

Price $130 $175
Unit Contribution margin $65 $105
Unit profit margin $25 $65
Variable cost = (1- CMR) * price $65 $70
Allocated fixed cost = Contribution $40 $40
margin – profit margin

Comparing the allocated fixed cost for the Standard and the Custom products, it seems that
Sunder employs the number of units as the allocation basis. This is the mechanism that
would lead to an identical allocated amount for each product. (If Sunder used machine
hours instead, the custom product should receive twice the allocation received by the
standard product.)

Also notice that Sunder’s total profit is (75,000 × $25) + (25,000 × $65) = $3,500,000.

b.
We now need to calculate the rate per machine hour. For this calculation, we need the total
overhead cost and the total number of machine hours.

We can use the allocated rate per unit (in part a) to back out total overhead. The rate is $40
per unit and there are 100,000 units (= 75,000+25,000). Thus, the overhead cost must be
100,000 × $40 = $4,000,000. We compute total machine hours as (75,000 standard × 2
hours /unit) + (25,000 deluxe × 4 hours /unit) = 250,000 hours. Combining the two
estimates, we have the rate per machine hour as $16 per machine hour. Thus, we have:

Item Standard Custom

Price $130 $175
Variable cost $ 65 $ 70
Unit Contribution margin $ 65 $105
Allocated fixed cost $ 32 $ 64
(2 hours × $16 ; 4 hours × $16)
Unit profit margin $ 33 $ 41

Notice that the profit margin for the standard product has increased from $25 to $33 while
that for the custom product has decreased from $65 to $41. However, Sunder’s total profit
is still (75,000 * $33) + (25,000 * $41) = $3,500,000. This equivalence emphasizes that the
allocation only divides the cost. The total is unaltered.

c.
The following table provides the required information. Notice that we treat capacity costs
as controllable for this decision. As the number of units changes, the capacity costs change
proportionately because the rate per unit stays the same.

Item Standard Custom

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New Units 50,000 50,000

Profit Margin per unit $ 25 $ 65
Total profit $1,250,000 3,250,000

Thus, Sunder expects to make $4,500,000 in profit with the new product mix. Also, notice
that total capacity costs stay at $4,000,000 although we changed the mix. We get this result
because the total number of units did not change even though the mix changed. Further, our
allocation scheme is as if each unit consumes the same amount of capacity resources,
regardless of the type of product.

Based on this projection, changing the product mix appears to be a good idea as it increases
expected profit.

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d.
The following table provides the required information. Notice that we treat capacity costs
as controllable for this decision. As the number of units made changes, the capacity costs
change proportionately because the rate per unit stays the same.

Item Standard Custom

New Units 50,000 50,000
Profit Margin per unit $ 33 $ 41
Total profit $1,650,000 2,050,000

Thus, Sunder expects to make $3,700,000 in profit with the new product mix. Also notice
that total capacity costs increases to $4,800,000. Total machine hours are (50,000 × 2) +
(50,000 × 4) = 300,000 hours, and the rate is $16 per machine hour.

Even though the total number of units did not change, the change in mix increased the
number of machine hours, increasing the total expected capacity cost.

While switching product mix still increases profit, the idea is not so compelling now. The
change in results underscores the importance of picking the right driver to estimate the
change in capacity costs. In this instance, machine hours probably are better suited as
deluxe products seem to require more work than standard products do.

9.54
:a.
Residential Commercial Total
Number of customers 200 300 500
Number of pickups per week 200 300 ×5 = 1,500 1,700
Revenue* $320,000 $3,600,000 $3,920,000
Variable costs* 56,000 720,000 776,000
Contribution margin $264,000 $2,880,000 3,144,000
Traceable fixed costs 150,000 225,000 375,000
Segment margin $114,000 $2,655,000 $2,769,000
Common fixed costs NA NA 1,100,000
Profit before taxes $1,669,000
* Residential Revenue = 200 × ($800,000/500 customers)
Commercial Revenue = 300 × ($1,200,000/100 customers)
* Residential Variable costs = 200 × ($140,000/500 customers)
Commercial Variable costs = 300 × ($240,000/100 customers)
b.
Let us first construct the allocation rates. We have $1.1 million in common fixed costs and
$2 million in total revenue. Thus, the allocation rate (for charging to segments) is $1.1/$2.0
= 55% of revenue. With this rate, we have the current income statement as:

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Residential Commercial Total

Number of customers 500 100 600
Number of pickups per week 500 500 1,000
Revenue $800,000 $1,200,000 $2,000,000
Variable costs $140,000 $240,000 $380,000
Contribution margin $660,000 $960,000 1,620,000
Traceable fixed costs 150,000 225,000 375,000
Segment margin $510,000 $735,000 $1,245,000
Common fixed costs 440,000 660,000 1,100,000
($800,000×.55;$1,200,000×.55)
Profit before taxes $70,000 $75,000 $ 145,000

Now, let us re-do the income statement, except let us assume that both segment and
common fixed costs vary in proportion to sales revenue. That is, sales revenue is the driver
for fixed costs. Then, as we calculated above, the rate for common fixed costs is 55% of
revenue. With respect to traceable fixed costs, the rates are $150,000/$800,000 = 18.75%
for residential customers and $225/$1,200 = 18.75% for commercial customers.

With these rates, we have:

Residential Commercial Total

Number of customers 200 300 500
Number of pickups per week 200 300 ×5 = 1,700
1,500
Revenue $320,000 $3,600,000 $3,920,000
Variable costs 56,000 720,000 776,000
Contribution margin $264,000 $2,880,000 3,144,000
Traceable fixed costs 60,000 675,000 735,000
($320,000×.1875;$3,600,000×.1875)
Segment margin $204,000 $2,205,000 $2,409,000
Common fixed costs 176,000 1,980,000 2,156,000
($320,000×.55;$3,600,000×.55)
Profit before taxes $ 28,000 225,000 $253,000

While profit increases relative to current levels, it is substantially lower than the estimate in
part (a). The key difference, of course, is framing the problem as a long-run instead of a
short-term problem. This change means that fixed costs are potentially controllable, and we
estimate the new level using sales revenue as the cost driver.

c.
Now, let us re-do the income statement, except let us assume that both segment and
common fixed cost vary in proportion to the number of pickups. That is, pickups are the
driver for fixed costs. Then, the rate for common fixed costs is $1,100,000/1,000 = $1,100
per weekly pick up. With respect to traceable fixed costs, the rates are $150,000/500 =
$300 per weekly residential pickup and $450 per weekly commercial pickup.

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With these rates, we have:

Residential Commercial Total

Number of customers 200 300 500
Number of pickups per week 200 300 ×5 = 1,500 1,700
Revenue $320,000 $3,600,000 $3,920,000
Variable costs 56,000 720,000 776,000
Contribution margin $264,000 $2,880,000 3,144,000
Traceable fixed costs* 60,000 675,000 735,000
Segment margin $204,000 $2,205,000 $2,409,000
Common fixed costs* 220,000 1,650,000 1,870,000
Profit before taxes $ (16,000) $ 555,000 $539,000

d.
The estimate in part (a), $1,669,000, is not reliable. The estimate assumes that capacity
costs would not change either in response to the change in the product mix or the change in
sales volume. This assumption seems odd because it is likely that commercial and
residential customers differ in terms of their resource demands. For example, commercial
clients need five times as many pickups as residential clients.

The estimates in parts (b) and (c) compute the expected change in capacity costs by using
allocations. However, they differ in terms of the driver used. It is difficult to uniquely
identify the single best driver – some costs might be driven by sales volume while others
might more closely relate to the number of pickup. Thus, neither measure is completely
accurate although we expect that the number of pickups is a better estimate than sales
revenue.

N&N’s management could be quite confident that the change in the nature of the business
would increase their profit. The best estimate might be a weighted average of the
estimates in parts (b) and (c), where the weights correspond to management’s belief that
the underlying activity (pickups or revenue) is the true driver of capacity costs.
9.55
Allocations of capacity costs to products and a mandate to recover full cost in prices are
among the most contentious of issues in firms. At some level, Paul has a valid point. On an
incremental basis, it is likely that the firm’s capacity costs would not change because of
this product. As Paul argues, the accounting department’s cost would not change.
However, such an incremental methodology is most appropriate for short-term decisions
only. Over the long-term, capacity costs are controllable. For instance, adding 10 such
products would change the cost in accounting. The allocation is a way, albeit a crude
way, of measuring the change in the firm’s capacity costs. The mandate to recover full
costs is then pricing from a long-term perspective, which is suitable for product planning
and portfolio decisions. For such decisions, we should consider capacity costs as being
controllable, and the allocations in the product cost sheet are a rough estimate of how these
costs would change if the firm were to add the new product.

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9.56
a.
The total capacity cost for Waymire is $13,500,000 and the firm has 135,000 labor hours.
Thus, the current rate for allocating capacity costs is $100 per labor hour
(=$13,500,000/135,000).

With the change in product mix, Waymire only expects 121,500 labor hours. Thus, if it
uses labor hours as the sole driver, its expected capacity cost would be 121,500 labor
hours × $100 per labor hour = $12,150,000.

b.
The total capacity cost for Waymire is $13,500,000. It appears that $3,540,000 of the cost
relates to marketing and the remainder of $9,960,000 pertains to manufacturing. Given that
that the firm has 81,000 machine hours. Thus, the current rate for allocating capacity costs
is $122.962 per machine hour (=$9,960,000/81,000). Similarly, the rate per sales $ is
$3,540,000 / $162,000,000 = 2.185%.

With the change in product mix, Waymire expects only 132,300 machine hours and sales
of $175,000,000. . Thus, if it uses machine hours as the sole driver, its expected capacity
cost would be 132,300 machine hours × $122.962 per machine hour = $16,267,872.

With the change in product mix, Waymire expects revenue of $175,000,000. Thus, its
expected capacity cost would be $175 million × 2.185% = $3,823,750.

Total overhead is therefore estimated at $20,091,622 = $16,267,872 + $3,821,750.

c.
It seems reasonable to use different drivers for different types of costs. The following is
one possible grouping (using the four available drivers only):

Item Driver
Materials handling and inventory Materials $
Supervision Labor hour
Payroll Labor hour
Factory administration Labor hour
Machine depreciation Machine hours
Machine operations Machine hours
Sales offices Revenue
Travel and other customer development Revenue
Selling administration Revenue

With this grouping, we have the following rates.

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Item Amount Driver units Rate / driver unit

Materials related costs $2,400,000 $48,000,000 $0.05 per material $
Labor related costs $2,700,000 135,000 $20 per labor hour
Machine related costs $4,860,000 81,000 $60 per machine hour
SG&A costs $3,540,000 $162 million 2.185% of revenue
Total $13,500,000 NA NA

With the new rates, we have the estimated capacity costs as:

Rate / driver unit Projected Projected amount

Item Driver units
$0.05 per material $52,000,000 $2,600,000
Materials related costs $
Labor related costs $20 per labor hour 121,500 hours 2,430,000
$60 per machine 132,300 hours 7,938,000
Machine related costs hour
SG&A costs 2.185% of revenue $175,000,000 3,823,750
Total NA NA $16,791,750

d.
The analyses in parts (a) and (b) use allocations to approximate the change in capacity
costs. The analysis in part (c) refines the allocation by considering the nature of the costs
being allocated and picking an appropriate driver. In this way, the analysis moves closer to
direct estimation, where we consider individual accounts. For example, it is possible that
the item payroll is not related to the number of labor hours but to the number of people
employed. Likewise, the cost of the item, “factory administration” might be better
estimated if we use both labor and machine hours as the drivers.

While refining the analysis this way brings us closer to direct estimation and potentially
greater accuracy, doing so is costly. In particular, we need to collect data on more drivers
and perform more analysis to assign costs to drivers. This is a difficult and subjective
exercise. Thus, we trade off accuracy in estimation with the ease in obtaining the estimate.

9.57
a.
We compute LuAnne’s margin as:

Revenue $400,000 Given

Manufacturing costs 320,000 @80% of sales revenue
Marketing costs 54,000 @13.5% of sales revenue
Margin $26,000

We compute the Betty’s margin at $22,750 = 6.5% × $350,000, where 6.5% is the
margin (= 100% - 80% - 13.50%).

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Thus, LuAnne has the higher margin under the old system.

b.
Under the revised allocation system, marketing cost is allocated based on orders. Hence,
we need to compute the cost per order and determine the margins.

Step 1: Determine the rate.

Marketing cost per order = Total cost / Total number of orders

We need to calculate both figures as neither is provided to us.

Total marketing cost = 13.50% of total revenue = 0.1350 × $60 million = $8,100,000.

Total orders = Total revenue/Average order size = $60 million/$8,000 = 7,500 orders.

Thus, we have:

Marketing cost per order = $8,100,000/7,500 = $1,080 per order.

Step 2: Use the rate to determine allocated costs.

We can compute the margins as:

Other
Item LuAnne salesperson Detail
Revenue $400,000 $350,000 Given
Manufacturing costs 320,000 280,000 @80% of revenue
Marketing costs (this is 60 orders × $1,080 per order;
step 2 of the allocation) 64,800 37,800 35 orders × $1,080 per order
Margin $15,200 $32,200

Observe that LuAnne now generates less than half the margin generated by Betty.

c.
It is difficult to answer the question with the data provided as the answer depends on the
nature and composition of marketing costs. The old system assumes that marketing costs
are proportional to revenue. This assumption is probably true for many marketing
expenses such as after-sales service or shipping. However, the assumption is probably not
true for other expenses such as invoicing and sales calls. The revised system makes the
opposite assumption that all marketing costs are related to the number of orders and not
sales volume. Thus, both systems are probably inaccurate.

Ideally, we would like to partition marketing costs into two pools – costs that relate to
revenue and costs that relate to order processing. We can then use sales revenue as the
cost driver for the first pool and orders as the driver for the other pool. This kind of a

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refined allocation, with two cost pools, is likely to generate a more “accurate”
estimate.

We hasten to note, however, that there is a limit to such refinements. We are still dealing
with large pools (in $ terms) when we go from one to two pools. Once we go past a few
pools (the exact number depends on the nature of the problem such the magnitude of the
costs, the number of cost objects, and correlations among cost drivers), we increase the
chance for measurement error. Thus, it is possible that any further increase in the number
of cost pools might decrease accuracy in reported costs.

d.
The manager can use this information to focus her sales person’s efforts on the right mix
of sales and activities. For instance, LuAnne’s ranking drops because her average order
size ($6,667 = $400,000/ 60 orders) is smaller than the average of $8,000. LuAnne
therefore imposes higher demands on organizational resources for the same sales volume.

The allocation is one way of sensitizing LuAnne to the financial implications of her
choices. Allocating some (or all) of the cost using orders as the allocation basis will
motivate LuAnne to consider order volume as well when dealing with customers. For
instance, under the accountant’s scheme, LuAnne incurs a “fixed” cost of $1,080 per
order and generates a contribution margin of 20% over manufacturing costs. Thus,
LuAnne should refuse to take any order less than $5,400 (= $1,080 / 0.2) as this is the
breakeven order size. Carefully crafted allocations, when coupled with incentive
compensation, can help encourage desired activities and penalize undesired actions.

9.58
In this setting, the objective is to set prices proportional to the damage inflicted on the
road due to use. Logic tells us that vehicle weight and distance traveled are two important
criteria in determining damage done. Thus, we can view the pricing scheme as an
“allocation” of the road cost to vehicles.

Viewed in this light, a flat charge per vehicle assumes equal damage from all vehicles
and is easy to implement. We only need to install booths at entrances to the toll way and
automating the toll-collection is relatively simple.

Adjusting the flat rate by vehicle category adjusts for weight. The scheme does not
discriminate among empty and loaded trucks. Implementing the scheme is still relatively
straightforward but may require a person to collect the differing toll amounts.

The third allocation basis, using actual weight, is yet more sophisticated. As a continuous
metric, we would term it a duration driver. There are likely significant measurement costs
as the toll authority must have a mechanism to weigh each vehicle using the toll way.

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The final scheme is perhaps best at estimating the cost inflicted on the toll way. However,
the scheme is also the most difficult from an implementation perspective. For instance,
we need to monitor where a vehicle enters and exits a toll way.

This problem highlights some of the tradeoffs involved in choosing an allocation basis.
Simple drivers such as the number of vehicles (which count and are sometimes termed
count drivers) are easy to implement but are inaccurate. More complex drivers which
account for weight (called duration drivers as they account for characteristics) are often
more accurate measures of resources consumed. However, measuring duration drivers
may impose higher costs and have greater measurement error. Overall, the choice is
judgmental, as evidenced by the many observed schemes for collecting tolls.

9.59
a.
An equal assessment implicitly assumes that each household derives equal benefit from
the improvement. The use of linear feet of road front ties the cost to the work done. The
idea here is that the cost is proportional to the linear feet of pipe laid and that
homeowners “own” the pipe that runs through their property. The use of property value is
based on the assumed “ability to pay.” The notion is that persons owning more expensive
homes have greater ability to pay for the upgrade and should be charged accordingly.

All of the metrics are somewhat arbitrary. All of them are easy to implement and have
some reasonable justification. Ultimately, cities make the choice based on political
considerations, with ability to pay often being the dominant criterion.

b.
It is more common to assess sidewalks based on linear feet of road front. Unlike sewer
lines, it is possible to partition sidewalks into discrete pieces that belong to the
homeowner. Indeed, in many cities, the homeowner is responsible for maintaining the
sidewalk (e.g., shoveling snow). The key distinction between sewer lines and sidewalks
appears to be in the ability to trace the cost to the individual homeowner. As sidewalks
can be installed in pieces, there is ample justification to attach the cost of the sidewalk for
a given home to that home. In contrast, sewer lines are a “public good” and the entire
system needs to be completed before benefits are realized.

9.60
Payroll Processing. There appear to be two types of costs in this category. The first
relates to payroll processing and the second relates to employee hiring and firing. Both
expenses are part of operating the business and therefore should be allocated to individual
branches for the purpose of evaluating branch profitability.

The answer is less clear for managerial performance evaluation. The cost of payroll
processing is not controllable by the manager except via his or her influence on the
payroll. Thus, the allocation makes sense if Maggie wants the managers to pay attention
to payroll costs. However, there are likely more direct mechanisms, such as boundary
controls that specify wages and staffing strength, for controlling payroll expense. In a like

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fashion, we can argue for allocating some payroll costs based on the number of new
employee hires. While more direct controls are also available (e.g., Maggie speaking with
the branch to reduce turnover), this allocation sensitizes the branch managers to the cost
of turnover.

Advertising. The cost of corporate advertising can be allocated to branches using sales $
as the basis. The problem text indicates a direct sales effect. Because sales are recorded at
the branch level, it seems reasonable to allocate the associated costs as well for
evaluating branch performance.

The logic is less compelling if the purpose is to evaluate managers. The branch managers
have little control over the cost and, thus, would see the allocation as being arbitrary.
Moreover, it is unclear what performance-evaluation purpose the allocation would serve.

Purchasing and Inventory Handling. This cost resembles the cost of payroll in terms of
its controllability by branch managers. Thus, a similar logic applies. The cost must be
allocated to branches for profitability assessments. Allocating at least a portion of the cost
based on the number of deliveries and using it for managerial performance evaluation
sensitizes managers to the cost of poor forecasting. However, as with payroll, more direct
mechanisms (e.g., all extra deliveries must be approved by Maggie) may suffice to
provide the required control.

This problem highlights three issues.

 The reason for the allocation determines if it makes sense for the firm to allocate
the cost. Taking advertising as an example, the allocation is justifiable for
assessing branch performance but not managerial performance.
 Allocations can modify behavior. If Maggie allocates personnel costs by the
number of hires and fires, and uses the cost in managerial performance evaluation,
branch managers have an incentive to be more careful in their hiring and firing.
However, please note that mere allocation is not enough. The allocated cost must
also influence managerial compensation for the allocation to provide the correct
incentives.
 Allocations are but one tool in the portfolio of controls available to management.
Given Yin-Yang’s size, direct mechanisms may work better and be more cost
effective than cost allocations to modify managerial behavior. It is easier to
conceive of a role for such “control-related” allocations in larger firms.

9.61
a.
There are at least two salient reasons that lead to the demand for a cost allocation in this
setting.

1. Inventory Valuation. The problem indicates that a typical project spans many
years. Great Lakes needs to value the inventory of parcels in its possession at year
end to determine the income reported for a given year. The overall cost (purchase
plus development) must be allocated to individual parcels for this financial

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accounting purpose.

2. Cost Justification. For political purposes, it is likely that Great Lakes will wish to
sell the parcel for the school at “cost.” Indeed, Great Lakes might even wish to
choose a basis that allows it to show a “loss” from the sale to the school board.
Similarly, Great Lakes probably deals with the same set of builders when selling its
many properties. The allocated cost may be shared with the builders to help build
the case for the price charged.

b.
Great Lakes could use many allocation bases (or cost drivers) to determine the cost
allocated to each parcel. The following is a representative list.

1. Area
2. Desirability (Qualitative)
3. Frontage (i.e., the linear feet of road abutting a property)
4. Estimated sales price.

In addition, Great Lakes may choose to sub-divide the $1.4 million of development cost
into smaller cost pools. It could then employ a separate driver for each cost pool.

c.
Great Lakes has competing motives in its choice of allocation bases. The following
criteria seem important:

1. Postpone realizing the gain from sale. For instance, suppose the project has three
stages to be sold in turn. Then, the firm can allocate in a way that leads to least
cost charged to Stage III, that would only become available after substantial
portions in stages I and II have been sold. This mechanism reduces the present
value of the taxes paid by postponing the recognition of income to later periods.
2. Increasing the cost allocated to the schools to maximize political benefit.
3. Increase the cost allocated to homebuilders and retail space to justify higher
prices.
4. Defensibility in public. The allocation scheme must make “sense” if there is a
possibility that the scheme might be subject to public scrutiny.

9.62
a.
During April, Quick Test produced 1,250 units, selling 750 of these units. These 750
units plus the 750 units in opening inventory comprise the total of 1,500 units sold.

Under variable costing, the 500 units in ending inventory (=1,250 – 750) would be valued
at the variable manufacturing costs. Thus, the value of the ending inventory under
variable costing = $25,000 = $50 × 500 units.

b.

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The table below provides the required computation:

Total COGS $105,000 This comprises mfg. costs only

Less: Cost of units from BI 45,000 Given
= Cost of units from this month $60,000
Cost per unit $80 $60,000/750
Less: Unit variable cost (mfg) 50
Equals Allocated fixed cost/unit $30
× Units made in April 1,250
Fixed costs in April $37,500 1,250 units × $30/unit

c.
The following table provides the required statement.
Quick Test Enterprises
Contribution Margin Statement – April
Sales volume (in units) 1,500
Production volume (in units) 1,250

Revenue $100 × 1,500 $150,000

Variable Costs
Manufacturing costs $33,750* + (750 × $50/unit) 71,250
SGA costs $18,000 (total) - $12,000 (fixed) 6,000
Contribution Margin $72,750
Fixed Costs
Manufacturing From part [c] $37,500
Marketing & sales Given 12,000
Profit before Taxes $23,250
* $45,000 total costs - $11,250 in allocated fixed costs

d.
We reconcile the income reported under the two formats as follows:

Income reported under variable costing $23,250

+ fixed overhead in ending inventory 500 units × $30 per unit 15,000
- fixed overhead in opening inventory $11,250 (given) 11,250
= Income reported under absorption costing $27,000

9.63
Understanding the purpose for this allocation helps us define the costs and benefits of
such mechanisms. The purpose is to convey to faculty the opportunity cost of using staff
time for special projects. The absence of allocations conveys the message that the
resource has no cost.

The benefit of allocating $50 per hour is sensitizing faculty to the resource’s cost. While
the project is supposed to be done only when time becomes available, it is easy to

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conceive of faculty applying pressure to get their project done, the Center’s staff feeling
personal responsibility for meeting promised schedules, and so on. Thus, even though
there is no direct additional cost to the college, we conceive of an opportunity cost
stemming from delays in the Center’s regular work and/or degradation in the efficiency
of their service. The arbitrary charge of $50 per hour is an attempt to measure this
opportunity cost and to convey its magnitude to the faculty seeking to use the staff for
special projects.

The cost of charging faculty $50 per hour is that faculty may not use the resource as
much. When the Center’s workload is low, meaning excess capacity is available, the
opportunity cost of available time is zero. The $50 charge therefore over-estimates
opportunity cost, and thus promotes inefficient resource usage.

Students may reasonably wonder about the feasibility of implementing a charge only
when the staff is busy and/or sticking to the norm of doing the projects only when time
becomes available. Both modifications aim to better measure the opportunity cost of staff
time. However, we anticipate practical difficulties in implementing either modification.
Whether the staff is busy is subjective, and few persons would admit to having
substantial slack time. Similarly, it may be difficult to adhere to the norm of doing
projects only when slack time becomes available.

Overall, we support the Director’s request to charge faculty for the center. The
actual charge per hour must necessarily be subjectively determined.

9.64
a.
The purpose appears to be to elicit the true benefits (only known by the divisions) to
acquiring the software. If such an allocation did not take place, each division would claim
considerable benefits and the firm might wind up acquiring software whose costs exceed
the real benefits derived by the divisions. The allocation sensitizes the managers to the
cost of the purchase, thereby modifying their behavior and estimates regarding realized
benefits.

b.
This is a difficult problem, with no obvious solution. The difficulty arises because there is
uncertainty about the number of cost objects (divisions) that should be charged.
Additionally, the allocation scheme would influence the division managers’ estimates of
benefits. For instance, an allocation scheme based on estimated benefits gives incentives
to reduce the estimate. If all managers lowball, it is possible that total estimates are too
low for the software to be acquired even though it would have been desirable absent these
agency conflicts and strategic effects.

The following four allocation schemes come to mind:

1. Equal allocation to all four product divisions. This method has the benefit of being
transparent and easy to implement. However, the allocation is quite arbitrary and has

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little correlation with the true benefits realized by each division. Thus, the decision to
acquire must be made prior to obtaining the data about benefits.

2. Allocate in proportion to benefits received. This scheme has the benefit that we could
condition the decision to acquire the software on the estimated demands. However, the
scheme also provides manages with incentives to lowball because such action shifts the
costs from their division onto other divisions. As argued earlier, such strategic behavior
could lead to the firm foregoing profitable opportunities.

3. Allocate by division size. This gets at the fact that different divisions might realize
different benefits (here the assumptions is that benefits are proportional to, for example,
revenue or assets in place). However, this method has the same faults as the equal
allocation method in terms of eliciting demand information.

4. Allocate only to divisions A and B. Charge Divisions C & D only if they subsequently
use the system, giving appropriate credit to A and B. This scheme is more complex than
the earlier schemes but begins to get at the timing issue. Again, there are incentives for C
& D to lowball their estimates (after all, the software has already been bought).
Additional problems like the one illustrated below in Part [c] also arise.

c.
The division manager has a point. However, if this becomes common practice, none of
the divisions would then become the “first user,” severely accentuating the under-
investment problem. Overall, we do not know of any easily implemented solution to this
problem. Indeed, this situation is the subject of ongoing academic research.

9.65
The following table identifies the costs and benefits of each allocation basis. Notice
that we have to apportion the common cost in some way among the users of The
Peninsula. The problem is that the parks, ponds, trails, and landscaping are public goods,
with the benefits being shared by all.

Basis Advantages Disadvantages

Property This “ability to bear” criterion imposes The retail stores might get
value costs on those most able to bear it. The affected the most as their
assumption is that persons living in value is often quite large. The
more expensive homes would be able to scheme may wind up ‘taxing’
afford more. these stores in favor of
homeowners.

Head This method attempts to measure usage. Retail stores benefit from this
count The method is fair if all parties derive method as their head count is
similar benefits from the common zero. Nevertheless, they too
facilities. derive benefits because of
increased volume and because

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their customers and employees

would also use the common
facilities.

Equal This method is simple and easy to The implicit assumption is

division implement. It assumes that each faulty. The method is also
household / store gets similar benefits regressive in that a condo and
from the park, regardless of its size. a large store would be treated
on equal footing, ignoring
differences in usage and the
ability to pay.

Fee-based This is perhaps the most equitable Some costs (e.g., landscaping)
to the method because it allows the consumer still need to be allocated. All fees
extent to pay only for facilities used. do is to reduce the magnitude of
possible. the problem. Further, there may
be significant administrative
costs associated with designing
and administering a fee-based
scheme.

9.66
In all three instances, there is a business related and a non-business related cost and
benefit. The total cost, however, is common, requiring Jean-Pierre to allocate the cost
among the two purposes.

For situation [a], we believe the Jean-Pierre should seek reimbursement for $5,000,
the business class fare. The travel afforded him an opportunity to increase his personal
enjoyment as well. This is akin to someone getting frequent flyer miles for traveling on
business, and using the miles to take a vacation or obtain an upgrade. (We note that some
firms have policies that appropriate the miles.) The firm did not incur incremental costs
due to Jean-Pierre’s actions. If anything, there is an incremental benefit because Jean-
Pierre might have been in a better state of mind when traveling with his spouse.

The situation in [b] is somewhat similar to that in [a], except that Jean-Pierre could claim
an extra $650 of reimbursement. We believe that Jean-Pierre should not seek
reimbursement for the additional $350. This expense stems purely from private
considerations, and the cost is accordingly not reimbursable.

Reimbursable amounts in situation [c] range from a low of the coach fare ($1,800) to the
entire amount ($5,000). Arguments for charging $5,000 include the idea that the firm is
willing to spend that amount on Jean-Pierre, and it is really up to him as to how he spends
it. For example, many would claim the entire per-diem allowance for meals even if their
actual expense were lower. On the other hand, the firm pays for business-class travel
because of the conveniences it provides. Jean-Pierre would be better able to transact

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business if he traveled in business class. One can argue that charging $5,000 in this case
is akin to taking the shuttle bus from the airport to the hotel but charging for a taxi fare.
Overall, we believe that Jean-Pierre should have discussed his choice with his boss and/or
with the Human Resources Department before acting. He should certainly disclose the
benefit ex post and act per his firm’s directions. In any case, it is clear that Jean-Pierre
should not charge for the extra day of hotel and meal expenses. These expenses stem
solely from private concerns.

9.67
a.
The following table lists the kinds of actions that you could take in response to the
allocation so as to reduce the amount allocated to you.

Item Actions
1 Division managers can reduce head-count by removing people from the firm’s
payroll and hiring them back as consultants. This action reduces the units of cost
drivers in the division, reducing the corporate expense allocated to it.

The action might actually increase total costs rather than reduce them. As a free-
lancer, a consultant would typically charge more than the firm would pay for an
employee. Further, there are additional coordination costs incurred for dealing with
external persons (e.g., security and confidentiality issues, dealing with invoices and
payments, etc.).

2 We can reduce the reported cost for the board by using components that perform
multiple functions in place of individual, function-specific components. For
example, think of an integrated stereo system rather than a system with a separate
amp, CD player, tuner, and speakers. This action reduces the number of components,
reducing reported cost.

The cost-benefit tradeoff is unclear. On the one hand, individual components might
increase product functionality and allow for better design. This might, in turn,
increase the product’s demand/price, thereby increasing product profitability.
However, dealing with many components could increase overhead costs (more
suppliers, more deliveries and so on).

3 We can reduce the reported cost for the board by using components common to this
and other products rather than components unique to this product. This action
reduces the number of unique components, reducing reporting cost.

The cost-benefit tradeoff is unclear as it is similar to that in situation [b]. On the

one hand, unique components might increase product functionality and allow for
better design. This might, in turn, increase the product’s demand/price, thereby
increasing product profitability. However, dealing with many more components
could increase overhead costs. Each unique component might trigger substantial

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costs such as developing and certifying a vendor and setting up a part number.

4 We can reduce the reported cost for our product by making the components
ourselves. This action substitutes labor cost for materials cost, thereby reducing the
amount of overhead allocated to our product.

This action likely increases total costs. The action requires more work to be done
at the plant, and will increase demand for labor hours. In turn, overhead costs might
also increase. Ideally make-or-buy decisions should consider all relevant costs and
benefits. The product manager will over-estimate materials costs, thereby increasing
the chances of an erroneous decision.

5 We can reduce the reported cost for our product by outsourcing components rather
than making them ourselves. This action substitutes materials cost for labor cost,
thereby reducing the amount of overhead allocated to our product.

This action likely increases total costs, as in situation [d]. Ideally make-or-buy
decisions should consider all relevant costs and benefits. The firm’s allocation system
might cause the product manager to over-estimate labor costs, thereby increasing the
chances of an erroneous decision.

b.
Item Actions
1 A firm incurs many costs associated with keeping an employee on the payroll,
particularly if the payroll is centrally administered. Allocating corporate expenses to
divisions based on head count is one way to sensitize division managers to the
hidden costs associated with head count. Unfortunately, unless the allocation is done
carefully, the charge likely over-estimates the true cost of adding employees, thereby
encouraging dysfunctional behavior.

2 Increasing the number of components increases manufacturing costs as each

component must be inserted into the board. Further, the firm has to maintain more
items. The allocation sensitizes design engineers to downstream manufacturing
costs. However, as argued earlier, the effort can backfire as the new design might
compromise product functionality.

3 Dealing with many more components increases overhead costs. Each unique
component might lead to substantial costs such as developing and certifying a vendor,
setting up a part number, and so on. The choice of the driver sensitizes design
engineers to these costs that are often “hidden” from them. The tradeoff, of course,
is that the attention to the count of unique parts might compromise product
functionality and design.

4,5 Consistent with earlier choices, this choice sensitizes product managers to the
overhead cost consequences of increasing materials cost and labor cost. Unless the

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allocation is carefully done, it is easy to overestimate this cost impact. Then, because
the product managers would view the allocated cost as a variable cost, they could
easily be misled into making erroneous make-or-buy decisions.

9.68
a.
The allocation serves to determine each person’s share of the bill. The cost is a joint cost
(visualize the wine being shared), leading to the need for an allocation. We implicitly
allocate costs every time we share a meal, in a restaurant, with friends and family.
(Sometimes, the allocation is all the cost to one person, the host, and none to the guests.)

There are several considerations. Equity in payment seems important, and is the source
of Julie’s frustration. Ease of computation is another consideration. Particularly with
“family style” meals, it may be impossible to determine consumption or other “equitable”
allocation bases. Ability to bear may be a third. Particularly if the friends had differing
economic abilities, we might expect the well-off friend to contribute more. Of these
considerations, only the first two would seem to apply in the situation described in the
problem.

b.
The following schemes come to mind.
1. Julie and/or Becky could be given an “ad hoc” adjustment because of the lower cost
associated with their food and drink choices.
2. Split out the cost of the liquor and the food. Divide each pool equally among the
friends who consumed liquor and food, respectively.
3. Track the cost of the entrée for each person. Subjectively add estimates for the
amount of liquor and other food (e.g., dessert) consumed.
4. Approximate split. That is, every one looks at the bill, estimates their share and adds a
percentage (say 20%) to cover tax and tip. If there’s slight over-contribution, it
usually goes to the waiter. If there’s an under-contribution, then often everyone chips
in a small amount. And if there’s significant under-contribution, then the problem
gets addressed rather than fall unfairly on someone’s shoulders.

The first scheme makes a move toward a more “equitable” split among the friends.
However, the scheme is not perfect. For instance, consider a friend who skipped dessert
because of a diet, or another who did not consume the main course because s/he was
watching his protein intake. Both of these persons could also claim an adjustment, with
each adjustment making the scheme more complex and ad hoc. The second scheme is a
modification that tries to capture the cost differences between liquor and food. The third
scheme takes the second scheme to a logical extreme. However, it is computationally
difficult and involves much subjectivity. Such a scheme defeats the purpose of having a
shared meal and can ruin the evening. Scheme 4, which is a compromise, often works
well in casual settings

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Overall, something like scheme 1 may be the best compromise between equity and
ease of computation.

c.
In this particular instance, we would be surprised if the front-end agreement
influenced the bill in any way. After all, the friends are on their way to becoming well
paid professionals and probably would not skimp on a celebratory dinner. Nevertheless,
allocation methods can influence behavior. The tendency is to order more liberally when
the cost is being split equally (that is, when you bear only a part of the cost of your
actions) compared to when you will bear the entire cost of your actions. This tendency is
exacerbated in groups where one person is perceived as consuming more than his or her
fair share.

MINI-CASES

9.69 a.
This is a classic short-term decision of the sort that we considered in Chapters 5 and 6.
Accepting or not-accepting the job will not substantively affect CG’s capacity costs.
Thus, these costs are not relevant for this decision.

CG is also in a situation of excess supply of capacity with respect to this decision. The
machines would be idle during weekdays, and there is no opportunity cost to using them
for this job.

The only clearly relevant cost for CG is the variable cost of $0.02 per page. One could
argue that we should consider the machine cost as well. Over its life, the cost per machine
hour is:

Total cost of machine $4,000,000

Total hours available 12,000
Cost per hour $333.33 per hour
Cost per page $0.0167 per page ($333.33/20,000 pages per hour)

Because 20 hours is such a small fraction of the machine’s 12,000 hour useful life, we
would not consider the machine cost to be relevant for this decision. Moreover, CG’s
overall machine costs are unlikely to change substantively because of this decision.

Thus, $0.02 is the controllable cost and is therefore the minimum price that can be
charged without lowering profitability. Of course, this does not mean that $0.02 is the
right bid. The marketing manager should charge what the market will bear, also taking
into account long-term strategic issues. For example, this might be a good opportunity to
get CG’s foot in the door with respect to the catalog business.

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b.
We disagree with the marketing manager’s logic because we view this decision as
spanning the medium term. That is, the firm is entering a new market and will have to
adjust capacity resources to account for the additional demand. Consequently, the pricing
decision for the catalogs must consider the cost of capacity resources consumed by
catalogs. These costs include variable costs, the costs for the machine, and the costs of
support staff.

c.
We agree with the accountant’s argument. We can compute the cost of the capacity
resources as:

Machine cost
$4,000,000/12,000 hours = $333.33 / hour,
= $0.0167 / page
($333.33/ hour/20,000 pages per hour)

Support cost
$2,250,000/4,000 hours = $562.50 / hour
= $0.0281 / page
= ($562.50/ hour/20,000 pages per hour)

Total overhead cost = $0.0448 / page

Adding the variable cost of $0.02 per page gives a total cost of $0.0648 per page, which
yields a price of $0.071 per page (= $0.0648 × 1.10), and is comparable to the current
market price of $0.07 per page.

Two points warrant discussion. First, notice that we computed the cost per machine hour
using the cost over the life of the machine. An alternate method is to employ the annual
cost of $1,000,000 (= $4,000,000/expected life of 4 years), then divide it into the
expected use of 4,000 hours per year to obtain a rate of $250 per hour or $0.0125 per
page. We believe that this alternate method is faulty because the machine’s useful life
will decrease if we use it for an additional 1,000 hours each year. That is, the useful life
only be 3 years (= 12,000 hours total life/4,000 hours each year) rather than four years as
projected with existing production.

Second, notice that we use the total cost of the support staff when computing the
overhead rate for this cost pool. An alternate method is to employ the $250,000
incremental cost only to compute the rate as $250,000/1,000 hours or $1,000 per hour (=
$0.0125 per page). We do not believe this alternate method is correct because CG is
adding an additional product line – it is not “incremental,” or temporary, business. Thus,
the catalog product must cover its full share of the support costs and not just the
incremental costs.

d.

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Let us examine each cost component separately to evaluate this argument.

 The variable cost per page has not decreased.

 The cost of the machinery per page also has not decreased. Prior to introducing
catalogs, the annual cost of machinery was $1,000,000 and the annual usage was
3,000 hours. These data yield a rate of $333.33 per machine hour. With the
catalogs, the annual cost is $1,333,333 ($4,000,000 over three years) and annual
usage 4,000 hours, again yielding a rate of $333.33 per hour.
 The support cost per hour has decreased, however. Prior to catalogs, the cost was
$2 million for 3,000 hours, leading to a rate of $666.66 per hour. With catalogs,
the rate is $562.50 per hour ($2,250,000 / 4,000 hours). The reduction occurs
because the incremental production of 1,000 hours does not proportionately
increase support overhead costs. The marginal rate for the new production is
$250,000/1,000 hours = $250 per hour, which is lower than the average rate.

Such reduction in rates could occur for two reasons. First, the additional production
consumed the excess capacity present earlier (thus, not as much was needed in
incremental cost). Second, scale economies resulted in marginal cost being lower than
average cost. In either case, we would argue for a beneficial cost impact on the cost of
producing magazines. That is, we see both the magazines and the catalogs benefiting
from better utilization of excess capacity and/or scale economies. Strategic considerations
should guide whether we should support the marketing manager’s move to share the cost
reduction with customers.

9.70
a. Income Statement - March
All of the units sold in March were produced in March as there is no opening inventory in
March. Thus, knowing that fixed manufacturing costs were $750,000 and 1,500 units
were produced, we determine the fixed cost per unit as $500 per unit = $750,000/1,500
units.

The total inventoriable cost under absorption costing is therefore $200 of variable
manufacturing cost + $500 of allocated fixed manufacturing costs = $700 per unit. We
have:

Total for
Detail March
Opening inventory (units) 0 units
Units made 1,500 units
Units sold 1,000 units
Ending inventory 500 units

Revenue $1,000 per unit × 1,000 units sold $1,000,000

Cost of Goods Sold $700 per unit *× 1,000 units sold 700,000
Gross Margin $300,000
Selling and Administrative Costs $100,000 + ($25 per unit × 1,000 units sold) 125,000

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Profit before Taxes $175,000

Ending Inventory Value $700 per unit × 500 units in ending
inventory $350,000

* $700 = $200 variable cost + $500 fixed cost allocation, ($500 = $750,000/1,500units)

Income Statement - April

1,250 units were sold in April but we do not know how many units were produced.
However, we do know that Emily began with an inventory of 500 units (value =
$350,000, as determined in part [a]) and ended with 0 units. Thus,

Units sold 1,250

+ Units in ending inventory 0
- Units in opening inventory 500
= Units produced 750

Of the units sold in April, 500 came from opening inventory, with the remaining 750
coming from current period production. We have to add the costs of these units to
determine the cost of goods sold. Units in opening inventory were valued at $700 per
unit. Let us therefore determine the cost per unit for April’s production.

Variable manufacturing cost $200

Fixed manufacturing cost 1,000 $750,000/750 units
Total cost per unit $1,200

The total cost of goods sold for April is:

Units from opening inventory $350,000 500 units × $700 per unit
Units from current production $900,000 750 units × $1,200 per unit
April COGS $1,250,000

Total selling and administration costs for April are $100,000 + ($25 per unit × 1,250
units) = $131,250.

With this data we have:

Total for
Detail April
Opening inventory (units) 500 units
Units made 750 units
Units sold 1,250 units
Ending inventory 0 units

Revenue $1,000 per unit × 1,250 units sold $1,250,000

Cost of Goods Sold $1,250,000, as calculated above 1,250,000
Gross Margin $0

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Selling and Administrative Costs $131,250, as calculated above 131,250

Profit before Taxes ($131,250)

Ending Inventory Value 0 units in inventory $0

b.
With the data provided, we have:
Detail March April
Sales volume (in units) 1,000 1,250
Production volume (in
units) 1,500 750

Revenues $1,000 × 1,000; $1,000 × 1,250 $1,000,000 $1,250,000

Variable Costs
Manufacturing costs $200 × 1,000; $200 × 1,250 200,000 250,000
Marketing costs $25 × 1,000; $25 × 1,250 25,000 31,250
Contribution Margin $775 × 1,000; $775 × 1,250 $775,000 $968,750
Fixed Costs
Manufacturing 750,000 750,000
Marketing & sales 100,000 100,000
Profit before Taxes ($75,000) $118,750

Note that the pattern of income reported under variable costing conforms to our intuition,
developed from CVP models (i.e., income increases in sales). This correspondence
always holds because, like the CVP model, the variable costing income statement
partitions costs into fixed and variable costs.

c.
We can reconcile the income reported under the two formats as follows:

Item Calculation March April

Income reported under
variable costing ($75,000) $118,750
+ Fixed overhead in 500 units × $500 per unit;
ending inventory 0 $250,000 0
- Fixed overhead in 0; 500 units × $500 per
opening inventory unit $0 ($250,000)

d.
Under both variable costing and absorption costing, Emily’s profit over the two months
equals $43,750. The difference in the income for each month arises because of the
differing treatment of fixed manufacturing costs.

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Under variable costing, the entire $750,000 of monthly fixed costs is expensed in the
income statement. In contrast, the cost is allocated to units under absorption costing. This
allocation means that the cost could be part of the inventory cost. The reconciliation
adjusts for the flow of fixed overhead costs via the inventory account.

Emily began March with zero inventories and ended April with xero inventories. Thus,
the flow of costs into inventory equaled the costs out of inventory for the two month
period. That is, there is no chance for fixed manufacturing costs to stay in the inventory
account. Because the sole difference between the methods is whether fixed
manufacturing costs stay in inventory or not, the profits must coincide over this period.
9.71
a.
There are several possible schemes:
1. Allocate the $7 million already spent to the military application and split the
balance equally between the two applications.
2. Allocate $9 million (its stand alone cost comprising of $7 million already spent
plus the $2 million to be spent) to the military application and the remainder of $1
million to the civilian application.
3. Allocate the $10 million equally to the two applications because they appear to
possess similar revenue characteristics.

Choosing among these methods is difficult, as we can argue both for and against each of
the mechanisms. The first mechanism best matches up the intent of the cost flow with the
application. The initial $7 million was spent for the military application and thus it seems
fair to allocate it as such. The remaining cost benefits both systems and thus is equally
split. The downside of this method is that it seems to give the civilian application a free
ride.

The second allocation treats the civilian product as a by-product and only charges it the
incremental cost of tailoring the technology for civilian use. The benefit is that the firm
gets the maximum reimbursement for developmental expenses, but at the cost of creating
the perception of “over-charging” the military application.

The final mechanism may be perceived by many to be most “equitable” but is not as
profitable. Ultimately, strategic considerations would dictate the choice. We believe that
most managers would choose method 2 because it is well within the initial estimate
provided to the government. That is, management would view the civilian application as
“found money,” or an unexpected bonus. In addition, government contracts often
consider the possibility of such civilian applications when negotiating contracts.

b.
The following table shows the cost allocated to each of the two applications under the
three methods.

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Overhead Overhead
Total of Rate per unit of allocated to allocated to
Total allocation allocation basis civilian military
overhead cost basis application application
Method 1 (Allocate based on materials cost)
$6 million (= $33 million $0.1818 for $3.27 million (= $2.73 million
$2 million + $4 (= $18 million each materials $18 million  (=$15 million 
million) + $15 million) $ (rounded) $0.1818 / dollar) $0.1818 /
dollar)

Method 2 (Allocate based on labor cost)

$6 million (= $27 million $0.2222 for $2.66 million $3.33 million
$2 million + $4 (= $15 million each labor $ (= $12 million  (= $15 million
million) + $12 million) $0.2222 / labor  $0.2222 /
dollar) labor dollar)

Method 3 (Allocate using two cost pools)

$2 million of $33 million $0.0606 for $1.091 million $909,000
materials- (= $18 million each materials (= $18 million  ( = $15 million
related + $15 million) $ (rounded) $0.0606/materials  $0.0606/
overhead $) materials $)
$4 million of $27 million $0.1482 for $1.777 million $2.222 million
labor-related (= $15 million each labor $ (= $12 million  (= $15 million
overhead + $12 million) (rounded) $0.1482 / labor  $0.1482 /
$) labor $)
Total $2.868 million $3.131 million

The choice among the mechanisms depends on the firm’s goals. From a decision making
perspective, method 3 seems to provide the best mapping between the cost of resources
consumed by, and the overhead allocated to, each product. From a reimbursement
perspective, method 2 is preferred because it allocates the maximum overhead to the
military application, thereby increasing C3’s revenue and profit.

c.
We would be hard pressed to argue that this behavior is outside the norms for ethical
behavior. In particular, the government contracted for a certain output and negotiated the
price for that output. The civilian application is an unanticipated externality. For an
example, we observe that federal funds support many research projects at universities.
Yet, the federal government lays no claim to any commercially viable inventions
produced in the research endeavor. (Note: Existing legislation such as the Bayh-Dole Act

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governs the government’s claim to profits from the invention.)

9.72
a.

There are costs and benefits associated with the firm’s choice to allocate overhead based
on labor hours, even as the firm encourages automation. The cost is that labor hours
may not appropriately measure resource consumption in an automated
environment. (The man-machine ratio would have to be the same across all processes for
this allocation to be even somewhat reasonable.) Thus, the allocated cost will poorly
measure the opportunity cost of consumed resources, possibly leading to poor decisions.

The benefit stems from the induced behavior. Product managers such as Karl and
Bjorn will view the allocation as a “tax” that increases the cost of labor. Thus, they will
seek to reduce their product’s labor content, which is behavior consistent with the firm’s
strategy. Suppose the firm’s product market prevents cost-based pricing (for example,
competition is fierce, rendering market price uncontrollable by any one firm). Then, the
benefit from the induced behavior may outweigh the potential for poor pricing decisions.

b.
Karl’s strategy reduces the amount of overhead allocated to Bjorn’s product line by
reducing the number of labor hours consumed. Outsourcing a product’s components
will result in the associated costs being classified as materials costs, which do not attract
an overhead charge. Instead, if Bjorn were to make the product, he would incur both the
cost of the raw materials and the cost of labor required to convert the raw material into
the component. The latter cost would attract an overhead charge.

We see other examples of similar behavior. When overhead is allocated based on head
count (i.e., the number of employees), division managers have incentives to lay off staff
and to rehire the same persons as consultants. The change affects the count of full time
employees (consultants are not employees) and thereby reduces the amount of overhead
allocated to the division.

c.
Suppose Bjorn follows Karl’s advice and outsources some components that are currently
in-sourced. We believe that this action is not likely to change, to any measurable
degree, the firm’s overall expenditure on overhead items. All that Bjorn’s actions
would accomplish is to reduce the overhead charged to his product line. The overhead
that he avoids will now be charged to other divisions within the firm. A popular analogy
is squeezing a balloon at one end. The action reduces the amount of air at that end but
does not reduce the total volume of air in the balloon.

We also believe that Bjorn’s actions will increase the firm’s overall expenditures. By
outsourcing, the firm avoids the materials and labor cost. However, the price paid to the
supplier must cover not only the cost of materials and labor but also the supplier’s

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overhead cost and its profit. Thus, the price to outsource likely exceeds the variable cost
of making the component in house, increasing the firm’s overall expense. Nevertheless,
Bjorn may be tempted to take this action because it would reduce the amount of overhead
charged to his division.

From Bjorn’s perspective, the overhead charge is a variable cost. It is very possible for
the company’s overhead charge to be large (particularly if it is based on labor hours in an
automated environment). Overhead rates of 200 or 400% of labor cost are not unknown.
Given such a charge, Bjorn may prefer to outsource because it reduces his total cost.
From the company’s perspective, the calculation may go the other way because the firm
would ignore the overhead cost as being not relevant for the comparison.

d.
We would be hard pressed to argue that Karl’s recommendation is unethical. In an
ideal setting, Bjorn’s and the firm’s goals would be perfectly aligned and employee
actions would benefit the firm as well. However, as we learned in Chapter 1, individual
and organizational goals differ. Such differences inevitably lead to “slippage” of the sort
described in this problem. (We termed this the “agency conflict.”) While firms employ
control mechanisms such as boundary controls and performance evaluations to reduce the
slippage, it may be prohibitively expensive to eliminate it altogether. Seen in this context,
Bjorn’s behavior falls within ethical norms, although it may not advance organizational
goals. From a positive perspective, one hopes that the firm’s management understands the
incentives created by their chosen allocation mechanism. The fact that they have
implemented the mechanism suggests that they consider the costs to be less than the
benefits, with one of the costs being product managers outsourcing components.

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 CHAPTER 10
Activity-Based Costing and Management
Solutions

REVIEW QUESTIONS

10.1 Unit profit margin equals a product’s unit contribution margin less the controllable cost
of capacity resources.

10.2 (1) Determine how to form cost pools, (2) identify which cost pools to allocate, (3)
identify the cost driver to use for allocating each cost pool, and (4) determine the
appropriate denominator volume of each cost driver to calculate allocation rates.

10.3 A business process converts organizational inputs into a measurable output. Each
business process is a collection of activities.

10.4 In ABC, we form cost pools by the activities that make up a business process.

10.5 An appropriate cost driver is one that has the strongest causal relation with the costs in
the cost pool.

10.6 Practical capacity is an estimate of the maximum possible activity level. The advantage
of a practical-capacity based allocation rate is that it does not change across periods.
Practical capacity is higher than both actual- and budgeted capacity, which reflect
realized and planned activity usage.

10.7 Because, ultimately, ABC is just another allocation system. Changing the method for
allocating costs does not change total cost.

10.8 Allocating lower amounts to some products and higher amounts to other products. In
such instances, products receiving higher allocations are said to cross-subsidize products
receiving lower allocations.

10.9 By better managing products, customers, and resources.

10.10 Decisions related to individual customers and market segments, including decisions
regarding who to sell to and the prices to charge.

10.11 Product-level profit analysis groups revenues, variable costs, and capacity costs by
product whereas customer-level profit analysis does so by customer.

10.12 “High cost to serve” customers (1) place small order sizes, (2) have rigid requirements,
(2) don’t pay on time, (4) require more customization, and (5) make frequent order
change requests. “Low cost to serve customers” (1) have larger order sizes, (2) pay on

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time, (3) have minimal order change requests, (4) require less pre-sales support, and (5)
require less after-sales support.

10.13 A whale curve plots customer profitability, after ranking customers in order of their
profitability. It has the appearance of a “whale” because for many firms, the top 20% of
customers account for the bulk of the profit, whereas the remaining customers actually
are unprofitable.

10.14 To improve the efficiency and effectiveness of organizational processes.

10.15 Non-value adding activities are those that cost money but do not provide commensurate
benefits. Firms can identify non-value adding activities by asking, “if we eliminate this
activity, would the customer notice?”

DISCUSSION QUESTIONS

10. 16 No. The costs of developing a product are sunk at the time the product goes into
production. These costs are not controllable. Proponents of activity based costing express
the view that these costs should not be viewed as product level costs and therefore should
not be assigned to products. Once incurred, these costs are not relevant for short-term
decisions about pricing. Of course, prudent managers will estimate these costs prior to
incurring them. That is, they will evaluate profitability including these costs, using long-
term prices to estimate revenues and quantities. The key challenge facing managers is to
ensure that both the short- and the long-run views are given appropriate weight when they
make decisions.

10. 17 This choice will matter whenever setting up different products for production does not
take the same amount of time. An implicit assumption in using number of setups as the
driver is that each setup is like every other setup. Every setup consumes the same amount
of organizational resources. If this is in fact the case, it does not matter whether we use
number of setups or number of setup hours as the driver (as these two drivers will be
perfectly correlated). On the other hand, if some setups are more time consuming than
others, then the number of setup hours is likely the better driver of resource consumption.

10. 18 Measuring practical capacity is difficult for most resources because it is hard to
determine the maximal utilization level possible for each resource. In the case of the
purchase department with five people, think about trying to determine how many
purchase orders each individual can maximally handle. First, there will be individual
differences arising from differences in efficiencies, abilities, experience and so on.
Second, we know that when human efficiencies are involved, some days are better than
others. That is, individual efficiencies can vary from day to day. We can only assess
practical capacity by analyzing the collective output of the department over a period of
time and determining the normal volume of work that the department is capable of
handling. In addition, it might be difficult to measure output uniformly. For instance,
some orders might be easier to process than others. We simply cannot compare one order

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for 100 different items with an order for 5 different items, or with 10 separate orders for
10 items each. Modern views of ABC seek to circumvent this problem by measuring all
resources in terms of base units (e.g., time or space available) and using these units as
cost drivers. See articles on Time-driven Activity Based Costing for more detail.

10. 19 As we have discussed in the text, there are many reasons why ABC systems are difficult
to implement and maintain in practice. First, ABC systems are information intensive.
Numerous measurements are necessary. Second, they require a stable operational
environment. As firms change over time, cost structures change and cost drivers and cost
rates have to be routinely updated. Therefore, maintaining the decision usefulness of
ABC systems in changing environments is onerous, time consuming and costly. Indeed, a
popular estimate is maintaining an ABC system for a medium sized facility requires a 0.5
FTE person or about $75,000 per year.

10. 20 Intuition would suggest that as we improve the cost system one cost pool at a time,
accuracy should also improve incrementally. But this is not always the case because
errors that traditional volume-based systems cause in allocating costs from multiple cost
pools can often be offsetting. As we improve the cost system by modifying one cost pool
at a time, errors from allocations of other cost pools surface because of the removal of the
offsetting nature of the errors. Consequently, in such settings, all errors must be removed
before we can be confident about the accuracy of product costs.

10. 21 In this respect, the ABC system is not any different from any other system. The purpose
of an ABC is to improve the accuracy of cost systems for product planning and resource
planning decisions. However, accuracy is not the main consideration when the objective
is to induce a certain behavior. Even well designed but seemingly arbitrary allocations
can serve this purpose (e.g., allocations based on labor cost to tax labor usage in order to
induce automation). This said, well designed ABC systems can help in inducing desired
behavior if incentives are appropriately tied to product profitability. For instance, a
natural incentive of product line managers would be to improve the efficiency of those
activities whose cost rates are high.

In terms of system design, we expect many more pools in systems that seek to facilitate
decisions. A large number might be required to capture better the variations in the
underlying production processes. In contrast, few pools might work better in systems that
seek to modify behavior because fewer pools increase the salience of the underlying
message. Likewise, a cause-effect relationship between the driver and costs rather than
the effect on expected behavior is likely more important in systems whose purpose is to
aid decisions.

10. 22 Many embrace the concept of total quality control and argue that inspection is a non-
value adding activity because the supplier of materials should provide complete quality
assurance. In practice, however, it is unreasonable to expect that suppliers would be able
to give such quality assurance. Often there are inherent process variations that are
impossible or prohibitively costly to get rid of, and therefore quality issues cannot be

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completely overcome. Consequently, some amount of inspection is value adding in such

environments.

10. 23 This question gets at the concept of “who is a customer?” For example, a single
household might have a mix of individual and joint accounts. When evaluating customer
profitability, the bank has to struggle with whether the individual or the household is the
right unit of analysis. Some banks overcome this problem by letting the customer link
accounts and thereby select their own profiles. The problem is even more complex in a
business-to-business setting. Here, the bank has to decide between evaluating each
division as a separate customer or the entire firm as one customer. The issue is
particularly acute when a large multi-divisional firm such as GE transacts with a large
bank such as JP Morgan Chase in numerous locations. Identifying and tracking who is
the customer can be the first big hurdle when performing customer profitability analysis.

10. 24 Cell phone companies, credit card issuers, and cable companies expect to recover their
upfront investments by holding on to their customer base for a reasonable time period (by
requiring customers to sign multi-year agreements) to generate sufficient revenues from
them over this period. For instance, cell phone companies offer attractive cell phone
instruments at highly subsidized prices to new customers (the same deal is not typically
offered to existing customers) but require two-year agreements. The expectation is that
revenues from cell phone usage over this two-year period will more than cover the initial
discount given on the cell phone. The traditional customer profitability report should be
modified to include revenues and costs for the entire horizon over which the company
expects to earn targeted returns from the customer (or the class of customers). Such life-
time value analysis is a natural extension of customer profitability analysis (which takes a
single snap shot of profitability for a month or year).

10. 25 If the firm does not cut spending on the resources freed up, and revenues stay the same,
then the reported profits will not change because the company is not translating improved
efficiencies into cash flow savings. The key additional step required is to either cut
spending on freed up resources or gainfully utilize freed up resources by producing and
selling more goods and services.

10. 26 As a typical student, I would get up in the morning at 7AM, rush through the daily
morning routine in 15 minutes, put on crumpled (but clean) clothes because there is no
time for ironing, prepare a cup of coffee to drink while driving to school because there is
no time to have a more healthy breakfast, get into the car and violate all speed limits to
make it to the class at 8AM only to discover that I forgot to bring with me the homework
assignment that kept me awake the previous night for submission in the class.

Can I plan better? Sure. Do homework on time so that I don’t have to stay up late. Plan
what I am going to wear the next day and iron the clothes to be more presentable. Pack
my bags the night before so that I don’t forget to take assignments and class material with
me. Get enough sleep so that I can get up a little early and give myself enough time to get
ready and have a good and healthy breakfast. That way I can concentrate in class without
thinking about food.

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10. 27 These charges essentially reflect the opportunity cost of capital for Iguana insurance. If
the customer makes one full annual payment, the company has to raise less money to
finance its working capital and therefore save on interest. By adding a surcharge for
quarterly or monthly payments, the company is essentially recovering the cost of raising
working capital. In addition, the firm has to process only one receiving transaction rather
than four. Similarly, automatic withdrawals reduce the transactions costs for the
company by facilitating timely withdrawals -- saving of these costs is justification for the
discount.

10. 28 The benefit is that all managers will be focusing on maximizing the overall customer
profitability and customer satisfaction. This is especially important in keeping large
customer accounts. The cost is that local managers may have other more profitable
demands on their time that they may have to forsake in order to serve large customers.
Local managers are often in a better position to make this trade-off. Consequently,
significant coordination is necessary across the organization to serve the needs of some
large accounts.

10. 29 Simply put, self-service kiosks and on-line services are less costly, more efficient ways of
dealing with check-ins. Moreover, even passengers are happier because they do not have
to patiently wait in long lines, and plan their arrival at airports better. All in all, this is one
area in which technology has resulted in a convenient and cost effective way of
organizing an important airline activity.

EXERCISES

10. 30
We first calculate the total cost of each activity by allocating the cost of individual
accounts to the various activities (stage 1). We do this by employing the percentage
allocations provided.

Process Process Balance Other Cost

deposits checks enquiries activities
Tellers $45,000* $60,000 $15,000 $30,000 $150,000
Assistant manager 7,500 7,500 3,750 56,250 75,000
Managers 1,800 2,700 4,500 81,000 90,000
Total $54,300 $70,200 $23,250 $167,250 $315,000
*
30% × $150,000. Similar computations apply for the other cells.

The next step is to divide the total cost in the cost pool by the denominator volume to get
the overhead rate per unit driver. We have:

Cost per deposit = $54,300/ 600,000 deposits = $0.0905 per deposit

Cost per check = $70,200 / 1,250,000 checks= $0.05616 per check

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10. 31
We first calculate the total cost in the cost pool for processing orders.

Consumed by the Total Cost Cost in pool

activity “process
customer order”
Manager time 10% $250,000 per year $25,000
Production 90% 3 persons * $85,000 229,500
planners per year * 0.9
Space 250 sq. feet 250 sq. feet * $17 per 4,250
square foot per year.
Supplies $15,000 15,000
273,750

Thus, the cost per order is $219 = $273,750/ 1,250 orders.

10. 32
a. The cost per setup = $1,248,000 / 600 setups = $2,080 per setup.

b. The total number of setup minutes is 26,000 = 400 minor *35 minutes + 100 major * 60
minutes per setup. Then, the rate is $1,200,000 / 26,000 minutes = $48 per setup
minute.

c. The number of setup of minutes is possibly a more accurate driver of costs, as it is able to
distinguish between major and minor setups. However, while it is easy to measure the
number of setups, it is more complex and costly to measure the number of setup minutes.

10. 33
a. Let us calculate the change in profit for the two parties.

Cost (10 Cost (16

persons) persons)
Revenue $75 per guest $750 $1,200
Variable costs $20 per guest $200 $320
Shopping $200 per engagement 200 200
costs
Cooking time [ 2 hours + 10 minutes * (# of 80 120
guests -10) ] * $40 per hour
Serving time [ 1 hour + 5 minutes * # of 40 60
guests] * $40 per hour
Clean up time 1 hour or 1.5 hours. 40 60
Profit $190 $440

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b. Nicole’s cost has batch level costs such as the cost of shopping, serving and cleaning
time. Nicole might therefore wish to offer discounts for “large” parties (with many
more than 10 persons). This strategy is likely to increase her appeal to people that
host such parties.

10. 34

a.
Under the old system, the cost of 15,000 units is $217,500 = 15,000 units * $14.50 per unit.

b.
Cost
Variable costs 15,000 units * $8 per unit $120,000
Unit-based allocation 15,000 units * $3.50 per unit 52,500
Batch-based allocation (3+2+2) batches * $3,500 per batch 24,500
Variety based allocation 3 varieties * $14,500 per variety 53,500
Total cost $250,500

The estimate under part (b) is likely to be more accurate because it models activities and costs at
a more granular level. For example, it accounts for the fact that Cesar will have to run 7 batches
and not 6 (= 15,000/2,500) as might be naively calculated.

10. 35
a. The current system is a volume-based allocation. Let us first compute the overhead rate
per labor hour.

Total overhead cost = $12,776,400

Total labor hours = (1,000,000 × 2.2) + (2,000,000 × 1.9)
+ (40,000 × 2.1) = 6,084,000
Rate/labor hour = $12,776,400/6,084,000 = $2.10/labour hour

We can now compute product profitability as follows:

Hand Lawn Estate
Held Sprinklers Sprinklers
Price $9.00 $8.50 $15.00
Variable cost 2.00 4.00 4.50
Contribution margin 7.00 4.50 10.50
Allocated overhead 4.62 3.99 4.41
(Hours × rate)
Profit margin $2.38 $0.51 $6.09

b. We now have to divide the overhead costs into two pools: labor related and batch related.
Let us compute the rate for each:

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Labor Batch
Total overhead cost in pool $7,300,800 $5,475,600*
Total of driver volume 6,084,000 hours 540 batches*
Rate /driver unit $1.2/labor hour $10,140/batch
* 540 batches = (1,000,000/10,000) + (2,000,000/5,000) + (40,000/1,000)
* $5,475,600 = $12,776,400 - $7,300,800.

With this data, we have:

Hand Held Lawn Estate

Sprinklers Sprinklers
Revenue $9,000,000 $17,000,000 $600,000
Variable cost 2,000,000 8,000,000 180,000
Contribution margin 7,000,000 $9,000,000 $420,000
Allocated overhead – labor 2,640,000* 4,560,000 100,800
Allocated overhead – batch 1,014,000** 4,056,000 405,600
Profit margin (total) $3,346,000 $384,000 $(86,400)
Profit margin/unit $3.35 $0.19 $(2.16)
* $2,640,000 = 1,000,000 units × 2.2 hours /units × $1.2/hour
**
$1,014,000 = (1,000,000 units / 10,000 per batch) × $10,140/batch

Notice that we now have to compute the total product profitability before we can
compute the unit profit. This step is required because we now employ batch-level drivers
to allocate costs.

10. 36
a. We know that the product attracts $8.40 of overhead per unit. Thus, the total
overhead allocated to the product is 200,000 × $8.40= $1,680,000. Further, because
this amount is only 70% of the firm’s overhead, the total overhead cost is $2,400,000.
The overhead rate is $8.40 for 24 minutes or $21 per labor hour.
b. The following table provides the required calculation:
Type of cost % of total Amount of % Amount
overhead overhead in allocated allocated
cost cost pool to Alex to Alex
Unit level costs 50% $1,200,000 70% $840,000
Batch level cost 30% $720,000 45% $324,000
Product level cost 15% $360,000 Traced $100,000
Total allocated $1,264,000
Cost per unit $6.32*
*
$6.32 = 1,264,000/200,000 units
Notice that we did not allocate the facility level costs (5% of 2,400,000 or $120,000)
to any of the products. This is because this cost is not controllable at the product
level.
Please also note that the revised cost is almost 25% lower than the overhead cost
allocated under the current system. This is because, unlike unit level costs, Alex does

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not consume 70% of batch and product level costs. By properly allocating these
higher-order costs to other products, the new system shows the Alex’s product is less
expensive to make than is currently believed.

10. 37
a. This pricing scheme is a classic example of volume-based allocations and pricing
strategies.
First, let us calculate the total number of participants. We have
Large: 20 seminars × 750 persons/seminar = 15,000 participants
Small: 50 seminars × 100 persons/seminar = 5,000 participants
Total = 20,000 participants

Because total cost is $309,000, the cost per participant is $309,000/20,000 = $15.45
per person. Then,
Price (large seminar) = $15.45/person × 750 persons × 1.4 (for markup) =
$16,222.50
Price (small seminar) = $15.45/person × 100 persons × 1.4 (for markup) = $2,163.00
The computed prices reflect that Milt calculates costs based on volume. The large
seminar costs 7.5 times as much as the small seminar because it has 7.5 times the
attendance.
b. The question suggests that Milt should consider two separate activities: A participant
level activity and a seminar level activity. While the number of participants is a good
driver for the first cost pool, the number of seminars might better capture the cause-
effect relation in the second cost pool.
From the problem, we know that the participant level costs amount to $225,000 and
seminar (batch) level costs are $84,000. Thus, we have:
Cost per participant = $225,000/20,000 = $11.25 per participant.
Cost per seminar = $84,000 / (20 + 50) = $1,200 per seminar.
Thus, for a large seminar we have:
Cost of organizing seminar $1,200
Cost of participants 750 persons × $11.25/person $8,437.50
Total cost $9,637.50
Markup 40% of cost $3,855.00
Price $13,492.50

Replicating the analysis for the small seminar, we have:

Cost of organizing seminar $1,200
Cost of participants 100 persons × $11.25/person 1,125.00
Total cost 2,325.00
Markup 40% of cost 930.00
Price $3,255.00

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10. 38
The calculations are as below:

Machine $1,200,000 This cost depends on the rate at which we

depreciation use up the machines. Although an
individual machine lasts for 5 years, we
can substantively alter the cost each year,
making it controllable.
Tools, jigs and 0 No need to allocate as the costs are
fixtures traceable to individual products
Machine operators 240,000 Cost depends on number of machine
hours consumed. Although the employees
are salaried, we can adjust staffing levels
over many months.
Oils, coolants and 67,500 Cost depends directly on number of
lubricants machine hours consumed
Factory power 87,500 Only 70% of the total cost of $125,000 is
related to machine operations as 30% is
used for general heating & lighting
Factory lease 0 This is a facility level cost. Changing the
number of machine hours will not affect
this cost. Also, the cost is not controllable
over the horizon for the decision
considered.
Total costs $1,595,000

Dividing the total cost by practical capacity yields a rate of ($1,595,000/25,000 hours) =
$63.80 per hour.

10. 39
a. Let us begin by computing the overhead rate. Her total overhead is $390,000 and her
total labor cost is [(1,000 × $75per unit) + (5,000 ×$50 per unit)] = $325,000. Thus,
her overhead rate is $390,000/$325,000 = $1.20/labor $.
With this rate in hand, we can compute her profit per print as follows.
Deluxe Standard
Prints / year 1,000 5,000

Price per print $350 $210

Materials 100 65
Labor 75 50
Overhead (@$1.20/labor $) 90 60
Profit /print $85 $35

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This analysis suggests that deluxe frames are more than twice as profitable as
Standard frames. In addition, it is easy to verify that Sonja makes total profit of
$260,000 (= ($85 × 1,000) + ($35, 5,000)) at this volume and mix.
b. The following table provides the required income statement.
Deluxe Standard Total
1,000 5,000

Revenue $350,000 $1,050,000 $1,400,000

Materials 100,000 325,000 425,000
Labor 75,000 250,000 325,000
Labor related overhead 36,000 120,000 156,000
Batch related overhead 68,250 68,250 136,500
Product related overhead 29,250 29,250 58,500
Product Profit $ 41,500 $257,500 $299,000
Facility costs 39,000
Profit $260,000
Profit/unit $41.5 $51.5

Notice that we have a labor overhead rate of $0.48/labor $, which we compute as the
labor related overhead cost of $156,000 divided by the labor cost of $325,000.
Likewise, we have 20 batches each of the deluxe and standard products (1,000/50,
5,000/250). Thus, the cost per batch is $136,500/40 batches = $3,412.50.
Product related overhead is equally allocated between the product lines. We do not
allocate facility level costs as these are not controllable at the product level.
c. Based on the answers to parts a and b, what insights could you offer to Sonja?

Sonja might wish to reconsider her emphasis on deluxe frames. She also might wish to
consider other options such as raising the price of a deluxe frame. Finally, she could also
improve margins (and this might be smartest thing to do) by figuring out how she could
manage her costs. For example, could she somehow reduce the cost per batch by
investing in automated equipment, or being able to store picture settings in an electronic
format?
10. 40
The required calculations are provided below.

Ryan Construction Wilson Builders Cost per activity unit

Sales $400,000 $400,000
Contribution margin 120,000 100,000
Volume-related 54,000 54,000 $0.27 per sales $
Number of orders 22,500 9,000 $450 per order
Number of deliveries 15,000 4,000 $100 per delivery

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Customer profit $28,500 $33,000

Note that Wilson builders is more profitable even though sales volumes are identical and
Wilson has the lower CMR. The lesser demand on capacity resources (fewer order and
deliveries) makes up for the smaller contribution margin.

10. 41

The following table provides the required calculations

New customer New customer Old customer (1

(1 product) (3 products) more product)
Contribution margin $300 $900 $300
Cost of getting application 450 450 150
Credit check 25 25 0
Admin cost per customer 50 50 50
Profit (225) $375 $100

Notice the scale economies that arise because many costs are incurred at the level of the
customer and are independent of the number of products.

10. 42
a. The first proposal to eliminate the air pump. That will save QwikFill $1,200 annually
per gas station. The total saving for all 243 gas stations will be $291,600. Of course,
we are assuming that there will be no loss in customer volume of the air pumps are
eliminated.

Under the second proposal, each gas station will make an additional amount of
$5,475 ($0.25 per minute × 3 minutes × 20 customers per day × 365 days). Thus, for
each gas station, QwikFill makes a profit of $4,275 (=$5,475 less the annual cost
$1,200 to operate the pump), for a total of $1,038,825.

b. Assuming again that charging for the use of the air pump does not bring down
customer volume, the second option is clearly more profitable for QwikFill. However,
what we are not considering here is not having the air pump, or charging money use
of the air pump can affect customer volume considerably, and the gas station’s
revenues from selling gas may be affected. To evaluate the relative merit of the two
proposals, we need to estimate the impact of each alternative on customer volume.

10. 43
a. For each day, West High spends $48 per cashier ($8 per hour × 6 hours). Thus West
High spends $192 per day to employ four cashiers. Annually, this expenditure
amounts to $48,000 (= $192 per day × 250 days). Over five years, the expenditure is
$240,000 (ignoring the time value of money).

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If the electronic system is implemented, the initial cost is $15,000. If we add the
annual cost of $2,000, the total cost over five years amounts to $25,000. Since two
cashiers will be needed as well, West High has to incur $120,000 over five years to
pay these cashiers ($120,000 = $48 × 2 × 250 × 5). So the total cost of this option is
$145,000. Clearly, this option is more cost effective for West High because there is a
cost saving of $95,000 relative to status quo.

b. The electronic system may be a lot more efficient, but more rigid. For instance,
students often forget to bring their cards, and may not have enough cash to pay.
Automated electronic systems may be less able to handle these exceptions. Having
cashiers may add an element of flexibility and a human element that is hard to
quantify.

10. 44

a. The following table provides the required calculation.

[ Cost Remarks
Materials and other variable costs $250,000At $250 per unit
Labor cost 200,000@ $200 per unit
Unit level overhead 150,000@ $150 per unit
25,000Need new batch. Cost per
Order processing and other batch level batch is $50 * 5,000 =
costs $25,000
Design and other product level costs $0 There is no incremental cost
Facility level cost 0 There is no incremental cost
Total cost $575,000
Cost per unit $575

b. If the firm allocates overhead on the basis of labor cost, the cost per unit is $750 = ($250
+ $200 + $300 in overhead). The overhead is computed at 150% of $200 = $300. Then,
the cost to product 1,000 more units would be estimated at $750,000 = 1,000 units * $75
per unit.

c. The estimate in part (a) reflects the presence of costs at the product and higher levels.
This detail is likely to lead to a more accurate estimate.

10. 45

a. Currently, two lines use up 3,000 hours. Total cost is $900,000. Thus, the cost per hour
on the line (based on actual use) is $3,000 per hour.

b. Practical capacity is given as 4,000 hours. Thus, the cost per hour is $900,000/4,000
hours = $2,250 per hour

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c. The calculation is part b is more beneficial. The $3,000 estimate comingles the cost of
used and unused capacity. The new calculation (which throws off $225,000 as the cost of
unused capacity) might be more helpful in identifying areas for cost management.

10. 46

a. The cost per payment is $1,512,000 / 80,000 = $18.90 per payment. The cost does not
change over the years because the total cost and the volume remain the same.

b. Alan’s department supplies 14 people * 1800 hours * 60 minutes = 1,512,000. Thus, the
cost per minute is $1. Since each order takes 20 minutes, the cost per order is $20.

c. After the improvement, the cost per order is only $10. We have $712,000 (=$1,512,000 -
$800,000) as the cost of unused capacity.

Note: The cost is higher with practical capacity because in part a, it is possible that 80,000 is
an over-estimate and /or some people worked overtime (put in more than 1,800 hours) to get
the job done. It also is possible that 20 minutes is an over-estimate per order.

10. 47
a. Using expected volumes as the denominator, the cost for the first year is $4,000 per hour
= $10 million/2,500 hours. As usage increases, the cost drops to $3,333.33 per hour in
year 2 and to $2,500 per hour in years three to five.

b. With practical capacity, the rate is $2,500 per hour for every year. However, in year 1,
the firm will also report the cost of unused capacity at $3,750,000 = $2,500 * 1,500 hours
and at $2,500,000 for year 2. The machine is fully utilized in years three to five.

c. With new machines it is common for there to be unused capacity early on during the
machines life. The low utilization can kick up the rates, thereby inducing lower
utilization. This process can set off a vicious cycle. One way for the firm to more
appropriately reflect costs is to calculate life time rates. That is, the total cost over 5 years
is $50 million and total expected usage is 15,000 hours 2,500 + 3,000 + 3 * 4000. Thus,
the cost per hour is $2,857 (rounded). The firm will then capitalize the unallocated cost as
a “deferred asset” and this amount will be gradually eroded in years three to five. In
particular, the allocated amount in year 2 is 3,000 * 2,857 = $8,571,428, creating a
deferred asset of $1,428,572. In each of years 3-5, the allocated cost is 4,000*$2,857 =
$11,428,000, and the firm will remove $1,428,000 from the deferred asset account.

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10. 48
a. The following table provides a list of representative activities. We have tried to
organize the table to mimic the life cycle of an account.

Activity Classification Detail

Open account Product level This activity is consumed once
per account, as part of the
process of creating an account.
The demand for this activity is
independent of the number of
checks or ATM transactions.

ATM transactions Unit level These activities are consumed

many times by each account.
Teller transactions Unit level There is likely to be
considerable variation of the
Electronic (internet) Unit level volume of this activity across
transactions different checking accounts.
These activities measure the
“volume” of business.

Mail Statements Batch level Each account consumes this

activity once per month.

Close account Product level This activity is incurred once

per account and is independent
of the volume of activity when
the account is open.

b. A bank might use this information to offer different kinds of checking accounts.
Some customers might use many ATM but few teller transactions, whereas others
might prefer working with tellers. As the costs of these activities differ, the cost of
servicing these customer segments differs. Thus, the bank might wish to offer
differing kinds of checking accounts to provide the maximum value to each customer,
while maintaining the bank’s ability to profit from each segment. We might therefore
observe a “student-oriented” account with low balance requirements and unlimited
ATM transactions but few teller transactions. We might also see a “seniors account”
with high balance requirements but unlimited teller transactions.

c. The decision context here is the profit from an individual account. Such an allocation
is not useful for estimating the cost of a checking account. Advertising cost is related
to the entire product and does not vary in proportion to the number of checking
accounts or the volume of teller / ATM transactions. The driver for advertising costs
is a product-level activity, meaning that the cost is not controllable (and thus not
relevant) for a decision that primarily affects unit- and batch-level drivers.

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10. 49
Greg’s pricing scheme implicitly reflects a volume-based allocation of cost. In essence,
by charging the same amount per lawn, Greg is assuming that each lawn takes the same
amount of work (i.e., time to mow). However, lawns vary greatly in the time needed.
Larger lawns take more time than smaller lawns; a rough terrain consumes more time
than a flat lawn; the number of landscaping features (e.g., trees) also increases the time
needed. These variations mean that the each lawn consumes different amounts of
capacity resources. Greg’s pricing scheme must reflect this variation.

Greg’s flat pricing scheme does not reflect the variation in resources consumed. If he
begins with an average mix of lawns, the difficult to mow lawns will be under-priced and
the easy to mow lawns over-priced. Over time, homeowners with easy to mow lawns may
get competing offers for lower prices and switch. Indeed, homeowners with difficult to
mow lawns may find Greg’s services low-priced and flock to his service. Over time, the
mix of lawns mowed will comprise mostly of difficult-to-mow lawns with a
corresponding increase in time.

A manufacturing analogy is a firm using volume-based allocations to determine cost, and

using the estimated cost to price its products. Over time, this firm may well find its
product mix shifting away from easy-to-make, high volume products toward difficult-to-
make low volume products.

10. 50
a. With deregulation and competition, firms have to become extremely efficient and
competitive to survive. They also have to control costs and offer better prices to their
customers. The cost systems have to be a lot more accurate. UPS realized that the cost
of carrying goods is not just a function of weight and distance, but also a function of
size, time and customer characteristics. For example, a bulky and unwieldy package
imposes greater costs on UPS even though it may be relatively light. Such a package
requires greater handling and often makes arranging packages on trucks tricky and
less efficient. Similarly, the time of pickup/delivery can affect UPS’s ability to
schedule its routes efficiently and cost effectively. It is easier to handle larger
customers that make routine shipments in predictable patterns. Better planning and
scheduling can help UPS save on costs, and in fact pass on some of the cost savings
to its customers, making UPS more competitive.

b. ABC can help UPS by improving its cost tracking and measurement by paying due
attention to the proper cost drivers. With a proper hierarchical cost system which
clearly distinguishes between package-level, move-level, and service-level costs,
ABC can help in measuring the margins UPS makes from its different services, and
thereby help in setting prices.

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PROBLEMS

10. 51
The current profit is 6,000 × ($16 - $14.017) = $11,898.

With a 25% sales increase, the sales level will be 6,000 + (6,000 × 25%) = 7,500 units.
With 750 units per batch, there will be 10 batches.

The next step is to compute the cost of making 7,500 units. The following table presents
the calculations:

Item Detail Cost per Total cost

unit / batch for 7,500
units
Unit Level expenses
Material Traced $ 0.52
Material related overhead 10% of materials 0.05
cost
Direct labor 4.40
Direct labor related overhead 120% of direct 5.28
labor cost
Machine related overhead ($16.50/mach. hr) 2.12
Total per unit 12.37 $92,775
Batch Level Expenses (10 Batches)
Setup $35 per hour $350.00
Production order $145 per order 145.00
Material moves $23.50 / move 188.00
Total per batch 683.00 $6,830
Product level Expenses 945
Facility level expenses $0.01 per $ of 742
unit level costs
Total cost $101,292
Cost per unit $13.506

The expected profit if both options are implemented = 7,500 × ($15.25 - $13.506)
= $13,080.

Thus, expected profit is higher if the firm implements both actions.

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10. 52
a. Compute Jim’s overhead using the new product mix, profit and contribution margins.
We can back out the new overhead cost as follows:

Total contribution from stems 90% × 50,000 × 0.12 $5,400

Total contribution from bouquets 10% × 50,000 × 0.15 750
Total contribution margin $6,150
Profit 750
= Fixed costs (overhead) $5,400/day

Thus, total overhead with the new product mix is $5,400 × 30 = $162,000 per month.

c. Notice that without the bouquets, the profit would have been $1,000 per day (=
50,000 × $0.12 - $5,000). The only reason that Vermeer’s profit has decreased by
$250 a day or $7,500 per month with the introduction of bouquets is a corresponding
increase in overhead costs. Let us verify this intuition by allocating the overhead to
individual products. Under the old system, each stem accounted for $0.10 of
overhead. Thus, 0.9 × 50,000 × $0.10 = $4,500 a day or $135,000 per month. The
remainder of $900 a day ($27,000 per month) must pertain to the bouquets. In other
words, each stem in a bouquet consumes $900 per day /5,000 stems per day= $0.18.

This higher consumption of overhead resources results in a negative profit margin for
bouquets. Even though the stems in bouquets have higher contribution margins, they
also consume more overhead, leading to lower profit margins. Thus, as the bouquet
business expands, Jim loses money.

d. It is not surprising that assembling stems into bouquets consumes proportionately

more overhead than selling them individually. First, there is labor involved in
assembling the bouquets. Second, bouquets consume some supplies such as ribbons,
paper and such. Third, assembling bouquets requires space, and, finally, they might
require more delicate handling relative to individual stems. These factors might
explain why total overhead increased even though the volume of stems processed did
not change.

10. 53
a. This problem is a useful exercise in illustrating how different cost objects consume
the same resources in different mixes.

Short Long
Regular room rate $1,800 /day $3,600 $16,200
Spending on meals $450/day 900 4,050
Miscellaneous items $400/$2,500 400 2,500
Total revenue $4,900 $22,750
Variable cost $150/day 300 1,350

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Room maintenance $300 per three days 300 900

Check in and check out $150/$250 150 250
Concierge service Varies 200 600
Guest spending on meals $450/day; Variable 360 1,620
etc cost is 40%
Guest spending on $400/ $2,500 for 160 1,000
miscellaneous services long-stay guests.
Profit per stay $3,430 $17,030
Profit per day $1,715 $1,892.22

b. The above analysis indicates that long-stay guests are more profitable than short-stay
guests. The difference in profitability arises from several factors: First, batch level
expenses such as the cost of check-in are spread out over more days. Second, the
intensity of resource usage (e.g., concierge) decreases as time passes. Third, the
amount of money spent on miscellaneous services increases as the hotel is able to
cross-sell some items (e.g., laundry, massages and so on.) However, the offset is that
long-stay guests might also increase some costs such as the welcome basket.

It appears that Vanessa might consider offering a 5-10% discount off the regular room
rate to long-stay guests. After all, maximizing utilization is the key to profits in the
hospitality industry, which has high fixed costs. (Note the ratio of profit to revenue).

10. 54
With the old scheme, we have:

Item Detail Amount

Number of packs 4,000,000
Packs per order 4
Number of orders 1,000,000
Kinds of drinks per order 2
% qualifying for discount -

Revenue from shipping $2.99 / order $2,990,000

Costs
$0.10/package
Picking costs per pack of pods of pods 400,000
Kinds of drinks 0.50/kind/order 1,000,000
Shipping costs $6/order 6,000,000
Net cost (4,410,000)

With the new scheme, we have:

Item Detail Amount

Number of packs of pods Assumed 4,000,000

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unchanged
Packs per order 4,000,000/600,000 6.67
Number of orders Given (60% of
current volume of
1 million orders) 600,000
Average kinds per order 3
% qualifying for discount 50% of orders

Revenue from shipping @$2.99 / order for

300,000 orders $897,000
Costs
Picking costs per pack of pods @$0.10/pack of
pods 400,000
Kinds of drinks @0.50/kind/order 900,000
Shipping costs @$6/order 3,600,000
Net cost (4,003,000)

Thus, Anna’s idea saves $397,000 (=$4,410,000 - $4,003,000) for the firm. The key idea
here is that costs are not proportional to the volume of operations. A substantial portion
relates to the number of orders (indeed, this is the largest component of total shipping and
handling costs). The promotion reducing order volume to 400,000, saving substantially
on shipping costs ($6.00 per order) while foregoing $2.99 in revenue on 50% of the
orders. This is the fundamental source of the gain from the “free shipping” promotion.

Note: The solution assumes that the total number of packs stays at 4 million (the problem
is silent on this front). With this assumption, the revenue and cost per pack are not
relevant. It is possible that the promotion also increases total number of packs. Then, if
the change is x packs, the incremental gain is $4X, where $4.00 is the contribution per
pack.

Note: The projected savings depend crucially on the number of orders dropping to
600,000 from 1 million currently. The average order size then has to increase to 6.67
packs per order (= 4,000,000 / 600,000 orders) from the current 4 packs per order. Some
trial and error shows that Anna’s idea would begin to lose if the number of orders (with
the revised scheme) is more than 668,000. Thus, the key assumption that the firm will
need to validate pertains to the reduction in the number of orders.

10. 55
Let us begin by calculating the costs directly traceable to each activity.

Inventory management
Staff 2.33 × $60,000
$140,000
Sheila 60% × $120,000
72,000

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Supplies 25,000
Total traceable 237,000

Production Planning
Assistants 1.33 × $60,000
$80,000
Asst Manager 1 × $90,000
$90,000
Supplies 25,000
Total traceable 195,000

Purchasing
Assistants 1.33 × $60,000
$80,000
Asst. Manager 90,000
Supplies 25,000
Total traceable 195,000

However, we still have not allocated 40% of Sheila’s time as well as the cost of the
administrative assistant. These are indirect costs with respect to these activities. Let
us take each item in turn and then allocate it.

Consider the administrative assistant’s salary. We can assign it as $4,375 for each
manager (12.5% of time per manager) and $26,250 to Sheila. In turn, because each
manager works for a unique activity, we can assign $4,375 of the assistant’s cost to
purchasing and production planning. Likewise, because Sheila spends 60% of her
time on inventory management, we could allocate 60% of the admin assistant’s cost
for Sheila (i.e., 60% of $26,250) to inventory management as well.

This still leaves with 40% of Sheila’s salary plus 40% of the admin assistant’s salary
allocated to Sheila. This amount is not directly traceable to any activity. We have to
assign it somewhat arbitrarily among the three activities. Alternatively, we could pool
this amount as a separate cost pool – Administration.

Thus, we have:

Inventory management
Total traceable 237,000
Admin Assistant’s salary 60% of (0.75 ×$35,000)
15,750
Total $252,750

Production Planning
Total traceable 195,000
Admin Assistant’s salary 12.5% of $35,000
4,375

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Total $199,375

Purchasing
Total traceable 195,000
Admin Assistant’s salary 12.5% of $35,000
4,375
Total $199,375

Administration
Sheila’s salary 40% of $120,000
48,000
Admin Assistant’s salary 40% of (0.75 × $35,000
10,500
Total $58,500

Notice that the total cost allocated among the four cost pools equals $710,000, the
total cost in Sheila’s department.

10. 56
Order processing encompasses all activities needed to process, serve and complete
customer orders. In this setting, order processing consists of the following:

 Six sales representatives spend 80% of their time generating customer orders and
entering them into the system. Because each sales representative’s annual salary is
$65,000, this cost is $312,000 (= 6 × $65,000 × 80%).
 Two employees in the shipping department spend 90% of their time processing,
assembling, packing and shipping orders. Given an annual salary of $40,000 per
employee, this cost is $72,000 (= 2 × $40,000 × 90%). Note that the warehouse
cost does not vary with the number of orders processed, and therefore should not
be included in computing the cost to process a customer order.
 The accounting manager estimates that 30% of the accounting department’s
activities are generated by invoicing and collection activities generated by
customer orders. This cost is $42,000 (= $140,000 × 30%).

Thus, the total annual cost to process customer orders is $426,000 (=$312,000 +
$72,000 + 42,000). This cost supports a volume of 5,000 orders in a typical year.
Therefore, the cost per customer order is $85.20 (=$426,000/5,000).

10. 57
The following table presents the profitability of each customer:
Quinn Ralph Sutliffe Thorne
Cases sold 8,750 60,800 31,800 3,900
Revenues $123,900 $802,560 $442,656 $50,544
Variable cost 105,000 729,600 381,600 46,800
Ordering cost 2,500 3,000 2,500 3,000

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Customer visits 240 480 160 240

Transportation cost* 240 360 640 1,600
Product handling 4,375 30,400 15,900 1,950
Expedited deliveries 300
$11,545 $38,720 $41,856 ($3,346)
*Transportation cost = Cost per mile × Miles per delivery × Number of deliveries

As we can see, customer Ralph has the desirable profile – high volume customer, but
places fewer, large volume orders (relatively speaking). On the other hand, customer
Quinn’s volume is a fraction of Ralphs’s volume, and yet the order cost is roughly the
same magnitude. Customer Thorne is a low volume customer, but generates the same
amount of order processing activity as customer Ralph. We can see that this customer is
not profitable. The company needs to work with customers like Quinn and Thorne to
change their ordering patterns and have them place fewer, larger orders like Ralph. One
way is to learn how Ralph is managing its purchasing function and share this information
with Quinn and Thorne (provided such information is not proprietary).

10. 58

a. Consider a new customer with one product. We have:

Profit in year 1 $600 - $200 =$400

Profit in year 2 $400 * (1-0.6) $160
Profit in year 3 $400 * 0.4 * 0.4 $64
Cost of acquisition (450)
Profit over three years =$174.

For a customer with 2 products, the profit over three years is :

Profit in year 1 $600 - $200 =$800

Profit in year 2 $400 * 0.6 $480
Profit in year 3 $400 * 0.6 * 0.6 $288
Cost of acquisition (450)
Profit over three years =$1,188

For an existing customer, we have to calculate the change in profit. If this customer
had stayed with one product, their profit would be $400 + $160 + $64 = $624. With
the new mix, their profit is $800 + $480 + $288 - $150 = $1,488. Thus, adding the
second product increases the profit by $1,488 - $624 = $864.
.
We learn that it is very profitable to sell multiple products to customers, because it
increases the “stickiness” of the customer to our firm. Thus, we might be willing to
offer a “bundle” discount to induce them to buy multiple items.

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10. 59
The following table presents the profitability of each customer:
A B C
Annual sales $1,300,000 $1,200,000 $850,000
Contribution margin 325,000 360,000 187,000
Discount for payment within 10 days 13,000
Ordering cost 2,400 1,200 1,800
Shipping cost 6,000 2,000 6,000
Order change cost 7,500 12,500
New product cost 20,000
Customer profitability $296,100 $356,800 $146,700

Customers A and B are larger customers with comparable sales volumes. The
contribution margin ratio is higher for customer B, implying that per dollar of sales,
contribution margin is more from customer B. Perhaps there is room here to improve
the contribution margin ratio for customer A by finding ways to reduce variable costs.
Customer B also places larger and fewer orders than customer A, and accepts delivery
in future shipments. This allows Sylvester Steel to economize on ordering and
shipping activities. One avenue for increasing profitability of customer A is to work
with the customer to reduce the number of orders and number of shipments, or
alternatively charge a higher price to cover these costs, depending on what the
customer is amenable to.

Customer C is a lower volume customer. The contribution margin ratio is even lower
than customer A. Moreover, customer C is also imposing more costs on Sylvester by
requesting order changes, and new product developments. It appears that these costs are
not being passed on to the customer via higher prices (and hence higher contribution
margin ratio). It is plausible that Sylvester is developing this customer by providing
additional services early on in the hope of turning this customer into a high profit
customer in the future. If this is the case, the current decision of Sylvester to bear upfront
product development costs may well be a wise one.

10. 60
a. The following table provides the required computations :

Student Homeowners Retirees

Annual revenue - checking $0.00 $33.001 $0.00
Annual revenue - savings $0.30 $6.002 $300.00
Monthly revenue $0.03 $3.25 $25.00
Overdrafts $2.50 $1.00 $0.00
Credit card balance $9.00 $0.00 $0.00
Auto loan 3
$8.33 0 $2.08
Total revenue $19.86 $4.25 $27.08

Savings interest 0.02 0.33 16.67

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Tellers 1.00 2.00 4.00

ATM Transactions 2.00 1.00 0.13
Check transactions 0.00 0.12 0.21
Bill pay charges 0.00 0.40 0.00
Telephone enquiries 0.00 1.00 0.50
Safe deposit box 0.02 0.75 0.67
Statements 1.35 0.60 0.03
Total Cost $4.39 $6.20 $22.21
Profit $15.47 ($1.95) $4.87
1
$33.00 = $1,100 × 0.03
2
$6.00 = 100 × 0.06
3
8.33 = (5,000 × .10 × .20)/12

b. UCU can take several actions to improve profitability. For instance, it can charge for
special services such as telephone enquiries (after a free limit). It also can tailor
offerings to individual customer segments to maximize the revenue gained from each.
For instance, while it might be prudent to charge students for statements (thus moving
them to electronic media), the move is probably unwise for retirees.

10. 61
a. Under the existing method of doing setups, a product with annual volume of 6,000
units would need 8 setups (750 units per batch). Each setup costs $273 ($65 per hour
× 4.2 hours). Therefore, the annual setup cost will be $2,184. This is cheaper than
investing in the die because the annual cost then would $2,500 ($5,000/2). Notice
that we do not require information about the batch size or the number of setups that
would be done if the die is acquired. All we need to compare the two options is the
total cost of the die (On the other hand, if there are some other batch level costs in
addition to the die cost, then we would need this information).

A product with annual volume of 7,500 units would need 10 setups (750 units per
batch). Therefore, under the existing method of doing setups, the annual setup cost
will $2,730. Clearly, investing in the die is better in this instance.

b. There are several advantages to acquiring the die. By making the product in small
batches when necessary, inventory costs can be reduced. Also, costs associated with
any damage that the product might suffer while in storage will also be less. As Moin
points out, the quality of the product is likely to improve as well. These benefits need
to be taken into account. Ultimately the volume of business is also an important
consideration (as we saw about). Even with an annual volume of 6,000, it may be
well worth acquiring the die because these qualitative benefits may outweigh the
difference in the annual cost of $316 ($2,500 - $2,184).

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10. 62
a. The total annual salary for the warehouse staff is $160,000 ($32,000 × 5). As this cost
level, the capacity available is 10,000 hours (2,000 hours per person × 5). Using this
capacity as the basis, the cost of warehouse staff is $16 per hour.

As per the activity list given in the problem, the warehouse staff is occupied for a
total of 9,330 hours. Thus, unused capacity is 670 hours (10,000 – 9,330), and the
cost of unused capacity is $10,720 (= 670 hours × $16 per hour).

b. We begin by reordering the list of activities into a logical sequence. We then group
the individual activities into related groups.
Value
Hours scale macro
D. Vehicle unloaded (for supplies) 1,300 3 A
G. Products compared to purchase order 400 1 A
H. Incorrect products sent back to supplier 300 1 A
E. Products checked for damage 500 1 A
F. Return damaged product to supplier 300 1 A
A. Products are physically stored 1,400 3 B
C. Inventory records updated for supply 200 2 B
O. Receive order from customer 300 3 C
B. Location of product is identified 700 1 C
M. Retrieve products from storage 1,500 3 C
I. Label and package products per customer order 400 2 D
J. Place orders on loading dock for shipment 30 2 D
K. Load vehicle for shipment to customer 1,400 3 D
L. Prepare invoice and notification 400 3 E
N. Update inventory records for shipment 500 2 E
9,630
Data show that Spring has numerous non-value adding activities. For instance, it
spends 1,500 hours for dealing with suppliers regarding incorrect shipments, damage
etc. Such activities do not add value to the customer. Spring might wish to invest in
coordinating actions with suppliers so that these actions are unneeded. E.g., it can
transmit orders electronically and get an electronic manifest to simplify (if not
eliminate) the need for checking shipments. Supplier training can avoid the need for
damage inspection.

10. 63
There are several things the lab could do to improve utilization.

Suggestion Costs Benefits

Create stand alone email / Requires additional space Frees up machines for more
printing stations intensive use. The lab can
use the older machines for

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this use.
Impose time limit on use Might unfairly affect users Gives everyone a chance to
use the machines.
Increase the number of Needs more investment in Improves availability.
machines machines, space and
staffing
Of the suggestions, the first appears to be the best use of available resources.

10. 64
a. We can calculate the expected total profit as follows:

Initial setup costs for 8 national products and 7 regional products = (8 × $15,000) + (7
× $10,000) = $190,000.
Costs for setting up 4,500 group sessions = 4,500 × $300 = $1,350,000
Costs for 80,000 participants = 80,000 × $30 = $2,400,000
Total estimated cost = $190,000 + $1,350,000 + $2,400,000 = $3,940,000
Expected profit = $4,000,000 - $3,940,000 = $60,000.

b. With the realized product mix, the profit can be calculated as:

Initial setup costs for 6 national products and 12 regional products = (6 × $15,000) +
(12 × $10,000) = $210,000.
Total number of groups set up = (6 × 500) + (12 × 250) = 6,000 groups
Costs for setting up group sessions = 6,000 × $300 = $1,800,000

Costs for 80,000 participants = 80,000 × $30 = $2,400,000

Total estimated cost = $210,000 + $1,800,000 + $2,400,000 = $4,410,000
Loss = $4,000,000 - $4,410,000 = ($410,000).

c. The main reason is the increase in the number of groups. The expected number of
groups was 4,500 as per planned product mix, but there were totally 6,000 groups.
While the number of groups for the national product was likely lower because the
number of national products (6) was lower than planned (8), the number of regional
products was much larger (12) than planned (8). Consequently, the total number of
required groups increased significantly although the number of actual participants
stayed at 80,000 as planned. That is, the participant-level costs of $2,400,000 were at
expected levels, but the group level costs were higher ($1,800,000) than planned
($1,350,000). Notice that product level costs were also higher by a small margin of
$20,000.

10. 65
a. The following table provides the cost estimates:

Setup cost / large clinic $5,000

Variable cost (regular) 2,850 950 × $3
Variable cost (advanced) 12,500 50 × $250

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Total cost $20,350

Cost per patient $20.35 $20,350/1,000 patients

The following is the cost estimate per patient per trip that sets up small clinics.

Setup cost / small clinic $7,500 $2,500 / clinic × 3 clinics

Travel costs 1,500
Variable cost (regular) 2,250 250 patients × 3 clinics × $3
Variable costs (advanced) not applicable
Total cost $11,250
Cost per patient $15.00

The total cost last year is therefore (3 large × $20,350) + (7 small × $11,250) =
$139,800
Cost per patient = $139,800/[(3 × 1,000) + (7 × 3 × 250)] = $16.95 (rounded)

b. Total expected patients = (4 × 1,000) + (6 × 3 × 250) = 8,500 patients

Cost = $16.95 × 8,500 patients = $144,075.

We would argue that this estimate is flawed. A better cost estimate is:
(4 large trips × $20,350/trip) + (6 small trips × $11,250/trip) = $148,900.
Using the per patient cost would underestimate Manuela’s cost by nearly $5,000, a
major shortfall for an NGO.
c. Notice that the cost per patient with the revised estimate is $17.52 (=$148,900/8,500
patients). Thus, the cost has increased by $0.50/patient, potentially indicating that the
NGO is becoming inefficient. However, this conclusion would be incorrect. We could
offer several rationales for why the revised cost is justified:

 We treat more advanced cases during the current year. In fact, if we do not
consider advanced cases, the cost per patient has come down.
 We also treat more patients during the current year. Volume would have increased
by 250 patients overall. (50 of these are advanced cases.)
 It is easier to get doctors to fly into and stay in a large city than to have them
move from place to place.
 If we did not treat these advanced cases, the patients could go blind. We are
saving 250 persons from potential blindness for $5,000. By any measure, this is a
tremendously worthwhile investment.

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10. 66
a. The cost per order is $374,400 /1,440 calls= $260 per call.

Every sales call would be charged out at $260 per order, regardless of the length of
the sales call or the distance traveled.

b. There are several issues to consider when evaluating Bill’s argument.

 The first issue is whether the time spent is a better driver than the number of sales
calls. The current system implicitly assumes that all sales visits consume the same
amount and variety of resources. This assumption is not true. Taking the time spent
on sales calls into account in allocating costs will increase the accuracy of the cost
system.
 The second issue is whether we should employ a single driver for all the costs or
whether we should form the costs into many pools and employ a separate driver for
each cost pool. In particular, Bill’s argument is that travel should be a separate cost
pool and allocated based on a measure such as “distance traveled.” Again, forming
more cost pools might lead to a better-designed cost system.
 Arguments about system complexity might offset these observations. We might
legitimately argue that travel costs are “small.” Refining the cost to serve by forming
multiple pools might result in charges of $240-$280 per visit, a number that is not
materially different from the current estimate of $260 per visit. It also is more
difficult to measure the length of a visit compared to measuring the number of visits.
The loss in accuracy of measurement might offset the gain from a better driver.

Overall, we would be hard pressed to argue for much further refinement of the
system. The amount involved is not large and the approximations seem reasonable.

10. 67
The potential for confusion arises because this setting employs two capacity
resources, the faculty and the classroom.

The Dean is correct that the classroom capacity is under-utilized. The school can
accommodate 15 more students without significant additional expense.

The best measure of faculty capacity is time devoted to teaching. More sections of the
same class, larger sections of the same class, or more classes could consume this
time. With the given data, we cannot estimate whether faculty members are fully
utilized. The school appears to be defining workload (capacity) by number of sections
taught. Under this metric, faculty capacity is now fully utilized (2 faculty × 3 courses
each = 6 classes). The Dean is then incorrect in asserting that resources have been
wasted. However, the school’s measure ignores other factors that affect utilization. It
is easy to conceive of adding a few more students per section without increasing
workload significantly. (Adding 15 may be too much as class size nearly doubles.)

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Barry’s discussion with the department chair should focus on the implied faculty
workload rather than on classroom capacity.

How should we manage the unused classroom space? For discussion purposes,
assume that faculty time is fully utilized. Then, we have a situation in which one
resource is fully used and the other has unused capacity. Ideally, Barry should reduce
the unused capacity by moving the class to a smaller room. If this action is not
feasible, then the cost of the unused capacity is not avoidable. It is therefore
inappropriate for Barry to charge the department with the task of reducing the cost of
unused classroom capacity.

Alternatively, if we assume that faculty also has some unused capacity, then there is
benefit from adding some more students, as revenue will increase with little or no
additional cost. Even in this situation, it is not fair to put the entire onus for managing
the cost of the unused capacity on the bio-mechanical department as the constraint for
moving the classroom is beyond their control.

This problem considers a familiar situation to highlight the difficulty in measuring

unused capacity and managing the cost of the unused capacity.

10. 68
This case illustrates the classic downward demand spiral or the “death spiral.” To see
this, let us compute the overhead rate over time.

Year Overhead cost Labor cost Overhead rate

2010 Rs. 75,000,000 Rs. 120,000,000 62.50% of labor cost
2011 Rs. 72,000,000 Rs. 110,400,0001 65.22% of labor cost
2012 Rs. 65,000,000 Rs. 92,400,0002 70.35% of labor cost
1
110,400,000 = 120,000,000 × (1 -0.08)
2
92,400,000 = 120,000,000 × (1 – 0.08 – 0.15)

The computation illustrates that the firm’s overhead cost rate has steadily increased even
though it has reduced the absolute amount of overhead costs. This is because the actual
capacity used to spread or allocate overhead has decreased at a faster rate than overhead
costs. Such instances occur because it is difficult to adjust overhead costs (and capacity)
to changing demand conditions.

Essentially, the firm operated at 92% of capacity in 2011. However, the firm retained
96% of capacity (Rs.72 million/Rs.75 million). Thus, the firm had unused capacity in
2007. The allocation procedure of charging all overhead costs to current production
implies that the cost of this unused capacity is loaded onto current production, as is
evidenced by the increase in the overhead rate from 2010 to 2011.

Unfortunately, this error also increased the price charged to the customer as the industry
appears to base prices on costs. The increased price might have led to the loss of another

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customer. If this trend continues, it is likely to result in further erosion in the firm’s
customer base and begin its death spiral.

As indicated in the textbook, one way to avoid the death spiral is to employ practical
capacity as the denominator to compute overhead costs.
10. 69
a. The accountant’s cost estimate does not appropriately reflect the cost to produce
each cooker. In particular, we view the Rs. 18 million of overhead expense each
month as providing Vijay with the capacity to produce 50,000 cookers. Spreading this
cost over the current production of only 20,000 cookers results in current production
absorbing both the cost of the capacity used to produce the cookers and the cost of
unused capacity (30,000 cookers). Thus, the procedure inflates the reported cost to
produce each cooker.

b. The marketing manager’s proposal essentially allocates the capacity cost of Rs. 18
million per month over the practical capacity of 50,000 cookers. This methodology
only charges the product for the cost of the resources that it consumes. If we believe
that the supply and demand of capacity will balance over the medium-term, this
argument properly allocates the capacity cost to the cookers.

c. Vijay’s options depend on the use for the allocated numbers. We visualize at least
two uses.
1. Pricing. For this purpose, the cost of the unused capacity (= Rs. 18 Million ×
30,000 / 50,000, or Rs. 10.80 million) stems from a strategic reason. Vijay
expects demand to skyrocket soon. He has accordingly procured more capacity
than is currently needed because it may be far more expensive to buy capacity
piece meal. (That is, the cost per unit capacity may not be linear because of
economies of scale). He therefore has to make a strategic decision. Ideally, he
should take a long-term view and allocate the total expected cost of the unused
capacity (over the next few years) over the entire production expected from the
plant.

This methodology is defensible if we consider that the initial investment decision

considered the cash inflow from all of the units produced over the life of the
machines and the outflow for the capacity costs over the same period. The cost of
the unused capacity arises because capacity is bought in a lump sum while
demand will start at a low level and take time to increase to its long-term level.
2. Income determination for the current year. For this purpose, Vijay needs to follow
the dictates of Generally Accepted Accounting Principles because determining
income falls under the purview of financial accounting. These principles indicate
the cost of the unused capacity be reallocated to the products made. That is, the
cost per unit reported in the income statement will be as if Vijay allocated
capacity costs using 20,000 cookers as the basis for determining overhead
allocation rates.

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MINI CASES

10. 70
a. Carolyn must consider the following costs in her pricing decision.

Cost of paper $0.02 per sheet × 120 sheets per $72.00

packet × 30 packets
Copy machine supplies 240 copies × $0.01 per copy × 30 $72.00
packets
Copyright fees $2 per article × 7 articles × 30 packets $420.00
Machine cost 240 copies × 30 packets × $0.01 per $72.00
copy
Student’s time – printing 2 hours × $8 per hour* $16.00
Student’s time – delivery ½ hour × $8 per hour $4.00
Set up machine ½ hour × $13.75 per hour* $6.875
Cost of assembling master ½ hour × $13.75 per hour $6.875
Obtain copyright 1.33 hours × $17.50 per hour* $23.275
Total cost $693.02
Cost per packet $23.10
* Each pack requires 240 copies / 60 copies per min = 4 mins printing time; 30 copies will require 120 mins
or 2 hours printing time Student rate is given. Assistant rate is $27,500/2,000 and Carolyn’s rate is
$35,000/2,000 hours.

Based on this estimate, Carolyn should probably price the course packet at approximately
$23.50. The slightly higher price would help compensate her for the supplies (binders etc)
used, as well as the cost of any unanticipated usage stemming from spoilage (e.g., because
the machine jams).

We note that the first five items are volume-driven (i.e., unit level) costs, items 6-8 are
batch-level costs, and the final two items are product-level costs.

b. Carolyn must consider the following costs in her pricing decision.

Cost of paper $0.02 per sheet × 120 sheets per $24.00

packet × 10 packets
Copy machine supplies 240 copies × $0.01 per copy × 10 $24.00
packets
Copyright fees $2 per article × 7 articles × 10 packets $140.00
Machine cost 240 copies × 10 packets × $0.01 per $24.00
copy
Student’s time – printing 40 minutes × $8 per hour* $5.33
Student’s time – delivery ½ hour × $8 per hour $4.00
Set up machine ½ hour × $13.75 per hour** $6.875
Total cost $228.205
Cost per packet $22.82

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The cost per packet has not changed much in spite of the batch level cost associated
with delivery and assembling the master. However, the product level cost (obtain
copyrights) no longer applies to this incremental order. In addition, note that we did
not include the time required to assemble the master. Anticipating such extra runs,
most print shops will retain the master copy for some time (typically a semester for
college copy centers) after the initial order, making this cost also a product-level cost.

However, Carolyn might wish to charge a premium price to reflect the rush nature of
the business.

c. The head of the Management & Organizations Department (a department that has
many classes with large course packs) believes that the pricing scheme should only
include the cost of papers and other consumables. He argues that the cost of the
machine, Carolyn’s salary and other such expenses are fixed costs and therefore not
relevant for the pricing decision. He further argues that this is a short-term decision
because each course-pack is valid only for one semester. Evaluate the merits of this
argument.

The Chairman’s argument is flawed. Every course pack consumes the capacity
available in the copy center. The allocations serve to approximate the opportunity
costs of these capacity resources. While it is true that capacity costs are fixed in the
short run, the decision is not a short-run decision. The number and variety of copies
made will determine the staffing in the copy center as well as the frequency of
machine replacement. Thus, Carolyn must consider these costs when developing
prices.

10. 71
a. First, let us calculate the total number of visits. We have:

500 individuals × 1 person / membership × 8 visits per person = 4,000 visits

200 families × 2 persons/membership × 2 visits per person = 800 visits.

Thus, we have 4,800 visits in total.

We therefore allocate:

(4,000/4,800) × $69,112 = $57,593.33 to individual members

(800/4,800) × $69,112 = $11,518.67 to family memberships.

With this, we have:

Individuals Family Total

Revenue $50,000 $32,000 $82,000
Costs (from above) $57,593 $11,519 $69,112
Profit ($7,593) $20,481 $12,888
Profit per membership ($15.19) $102.41

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Profit per person ($15.19) $51.20

The above analysis indicates that clearly, Tom is on the right track – they are actually
losing money on their individual memberships.

b. Let us now replicate the analysis using detailed data.

Item Driver Individual Family Total
Revenues Traced $50,000 $32,000 $82,000
Supplies - towels etc # of visits 18,750 3,750 22,500
Supplies – for classes # of classes 595 1,905 2,500
Water – pool # of visits to pool 500 1,000 1,500
Water – other # of visits 1,250 250 1,500
Credit card fees Payments 500 512 1,012
Equipment wear and tear - # of cardio
cardio minutes 833 667 1,500
Equipment wear and tear - # of minutes on
weights weight machines 750 150 900
Instructor salaries etc # of classes 2,857 9,143 12,000
Pool maintenance # of visits to pool 400 800 1,200
Contribution margin $23,565 $13,823 $37,388
Utilities (electric and gas) Facility 2,500
Staff salaries (front desk etc) Facility 13,500
Rental Facility 5,000
Other admin expenses Facility 3,500
Profit $12,888

Contribution per person $47.96 $33.52

c. Comparing the analysis in the above two parts alerts us to the dangers of using just one cost
driver. There is considerable variability in the cost of Hercules’ resources. Once the facility
level expenses are taken care of, supplies and classes are the most expensive. While
individual members consume the most supplies (based on visits), the families are heavy users
of the classes and the pool. It almost appears that Hercules is catering to two segments – one
that is interested in hardcore strength training and the other that is interested in a “fitness
experience,” consisting of some cardio exercises (treadmill etc), some classes, a dip in the
pool and time in the sauna. This insight might help Tom and Lynda tailor their marketing
strategies ….the decision will affect the club’s composition (and feel) over the long-term.

d. This is not an easy question to answer. At some level, the detailed analysis takes into account
the different types of activities consumed by members. Moreover, we are separating out
facility level costs. These features argue for classifying the analysis as ABC. However, notice
that all of the drivers are still volume related drivers…there are no batch or product level
drivers. Moreover, the grouping really looks at resource groupings (exercise machines, cardio
machines, office, pool and so on) rather than activity groupings. (There is considerable
overlap in the situation at Hercules, though). We also do not break out unused capacity.
These features suggest that the analysis is more in the nature of increasing the number of
drivers than implementing ABC. This ambiguity illustrates that there is no “bright line” test
for determining when we might call a system ABC. Like Hercules, many firms that start out

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implementing ABC wind up with a compromise system that has features of both traditional
and ABC systems.

10. 72
a.
Eyepieces Binoculars Camera Lens
Price $53.00 $ 78.00 $160.00
Variable cost 30.00 45.00 118.00
Unit contribution margin 23.00 33.00 42.00
Allocated overhead 25.50 32.30 35.70
Profit margin $(2.50) $ 0.70 $ 6.30

In this computation, notice that Zeus’s overhead rate is $17 per labor hour. We first
compute the total number of hours as [(16,000 eyepieces × 1.5 hours/unit) + (20,000
binoculars × 1.9 hours/unit) + (3,000 lens× 2.1 hours/unit)] = 68,300 hours. We then
find the overhead rate by dividing the total overhead of $1,161,100 by the 68,300
total hours. In turn, the amount allocated to each eyepiece is 1.5 hours × $17/hour =
$25.50, and so forth.
b. We have:

Cost pool Amount Cost driver Denominator Allocation rate

volume
Labor related $ 614,700 Labor hours 68,300 $ 9.00
Order related $ 188,000 Number of batches 40 $4,700.00
Inventory etc $ 156,250 Number of 1,250 $ 125.00
transaction
Product $ 90,000 Number of product 3 $ 30,000.00
development
Facility level cost $ 112,150 n/a n/a

c.

Eyepieces Binoculars Camera Lens

Price $ 53.00 $78.00 $ 160.00
Variable costs 30.00 $45.00 118.00
Unit contribution margin $ 23.00 $33.00 $ 42.00
Labor related 13.50 17.10 18.90
Order related 1.471 4.702 23.50
Inventory etc 0.31 1.31 41.67
Product development 1.88 1.50 10.00
Profit margin $ 5.84 $8.39 $(52.07)
1
$1.47 = $4700 per batch / 3200 Eyepieces per batch
2
$0.31 = ($125 per transaction × 2 components × 20 transactions)/16,000 Eyepieces

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On a total basis, we have:

Eyepieces Binoculars Camera Lens Total
Price $848,000 $1,560,000 $480,000
Variable costs 480,000 900,000 354,000
Contribution
margin $368,000 $660,000 $126,000
Labor related 216,000 342,000 56,700
Order related 23,500 94,000 70,500
Inventory etc 5,000 26,250 125,000
Product
development 30,000 30,000 30,000
Product profit $105,050
margin $93,500 $167,750 ($156,200)
Common costs $112,150
Profit ($7,100)

d. Based on the ABC profit margins, what actions would you recommend for Zeus’
management.

Based on the ABC profit margins, it appears that camera lenses are a loss-making
product. Increasing the volume of this product line is perhaps one reason why Zeus
has begun to make losses. The market for eyepieces appears to be very profitable.
Current return on sales is over 10%, which perhaps explains why Zeus is
encountering intense competition in this segment.
In terms of actions, it appears wise to continue to price-compete on eyepieces but
perhaps to raise prices on lenses. More important, Zeus could also think about
reducing both the number of orders for binoculars (why are we processing so many
orders for this product line? Is there a way to reduce the cost per order?) and the
number of transactions for the lens line. The latter course in particular appears to be a
very viable strategy to restore this product line to profitability.

e. It is certainly seems possible to refine the ABC estimates.

One avenue is to explore the number of cost pools. It might be worthwhile to split out
volume related costs into labor related costs and machine related costs. The benefits
from this split depend on the extent to which consumption of labor hours (across
products) differs from the consumption of machine hours. As we know, the benefit is
small if the patterns are the same. (If they are identical, we will get no change in the
reported costs.) However, implementing the change requires that we collect data on
the number of machine hours used by each product.
Another avenue might be to refine the drivers used. For instance, we currently assume
that all production orders require the same amount of work. It is possible that some
orders are more complex than others. Therefore, we might benefit from a driver that
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captures the variation in complexity. Again, while we might obtain a superior driver,
it may be difficult to measure such a driver accurately.
Finally, we might consider employing the idea of practical capacity for each cost pool
to identify the cost of unused capacity. However, as explained in the text, it is
difficult to measure practical capacity well.

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 CHAPTER 11
Managing Long-Lived Resources: Capital Budgeting
Solutions

REVIEW QUESTIONS
11.1 Capital budgeting refers to the set of tools companies use to evaluate large expenditures
on long-lived resources.
11.2 The time value of money arises because a dollar today is worth more than a dollar tomor-
row. Time value of money is important for project evaluation as cash inflows and out-
flows occur at different points in time – thus, we need to put these different cash flows on
equal footing to compare them.
11.3 A lumpy resource is one where it is difficult to match the demand for capacity with the
supply. As the text discusses, we cannot buy three-fourths of an MRI machine – capital
budgeting techniques recognize this and account for the timing and magnitude of all cash
inflows and outflows associated with resource acquisition, use, and disposal.
11.4 Capital budgets link strategic and operating budgets. Operating budgets allocate the
firm’s productive capacity among products, whereas capital budgets allocate scarce capi-
tal among available investment opportunities.
11.5 (1) Initial outlay, (2) estimated life and salvage value, (3) timing and amounts of operat-
ing cash flows, and (4) cost of capital.
11.6 Net present value is the total present value of all cash inflows and outflows. We compute
net present value by discounting future cash inflows and outflows (using present value
tables for our selected discount rate) back into today’s dollars.
11.7 The internal rate of return (IRR) is the discount rate at which a project has zero net pre-
sent value. We can compute the IRR using the appropriate formula in Excel or a financial
calculator
11.8 (1) The initial cash outflow takes place at the beginning of the period; (2) Subsequent
cash inflows and outflows occur at the end of the relevant period; (3) the firm reinvests
future cash inflows in projects that yield a return that equals the cost of capital.
11.9 The payback method is easy to use and understand (e.g., we do not need to determine the
opportunity cost of capital). The payback method also focuses on a project’s downside
risk.
11.10 The modified payback method computes the payback period using discounted cash flows,
meaning that the method accounts for the time value of money.
11.11 The accounting rate of return equals the average annual income from a project divided by
the average annual investment in the project.
11.12 Taxes are important because they affect both the amount and timing of cash flows.
11.13 A depreciation tax shield for any given year equals the depreciation deduction for the
year multiplied by the tax rate. We can view the tax shield as a cash inflow or as a reduc-
tion in cash outflows.

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11.14 The hurdle rate is the minimum expected rate of return from any project.
11.15 To minimize the risks associated with taking on large-scale projects. Small scale projects
allow firms to gain feedback and information regarding whether the large-scale project
will be successful.

DISCUSSION QUESTIONS

11.16 Capital budgeting explicitly considers this time value by discounting future cash inflows
and outflows to their current or present value to compute the value of an asset. It allows
us to express all future cash flows—cash flows occurring at different future points in
time—in terms of their respective present values. This way, we can put these different
cash flows on an equal footing and compare them.

On the other hand, cost allocations that we considered in chapters 9 and 10 do not explic-
itly take into account either the time value of money or the lumpy nature of long-term as-
sets. However, the purpose there was to evaluate the profitability of products or services
offered so that proper product portfolio decisions can be made. In capital budgeting, the
purpose is to evaluate the benefits from buying a long-term asset that provides the neces-
sary capacity to produce or support a given product portfolio. In other words, the objects
of analyses are different.
11.17 There is nothing wrong with this argument. If the company is consistently making mon-
ey, then it must be the case that a formal capital budgeting exercise would in fact indicate
a positive net present value scenario. This said, however, it is always better to be “ap-
proximately correct” than “precisely wrong.” Forecasting future cash flows is indeed a
difficult exercise. However, managerial experience and talent really help in coming up
with reasonable and good estimates. It could well be possible that a manager may be un-
der the wrong impression that the company is making money when it is in fact not be-
cause profitability is not being assessed in the right manner. So we would advice a man-
ager that a roughly conducted capital budgeting analysis is better than no analysis at all.
11.18 If there is a difference between the price at which the asset is being sold and its carrying
value, then there will be a cash outflow or inflow in the form of tax payment or tax sav-
ings. In particular, if the asset is being depreciated in an accelerated manner for tax pur-
poses, the carrying or net book value is likely to be low. If it is sold for a price that is
higher than the carrying value, then there is a taxable gain, and the company will incur a
cash outflow in the form of tax payment.
11.19 First, the net present value is simpler to compute. The internal rate of return is difficult to
determine because it involves solving a complex mathematical expression. Moreover,
there can often be multiple solutions, in which case one has to use good economic intui-
tion to determine the right solution. Second, the internal rate of return assumes that future
net cash inflows can be invested at the same rate as internal rate of return, whereas the net
present value method assumes that the future net cash inflows can be invested at the cost
at which capital is available to the firm. The latter assumption is more reasonable,

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11.20 Refer to the answer to 11.19.

11.21 Under the net present value method, we use the cost of capital as the discount rate. In do-
ing so, we are essentially assuming that firms reinvest future cash inflows in projects that
yield a return that equals the cost of capital. This assumption is reasonable because capi-
tal providers make available the capital at a cost based on the return they might secure if
they invest the same money elsewhere.
11.22 One can make serious errors with the payback method. As you learned in the chapter, the
payback method does not take into account the time value of money. It treats a cash in-
flow of $1 ten years from now in the same way as a cash inflow of $1 today, when in re-
ality it is worth much less. Consequently, the payback method distorts a capital invest-
ment’s potential.
11.23 Yes. See the answer to 11.17. It is better to quantify non-financial benefits and costs even
if only approximately than to ignore them. In a competitive market, ignoring non-
financial benefits can result in a firm underestimating an investment’s profit potential and
foregoing really profitable opportunities.
11.24 The payback method is a good way to evaluate a project’s downside risk. A risk-averse
manager might prefer a project with a small payback period because the risk of actually
losing money is lower. The manager can always claim that “we did not lose a dime on the
deal,” ignoring the lost opportunity for making more money in another project. Such be-
havior to avoid losses (even at the cost of foregoing gains) is commonly observed in or-
ganizations.
11.25 First, the accounting rate of return is straightforward to compute. Second, it meshes well
with annual performance measures used to evaluate managers (we consider this in greater
detail in Chapter 13). However, it does not take time value of money into account and
could be misleading performance measure.
11.26 A project is acceptable if its IRR exceeds its opportunity cost of capital. Many companies
use a subjectively determined internal hurdle rate instead of the cost of capital for project
acceptance decisions. The hurdle rate is the minimum expected rate of return of the man-
agement from any project. Thus, any project that has an IRR greater than the hurdle rate
(which means that the project will have a positive NPV when discounted at the hurdle
rate) would be acceptable.
11.27 Let us discuss the NPV method first. All else equal, it makes sense to choose the project
with the highest NPV for a given level of capital. However, sometimes projects with low-
er NPV may be preferable if they offer synergies with existing operations – synergies that
were not explicitly considered in computing NPV because of the difficulty in quantifying
them. With respect to IRR, a similar argument applies. In addition, we know from the
chapter that the IRR method can rank alternatives differently compared to NPV. Thus, it
is not clear that choosing the project with the highest IRR is the best thing to do.
11.28 U.S. tax laws also allow depreciation deductions as stipulated by the Modified Accelerat-
ed Cost Recovery System (MACRS). MACRS allows firms to take higher depreciation
charges earlier in the asset’s life. In turn, because a dollar saved in tax payments today is
worth more than a dollar saved tomorrow, firms generally prefer MACRS when it comes
to project planning.

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11.29 Depreciation methods used to compute accounting income are not relevant for project
evaluation; only the methods used to compute taxable income are relevant. This is be-
cause depreciation by itself does not involve any cash flow. It is the tax deductibility of
depreciation which has a cash flow implication.
11.30 In the context of investing in advanced manufacturing technologies, the current state of
affairs is not the appropriate baseline for evaluating project benefits. The reason is that
competitive forces might result in the firm losing market share and profitability if it does
nothing. Thus, the firm cannot assume that current cash flows will continue if it does not
upgrade its machines and practices.

EXERCISES
11.31
Treating each row of the table independently compute missing information.
For each setting, we use the appropriate present value factors from the tables in Appendix
B. The relevant table and the factor are given in parentheses for each setting.

Life Discount rate Future value

Setting Initial outlay (years)
(compounded an-
(at the end of life)
nually)

1 $225,000 5 10% $362,475

(Table 2: Factor 1.611)

2 $128,800 10 12% $400,000

(Table 1: Factor 0.322)
3 $157,950 8 14% 450,000
4 $150,000 8 12% $371,400

11.32
We can find the annuity factor in Appendix B, Table 3, corresponding to 5 years and 10
percent. This factor is 3.791. Thus,
Annual installment amount × 3.791 = $150,000, which yields an annual installment
amount as $39,567.40.
11.33
a.
Since Diana and Jason are making a down payment of $84,000, they have to secure a
loan for $400,000. With a thirty-year fixed mortgage, they will be making 360 (= 30
× 12) monthly payments. Following the hint in the problem, the monthly discount rate
is 0.5% (6%/12).
We can use the PMT function in excel as PMT(0.06/12,360,400000) = $2,398.20
(rounded).

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For an alternate approach, note that the stream of payments is an annuity. We cannot
use Table 2 in Appendix B to identify the annuity factor corresponding to a discount
rate 0.5% and 360 periods. However, we can use the PV function in Excel to calculate
this factor as PV(0.5%,360,1) = 166.792. Therefore, monthly mortgage payment
×166.792 = $400,000, which yields a monthly mortgage payment of $2,399 (round-
ed).
b.
At the end of five years, Diana and Jason would have already made 60 monthly pay-
ments, which means that only 300 monthly payments will remain. The loan balance
remaining will be the present value of the 300 monthly payments of $2,399 discount-
ed at a monthly rate of 0.5%, or PV(0.5%,300,$2399) = 372,341 (rounded)
Note: Why is it that such a substantial amount of the original loan of $400,000 still
remaining after 5 years? The reason is that in the initial years, a major portion of the
monthly payments goes toward interest payments and only a small portion of it re-
duces the loan principal. Toward the later years, this portion will increase substantial-
ly while the interest portion reduces.

11.34
a.
Sally’s loan would have grown to $44,163.23 at the end of four years. This amount can
be calculated in Excel as FV (0.04,4,10000,1) where the first entry is the interest rate, the
second is the number of periods, the third is the amount and the final entry indicates that
the annuity is at the start of the period. Alternatively, we can calculate that the first in-
stallment would have grown to $10,000 * (1.04)4, the second to $10,000 * (1.04)3 and so
on. Summing these values yields $44,163.23.
b.
We can calculate the monthly payment as PMT(0.06/12,120,44163.23) = $490.30. Note
that we divided the interest rate by 12 to determine the monthly compounding of the in-
terest. In general, be sure to match the interest rate with the number of periods. You will
get incorrect answers if you couple an annual rate with monthly payments.

11.35
The present value of a stream of payments of $1 at 6% for 25 years (see row for 6% and
the column for 25 years) is 12.783. Thus, Molly expects to receive $1,500,000 / 12.783 =
$117,343.35 each year as her payout.

We also can compute this amount in Excel as $117,340.08 = PMT(0.06,25,1500000),

with the $3.27 difference arising due to rounding.

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11.36
a.
Using the PMT function we have $463.99 = PMT(0.06/12,60,24000). We cannot calcu-
late this number from the tables because the values do not extend out to 60 payments.
b.
The present value of an annuity with 60 payments of $1 and an interest rate of 0.5% per
period (note that the interest rate corresponds to the time period for each payment) is
51.73. Since he can pay $350 per month, he can therefore borrow $18,103.95 =51.73 *
$350. Rounding down, Xavier can finance $18,100.
11.37
We can calculate the interest rate by trial and error. Begin with a 10% rate to compute
$23,033 = PV(0.10/12,60,399,7000). The last entry in the PV function represents that the
dealer gets a payment of $7,000 (the returned car) in 60 months. Since this amount is
higher than the purchase price, we need to raise the interest rate. (Higher rates will lower
the PV of the stream of payments.) At a 11% rate, $22,400=PV(0.11/12,60,399,7000).
Please note the matching of the interest rate with the time period. We converted a 11%
rate into a monthly rate.

11.38
The book value of the fork-lift is $11,300 (= $50,000 - $38,700). Therefore, the gain on
sale is $1,200 (= $12,500 - $11,300). At a tax rate of 45%, this gain gives rise to a tax bill
of $540 = $1,200 × 0.45. Therefore, the after-tax cash inflow from the sale of the forklift
is $11,960=$12,500- $540.

11.39
a.
Using the PV function, we have $12,158.41 = PV(0.08,30,1000,0,1) where the last 1 in-
dicates that payments occur at the start of each period.
b.
Using the PV function, $2,981.31 = PV(0.08,30,0,30000), where the middle 0 indicates
that we make no periodic payments.
c.
Together, the answers to parts a and b show that the cost of the “free” insurance is
$9,177.10 = $12,158.31-$2,981.31. We can of course compute the cost directly as
PV(0.08,30,1000,-30000,1) by putting in both the periodic payment and the lump sum
payment into the same formula.

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11.40
a. From the tables, the present value of a 3-year annuity at 10% is 2.487. Thus, the net
present value of project A is $2,435 = 2.487*$5,000 - $10000. Similarly, the NPV
for project B is $4,714. Project B has the greater NPV.

b. The investment divided by the periodic flow is 2 = $10,000/$5,000 for Project A ad is

2.2727 = $50,000/$22,000 for project B. Looking down the column for 3 years in the
annuity table, the NPV for project A is zero at a rate between 22 and 24% (the PV
factors are 2.042 and 2.981 respectively). Similarly, the IRR for project B is be-
tween 15 and 16% (the PV factors are 2.283 and 2.246, respectively). Project A has
the higher IRR.

c.
Project B is larger (5 times as much) than project A. Because NPV is a $ measure, the
larger size overwhelms the lower profitability, giving the advantage to project B. IRR, as
a percentage, is neutral toward size and focuses purely on profitability. As both profita-
bility and absolute profit are important, firms therefore often use multiple criteria when
evaluating projects.

11.41
a.
The present value of minimum annual cash inflows over the furnace’s life of 10
years, discounted at 8% should at least equal initial investment of $2,500,000. That is,
its net present value (NPV) should be positive. Referring to Table 3 in Appendix B,
the appropriate annuity factor (10 years, 8%) is 6.710. Therefore,
Annual cash inflows × 6.710 ≥ $2,500,000, or annual cash inflows ≥ $372,578
(rounded). Quality Metal Works Inc. must generate minimum annual (net) cash in-
flows of $372,578 to justify investment.
b.
We are assuming straight-line depreciation for tax purposes. The annual depreciation
is $2,500,000/10 = $250,000. Because depreciation is tax deductible, the annual tax
savings offered by depreciation is $250,000 × 30% = $75,000.
The present value of this depreciation tax shield over the furnace’s life of 10 years, at
a discount rate of 8% is $75,000 × 6.710 = $503,250.
c.
The minimum annual operating cash inflows will decrease by $75,000 to $297,578
($372,578-$75,000) because of the tax savings offered by depreciation.

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11.42
Polyplast’s cost of capital of 12% should be used in evaluating the second option. The
annual cash flows from the second option are:
 After tax net cash inflows = $108,000 × (1 – 0.30) = $75,600
 Depreciation tax shield = $50,000 × 0.30 = $15,000 because annual depreciation
is $50,000 = $500,000/10 years.
Together, we obtain a annual net cash inflow of $90,600. Referring to Table 3 in Appen-
dix, the appropriate annuity factor corresponding to 10 years and a discount factor of
12% is 5.650. Therefore, the present value of an annuity of $90,600 over 10 years at a
discount rate of 12% is 90,600 × 5.650 = $511,890 (rounded).
Thus, the net present value from the second option is $11,890 (= $511,890 - $500,000).
Polyplast should prefer the second option because it has a higher net present value.
11.43
a.
By the definition of the internal rate of return, the net present value from investing in
injection molding machine should be zero. Referring to the solution to 11.42, the pre-
sent values of annuities of $90,600 over 10 years discounted at this rate should equal
$500,000. In other words,
$90,600 × annuity factor = $500,000, or annuity factor = 5.52.
Using the RATE(10, 90600, -500000) function of the Excel Spreadsheet, this annuity
factor corresponds to a discount rate of 12.58% (rounded). We also can use the trial
and error method and the table in the Appendix to determine that the rate is between
12 and 13%. This rate is less than 14%, and, as per company policy, this project
would be rejected.
b.
No, it will not. The company has to go by what is the best alternative use of the funds.
The only other use for the funds, as given in 11.42, is to invest the money in shares to
earn an expected return of 12%. And, as we saw in 11.42, investing in the injection
molding machine is a better option. Therefore, sticking to the company policy and re-
jecting the project is not in the company’s best interest.
11.44
a.
The payback period is $500,000/$90,600 = 5.52 years (rounded).
b.
The following table identifies the modified payback period (PV factors from Table 1
in Appendix B):
Initial investment = $500,000, Life 10 years, Cost of capital 12 percent

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11-9

Present
Net Cash
value Present Cumulative
Flow
Year factor Value Present Value
Year 1 $90,600 0.893 $80,906 $80,906
Year 2 90,600 0.797 $72,208 $153,114
Year 3 90,600 0.712 $64,507 $217,621
Year 4 90,600 0.636 $57,622 $275,243
Year 5 90,600 0.567 $51,370 $326,613
Year 6 90,600 0.507 $45,934 $372,547
Year 7 90,600 0.452 $40,951 $413,498
Year 8 90,600 0.404 $36,602 $450,100
Year 9 90,600 0.361 $32,707 $482,807
Year 10 90,600 0.322 $29,173 $511,980

Thus, only in the tenth year, the initial investment is fully paid under the modified
payback method. Thus, the modified payback period is 10 years (rounded).
c.
Since annual net cash inflows are identical in all 10 periods and depreciation is
straight line, the accounting income is identical in all 10 periods. We can calculate
this income as follows:
Accounting income = (Net cash inflows – Depreciation) × (1 – tax rate)
= ($108,000 – $50,000) × (1 - 0.30)
= $40,600
Average investment = $500,000/2 = $250,000
Accounting rate of return = $40,600/250,000 = 0.1624, or 16.24%.
11.45
a.
Increased revenues from the investment = 8,000 hours × $50/hour = $400,000.
Therefore, payback period = $1,200,000/$400,000 = 3 years.
b.
The following table identifies the modified payback period (see Table 1 in Appendix
B for PV factors):
Initial investment = $1,200,000, Life 5 years, Cost of capital 10 percent
Present
Net Cash
value Present Cumulative
Flow
Year factor Value Present Value
Year 1 $400,000 0.909 $363,600 $363,600
Year 2 400,000 0.826 $330,400 $694,000
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11-10

Year 3 400,000 0.751 $300,400 $994,400

Year 4 400,000 0.683 $273,200 $1,267,600
Year 5 400,000 0.621 $248,400 $1,516,000

As we can see, the investment of $1,200,000 is fully recovered in Year 4. So the modified
payback period is 4 years (rounded). To be precise, the payback is 3 + ($1,200,000 -
$994,400)/$273,200 = 3.75 years.
c.
Accounting income from the investment is the same as net cash flow in this instance, and
therefore the accounting rate of return = 400,000/600,000 = 0.66666 or 66.67%. Notice
that the average investment is $1,200,000 / 2 = $600,000.

11.46
a.
Initial investment for the project is $5,000,000. Because the project has a life of five
years, depreciation for tax purposes is $1,000,000 ($5 million/5 years) using the
straight-line method. Because the tax rate is 30%, depreciation gives rise a tax saving
of $300,000 (= 30% × $1,000,000) every year.
The after-tax annual cash flow expected from the project is $1,400,000 × (1 – 0.30) =
$980,000. Thus, the net cash flow per year is $1,280,000 (= $980,000 + $300,000).
Therefore,
Payback period = $5,000,000/$1,280,000 = 3.90 years = 4 years (rounded).
b.
The following table identifies the modified payback period:
Initial investment = $5,000,000, Life 5 years, Cost of capital 12 percent
Present
Net Cash
value Present Cumulative
Flow
Year factor Value Present Value
Year 1 $1,280,000 0.893 $1,143,040 $1,143,040
Year 2 $1,280,000 0.797 $1,020,160 $2,163,200
Year 3 $1,280,000 0.712 $911,360 $3,074,560
Year 4 $1,280,000 0.636 $814,080 $3,888,640
Year 5 $1,280,000 0.567 $725,760 $4,614,400

As we can see, the investment of $5,000,000 is not fully recovered in Year 5. So the
modified payback period is a little over 5 years.

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11-11

c.
Since annual net cash inflows are identical in all 10 periods and depreciation is
straight line, the accounting income is identical in all 10 periods. We can calculate
this income as
Accounting income = (Net cash inflows – Depreciation) × (1 – tax rate)
= ($1,400,000 – $1,000,000) × (1-0.30)
= $280,000
Average investment = $5,000,000/2 = $2,500,000
Accounting rate of return = $280,000/2,500,000 = 0.112, or 11.20%.
11.47
a.
Rahul should ensure that the amount he invests is not greater than the present value of the
cost savings the proposal generates, for it will be a negative net present value project oth-
erwise. Referring to Table 3 in Appendix B, the appropriate annuity factor (5 years, 8%)
is 3.993. The present value of annual cost saving of $275,000 for the next five years is
$275,000 × 3.993 = $1,098,075. You also could calculate this amount in Excel as
PV(0.08,5,275000) = ($1,097,995), or equivalently, you could spend $1,097,995 and not
be worse off. The slight difference in the answers is due to rounding.

b.
Payback period = $825,000/275,000 = 3 years (rounded).
c.
Note that the internal rate of return is also 8% because the net present value would
exactly be zero if Rahul invests $1,098,075. You can verify this by entering -1097995
in cell A1 and 275000 in cells A2-A6. Then enter NPV(0.08,A1..A6) in cell A7 to get
a NPV of -0.24 (the difference is due to rounding).

11.48
a.
The following table presents the cash outflows and cash inflows and presents the net pre-
sent value calculations (see Table 1 in Appendix B for PV factors).
Initial investment = $3,400,000, Life 8 years, Cost of capital 10 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($3,400,000)
Year 1 $707,500a 0.909 $643,118 $643,118

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11-12

Year 2 $707,500 0.826 $584,395 $1,227,513

Year 3 $707,500 0.751 $531,333 $1,758,845
Year 4 $707,500 0.683 $483,223 $2,242,068
Year 5 $707,500 0.621 $439,358 $2,681,425
Year 6 $707,500 0.564 $399,030 $3,080,455
Year 7 $707,500 0.513 $362,948 $3,443,403
b
Year 8 $1,107,500 0.467 $517,203 $3,960,605
Net present value ($3,960,605 - $3,400,000) $560,605
a
Annual after-tax net cash inflow for Years 1-7 = (1,600,000 – 750,000)×(1-0.30) +
375,000*0.30= $707,500. In this calculation, the amount $375,000 represents depreciation (De-
preciation = (3,400,000-400,000)/8). Therefore, the annual tax saving from depreciation is
$375,000 × 0.30.
b
Year 8 cash flows include the salvage value of $400,000 (keep in mind that salvage value does
not have any tax implication as long as there is no gain from sale. The book value at the end of
Year 8 would be exactly equal to expected salvage value, and therefore there will be no gain from
sale). $1,107,500 = $707,500+$400,000.
Note: Using a more accurate (i.e., more than 3 decimal places) PV factor leads to slightly
different answers.
b.
In the first seven years, undiscounted annual net cash flows are $707,500. Therefore:
Payback period = $3,400,000/$707,500 = 4.80 or 5 years (rounded). Note that we are
ignoring salvage value in calculating the payback period.
Note from the table above that the modified payback period is close to seven years be-
cause the cumulative present value exceeds $3,400,000 at the end of seven years. Again,
note that we are ignoring salvage value.
11.49
a.
The following table presents the cash outflows and cash inflows and presents the net pre-
sent value calculations.
Initial investment = $2,350,000, Life 3 years, Discount rate 10 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($2,350,000)
Year 1 $910,000 0.909 $827,190 $827,190
Year 2 $1,050,000 0.826 $867,300 $1,694,490
Year 3 $1,120,000 0.751 $841,120 $2,535,610
Year 3 $250,000 0.751 $187,750 $2,723,360
Net present value ($2,723,360 - $2,350,000) $373,360

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a
Annual after-tax net cash inflow plus depreciation tax shield. Depreciation = (2,350,000-
250,000)/3) = $700,000. Therefore, the annual tax saving from depreciation is $700,000 × 0.30 =
$210,000. Annual after-tax cash inflow in year 1 $910,000 = $1,000,000 × (1-0.30) + $210,000.
b
Salvage value expected to be realized from sale at the end of Year 3.
b.
The internal rate of return is the discount rate at which the net present value is ex-
actly equal to zero. Using Excel, we can calculate this rate as 18.23%. The for-
mula to use in cell A5 is IRR(A1..A4) after entering the annual cash flows in cells
A1-A4. Be sure to enter the year 0 cash flow with a negative sign and the total
year 3 cash flow of $1,370,000 in cell A3.
11.50
a.
The following table presents the cash outflows and cash inflows and presents the net pre-
sent value calculations.
Initial investment = $6,750,000, Life 5 years, Discount rate 8 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($6,750,000)
Year 1 $2,610,000 0.926 $2,416,860 $2,416,860
Year 2 $2,610,000 0.857 $2,236,770 $4,653,630
Year 3 $1,360,000 0.794 $1,079,840 $5,733,470
Year 4 $1,060,000 0.735 $779,100 $6,512,570
Year 5 $610,000 0.681 $415,410 $6,927,980
Year 5 $750,000 0.681 $510,750 $7,438,730
Net present value ($7,438,740 - $6,750,000) $688,730
a
Annual after-tax net cash inflow plus depreciation tax shield. Depreciation = (6,750,000-
750,000)/5) = $1,200,000. Therefore, the annual tax saving from depreciation is
$1,200,000 × 0.30 = $360,000.
b
Salvage value expected to be realized from sale at the end of Year 5.
b.
At the end of the first three years, cumulative undiscounted net cash flows are
$6,580,000. The investment in the project is $6,750,000. Thus, the payback period is a
little over three years (rounded).
c.
From the table above that the modified payback period is a little over 4 years. The cumu-
lative net present value at the end of four years is $6,512,570 which is a little below the
initial investment of $6,750,000.

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PROBLEMS
11.51
a.
We first calculate the present value of annuities of $35,000 at the start of years 18-21, or
as of the end of the Year 17 (or the beginning of Year 18). Since cash flows are assumed
to occur at the beginning of each year, the first installment occurs at the beginning of
Year 18. Therefore, we need to calculate the present value of the remaining three annui-
ties of $35,000 at the start of years 19-21, as of the end of the Year 17 (or the beginning
of Year 18). Referring to Table 3 of Appendix, the annuity factor corresponding to three
years and 8% is 2.577. Therefore,
Present value of annuities of $35,000 at the start of years 18-21, as of the end of the Year
17 (or the beginning of Year 18) = $35,000 + ($35,000 ×2.577) = $125,195.
Now, we would like to know how much Haidan and Ying Li must invest now for the
money to grow to $125,195 at the end of 17 years at a discount rate of 8%. Using Excel
(use the formula 1/((1+0.08)^17) OR use a calculator and the supplied formula for pre-
sent value at the top of Table 1 in Appendix B), we determine the corresponding present
value factor is 0.270. Therefore:
The amount to be invested now = $125,195 × 0.270 = $33,803.
b.
In this case, the future value of 18 annuity payments should equal $125,195. Either by us-
ing Excel or by using the formula at the top of Table 4 in Appendix B, the appropriate
discount factor (8%, 18 years) is 37.450. Thus:
Annual payment × 37.450 = $125,195, which yields an annual payment of $3,343
(rounded).
11.52
a.
The following table presents the net present value calculation for this option.
Initial investment = $90,000, Life 3 years, Discount rate 12 percent
Year After-tax Present Present Cumulative
Net Cash value fac- Value Present
Flow tor Value of
inflows
Year 0 Sale of old copier $12,000
a
Year 1 (tax on gain) ($1,750) 0.893 ($1,563) $10,437
a
Year 1 $47,500 0.893 $42,418 $52,855
a
Year 2 $42,500 0.797 $33,873 $86,728
a
Year 3 $32,500 0.712 $23,140 $109,868
Net present value ($109,868 - $90,000) $19,868

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a. Year 1 tax on gain = ($12,000-$5,000)*0.25. Annual after-tax net cash inflow plus deprecia-
tion tax shield. Depreciation = (90,000/3) = $30,000. Therefore, the annual tax saving from
depreciation is $30,000 × 0.25 = $7,500.
b.
Using Excel Spreadsheet, we can the internal rate of return to be 27.2%. If discounted at
this rate, the net present value is zero (subject to rounding off). Notice that year 0 cash
flow is -78,000 = ($90,000) + $12,000 and year 1 flow is $45,750 = ($1,750)+$47,500.
Use the formula IRR(A1..A4) in Excel. Cells A1 through A4 contain the cash flow for
now and years 1-3 respectively.

c.
The following table presents the net present value calculation for this option.
Initial investment = -, Life 3 years, Discount rate 12 percent
After-tax Present
Cumulative
Net Cash value fac- Present
Present
Year Flow tor Value
Value
a
Year 1 $10,416.67 0.893 $9,301 $9,301
a
Year 2 $8,416.67 0.797 $6,710 $16,010
a
Year 3 $5,416.67 0.712 $3,855 $19,866
Net present value $19,866
a
Annual after-tax net cash inflow plus depreciation tax shield. Depreciation = (5,000/3) =
$1,666.67. Therefore, the annual tax saving from depreciation is $1,666.67 × 0.25 =
$416.67.
Note: The cost of the old copier is a sunk cost and should not be considered.
d.
The net present value from keeping the old copier is $19,867 (from part c). The net pre-
sent value from the replacement decision is $19,862. The two options are almost the
same from a financial perspective. The net present value method assumes that the mon-
ey that is freed up will earn a return of 12%.
e.
The new copier is likely to yield better quality copies. The old copier may break
down more often and is likely to be more difficult to maintain. The problem already
states that the additional risk of losing customers -- because the old copies lacks the
features the new copier offers -- has already been taken into account in the estimates.
Still, these issues are hard to quantify and require managerial judgment.

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11.53
Total investment involved in purchasing the advanced milling machine and making it op-
erational = $2,500,000 + $500,000 = $3,000,000. Costs that are incurred to make the
milling machine operational should be included in the investment cost.
The variable material cost per unit using the milling machine = $8 × (1 - 0.20) = $6.40
The variable labor cost per unit using the milling machine = $12 × (1 – 0.40) = $7.20.
Annual saving in variable costs per unit = $8 + $12 - $6.40 - $7.20 = $6.40.
Total after-tax annual cost savings = 200,000 units × $6.40 per unit = $1,280,000 × (1 -
0.35) = $832,000.
Annual depreciation for the milling machine = $3,000,000/5 = $600,000
Tax saving from depreciation = $600,000 × 0.35 = $210,000
Thus, total net annual cash inflow per year for the next five years if Jayant purchases the
milling machine = $832,000 + $210,000 = $1,042,000.
Present value of net annual cash inflow of $1,042,000 for the next years discounted at
14%
= $1,042,000 × Annuity factor (5 Years, 14%) from Table 3 in Appendix B
= $1,042,000 × 3.433
= $3,577,186.
Therefore, net present value of the milling machine purchase
= $3,577,186 – 3,000,000 = $577,186.
11.54
a.
The following table presents annual net after-tax cash flow for ten-year life of the pro-
posed product line.
Year Sales Variable Fixed After-tax Depreciation Total annual
cost cost operating tax shieldb net cash flow
cash flow a
Year 1 $4,000,000 $1,600,000 $750,000 $1,155,000 $240,000 $1,395,000
Year 2 $4,400,000 $1,760,000 $750,000 $1,323,000 $240,000 $1,563,000
Year 3 $4,840,000 $1,936,000 $750,000 $1,507,800 $240,000 $1,747,800
Year 4 $5,324,000 $2,129,600 $750,000 $1,711,080 $240,000 $1,951,080
Year 5 $5,324,000 $2,129,600 $750,000 $1,711,080 $240,000 $1,951,080
Year 6 $5,324,000 $2,129,600 $750,000 $1,711,080 $240,000 $1,951,080
Year 7 $5,324,000 $2,129,600 $750,000 $1,711,080 $240,000 $1,951,080
Year 8 $3,993,000 $1,597,200 $750,000 $1,152,060 $240,000 $1,392,060
Year 9 $2,994,750 $1,197,900 $750,000 $732,795 $240,000 $972,795
Year 10 $2,246,063 $898,425 $750,000 $418,346 $240,000 $658,346

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(Sales – variable cost – fixed cost) × (1-0.30). Sales in year 1 are $4,000,000 =
a

200,000 * $20 and $4,400,000 = 200,000 * 1.1 * $20 in year 2.

b
Depreciation × 0.30, where depreciation = $8,000,000/10 = $800,000. The tax shield
is therefore $240,000 = 800,000 * 0.3.

b.
The following table presents the net present value calculations.
Initial investment = $8,000,000, Life 10 years, Discount rate 12 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($8,000,000)
Year 1 $1,395,000 0.893 $1,245,735 $1,245,735
Year 2 $1,563,000 0.797 $1,245,711 $2,491,446
Year 3 $1,747,800 0.712 $1,244,434 $3,735,880
Year 4 $1,951,080 0.636 $1,240,887 $4,976,766
Year 5 $1,951,080 0.567 $1,106,262 $6,083,029
Year 6 $1,951,080 0.507 $989,198 $7,072,226
Year 7 $1,951,080 0.452 $881,888 $7,954,115
Year 8 $1,392,060 0.404 $562,392 $8,516,507
Year 9 $972,795 0.361 $351,179 $8,867,686
Year 10 $658,346 0.322 $211,987 $9,079,673
Net present value ($9,079,673 - $8,000,000) $1,079,673
Note: The above answer uses the PV factor to 3 decimal places only.
c.
The internal rate of return equates the present value of cash flows over the next ten
years to the initial investment of $8,000,000. Using Excel, we can determine this rate
to be 15.35% (rounded). Use the IRR formula after inputting the net undiscounted
cash flows in cells A1-A11, and entering the initial investment with a negative sign.
11.55
a.
The following table presents the net present value calculations for the two proposals:

Proposal 1
Annual after-tax operating cash inflow = ($800,000 - 350,000 - 100,000) × (1 - 0.30) =
$245,000
Annual depreciation = $1,500,000/10 = $150,000
Annual tax saving from depreciation = $150,000 × 0.30 = $45,000
Total annual cash inflow = $245,000 + $45,000 = $290,000
Annuity factor (10 years, 12%) from Table 3 in Appendix B = 5.650

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Present value of annuity of $290,000 (10 years, 12%) = $290,000 × 5.650 = $1,638,500
Initial investment = $1,500,000
Net present value = $1,638,500 - $1,500,000 = $138,500.

Proposal 2
Annual after-tax operating cash inflow = ($800,000 - 475,000-100,000) × (1 - 0.30) =
$157,500
Annual depreciation = $1,000,000/10 = $100,000
Annual tax saving from depreciation = $100,000 × 0.30 = $30,000
Total annual cash inflow = $157,500 + $30,000 = $187,500
Annuity factor (10 years, 12%) from Table 3 in Appendix B = 5.650
Present value of annuity of $280,000 (10 years, 12%) = $187,500 × 5.650 = $1,059,375
Initial investment = $1,000,000
Net present value = $1,059,375 - $1,000,000 = $59,375.

Therefore, the NPV method ranks Proposal 1 higher than Proposal 2.

b.
The present value of future cash flows, calculated using IRR should exactly equal the ini-
tial investment amount. That is,

Total annual cash flows × Annuity factor (10 years, IRR) = Initial investment.

Proposal 1

$290,000 × Annuity factor (10 years, IRR) = $1,500,000, or

Annuity factor (10 years, IRR) = $1,500,000/$290,000 = 5.172
Referring to Table 3 in Appendix B, for a 10 year life, this factor corresponds to be a lit-
tle over 14%. Using Excel, we can determine this rate more precisely to be 14.22%

Proposal 2

$187,500 × Annuity factor (10 years, IRR) = $1,000,000, or

Annuity factor (10 years, IRR) = $1,000,000/$187,500 = 5.333
Referring to Table 3 in Appendix B, for a 10-year life, this factor corresponds to be a lit-
tle below 14%. Using Excel, we can determine this rate more precisely to be 13.44%

Therefore, the IRR method also ranks Proposal 1 higher than Proposal 2.

Alternatively, we can enter cash flows of -1,500,000 in cell A1 and $290,000 in cells A2-
A11. Then IRR(A1..A11) gives the IRR for Proposal 1. A similar calculation applies for
Proposal 2 (Cell A1 = -1,000,000 and A2-A11 are $187,500).

c.

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Yes, Proposal 1 involves a larger outlay than Proposal 2, and larger projects tend to have
larger NPV, all else equal. However, in this problem, there is also another difference.
Proposal 1 involves more upfront investment than Proposal 2, but the variable costs are
less. Thus, the two proposals are very different in terms of the risks involved, as the next
part of this problem shows.

d.
Referring to Chapter 5, operating leverage at any volume of activity = Fixed costs/Total
costs.
Proposal 1
Annual fixed costs = $250,000 (including depreciation of $150,000)
Variable costs = $350,000
Total costs = $600,000
Operating leverage = 250,000/600,000 = 0.417 (rounded)

Proposal 2
Annual fixed costs = $200,000 (including depreciation of $100,000)
Variable costs = $475,000
Total costs = $675,000
Operating leverage = 200,000/675,000 = 0.296 (rounded)

Note that we are ignoring taxes in calculating operating leverage because we are in-
terested in the firm’s operating cost structure. Thus, Proposal 1 has higher operating
leverage than Proposal 2 because of its higher fixed costs and lower variable costs.
11.56
a.
Referring the data in 11.55,

Payback period for Proposal 1 = $1,500,000/$290,000 = 5.17 years.

Payback period for Proposal 2 = $1,000,000/$187,500 = 5.33 years.

Therefore, the payback period method ranks Proposal 1 higher than Proposal 2.

b.
The modified payback period method identifies when the present value future cash flows
covers initial investment.

The annuity factor for Proposal 1 = $1,500,000/$290,000 = 5.17.

Referring to Table 3 in Appendix B, this annuity factor falls somewhere between the 8th
and 9th year of the investment life. Therefore, the modified payback period is less than 9
years. Using Excel, we can determine this period more precisely to be 8.20 years (=8
years + $60,730/$290,000, where $60,730 is the deficit after the first eight years.)

The annuity factor for Proposal 2 = $1,000,000/$187,500 = 5.33.

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Referring to Table 3 in Appendix B, this annuity factor falls close to 9 years. Therefore,
the modified payback period is 9 years.

Therefore, the modified payback period method also ranks Proposal 1 higher than
Proposal 2.

c.
Proposal 1

Accounting income = (After-tax operating income – depreciation) × (1 – tax rate)

= ($245,000 – $150,000) × (1 - 0.30) = $66,500
Average investment = $1,500,000/2 = $750,000.
Accounting rate of return = $66,500/$750,000 = 0.0887 or 8.87%

Proposal 2

Accounting income = (After-tax operating income – depreciation) × (1 – tax rate)

= ($157,500 – $100,000) × (1 - 0.30) = $40,250
Average investment = $1,000,000/2 = $500,000.
Accounting rate of return = $40,250/$500,000 = 0.0805 or 8.05%

d.
All the methods rank Proposal 1 higher than Proposal 2. However, this is an unusual ex-
ample and in general, the rankings will not coincide across all methods.
11.57
a.
The following table provides the required calculation.

Period PV Factor Net Present

Cash flow (at 15%) Value
0 -25,000 1 -$25,000.00
1 -1,200 0.8696 -1,043.52
2 -1,200 0.7561 -907.32
3 -1,200 0.6575 -789.00
Total -$27,739.84
* Cash flow = -1,200, the operating cost

This analysis suggests that Tom and Lynda should not invest in the new machines. After
all there is no positive cash flow associated with replacement.

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b.
The following table provides the required calculation, with the revised cashflow. Notice
that we are including the lost contribution from departing members, as this amount is
now controllable.

Period PV Factor Net Present

Cash flow (at 15%) Value
0
$(25,000.00) 1.000 $(25,000.00)
1 10,500.00 0.869 9,124.50
2 14,400.00 0.756 10,886.40
3 18,300.00 0.657 12,023.10
Total $7,034.00
* Cash flow = number of members that would have been lost× $65 × 12 -1,200, the operating
cost
This analysis suggests that Tom and Lynda should invest in the new machines. This cost
is a part and parcel of their business. The benefit is not the addition of new members but
the prevention of the loss of members.
c.
This exercise illustrates two things. First, most NPV analyses implicitly assume a status
quo of zero cash flows. This is usually not a good assumption, particularly in a dynamic
world. Second, the replacement of capacity is a long-term decision. This is a cost of ser-
vicing membership. It is this cost that appears as “depreciation” in Hercules’ capacity
(fixed) costs. Thus, allocating the costs to members is a way to estimate the long-term
cost of providing member service.

11.58
Option 1 results in a saving in variable cost of $3 per unit (= $18 unit price + $2 after
sales customer support cost – $16 unit variable cost of option 1 - $1 after sales customer
support cost of option 1) relative to option 2.
Therefore annual after-tax cost saving in variable costs = 250,000 × $3 × (1 - 0.30)
= $525,000
However, option 1 involves an annual after-tax fixed costs of $140,000 (= $200,000 × (1
- 0.70)) and a depreciation tax saving of $45,000 (=$1,500,000/10 × 0.30).
Thus, net after-tax cost savings = $525,000 + $45,000 - $140,000 = $430,000.
Present value (10 years, 12%) of cost savings = $430,000 × 5.650 = $2,429,500 where
we obtain the factor from Table 3 in Appendix B.
Initial outlay = $1,500,000
Net incremental saving from option 1 = $2,429,500 - $1,500,000 = $929,500.
Therefore, Simco Blenders should go with Option 1.

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11.59
The minimum price should ensure that the net present value of the investment does not
become negative. Since the initial outlay is $22,250,000, it must be the case that

Annual after-tax cash inflow × Annuity factor (15 years, 12%) ≥ 22,250,000

Using Excel to calculate the annuity factor (or the formula on top of Table 3 in Appendix
B), we have

Annual after-tax cash inflow × 6.811 ≥ 22,250,000, or

Annual after-tax cash inflow ≥ $3,266,774 (rounded).

Now,

Annual after-tax cash inflow

= Annual after-tax operating cash inflow + Tax saving from depreciation
= [(Price – 85) × 80,000 – 400,000] × (1 - 0.25) + ($ 1,483,333 × 0.25)

(Note: Depreciation = $22,250,000/15 = $1,483,333 (rounded)).

Thus, the price per unit of the product must be such that

( [(Price-85)X 80,000-400,000] X (1-.25) )+ (1,483,333 X.25) > = 3,266,774;

Then, the following is some algebraic simplification

step 1 ((80,000 X-6,800,000-400,000)*.75) + (370,833.25) >= 3,266,774
step 2 ((80,000 X-7,200,000)*.75) + (370,833.25) >= 3,266,774
step 3 ((60,000 X-5,400,000) + (370,833.25) >= 3,266,774
step 4 60,000 X-5,026,166.75 >= 3,266,774
step 5 60,000 X >= 8,295,940.75

Or, Price ≥ $139 (rounded to the next dollar) per unit.

11.60
a.
Proposal 1
The following table presents the net present value calculations for Proposal 1.
Initial investment = $8,750,000, Life 5 years, Discount rate 10 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($8,750,000)

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Year 1 $3,750,000 0.909 $3,408,750 $ 3,408,750

Year 2 $4,250,000 0.826 $3,510,500 $ 6,919,250
Year 3 $2,000,000 0.751 $1,502,000 $ 8,421,250
Year 4 $700,000 0.683 $ 478,100 $ 8,899,350
Year 5 $250,000 0.621 $ 155,250 $ 9,054,600
Net present value ($9,054,600 - $8,750,000) $304,600

Proposal 2
The following table presents the net present value calculations for Proposal 2.
Initial investment = $8,750,000, Life 5 years, Discount rate 10 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($8,750,000)
Year 1 750,000 0.909 $ 681,750 $ 681,750
Year 2 1,000,000 0.826 $ 826,000 $ 1,507,750
Year 3 3,250,000 0.751 $2,440,750 $ 3,948,500
Year 4 3,875,000 0.683 $2,646,625 $ 6,595,125
Year 5 4,250,000 0.621 $2,639,250 $ 9,234,375
Net present value ($9,234,375 - $8,750,000) $484,375

Therefore, the NPV method ranks Proposal 2 higher than Proposal 1.

b.
Payback period for Proposal 1 is somewhere between 2 and 3 years, because the undis-
counted cash flows at the end of first 3 years total $10,000,000 ($3,750,000 + $4,250,000
+ $2,000,000), but the undiscounted cash flows at the end of 2 years only amount to
$8,000,000 ($3,750,000 + $4,250,000).
In contrast, the payback period for Proposal 2 is almost 4 years because the undiscounted
cash flows at the end of 4 years total $8,875,000 ( = $750,000 + $1,000,000 +
$3,250,000 + $3,875,000), but the undiscounted cash flows at the end of 3 years only
amount to $5,000,000 ( = $750,000 + $1,000,000 + $3,250,000).
Therefore, the payback period method will rank Proposal 1 higher than Proposal 2.
c.
Notice that in Proposal 2, the bulk of the cash inflows occur in later years relative to Pro-
posal 1. Thus, it will take longer for Proposal 2 to pay back. The payback method simply
ignores the magnitude of cash flows that come in after the investment is “paid back.”
Indeed, the cash flows that occur in later years for Proposal 2 are much larger in magni-
tude, and thus their present values are much higher than Proposal 2, making Proposal 2
attractive from a net present value perspective.

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11.61
a.
Project 1
The following table presents the net present value calculations for Project 1.
Initial investment = $6,750,000, Life 5 years, Discount rate 10 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($6,750,000)
Year 1 $2,000,000 0.909 $1,818,000 $ 1,818,000
Year 2 $2,000,000 0.826 $1,652,000 $ 3,470,000
Year 3 $2,000,000 0.751 $1,502,000 $ 4,972,000
Year 4 $1,400,000 0.683 $ 956,200 $ 5,928,200
Year 5 $1,400,000 0.621 $ 869,400 $ 6,797,600
Net present value ($6,797,600 - $6,750,000) $47,600
Project 2
The following table presents the net present value calculations for Project 2.
Initial investment = $6,750,000, Life 5 years, Discount rate 10 percent
After-tax Present
Net Cash value Present Cumulative
Year Flow factor Value Present Value
Year 0 Initial investment ($6,750,000)
Year 1 2,500,000 0.909 $2,272,500 $ 2,272,500
Year 2 2,500,000 0.826 $2,065,000 $ 4,337,500
Year 3 2,500,000 0.751 $1,877,500 $ 6,215,000
Year 4 800,000 0.683 $ 546,400 $ 6,761,400
Year 5 800,000 0.621 $ 496,800 $ 7,258,200
Net present value ($7,258,200 - $6,750,000) $508,200
Therefore, the NPV method ranks Project 2 higher than Project 1.

b.
Payback period for Project 1 is somewhere between 3 and 4 years, because the undis-
counted cash flows at the end of first 3 years total $7,400,000 ( = $2,000,000 +
$2,000,000+ $2,000,000+$1,400,000), but the undiscounted cash flows at the end of 3
years amount to only $6,000,000 ( = $2,000,000+$2,000,000+$2,000,000).
In contrast, the payback period for Project 2 is somewhere between 2 and 3 years because
the undiscounted cash flows at the end of 3 years total $7,500,000 (= $2,500,000 +
$2,500,000 + $2,500,000), but the undiscounted cash flows at the end of 2 years amount
to only $5,000,000 (= $2,500,000 + $2,500,000).
Therefore, the payback period method will rank Project 2 higher than Project 1.

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c.
We can determine modified payback periods from the present value tables presented for
the two projects in part (a) of this problem.
In particular, the modified payback period is almost 5 years for project 1 because the cu-
mulative present value of cash inflows exceeds the initial investment of $6,750,000 only
in the 5th year.
In contrast, the modified payback period is 4 years for project 2 because the cumulative
present value of cash inflows exceeds the initial investment of $6,750,000 at the end of
the 4th year.
Again, the modified payback method ranks Project 2 higher than Project 1.
Mini-Cases
11.62
a. From the standpoint of building the new barn, the incremental cash flows are…

Year 0 Year 1 Year 2 Year 3

Sale of new barn $3,500
Repair savings net of tax $7,000
Depreciation tax savings $12,000 $12,000 $12,000
After-tax operating cost savings $49,000 $49,000 $49,000
Sale of old barn $49,500

Purchase new barn ($180,000)

Loss of salvage on old barn ($2,100)
Total ($130,500) $68,000 $61,000 $62,400
$49,500= $45,000 from the sale of the old barn + 0.30 * tax loss of $15,000. Note that book
value of the old barn is $60,000 and the sale proceeds are $45,000 only; $3,500 = $5,000 *
(1-0.3); $7,000 = $10,000 * (1-0.3).

b.
We have:

Year Cash Flow PV Factor NPV

0 ($130,500) 1 ($130,500)
1 68,000 .909 61,812
2 61,000 .826 50,386
3 62,400 .751 46,862
NPV $28,560

c.
So, Yes…invest in the new barn.

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11.63
a.
First, it is worthwhile making a few overall observations about the two options. It is
clear that in industries such as the one analyzed in this problem, technological ad-
vances shorten product life cycles. Martha has no option but to embrace the new
product eventually. The only real decision is one of timing. If Martha’s makes the de-
cision to invest in the new product immediately, she risks losing the opportunity of
squeezing some returns from the old product. This is option 1.
If, on the other hand, she decides to introduce the new product a year later, she can
better recoup some of the returns from the old product, but then she risks losing mar-
ket share on the new product to competition. This is option 2.
The following table presents the present value calculations corresponding to option 1.
Initial outlay at the end of 2013 to make
C300G $15,000,000
Cash flows Cash flows Total cash Net after-tax PV factor Cumulative
Year C300G C200H flow cash flowa (14%) PV present value
2013 $10,000,000 $2,200,000 $12,200,000 $10,340,000 0.877 $9,068,180 $9,068,180
2014 $6,000,000 $850,000 $6,850,000 $6,595,000 0.769 $5,071,555 $14,139,735
2015 $4,000,000 $250,000 $4,250,000 $4,775,000 0.675 $3,223,125 $17,362,860
2016 $2,000,000 0 $2,000,000 $2,525,000 0.592 $1,494,800 $18,857,660
Outlay at the end of 2008 ($15,000,000)
Net present value $3,857,660
a
After-tax cash flow = Total cash flows × (1-tax rate) + Depreciation × tax rate (new investment) + Depreciation ×
tax rate (old investment). Depreciation of new investment = $15,000,000/4 = $3,750,000. Depreciation of old in-
vestment = $9,000,000/4 = $2,250,000. The old investment will be fully depreciated by 2011. Consequently, net
after-tax cash flows will not include the depreciation tax saving from the old investment. Tax rate is 30%.
The following table presents the present value calculations corresponding to option 2.
Initial outlay at the end of 2014 to make C300G $15,000,000
Cash flow Cash flow Total cash Net after-tax PV factor Cumulative
Year C300G C200H flow Cash flowa (14%) PV present value
2013 0 $6,500,000 $6,500,000 $5,225,000 0.877 $4,582,325 $4,582,325
2014 $6,000,000 $500,000 $8,500,000 $7,750,000 0.769 $5,959,750 $10,542,075
2015 $4,500,000 $150,000 $5,150,000 $5,405,000 0.675 $3,648,375 $14,190,450
2016 $2,000,000 0 $2,000,000 $2,525,000 0.592 $1,494,800 $15,685,250
2017 $1,000,000 0 $1,000,000 $1,825,000 0.519 $947,175 $16,632,425
Outlay at the end of 2014 ($15,000,000) 0.877 ($13,155,000) ($13,155,000)
Net present value $3,477,425
a
After-tax cash flow = Total cash flow × (1-tax rate) + Depreciation × tax rate (new investment) + Depreciation ×
tax rate (old investment). Depreciation of new investment = $15,000,000/4 = $3,750,000. Depreciation of old in-
vestment = $9,000,000/4 = $2,250,000. For 2014, notice that we do not have any depreciation from the new in-
vestment. Thus, we have $5,225,000 = $6,500,000*(1-0.3)+0.3*$2,250,000. Likewise, the old investment will be
fully depreciated by 2016. Consequently, net after-tax cash flow will not include the depreciation tax saving from
the old investment. Tax rate is 30%.

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Thus, the first option has a higher net present value and should be preferred. Thus,
this problem highlights the importance of timing of new investment. Hasty decisions
can be costly sometimes.
It is also worth noting that the second option spans a longer horizon that the first op-
tion because we include expected cash flow from 2017 as well under this option. Un-
der the first option, both the new and the old investment will be fully depreciated by
the end of 2016.
b.
There are a few issues to consider. First, Martha may wish to consider disposing of
the old machines once the new investment is in place. This way, the organization can
focus on marketing one product instead of having to allocate some resources to the
old product as well. In this case, selling the old machines ahead of its full life will re-
sult in some cash inflow in the form of salvage value. The present value of these cash
inflow must be considered.
On the other hand, having multiple products at different price points may be benefi-
cial as customers would then have a choice. One option is to reduce the price on
C200H, and market both products. In this case, the expected cash flows are likely to
change.

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 CHAPTER 12
Performance Evaluation in Decentralized Organizations
Solutions

REVIEW QUESTIONS
12.1 Firms decentralize because, as organizations grow, the number and types of decisions that
need to be made increase substantially. A single individual will not have the relevant ex-
pertise and knowledge to make all of these decisions – thus, firms delegate decision-
making responsibility.
12.2 The benefits include (1) timely decisions, (2) tailoring managerial skills and specializa-
tions to job requirements, (3) empowering employees, and (4) training future managers.
The costs include (1) an emphasis on local versus global goals; (2) requires coordination
of decisions; and (3) can lead to improper decisions because of a divergence between in-
dividual and organizational goals.
12.3 (1) Cost centers, (2) Profit centers, and (3) Investment centers.
12.4 Minimize the cost of producing a specified level of output or service.
12.5 Both minimize costs and maximize revenues. That is, maximize profit.
12.6 Maximize the returns from invested capital, or to put the capital invested by owners and
shareholders of the organizations to the most profitable uses.
12.7 Controllability and informativeness.
12.8 An ideal performance measure (1) aligns employee and organizational goals, (2) yields
maximum information about the decision or actions of the individual or organizational
unit, (3) is easy to measure, and (4) is easy to understand and communicate.
12.9 In the short-term, via budget variances. In the long-term, by techniques such as bench-
marking and kaizen.
12.10 Kaizen is a philosophy of continuous improvement.
12.11 By budget variances and comparing actual profit with past profit and industry profit. Or-
ganizations also use revenue-oriented measures such as customer satisfaction and market
share. Additional cost-oriented measures might focus on employee turnover or process
improvements.
12.12 ROI = return on investment = profit divided by investment. ROI is an effective summary
of business profitability – it controls for size by expressing the return per investment dol-
lar. Consequently, it is easy to compare the performance of investment centers of differ-
ent size. We also can decompose ROI into smaller pieces, allowing managers to see how
individual actions map into overall profitability. The major criticism of ROI is that it can
foster underinvestment. For example, if current ROI is 20%, a manager may not invest in
a project with an ROI of 18% even though the firm’s cost of capital is 15%. It also favors
divisions with older assets.

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12-2

12.13 Residual income = Profit – (required return * Investment). Residual income represents
the additional profit or value generated by an investment after meeting the required rate
of return. Economic value added is a modified calculation of residual income – it uses a
weighted average cost of capital and adjusts for the operating and capital costs of a busi-
ness, including taxes.
12.14 Because multiple divisions often deal with each other in the normal course of business,
diverting a portion of their resources from external business to serve internal needs.
12.15 (1) Cost-based transfer prices, (2) market-based transfer prices, and (3) negotiated trans-
fer prices. Market based prices do best in evaluating opportunity costs and in preserving
arms-length transactions. But, the market may not exist. Negotiated transfer prices truly
respect autonomy but might be time consuming and tedious. Cost-based prices can be
used under all situations but defining what is the right cost and the right markup to use
can lead to many disputes.

DISCUSSION QUESTIONS
12.16 The phase “co-locates knowledge and decision rights” means giving the decision making
authority to individuals in the organization that have the requisite knowledge and infor-
mation to make the right decision. For example, decisions regarding material purchases in
a manufacturing company such as when to purchase, how much to purchase, and which
suppliers to purchase from is best left to individuals dealing with the purchase function
routinely. Similarly, sales promotion decisions are best made by marketing personnel
who have the knowledge of market conditions and consumer behavior. Decentralization
of decision making is not always beneficial because it might to lead decision makers at
lower levels to choose actions that are in their best interests and not necessarily in the
best interests of the firm. It also requires considerable coordination across all levels in the
organization to ensure that all decisions are properly coordinated.
12.17 Parents often take the responsibility for cooking and cleaning, and children may be asked
to take out the trash and mow the lawn. Parents may not need much incentive to do their
tasks because it is after all their house. But, children likely find taking out the trash and
mowing the lawn to be boring and, thus, a small monetary reward and some monitoring
may do the trick.
12.18 Yes. Decentralization promotes “local” maximization and not “global” maximization.
Each divisional manager is interested in casting his/her own performance in the best pos-
sible light relative to other divisional managers. As long as divisional profit is used to
evaluate performance, each divisional manager has a natural incentive to find ways in
which to increase his/her own divisional profit even if the chosen ways might hurt other
divisions.
12.19 Both the U.S. Army and the University of Texas are not-for-profit organizations. The
U.S. Army’s objective is to defend the country and its borders. As we all know, discipline
and preparedness are extremely important for the Army. So it has a well established chain
of command and decision structure. The Army does not use bonuses and monetary re-
wards to motivate its employees. Rather, monitoring mechanisms are used and rules are
rigidly enforced. The University of Texas’ mission is to impart education. The employees

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of the University are civilians. Military regimen does not work. Rather, salary structure
and monetary incentives are very much necessary to attract good faculty. Decision mak-
ing is highly decentralized. Each branch of education is managed by a dean and her asso-
ciates. The deans report to the President/Chancellor of the University. Being a state
school, its actions and decisions have to conform to the state legislature’s policies and
tenets. Any deviations can affect its access to state resources.
12.20 As we learned in the chapter, a controllable performance measure reflects the conse-
quences of the actions taken by the decision maker. We should hold a production manag-
er accountable for production delays but not for the overall volume of production, which
is driven by market demands. Marketing managers have the authority to change prices
and offer promotions that affect actual sales, which determine the required production.
Production managers, therefore, have little control over the volume of production. It is
not reasonable to hold them accountable for someone else’s decisions or random market
conditions.

(Advanced) Determining controllability precisely may be difficult in practice. For exam-

ple, if the production manager’s quality choices affect the volume of production, the
measure is informative.

A performance measure is informative if it provides information about a manager’s ef-

fort, even if the manager does not have control over it. Most controllable measures are in-
formative. For example, students control their performance on a quiz, and their score is
informative about their grasp of the subject matter. However, the student has little control
over how the rest of the class performs. Yet, the overall class performance is useful in-
formation in evaluating each individual student’s performance because it tells us how
hard the quiz is.
Similarly, if a firm incurs losses when other firms in the industry are highly profitable,
we may attribute those losses to poor managerial performance. However, if other firms in
the industry are doing even worse, then the firm’s management may actually be doing a
terrific job of dealing with adverse business conditions. Thus, evaluating a firm relative
to other firms in the industry, or relative performance evaluation, is useful, even though
the firm’s managers may have little control over how other firms do.
12.21 The problem with this argument is that each manager cannot control the actions of the
other managers, and the impact of their actions on the firm’s profit. Thus, it is possible
that even though the division is doing extremely well, its manager may not receive com-
mensurate reward if the firm as a whole is not doing well because of the actions of other
managers.
12.22 Variance analysis is useful for both profit centers and cost centers. As we learned in
Chapter 8, the overall variance of actual performance from budgeted performance can be
split into sales volume variance and flexible budget variance. Sales volume variances
point to the impact on profit of the difference between budgeted sales volume and actual
sales volume. It is useful in evaluating profit centers. Flexible budget variances are useful
in analyzing the reasons for deviation of actual performance from expected performance
at the actual volume. Flexible budget variances are useful for evaluating both profit cen-
ters and cost centers.

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12.23 When the net book value is used to measure investment, the asset’s age becomes a factor.
As the asset becomes older, the accumulated depreciation increases and the net book val-
ue decreases. Consequently, ROI often is higher for older assets. As a result, managers
may have less of an incentive to undertake timely asset replacement decisions.
12.24 Consider the following example. Division A has an income of $10,000 on an investment
of $100,000. Division B has an income of $100,000 on an investment of $1,000,000. As-
sume that the require rate of return is 8%.
The ROI for both the divisions is 10%. But the residual income for Division A is $2,000
(=$10,000 – (8% × $100,000)), and the residual income for Division B is $20,000
(=$100,000 – (8% × $1,000,000)). Why? This is because the residual income is sensitive
to project size. All else equal, larger investments will have higher residual incomes.
12.25 Yes, both ROI and RI are short-term performance measures. ROI is widely used because
it is easy to compute and is well understood. As we learned in the chapter, ROI can be
conveniently decomposed into profitability and asset turnover ratios. By evaluating the
trends in these ratios, one can make reasonable assessments of the firm’s future. Also,
ROI is but one of several measures that analysts and outsiders employ to evaluate the
firm’s performance and its future potential.
12.26 When the supplying division is fully utilized, any transfer to the buying division is divert-
ing capacity away from profitable uses. Unless the firm can earn a great profit by divert-
ing capacity, it does not make sense to transfer. In a decentralized environment in which
both the buying and selling divisions are acting as profit centers, the transfer price must
compensate the selling division for lost profit. The buying division will be willing to do
so only if it is still able to make a profit for itself. In this case, the company as a whole is
better off because the selling division’s capacity will have been put to the most profitable
use.
12.27 In such instances, there is a natural incentive for the firm’s management to provide busi-
ness to its subsidiaries even if the same services can be obtained from other sources for
lower prices and at better quality.
12.28 Intellectual property is inherently difficult to price. It is very much unlike a typical prod-
uct which has a certain definite determinable life, and whose cost of production is deter-
minable to a fair degree of accuracy. On the other hand, the life of intellectual property is
difficult to estimate. Sometimes new technologies emerge suddenly rendering the intel-
lectual property totally worthless immediately. On the other hand, some intellectual prop-
erty has indefinite lives. Another problem is that the dissemination of intellectual proper-
ty is not easily controllable. The acute problem of piracy in the software industry is a
good example.
12.29 In such instances, most companies use some form of cost-based transfer prices i.e., varia-
ble cost plus some margin, or full cost plus some margin. However, these transfer pricing
schemes are arbitrary at best. When the supplying division has no ready market for its
product, it may be best to not view the supplying division as a profit center because it re-
ally has no discretion over its revenue sources. Rather, it is better to structure the division
as a cost center from a performance evaluation perspective.

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12.30 It is not advisable for the head office to interfere in transfer-pricing disputes because it
would compromise the very purpose of decentralization. This said, however, if disputes
take time, then some resolution mechanism would be necessary so that the company as a
whole does not lose.

EXERCISES
12.31
a.
We believe that Karl should be evaluated as a cost center. While he provides a useful and visible
service, there is no direct impact on revenue. Further, he does not influence prices or determine
the level of output. His job is to keep up the buildings to specified quality levels within allowed
costs. This is a central characteristic of a cost center.

b.
The university should use a mix of financial and non-financial measures. Relying on financial
measures alone is not advisable because Karl can always postpone maintenance to come in be-
low budgeted expenditures. However, we do need to make sure that the budget is not over-spent
by a lot. Non-financial measures such as time to respond to complaints and a general score on
upkeep seem useful as a way to ensure that Karl is providing the desired service quality.

12.32
a.
We believe that the branches should be evaluated as profit centers. At first blush, it appears that
the branches should be cost centers because branch managers do not decide on product choices
or prices. However, branch managers do influence volume – the other determinant of revenue.
They influence volume via the general atmosphere in the cantina, speed of service, cleanliness,
and so on. Evaluation as a profit center would sensitize branch managers to the revenue implica-
tion of their actions.

b.
From a financial perspective, Gordon should focus on budgeted and actual profit. He also
would be wise to pay attention to budget-actual comparisons of key cost items such as labor,
electricity, and so on. Unless he is using a transfer pricing scheme to charge branches for food
used, tracking spoilage seems useful. We also recommend that Gordon monitor key non-
financial metrics such as time to serve, table availability and so on. Indeed, because of the
many factors that affect success, it may be wise for Gordon to spend ½ a day to a full day per
week at different branches just monitoring what is going on.

12.33
The following table provides the required classification, along with a brief justification.

Marketing Profit Center. It would appear that marketing should be evaluated based on reve-
nues alone as it does not control costs. However, the firm makes substantive com-
mitments based on marketing forecasts and, in this way, marketing influences
costs. Plus, few units only have revenues and no costs. Key performance measures

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include budget-actual comparisons of profit, as well as non-financial measures

such as customer satisfaction and market share.

Plant Cost center. This unit’s primary job is to respond to marketing’s forecasts (i.e.,
they do not control quantity or price) and to make the product at the budgeted cost
or lower (subject to quality and other standards). This is an engineered cost center
because we can reasonably relate output to expected cost. Key performance
measures include budget-actual comparisons of cost, as well as non-financial
measures such as average outgoing quality and delivery reliability.

Planning Cost center. This unit has no revenue responsibility or influence over it. Further,
there is no direct link between their output (plans) and costs. Thus, this function
would be a discretionary cost center. Key performance measures must be subjec-
tive.

Maintenance Cost center. This unit has no revenue responsibility or influence over it. Some por-
tion of their operations are discretionary (e.g., general upkeep, planned overhauls),
while others relate to work done (e.g., machine hours run determine the mainte-
nance needed.) Overall, we believe that the engineered portion will dominate the
operations, and we lean toward evaluating the unit as an engineered cost center.
However, we need to make sure the budget has both a fixed (for discretionary) and
variable (for the output driven) portion to reflect the mixed nature of the opera-
tions. Key performance measures include budget-actual comparisons of cost, as
well as non-financial measures such as uptime and time to respond to complaints.

Purchasing Cost center. This unit has no revenue responsibility or influence over it. It is diffi-
cult to determine a good measure of output because measures such as purchase or-
ders, purchase order lines, and number of new items are deficient in measuring the
multi-faceted nature of operations. Thus, we lean toward evaluating this unit as a
discretionary cost center. Key performance measures include purchase price var-
iances, as well as non-financial measures such as stock outs, new vendor develop-
ment, and so on.

12.34
The strategic performance group should be evaluated as a discretionary cost center. There is no
clear identification of their output and the relation between their output and input is unclear. This
group exists because management believes that it is worth spending money on the help regarding
strategy formulation and implementation. The group’s performance has to be measured subjec-
tively. At a less critical level, some cost comparison relative to budget is also appropriate.

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12.35
a.
There are both positive and negative aspects of performance. On the one hand, overall vol-
ume and revenue are significantly above target. However, the average revenue per frame is down
from $120 ($9.6 million/80,000 frames) to $110 ($11 million/100,000 frames). This reduction is
bothersome in light of the division’s strategy to sell high-quality products for premium prices.

b.
Again, there are both positive and negative aspects of performance. Here, while the overall
margin is positive ($130 per frame = $9.1 million / 70,000 frames), the volume is down nearly
10%. Both situations are cause for concern. Additional data on market size and share would be
useful. It also might be prudent to revisit the forecasting process because such large swings
should be the exception and not the norm.

Note: You can also relate this analysis to the sales volume and price variances discussed in
Chapter 8. Note that we cannot compute a volume variance exactly because we do not know the
variable cost per frame.

12.36
The data pertain to an engineered cost center. That is, volume affects total cost. We need to con-
struct a flexible budget and perform cost variance analysis. We have:

Flexible
Budget Actual
budget*
Production volume (units) 175,000 200,000 200,000
Total variable costs $7,875,000 $9,000,000 $9,450,000
Total fixed costs 1,200,000 1,200,000 $1,350,000
* As we know from Chapter 8, the flexible budget adjusts costs for the actual volume of operations. Thus, we
have ($7,875,000/175,000) × 200,000 = $9,000,000. Fixed costs do not change.

After adjusting for volume, the efficiency variance is $450,000 U and the fixed cost spending
variance is $150,000 U. While some of the cost over-runs might be legitimately attributed to the
higher volume (e.g., poorer quality materials, more supervisors hired etc), the increase is signifi-
cant and warrants investigation. Overall, the data reflect cause for concern.

12.37
a.
The data pertain to an engineered cost center. That is, volume affects total cost. That is, we need
to construct a flexible budget and perform cost variance analysis. We have:

Flexible
Budget Actual
budget
Production volume (units) 200,000 150,000 150,000
Total variable costs $9,200,000 $6,900,000 $6,875,000
Total fixed costs 1,300,000 1,300,000 $1,315,000

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* As we know from Chapter 8, the flexible budget adjusts costs for the actual volume of operations. Thus, we
have ($9,200,000/200,000) × 150,000 = $6,900,000. Fixed costs do not change.

After adjusting for volume, the efficiency variance is $25,000 F and the fixed cost spending vari-
ance is $15,000 U. While we would not be concerned about either variance (i.e., the production
department seems to have done a fine job), we would be very concerned about the substantial
reduction in volume. The lower volume would be the primary focus of our investigation. Overall,
the data reflect cause for concern even though the variances (from the production department’s
perspective) are negligible.

b.
The cost data, taken alone, seem to show that the production department did a very good job dur-
ing the year. After adjusting for costs associated with the breakdown, the production department
has substantially favorable ($25,000 F + $120,000 = $145,000 in variable and $15,000 U -
$75,000 = $60,000 F in fixed) variances. However, we have to ask: Why did the machine break-
down? With proper maintenance, such a disaster should not occur. The firm must have lost con-
siderable money from lost sales. Unless an investigation shows that the breakdown is due to una-
voidable and unexpected causes, we might be inclined to blame the production manager. Overall,
the manager’s job is to run the plan efficiently (as per variances) and effectively (get full use out
of the resources.) At higher levels, effectiveness measures are perhaps more informative than
measures of efficiency.

12.38
a.
An alternate view of Greg’s performance might be that he focuses on short-term results at the
expense of long-term performance. Examples include channel stuffing (i.e., recognizing profit
on units pushed out to dealers even if they cannot be sure of selling them), sacrificing quality,
training and maintenance, and not investing in future products. Such actions might produce im-
mediate gains but lead to ruin in the long run. Effective managers consider both the short- and
long-term effects of their decisions.

b.
Non-financial measures might be a good way to constrain managers who seek to short-change
the future. Periodic measurements of key process measures such as quality, machine up time, and
customer satisfaction can help ensure that managers are investing in the drivers of future value in
addition to taking care of current quarter results.

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12.39
The following table provides the required computations.

Operating Required rate

Investment ROI RI
income of return
12.5% ($27,000)
1 $225,000 $1,800,000 14%
(see 1.1) (see 1.2)
$250,000 $50,000
2 $2,500,000 10% 8%
(see 2.1) (see 2.2)
$5,000,000 7.5%
3 $500,000 10% $125,000
(see 3.1) (see 3.2)
12.5% 14.0%
4 $150,000 $1,200,000 ($18,000)
(see 4.1) (see 4.2)
Detail of computation:
1.1 $225,000/$1,800,000 = 12.5% 1.2 $225,000 - (0.14 × $1,800,000) = ($27,000)
2.1 $2,500,000 × 0.10 = $250,000 2.2 $250,000 -($2,500,000×0.08) = $50,000
3.1 $500,000/0.1 = $5,000,000 3.2 $500,000 – ($5,000,000 × X) = $125,000
4.1 $150,000 / 1,200,000 = 12.5% 4.2 $150,000 – ($1,200,000 × X) = ($18,000)

12.40
a.
We have:

Residual income (Div A): $3,750,000 – (0.1 × $31,250,000) = $625,000

Residual income (Div B): $1,100,000 – (0.1 × $5,500,000) = $550,000.

Division A is higher ranked.

b.
Repeating the exercise, we have:

Residual income (Div A): $3,750,000 – (0.14 × $31,250,000) = ($625,000)

Residual income (Div B): $1,100,000 – (0.14 × $5,500,000) = $330,000

Division B is higher ranked.

c.
This problem shows that residual income is subject to a size effect. Notice that Division A’s ROI
is 12% and the ROI for Division B is 20%. When we use a 10% required rate, the size for divi-
sion A propels its RI above that for division B. However, like leverage, the size also rapidly re-
duces RI when we increase the rate to 14%. Thus, RI is not a good way to compare divisions that
differ greatly on size.

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12.41
a.
We have:

Residual income (Eastern): $3,000,000 – 0.1 × $24,000,000 = $600,000

Residual income (Western): $780,000 – 0.1 × $3,900,000 = $390,000.

The Eastern division has the higher residual income.

b.
We have:

Return on Investment (Eastern): $3,000,000 / $24,000,000 = 12.5%

Return on Investment (Western): $780,000 / $3,900,000 = 20%.

The Western division has the higher ROI.

c.
This problem shows that residual income is subject to a size effect but ROI is not. In part A, the
larger size for the Eastern Division (which is more than 6 times that of the Western Division)
overcomes its lower profitability, as measured by ROI. Thus, RI is not a good way to compare
divisions that differ greatly on size.

12.42
a.
Ge’s current income is 26% * $300,000 = $78,000. With the project, her income therefore in-
creases to $83,000 = $78,000 + $5,000, and her average assets to$350,000. Her updated ROI is
therefore $83,000 / $350,000 = 23.71%.

b.
Ge would be reluctant to invest in the project because it brings down ROI for the year. Even
though it might be profitable in the long-run, it might have adverse consequences on her perfor-
mance evaluation for this year.

12.43
a.
From a long-run perspective, Premium should not invest Project A because its return is lower
than the firm’s cost of capital. Project B, on the other hand, is a good investment.

b.
If evaluated solely based on profit, the managers will likely invest in both projects. The over-
investment in project A takes place because the managers do not incur the cost of capital but re-
ceive the benefits.

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c.
If evaluated based on ROI, the managers will consider the ROI after the project. Their current
RO is 25% = $250,000 / $1,000,000. Both projects have a lower ROI (12 and 18% respectively),
meaning that the blended ROI (after the project) will be lower than 25%. Thus, the project nega-
tively affects their performance metric. The managers will likely not invest in the project.

12.44
a.
Let us begin by calculating Julia’s current profit. It is 30% * $ 300,000 = $90,000. The ROI af-
ter the investment is ($90,000 + $8000)/ $350,000 = 28%. .

b.
The residual income from the project (For year 1) is: $8,000 – 0.15 * 5,000 = $500.

c.
Thus, adding the project lowers current period ROI, making the project unattractive from
Julia’s viewpoint. However, investing in the project increases residual income, motivating Julia
to accept the project

d.
Even with RI as a performance measure, the project also becomes unattractive. The change
in residual income is ($7,500) = $0 – 0.15* $50,000. This observation illustrates that RI does not
remove all of the incentives to under-invest. The pattern of cash flows still matters.

12.45
a.
Esparanza’s current ROI (without the project) is $225,000 / $900,000 = 25%. Thus, she expects
to earn a bonus of $20,000 = (-.25- 023) * $10,000.

b.
The NPV of the project is approximately $13,437 = -90,000 + 8,000/1.15+ 10,000/(1.15)^2 +
136,000/(1.15)^3. This is obviously a profitable project.

c.
If Esparanza invests in the project, the following is her ROI over the next three years:

Net asset Net asset Total Profit (cur-

value (on value (pro- net as- rent + from
Year going ject) sets project) ROI
1 900000 75000 975000 233,000 22.9%
2 900000 45000 945000 235,000 24.9%
3 900000 15000 915000 361,000 39.5%
Note that this assets in year 1 (from the project) is $75,000 = ($90,000 + $60,000)/3; the decline
of $30,000 is the depreciation in asset value.

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d.
If Esparanza is planning to leave in two years, she likely will not invest in the project as doing so
reduces his bonus for the next two years. Indeed, she makes zero bonus this year because the
projected ROI of 22.9% is below the target of 23%.

A longer time horizon makes the answer ambiguous. The project greatly helps Esperanza in year
3 as her bonus increases by $145,000 (relative to reporting an ROI of 25%, as she would without
the project). Depending on her time value of money, it is likely that she will invest in the project.
A sophisticated answer also might consider the uncertainty in the estimates of cash flows and
Esperanza’s attitude toward risk.

12.46
a.

Revenue 900,000 cans * $1.50 per can $1,350,000

Variable cost 450,000
Contribution 900,000
Fixed cost 1,080,000
Profit (180,000)

b.
Full cost is $1,530,000 / 90,000 = $1.7. Thus, the transfer price is $1.7 * 1.1 = $1.87.

Revenue 900,000 cans * $1.50 per can $1,683,000

Variable cost 450,000
Contribution 1,233,000
Fixed cost 1,080,000
Profit $150,000

c.
Absent tax implications, there is no impact on the firm’s overall profit. Transfer pricing is
merely a way to apportion the total income among organizational sub-units.

12.47
a.
Full cost is variable cost plus allocated manufacturing cost. Thus, the full cost for this product is
$10 + $(1,500,000/250,000 units) = $16 per unit.

Thailand USA Total

Revenue $6,250,000 $6,250,000
Transfer out $4,000,000
Cost of transfer in $4,000,000
Variable cost $2,500,000 $2,500,000
Fixed cost $1,500,000 -- $1,500,000
Profit 0 $2,250,000 $2,250,000

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Note that the cost of the transfers out and in cancel when we consolidate the two divisional
statements.

b.
With the new data, we have:
Thailand USA Total
Revenue $6,250,000 $6,250,000
Transfer out $5,000,000
Cost of transfer in $5,000,000
Variable cost $2,500,000 $2,500,000
Fixed cost $1,500,000 -- $1,500,000
Profit 1,000,000 $1,250,000 $2,250,000

The change in the transfer price redistributes the profit between the two divisions. How-
ever, it does not change total profit in any way.

c.
On a pre-tax basis, transfer prices only distribute the total profit among divisions. The transfer
price has no effect on total pre-tax profit. This conclusion is not true for after-tax profit be-
cause the different divisions might face different tax rates. Thus, where we recognize profit mat-
ters.

12.48
a.
The variable cost for an engine is Rs. 6,000 + 3,000 + 1,000 = Rs. 10,000. Adding the 20 %
mark-up gives a price of Rs. 12,000 per engine.

b.
The full cost is variable cost plus allocated manufacturing overhead. Thus, the full cost for an
engine is Rs. 10,000 + 2,000 = Rs. 12,000. Adding the 10 % mark up gives a price of Rs. 13,200
per engine.

c.
The problem text indicates that there is a ready market for these engines. Therefore, the market
price of Rs. 18,000 per engine is the appropriate transfer price. This is the only price that
properly reflects the opportunity cost of using up the capacity in the Engines Division. A lower,
cost-based price would artificially depress profit at the Engines Division and raise the profit re-
ported in the Assembly Division.

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12.49
a.
Carols’ variable cost is $108,000 / 18,000 = $6 per meal. This also will be her transfer price.

b.
Carol’s full cost is ($108,000 + $135,000) = $243,000. Thus, at full cost, her transfer price would
be $13.50 per meal.

c.
The market price per meal is given as $12.00. Thus, if she were to transfer at the market price,
Carol records a loss of $1.50 per meal or $27,000 = 18,000 meals * $1.50 per meal.

d.
The cafeteria should charge the department so that they are aware of the costs of the services
they are consuming. Transferring at market price (the preferred choice) allows management to
see the relative monetary value of the cafeteria. Even though it is making a modest loss, man-
agement might decide to keep the cafeteria open for strategic reasons

12.50
a.
If division A is only making 12,000 screens, they have considerable excess capacity of 8,000
screens (=20,000 capacity – 12,000 used). The opportunity cost of this excess capacity is zero.
Thus, their minimum price is just their variable cost of $105 per custom screen.

b.
If Division A is at capacity, they will have to sacrifice making standard screens to make custom
screens. Each standard screen generates a contribution margin of $210 - $90 = $120. This is the
opportunity cost of using capacity to make custom screens. Thus, the minimum transfer price is
$105 + $120 = $225 per custom screen.

c.
In this case, Division A has some (but not enough) excess capacity. Thus, it will have to sacrifice
1,000 standard screens. Thus, the lost contribution is $120 per standard screen × 1,000 =
$120,000, or $120,000/5,000 screens = $24 per custom screen. Adding this opportunity cost to
the variable cost of $105 gives the minimum price of $129 per custom screen.

Note: This exercise illustrates how the opportunity cost of capacity changes as we change the
baseline situation.

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PROBLEMS
12.51
a.
The CRG (Central Research Group) should be evaluated as a profit center, with a target profit
of zero. While it has clearly defined customers and products, the group is not allowed to make a
profit. Charging for the service is good because it sensitizes line managers to the idea that these
services are costly. However, pricing at cost encourages use (which might save the firm more
money in the long run). The downside to this approach is that there is no built-in incentive for
the group to save costs or become more efficient. We can easily see the group’s budget growing
each year, with the result that the users wind up paying a great deal for this service (they have no
other option).

b.
In addition to financial measures, it would be worthwhile to benchmark the cost (price per
hour) with independent consultants. Further, there should be periodic surveys of customer satis-
faction and quality. Indeed, we advocate for the division managers to have control over
whether and how much to use the CRG. Notice that the CRG has a built-in cost advantage
both because it does not charge a profit markup and because it will always have greater institu-
tional knowledge relative to outside consultants. If the divisions still prefer to use outside con-
sultants, the corporate office would get a strong indication that something is seriously wrong.

12.52
a.
Let us begin by constructing a flexible budget and calculating variances.
Flexible Variance
Budget Actual
budget
Production volume (units) 40,000 45,000 45,000
Revenues $8,000,000 $9,000,000 $8,550,000 ($450,000)
Variable production costs $4,000,000 $4,500,000 $4,050,000 $450,000
Total fixed production costs 800,000 $800,000 $780,000 $20,000
Variable marketing and cus- 400,000 $450,000 640,000 ($190,000)
tomer care costs
Fixed marketing and custom- 250,000 $250,000 450,000 ($200,000)
er care costs
Profit before taxes $2,550,000 $3,000,000 2,630,000 ($370,000)

The variances, taken alone, show that the production manager did a very nice job. The de-
partment saved 5% relative to the variable cost in the flexible budget and was below the budget
for fixed costs as well. The marketing department, however, seems to have dropped the ball.
They had to cut prices even though they incurred substantially more marketing costs than budg-
eted. The loss from marketing more than wiped out the gain from production.

b.
It is certainly possible that marketing has a legitimate case. The lower cost for production
might have resulted for using lower quality materials or rushing the product through. These items
translate to more difficult to sell items, as well as higher warranty expenses. We would have to

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look at the line item variances (i.e., variances for individual expense categories) to determine if
there was substance to the allegations.

c.
This problem might have arisen because the firm focused purely on financial measures. Us-
ing non-financial metrics such as average outgoing quality might help prevent such problems in
the future. Some firms evaluate their production departments as profit centers (using a transfer
price to value output and passing through costs related to quality) to sensitize production manag-
ers to the market consequences of their decisions.

12.53

This problem highlights the deficiencies in the traditional classification of cost and profit
centers. Clearly, Sarah is not a cost center as she generates considerable revenues. Virtually all
of the money she expends on her labs are grant funds, and the University has only a record keep-
ing role. Indeed, the University collects a “profit” if the overhead charge is more than the direct
costs of grant administration. Further, Sarah generates revenue via her clinical service. There,
she does not control price, but surely influences the quantity of patients he sees.

Sarah also is not a profit center. Making profit is not the reason the University employs Sarah,
and it would be sending her the wrong signals (and upsetting its own donors and other constitu-
ents) if it evaluated Sarah as a profit center. Nevertheless, virtually all universities require estab-
lished medial researchers to support their research, and view the overhead recovery as an im-
portant component of their inflow of funds.

In practice, Universities give considerable latitude to people such as Sarah. They are allowed to
run their own show (subject to broad oversight) because they are almost entrepreneurs working
for the University. We suspect that Sarah would be subject to little in the form of formal targets
(e.g., number of patients, research papers or students) but be governed via broad policies that ap-
ply to many people. The job of her boss is to keep such a high-powered, self-motivated individu-
al on track with respect to the University’s goals.

12.54
a.
ROI (travel) = $600,000 / $4,000,000 = 15%
ROI (leather) = $1,200,000 / $6,000,000 = 20%.

b.
Residual income (travel bags) = $600,000 – (0.12 × $4,000,000) = $120,000.
Residual income (leather) = $1,200,000 – (0.12 × $6,000,000) = $480,000.

c.
First, let us calculate the firm’s weighted average cost of capital (WACC). Referring to the for-
mula:

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WACC = [(1 - 0.3) × 0.3× 0.08] + (0.7 × 0.12) = 10.08%.

The first term reflects the tax shield (1 - 0.3), the proportion of debt financing (30%) and the cost
of debt. The second term shows the proportion of equity financing and the cost of equity capital.

Next, we have:

EVA (travel) = ($600,000 × 0.7) – [0.1008 × ($4,000,000-$175,000)] = $34,440.

EVA (leather) = ($1,200,000 × 0.7) – [0.1008 × ($6,000,000 – $800,000)] = $315,840.

Notice that we multiplied the pre-tax income by (1 - tax rate) to determine the after tax operating
income.

d.
As discussed in the text, each of the measures has costs and benefits. ROI is easy to compute and
communicate but can spur poor investment decisions. EVA is conceptually the most accurate
method but is complex to implement, particularly when we have to make substantive corrections
to GAAP statements (as is traditionally the case). Nevertheless, we lean toward using EVA
mostly because it has stronger theoretical foundations.

12.55
a.
ROI = Operating income / Net book value of assets
= $125,000 / $350,000 = 35.71%

b.
Residual income = $125,000 – (0.14 × $350,000) = $76,000.

c.
First, let us calculate the firm’s weighted average cost of capital (WACC). Referring to the for-
mula:

WACC = (1- tax rate) × % debt × cost of debt + % of equity × cost of equity

= [(1 - 0.28) × (1/7) × 0.12] + (6/7 × 0.15) = 14.09%.

The first term reflects the tax shield (1 - 0.28), the proportion of debt financing (50,000/350,000)
and the cost of debt. The second term shows the proportion of equity financing and the cost of
equity capital.

Next, we have:

EVA (leather) = ($125,000 × 0.72) – [0.1409 × ($350,000 – $72,000)] = $50,829.80.

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Notice that we multiplied the pre-tax income by (1 - tax rate) to determine the after tax operating
income.

d. The ROI for Hercules seems particularly high at 35.71%. We propose that a large portion of
this value might arise because of a small value for net assets – the denominator in ROI. The
small value makes sense in this context because we know that Hercules relies more on per-
sonal service and attention for its business than on modern facilities. Thus, we expect its
equipment and buildings to be somewhat dated. Naturally, the capital assets are mostly de-
preciated, leading to small book value and a high ROI.

e. We believe that Tom and Lynda will accept the project. Surely, the project would lower re-
ported ROI. But, as owners of the business, Tom and Lynda are not as concerned about year-
ly fluctuations in ROI. Their focus is to the best for Hercules, taking a long-term view.

In contrast, a division manager (such as might operate Hercules, if it were part of a large
chain) might be reluctant to take the project. The reluctance will be greater if the manager
is evaluated based on ROI, particularly year over year changes in ROI. The project puts the
manager in poor light.

The difference arises because of differences in goal congruence. There is goal congruence
in the first instance: Tom and Lynda are owner-managers of Hercules. In contrast, separating
ownership from management leads to goal incongruence. Firms use performance measures
and incentives to reduce the adverse effects due to such incongruence. However, the correc-
tion is never perfect leading the manager not to always take actions that maximize firm value.

12.56

a.
Alisha’s performance evaluation system might be contributing to the problem. Currently,
the system rewards machine uptime, which seems to be a good thing to do. After all, if the ma-
chine is running well, it is because it has been repaired well. However, the system does not re-
ward quick turnaround. Such a quick job might be the best thing to do if a major sale is on the
line. Alisha’s reward system does not give her any rewards for cooperating with the production
and sales managers. Thus, his insistence on “good quality,” because a super repair job (which
might take a long time) ensures high run time (both because the machine has been fixed right and
because the production manager cannot afford to let it go back to the shop), which increases her
budget.

b.
It might be useful to augment Alisha’s performance evaluation system either by adding
more non-financial measures (e.g., average time per repair) and by adding higher unit per-
formance measures (e.g., total value of goods shipped per month). Both measures, particular-
ly the latter, give her an incentive to cooperate with the production and marketing folks to trade
off the need for time to make good quality repairs versus the need to get the machine back on
line as quickly as possible.

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12.57
The use of upper-level performance measures is one way to encourage cooperation among
lower-level managers. For instance, if two branches had many shared customers, poor customer
service by one branch could affect revenues at the other branch. Firms can sensitize managers to
the firm-wide effects of their actions by using upper level performance units. Basing bonus pay-
ments on the profits of both branches makes the manager in either branch consider the effects of
their actions on the other branch as well. The downside is that upper level measures sever the
direct link between the manager’s actions and their consequences. It is easy to relate branch prof-
it to a branch manager’s actions, but is far more difficult to relate corporate profit.

The problem highlights differing tradeoffs of these costs and benefits. Firm A appears to have
considerable inter-linkages among branches. Thus, it makes sense for the firm to use upper-level
measures to induce team-based perspectives. In contrast, branches in Firm B are mostly inde-
pendent of each other. Thus, it makes sense to base performance on the directly measures at the
branch level itself.

12.58
a.
The following is the required table:
Return on Investment Residual Income
Net book Gross Net book Gross book
value book val- value value
ue
Houston 18.333% 17.857% $1,500,000 $1,980,000
Atlanta 16.667% 19.277% $1,400,000 $2,310,000
Seattle 14.444% 18.662% $1,200,000 $2,460,000

Consider the first column. For Houston, we have income with (Net book value) = $8.5 - $2.8 -
$2.4 = $3.3 million and net book value is $18 million. Thus, ROI is $3,300,000 / $18,000,000 =
18.33%. Considering the third column, the residual income (with net book value) is $3,300,000
– (0.1 × $18,000,000) = $1,500,000. Similar computations apply to the other locations.

Now, let us turn to the computations with the gross book value. First, we calculate gross book
value by adding back the annual depreciation × age of assets. Then, to be consistent, we remove
depreciation from income as well. Relevant data are as follows.

GBV = Net book Adjusted income

Net book value + age * de- with depreciation
value Depreciation Age preciation added back
Houston $18,000,000 $1,200,000 6 $25,200,000 $4,500,000
Atlanta $21,000,000 $1,300,000 3 $24,900,000 $4,800,000
Seattle $27,000,000 $1,400,000 1 $28,400,000 $5,300,000

Thus, for Houston, we have income with (gross book value) = $3,300,000 + 1,200,000 =
$4,500,000. Thus, ROI is $4,500,000 / $25,200,000 = 17.857%. The residual income is

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$4,500,000 – (0.1 × $25,200,000) = $1,980,000. Similar computations apply to the other loca-
tions.

b.
We find the Houston location to be most profitable as measured by ROI (NBV), which is the
traditional measure. However, notice that age helps this location. Older assets tend to have lower
net book value (have had greater time to depreciate), which lowers the denominator in the ROI
calculation. Further, lower depreciation (if using accelerated depreciation) also helps increase the
numerator. In general, otherwise identical operations will report different ROI solely because of
their age.

Switching measures to residual income does not solve this problem. RI has the same deficiency
with respect to age.

Changing measurements to gross book value might help us better understand these issues. With
GBV, we see that the three locations are approximately equal in terms of profitability. Indeed,
the Houston location is the least profitable. The point to note here is that we have to adjust in-
come and investment for depreciation to perform this computation. However, even this adjust-
ment is imperfect because it assumes that investment prices did not change over time. Further, it
does not reflect our net investment in the assets, which might be a better measure of remaining
life. (After all, we have 4 more years of service from Houston but 9 from Seattle, if we assume a
10-year horizon).

The over-arching point is that variations in measurement affect the ranking of divisions. We
need to pay attention to the purpose of the ranking and use the appropriate measure for
the decision at hand. Thus, if we are deciding whether to keep or sell the asset, current market
value is the choice as it best reflects the opportunity cost of retaining the asset.

12.59
The main difficulty in this problem is calculating profit for the year 2013. We know that revenue
will be $3 million. We also know that COGS and selling expenses both are mixed costs (i.e.,
contain both fixed and variable components). We need to break these portions out to generate an
accurate profit estimate. Let us use the high-low method (see Chapter 4) to estimate the COGS
and selling expenses at the projected sales level.

We can write COGS as:

$1,800,000 = COGSfixed + Variable cost per sales $ × $2,400,000

$2,010,000 = COGSfixed + Variable cost per sales $ × $2,700,000

Subtracting one equation from the other, we can calculate the variable portion as:

Variable cost per sales $ = ($2,010,000 -$1,800,000)/ ($2,700,000 - $2,400,000)

= $210,000 / $300,000 = 70%.

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We can then use either equation to calculate COGSfixed as $120,000 = $1,800,000 - (0.7 ×
$2,400,000).

We can perform similar computations for selling expenses to calculate the variable selling cost at
10% of each sales $ and the fixed selling cost at $240,000.

With these data in hand, we can project the income statement for 2013.

Year 2013
Sales $3,000,000 Given
Cost of goods sold 2,220,000 $120,000 + (0.7 × $3,000,000)
Gross margin 780,000
Selling expenses 540,000 $240,000 + (0.1 × 3,000,000)
Profit before tax $240,000

Then, the ROI is ($240,000 / $2,275,000) = 10.55%.

The division’s residual income is $240,000 – (0.1 × $2,275,000) = $12,500

12.60
a.
With the current arrangement, we would argue that Raja should be evaluated as a cost center. He
exercises limited control over revenues – the buying divisions determine the quantities and the
HQ determines the “price” per unit.

b.
This is a tricky question to answer. It really depends on whether Raja has the ability to downsize
his plant to 900,000 units. In other words, why did the unused capacity of 300,000 cans arise and
what can we do about it? If the capacity arose because demand fluctuates (peak demand > 1.2
million cans), then the buying divisions should bear the cost. Dividing by actual use accomplish-
es this purpose. If, on the other hand, a practical capacity of 900,000 is indeed feasible, then the
transfer price should be based on practical capacity of 1.2 million. This way, the pricing does not
pass on Raja’s inefficiency to the buying plants. Rather, the cost of the unused capacity is sepa-
rately recognized and reported for managerial action.

c.
In general, having market price as the transfer price provides the cleanest economic signals.
Here, this use will generate a loss of 900,000 * 1.50 – ($450,000 + $1,080,000) = $180,000 in
Raja’s division. This loss comingles the cost of the unused capacity plus any inefficiency in Ra-
ja’s operation. This amount is the “cost” that management has to tradeoff with the “benefit” of
having a captive supplier of cans for the paint divisions.

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12.61
a.
For this problem, we have to think about the after-tax cash flows. Suppose the machine were to
be sold in Europe. Then, we would want to recognize as much of the profit as possible in the
United States because the tax rate in Europe is higher. Thus, the transfer will take place at
$750,000, meaning that the U.S. division will recognize profit of $125,000 and the European di-
vision will recognize profit of zero. Then, Cassandra’s total profit is:

= After-tax profit in U.S. + After-tax profit in Europe

= [(1 – 0.35) × ($750,000 - $625,000)] + [(1- 0.45) × ($750,000 - $750,000)] = $81,250.

If instead the machine were to be sold in Asia, we want the profit to be recognized in Asia. That
is, the transfer price would be $625,000, meaning that we have zero profit in the United States.
Then, Catlow’s profit is

= After-tax profit in U.S. + After-tax profit in Asia

= [(1 – 0.35) × ($625,000 - $625,000)] + [(1- 0.20) × ($775,000 - $625,000)] = $120,000.

Comparing the two profits, Cassandra would prefer to sell the machine in Asia, set the transfer
price at $625,000, and made $120,000 in after-tax profit.

b.
The U.S. division cares more about its profit. Thus, left alone, it would prefer to take the
$700,000 bid from Europe over the $675,000 bid from Asia. Notice that the $50,000 forfeited fee
is sunk for this purpose, as is the money spent on making the machine. If this transfer were to
take place at $700,000, the net profit for Cassandrais:

= After-tax profit in U.S. + After-tax profit in Europe

= [(1 – 0.35) × ($700,000 - $625,000)] + [(1- 0.45) × ($750,000 - $700,000)] = $76,250.

Notice that this amount is lower than either of the two amounts calculated in part A. Thus, allow-
ing the divisions to bargain and decide for themselves might lead to a sub-optimal outcome from
the corporate perspective.

c.
The benefit of allowing for decentralized operations is that division managers gain autonomy and
can be held accountable for their output. This action is most consistent with the entire philosophy
of decentralization. This might lead to profit being less than it could have been had the central
office intervened to force the “right” transfer. However, such intervention might prove even
more expensive in the long-run because it saps the division managers of their authority.

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12.62
The division controller is in a difficult situation. While some costs are clearly fixed and others
clearly variable, many costs could be classified as mixed. There is legitimate disagreement about
what portion of the cost is fixed and what portion is variable. The transfer pricing rule provides
considerable incentives for the division to classify as many of the costs as possible as being vari-
able in nature. The division manager also could take actions (e.g., outsource production) that
convert fixed to variable costs. Thus, it is not clear that the division controller can outright reject
the manager’s request. At the same time, ethical and professional considerations bar the control-
ler from misrepresenting a fixed cost as being variable. Ultimately, we expect that most people in
this situation would take another hard look at “fixed” costs to see if any of them have a reasona-
ble basis (even with some stretching of definitions) to be a variable cost. However, we also are
sure that professional accountants would not cross the line and misrepresent the nature of a cost.

Ultimately, the conflict comes about because of a flaw in the transfer pricing system. Any system
that imposes an arbitrary pricing rule creates incentives to reclassify costs, much like the reim-
bursement systems provided incentives to strategically allocate costs. The central office in Pack-
ages would be wise to revisit the transfer pricing issue and consider alternate solutions.

12.63
a.
The change might help the division by boosting the transfer price. After all, the new machines
(which make the foil printers) consume very little labor while the old machines (which make the
parts sold at full cost to other divisions) consume a great deal of labor. Thus, a labor based sys-
tem would shift the overhead to the old machines, and via the transfer price, to the other divi-
sions. The co-mingling of costs into a single pool aids this process by mixing the costs of the
new machines (likely a lot) with the costs of old machines.

b.
We believe that the division controller should resist this suggestion vigorously. There is little ba-
sis (from a decision making perspective) for mingling the costs of unlike machines together into
one pool. Moreover, labor hours seem like a poor cost driver for allocating the costs of new ma-
chines. The method seems to be designed for strategically shifting costs, and such massaging of
allocations do not appear to comply with the ethical rules promulgated by the IMA.

12.64
a.
Full cost is variable cost plus allocated fixed cost. Thus, the full cost is $6.6 million and
the transfer price is $6.6 × 1.1 = $7,260,000. With this, we have:
Division A Division B Total (firm)
Revenues $12,500,000 $12,500,000
Transfer revenue $7,260,000
Total revenue $7,260,000 $12,500,000 $12,500,000
Transfer cost $7,260,000
Direct material costs $2,500,000 $1,800,000 $4,300,000
Direct labor $2,000,000 $1,500,000 $3,500,000
Variable overhead $500,000 $375,000 $875,000

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Allocated fixed overhead $1,600,000 $1,200,000 $2,800,000

Total cost $6,600,000 $12,135,000 $11,475,000
Profit $660,000 $365,000 $1,025,000

Notice that the total column eliminates the transfer revenue and cost as the amounts offset each
other. In particular, the total cost $11,475,000 = $6,600,000+$12,135,000 -$7,260,000.

b.
The division’s variable cost is $5 million. The $5.0 × 1.2 = $6,000,000. With this, we
have:
Division A Division B Total (firm)
Revenues $12,500,000 $12,500,000
Transfer revenue $6,000,000
Total revenue $6,000,000 $12,500,000 $12,500,000
Transfer cost $6,000,000
Direct material costs $2,500,000 $1,800,000 $4,300,000
Direct labor $2,000,000 $1,500,000 $3,500,000
Variable overhead $500,000 $375,000 $875,000
Allocated fixed overhead $1,600,000 $1,200,000 $2,800,000
Total cost $6,600,000 $10,875,000 $11,475,000
Profit ($600,000) $1,625,000 $1,025,000

Again, notice that $11,475,000 = $6,600,000 + $10,875,000 - $6,000,000.

c.
Division A Division B Total (firm)
Revenues $12,500,000 $12,500,000
Transfer revenue $8,000,000
Total revenue $8,000,000 $12,500,000 $12,500,000
Transfer cost $8,000,000
Direct material costs $2,500,000 $1,800,000 $4,300,000
Direct labor $2,000,000 $1,500,000 $3,500,000
Variable overhead $500,000 $375,000 $875,000
Allocated fixed overhead $1,600,000 $1,200,000 $2,800,000
Total cost $6,600,000 $12,875,000 $11,475,000
Profit $1,400,000 (375,000) $1,025,000

d.
The comparison shows that the chosen transfer price affects divisional profit significantly. How-
ever, the choice does not affect corporate (pre-tax) profit because the revenue and cost cancel out
when we consolidate. Note, however, that the choice would affect after-tax profit particularly if
the two divisions were in different tax jurisdictions.

We can justify each of the transfer prices. Variable cost based pricing might be appropriate when
Division A has considerable excess capacity. In this case, such a price appropriately communi-
cates the cost of idle capacity. A full cost based price is appropriate when the division is operat-

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ing at capacity but there is no ready market price. In this case, a full cost based price approxi-
mates market price. Finally, a market price is the best as it clearly separates the operations in the
two divisions.

12.65
a.
We would argue that the market price is the correct transfer price that appropriately reflects the
opportunity cost of capacity in the microprocessor division. From the viewpoint of Quest, the
transfer should not happen. Notice that Quest obtains $250-$100 = $150 per micro-processor
transferred. However, it loses $70 in the PC division for a net contribution of $80 per chip
(=$1,000 -$820 - $100). It is better off if it sells the chip only and closes down the PC division.

b.
Now, the problem is a bit different because there is unused capacity in the MP division. This ca-
pacity has an opportunity cost of zero for 12,500 chips. (No external sales would be displaced at
this level). Then, the minimum price that the MP division would accept is $100 (its variable cost)
and the maximum price that PC division would pay is $180 = $1,000 - $820 (the value at which
its contribution is zero). Any price between $100 and $180 leaves both divisions better off rela-
tive to not transferring the chip.

The transfer also is profitable from the firm’s perspective. It makes $1,000 - $820 - $100 = $80
per chip if it uses the unused capacity to make chips for use by the PC division.

c.
This new information changes the nature of the opportunity cost in the MP division. Currently,
with sales of 37,500 chips, it is making a contribution of 37,500 × ($250 - $100) = $5,625,000. If
it were to lower the price, its contribution would be 50,000 × ($225- $100) = $6,250,000. Thus,
from the MP division’s perspective, it needs to make $6,250,000 in contribution for it to see the
transfer as being profitable.

We can calculate the minimum transfer price acceptable to the MP division as:

12,500 × (X – 100) + 37,500 × $(250-100) = $6,250,000

Or X = $150.

Note that if it makes the transfer, there is no need to lower the price on the 37,500 chips now be-
ing sold. At a price of $150 per chip transferred, the MP division is indifferent to the transfer or
selling the product elsewhere. At this price, the PC division makes a contribution of $30 per chip
transferred. Thus, the transfer is worthwhile from the view point of the overall corporation as
well.

Note that the transfer is not at the market price, even though a ready market for the product ex-
ists. Such a situation has arisen because the market for chips does not appear to be efficient. In
the long-run, such discrepancies will not persist.

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12.66
Calculating the ROI is straight forward as shown below.
Basis Operating Asset ROI = profit / in-
Profit base vestment
Net book value $125,000 $900,000 13.88%
Replacement cost $125,000 1,250,000 10.00%
Sales value 125,000 1,700,000 7.35%

The measures are all useful but in different contexts.

The ROI with net book value is useful as a way of evaluating historical trends. It is most useful
when a business is stable and the replacement of capacity is on going process and the business is
not growing or shrinking, and prices are stable.

The ROI with replacement cost is useful for evaluating whether the business is a viable long-
term entity. After all, the replacement cost ROI indicates that Tom and Lynda’s profitability will
only be 10% (even assuming no further escalation in equipment prices, which might be one rea-
son why the replacement cost is substantially higher than book value.)

The ROI with sales value is a good way to evaluate opportunity cost. After all, one option open
to them is to sell the gym and invest the capital (earning, lets say, 12%). Then, they have to eval-
uate whether the intangible benefits of operating the gym compensate for the lower profitability.
(0.12 × $1,700,000 = $204,000 as compared to the $125,000 they currently make.)

As is evident, we can compute ROI using differing measures of both income and investment.
The decision context determines the relevant measure.

12.67
We have:
Proportion
Net oper-
Cost of Cost of of debt in
ating prof-
Invested Current debt equity total capi-
it after WACC EVA
capital liabilities capital capital tal
taxes
(kD) (kE) (d)
(NOPAT)
1 $200,000 $1,600,000 $150,000 8% 12% 0.75 7.50% $91,250
2 $200,000 $1,600,000 $150,000 8% 12% 0.5 9.00% $69,500
3 $200,000 $1,600,000 $350,000 8% 12% 0.5 9.00% $87,500

Detail of computation:
Row 1: ((1-0.25) * 0.75 * 0.08) + (0.25 * 0.12) = 0.075
$200,000 – [0.075 × ($1,600,000 - $150,000)] = $91,250
Row 2: [(1-0.25) * 0.5 * 0.08] + (0.5 * 0.12) = 0.090
$200,000 – [0.090 × ($1,600,000 - $150,000)] = $69,500
Row 3: $200,000 – [0.09 × ($1,600,000 - $350,000)] = $87,550

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Comparing the rows shows the effect of financing strategies on EVA. The proportion of debt (a
lower cost, and tax advantaged instrument relative to equity) decreases from row 1 to row 2.
Thus, the cost of financing goes up, decreasing EVA. In row 3, the firm finances by relying on
current liabilities (“free financing” from suppliers) more so than in row 2. Naturally, EVA in-
creases.

Note: In general, we expect a firm moving from row 2 to row 3 to also pay higher prices, which
will depress current income and thus EVA. Likewise, it will be difficult to obtain debt at the
same rate when we increase the percent financed by debt.

Mini-cases
12.68
a.
To evaluate the investment, let us first calculate the annual after-tax cash flow.

Pre-tax cash flows are $800,000 - $300,000 - $100,000 = $400,000.

Taxable income per year = $400,000 - $150,000 = $250,000.
Taxes paid = 0.3 × $250,000 = $75,000.
Thus, after tax cash flow per year = $400,000 - $75,000 = $325,000.

The NPV of this proposal (at 12% rate) is $336,332.

We can also treat the cash inflow as an annuity. The annuity tables (see Chapter 11) for 10 years
and 12% show a factor of 5.650, meaning that the present value of the cash inflows is
$1,836,322. (Notice that this amount for the PV of the cash inflows reconciles with the Net Pre-
sent Value of $336,332 = $1,836,332 - $1,500,000.)

The payback period is just under five years.

Thus, the project meets corporate standards for funding. The project should be accepted.

b.
We know that Wendy’s expected ROI without the investment is:

$2,400,000 / $6,800,000 = 35.29%.

Let us now calculate her ROI with the investment:

Her new income is ($2,400,000 + $250,000) = $2,650,000

Her new asset base is (6,800,000 + $1,425,000) = $8,225,000.

Notice that the new project only adds $1,425,000, which is the average of the beginning and end-
ing values ($1,500,000 and $1,350,000)

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Thus, her revised ROI is 32.2% (=$2,650,000 / $8,225,000). Wendy is not likely to push for
the project.

c.
The RI without the investment is $2,400,000 – (0.12 × $6,800,000) = $1,584,000.
The RI with the new investment is $2,650,000 – (0.12 × $8,225,000) = $1,663,000.
That is, the project increases the division’s residual income. Wendy is likely to favor the pro-
ject.

d.
This example illustrates the incentive to under-invest that is created when using ROI as a
performance measure. Because it is a ratio, we can think of a division’s ROI as a weighted av-
erage of the ROI of all the projects undertaken by the division. If we add a new project that is
below the weighted average, it will drag down the division’s ROI. Thus, the division manger
would be disinclined to push for the project. The use of residual income reduces this incentive.
This simple answer is enough for the case because the annual cash flows are identical over time.

Note: A more general analysis also takes into account the pattern of cash flows and depreciation.
Generally, investments generate low income and add greatly to the asset base during the early
years. That is, the annual ROI of a project increases over its life. This feature adds to the prob-
lem. This feature also reduces the power of residual income to alleviate the under-investment
problem. The conflict arises because accounting measures usually capture performance over one
year only, while investment decisions (by definition) span many years.

12.69
a.
Annie’s choice of performance measure (ROI) indicates that she views each store as an invest-
ment center. This choice seems odd at first glance. After all, managers seem to have little control
over investments – any amount over $1,000 is personally approved by Annie using somewhat
subjective criteria. Further, the manager exercises limited control over the cost of the land and
buildings, the primary fixed assets for a nursery.

However, further reflection indicates that ROI might be a good measure. After all, inventories of
plants and supplies are probably the largest item in the balance sheet for a branch. The manager
exercises considerable control over inventory values both by controlling the variety and quantity
of plants ordered. If Annie did not “charge” for inventory in some way, the managers have the
incentive to over-order (which is expensive) and limit the store’s profitability. All in all, we
would generally agree with Annie’s classification of the stores as investment centers.

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b.
Let us begin by verifying these estimates. The following table provides key data regarding the
investment value over time.

Investment Investment at Average Deprecia-

at start of the end of investment tion
year year
Current year
(year 0) $20,000 $18,000 $19,500 $2,000
Year 1 $18,000 $14,000 $16,000 $4,000
Year 2 $14,000 $10,000 $12,000 $4,000
Year 3 $10,000 $6,000 $8,000 $4,000
Year 4 $6,000 $2,000 $4,000 $4,000
Year 5 $2,000 0 $1,000 $2,000
With this data in hand, we can calculate the income from the project, each year

Sales Contribution Depreciation Fixed Reported Cash flow

(Growth at margin costs Income from oper-
12% (50)% ations
Current year
(year 0) $ 8,500 $4,250 $2,000 1,250 $1,000 $3,000
Year 1 $17,500 $8,750 $4,000 2,500 $2,250 $6,250
Year 2 $19,600 $9,800 $4,000 2,500 $3,300 $7,300
Year 3 $21,952 $10,976 $4,000 2,500 $4,476 $8,476
Year 4 $24,586 $12,293 $4,000 2,500 $5,793 $9,793
Year 5 $27,537 $13,768 $2,000 2,500 $7,268 $11,268

Let us now calculate the ROI for the project, year-by-year.

Average
Income investment ROI Cash flow
Current year ($20,000) + $3,000
(year 0) $1,000 $19,500 5.13% = $(17,000)
Year 1 $2,250 $16,000 14.06% $6,250
Year 2 $3,300 $12,000 27.50% $7,300
Year 3 $4,476 $8,000 55.95% $8,476
Year 4 $5,793 $4,000 144.83% $9,793
Year 5 $9,268 $1,000 926.83% $11,268
NPV (at 20%) $7,434

Thus, the project seems to meet all of the cash flow hurdles. Further, it is in line with Annie’s
overall strategy.

Mike would be reluctant to invest in this project because of the pattern of cash flows. The project
has a negative ROI for the current year and is below 20% for the next year. Adding this project
would therefore dilute Mike’s ROI. With the project, Mike’s current year ROI would be
($92,400 + $1,000) / ($330,000 + $19,500) = 26.7%. His bonus adjustment factor would de-
crease from 28/25 = 1.12 to 26.7/25 = 1.07. The project also drags his ROI (and therefore his bo-

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nus) down for the next year. The lower ROI numbers could potentially remove Mike from the
running for region chief. Taylor, who might take over, would reap the benefits of the investment.

Mike might be inclined to go forward with the project if he is able to get it into next year’s budg-
et. This way, the effect of the project would show up both in the budget and actual results. Many
managers would still be reluctant because a new project tends to lower year-over-year ROI. A
new project adds immediately to investment and only slowly to income. The resulting pattern of
ROI tends to discourage new investments in firms that focus on ROI as a performance measure.

c.

Annie’s way of calculating ROI is quite standard. In particular, it makes sense to average in-
vestment over the year to get the “average” amount at stake. Otherwise, managers might be in-
duced to play games with the timing of investments.

Her use of net book value also is common. However, it is subject to the criticism that it favors
older investments. Her use of a budget as a benchmark would substantially alleviate this problem
because she can adjust the budget to reflect the differing ages.

We also agree with Annie’s strategy of using pre-tax income to calculate ROI. After all, the
managers have limited control over the taxes, which are computed at the corporate level in any
case.

Some might argue that Annie should leave out “non-controllable” investments such as land and
buildings when computing the ROI. Two factors work in favor of including these items. First,
the inclusion sensitizes managers to the value of ALL assets that they use to generate income.
Second, the inclusion would affect both the budget and the actual results in similar ways. Using
the budget as a benchmark substantially removes any negative effects from including the
amounts in the investment base.

Finally, Annie could use other measures such as residual income. We do not believe that such a
move would confer great benefits, mostly because ROI is a simple, well-understood metric. Fur-
ther, a move to RI would not eliminate the incentive to under-invest because a project’s RI
would be subject to the same pattern (increasing over time) that causes the problem with ROI.

d.
The compensation plan appears to be well designed. Many plans start the payout at 90% of
the target as a way to motivate managers to set stretch targets. This feature also reduces the in-
centive to play games with the target.

The cap on the payout ratio likewise reduces the incentive to manage the target. It also reduces
the payout for random events that substantially and favorably affect operations. However, the
downside of the cap is that managers lose motivation to push operations beyond the level implied
by the cap.

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In general, basing at least a part of the compensation on upper-unit performance measures is use-
ful for inducing cooperation. This way, a branch might be inclined to help another branch out
because both contribute to regional performance. The benefit in Annie’s case seems small be-
cause we cannot visualize too much interaction across branches. It is not likely that a customer at
the Columbus branch would also shop at the Cleveland branch.

We also like the idea of a formula-based plan because it increases the transparency in the system. Howev-
er, notice that the bonus pool itself is somewhat subjectively determined. Thus, Annie can adjust the pay-
out for factors that affected operations during the year. Overall, the system seems like it would work well.

12.70
a.
Let us calculate profits at the two divisions, relative to the benchmark:
$170 per unit $200 per unit $230 per unit
Seth’s division ($170 - $125) × ($200 - $125) × ($230 - $125) ×
20,000 = $900,000 20,000 = $1,500,000 20,000 = $2,100,000

Brenda’s division ($170 - $170) × ($170 - $200) × ($170 - $230) ×

20,000 = 0 20,000 = ($600,000) 20,000 = ($1,200,000)

Firm as a whole $900,000 $900,000 $900,000

For Seth’s division, notice that we focus only on the contribution margin. This view assumes that
the division has enough extra capacity, which makes the opportunity cost of its capacity is zero.

For Brenda’s division, the change in profit is directly proportional to the price differential paid.

The firm’s overall profit is unchanged at $900,000. If indeed, there is no other use for the ca-
pacity in Seth’s division, the firm benefits $900,000 by requiring an internal transfer.

b.
The VP confronts a difficult problem.
One solution is to require a transfer. This solution has the benefit of increasing the firm’s overall
short-term profit by $900,000. This approach puts the excess capacity in Seth’s division to good
use. The price on the transfer is likely to be a sticking point as the price effectively apportions
the surplus between the two divisions. Brenda will push for a price close to $170 as that is her
opportunity cost. Seth would push for a price close to $230, citing the development cost and the
higher quality. No matter the final price, this solution is unlikely to be acceptable to at least one
of the two division mangers.

An alternate solution is to do nothing. This solution seems odd at first blush because it leaves
nearly a million dollars “on the table.” However, this might be the preferred solution. To under-
stand why, notice that the opportunity costs for Seth and Brenda are key for the negotiations.

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 From Brenda’s perspective, her lowest estimate is $170 per unit. However, she is likely
to go higher because she recognizes the higher quality from Seth. She also surely recog-
nizes the value from nurturing a long-term relationship with a “reliable and high quality
vendor.” Nevertheless, she has incentives to claim a low opportunity cost purely as a ne-
gotiating tactic. After all, every dollar she shaves off the price adds $20,000 to her bottom
line.

 From Seth’s perspective, the opportunity cost of the excess capacity is the key determi-
nant of the validity of his stance. (The $240,000 in design is a sunk cost and should not
affect his decision.) If the opportunity cost is truly zero (i.e., there is no other use for this
capacity), then the computations in part (a) apply. However, only Seth is the person best
equipped to estimate this opportunity cost. He has to consider the effect of a low price to
Brenda on his other sales. Plus, he has been pursuing a high quality –high price strategy
and that appears to be paying off as he has received orders over the last six months. It is
possible (and we do not have the necessary information to evaluate this outcome) that the
market for Seth’s capacity is on an upturn and that more orders are over the horizon. This
feature would raise the opportunity cost of Seth’s capacity. And, Seth is privy to this in-
formation.

From the VP’s perspective, requiring a transfer generates an immediate gain of $900,000 but is
predicated on the assumption that the VP knows more than Seth about alternate opportunities for
Seth’s capacity. It thereby undermines the philosophy of decentralization.

We believe that it is worthwhile for the VP to let the division managers figure this one out
themselves. Negotiating such difficult issues is how managers distinguish themselves and nei-
ther Brenda nor Seth is likely to leave a million dollars on the table. One or the other will yield
and the resolution will likely reflect the true opportunity cost for either party, as perceived by the
division managers.

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 CHAPTER 13
Strategic Planning and Control
Solutions

REVIEW QUESTIONS
13.1 Cost leadership, and value differentiation.
13.2 (1) Industry competitors, (2) new entrants, (3) substitute products, (4) supplier power, and
(5) customer power.
13.3 The key source of customer value.
13.4 Yes, this is generally true.
13.5 The value chain is a set of logically sequenced, value-adding activities that convert input
resources into products or services in a manner consistent with the chosen business strat-
egy.
13.6 (1) List all activities and prepare the activity map, (2) Identify performance linkages
across activities, (3) Engineering activities, and (4) Determine activity-sourcing.
13.7 Product life-cycle analysis emphasizes that the objective is to maximize the profitability
of a product over its entire life cycle and not stage-by-stage.
13.8 (1) Development, (2) Introduction, (3) Growth, (4) Maturity, and (5) Decline.
13.9 Target costing as a structured approach to cost planning and management – it determines
cost by working backward from the customer’s value.
13.10 Because it’s important to know where we have been and where we are going. Lagging
indicators reflect past performance, whereas leading indicators are drivers of future per-
formance.
13.11 Financial measures are (1) aggregate, (2) are not always timely, and (3) do not provide
specific information about potential areas of concern.
13.12 Just like a pilot, managers need to attend to multiple measures and gauges of a perfor-
mance to ensure that the company is headed in the right direction.
13.13 Critical success factors, also known as key performance indicators, are performance
measures that must go right for an organization to implement its strategy and successfully
achieve its mission. Outcomes of the critical success factors are the pulse of the organiza-
tion’s survival. Organizations have both short- and long-term critical success factors.
Critical success factors should be: (1) simple and easy to understand, (2) readily quantifi-
able, (3) easy to monitor, and (4) linked to strategy.
13.14 A balanced scorecard is a performance measurement system that includes a systematic
approach for linking strategy to planning and control. The four components, or perspec-
tives, are (1) financial, (2) customer, (3) internal business, and (4) innovation and learn-
ing.

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13.15 Balance is obtained by attending to (1) financial and non-financial measures, (2) short-
and long-term objectives, (3) past and forward-looking measures, (4) “hard” and “soft”
measures, and (5) external and internal measures. That is, excessive weight is not placed
on any single measure or perspective.

DISCUSSION QUESTIONS

13.16 Ultimately, the value proposition offered by top-tier business schools is the increased
probability of future success in a business career. This gain arises from several sources
which include the value of alumni network, the “halo” effect that arises from a degree
from a prestigious program, access to top-notch faculty and facilities and so on.
13.17 America Online, Inc. (AOL) offers a broad range of features including real-time talk,
electronic mail, electronic magazines and newspapers, online classes and shopping, and
Internet access. It generates revenues principally from consumers through membership
fees, advertising, commissions on merchandise sales and other transactions, and from
other businesses through the sale of network and production services. Google’s core
competencies are in coming up with fast and efficient search engines, and its revenues are
mostly from online advertisements, commissions from online intermediation. An im-
portant element of strategy is to induce people to use its search engines. It has been suc-
cessful so much so that “Google” has come to be accepted as a verb in the English lan-
guage as a synonym for “search” in the online world.
13.18 A key benefit from offshoring, of course, is cost. However, innovation can only happen
where there is requisite talent. India has come to be accepted as a center for innovation in
the IT industry in recent years because of the availability highly skilled software engi-
neers at a low cost. But, even in India, costs are going up as wages have naturally in-
creased, and there may come a point what the cost advantage may vanish. The downside
of offshoring innovation is the risk of “intellectual pilferage” due to lack of adequate
monitoring and security.
13.19 Obviously, the issue is one of ethics. Absent legal liability, a company might choose to
dispose dangerous material in a careless manner to avoid costs of disposal. In this case,
cost is not a consideration (The unfortunate Union Carbide episode in Bhopal, India
comes to mind). However, firms have a social responsibility to dispose hazardous materi-
al in an environmentally safe manner. Good economic analysis would dictate that such
costs be taken into account in decision making.
13.20 At the time of product introduction, firms should estimate life-cycle revenues by taking
into account the expected downward trend in prices in order to compute expected life-
cycle profit. Failure to do so might well lead to the launching of products that may be end
up being loss makers for the firm.
13.21 In general, target costing is effective for products with well-defined and discrete features
because it helps make proper trade-offs among price, quality, and functionality with re-
spect to each product feature. Target costing is less effective in firms that deal with com-
modity-type products because there is little scope for differentiating products by their fea-
tures. Poultry and other animal products are commodity products with stable demand and

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little scope for differentiation. Cost control should in fact be the key focus for Tyson
foods because of the low margins and high levels of competition. Factors such as cost ef-
ficient distribution channels, timely delivery of supplies are key to its success.
13.22 This is a strategic decision. Sometimes marketing an apparently unprofitable product is
necessary to develop or hold on to a market segment so that profits can be generated by
marketing other profitable products. Such synergies are often hard to quantify but are im-
portant to consider qualitatively.
13.23 The New York Yankees serve one of the biggest sports markets in the country. Keeping
the large fan base excited is extremely important for its long-time survival. Fans come to
the baseball stadium to cheer their team and see their team win. We can think of many
performance measures: number of games won in a season, team batting average, earned
run average, and so on.
13.24 To a point, yes. However, one must keep in mind that “local” maximization does not of-
ten lead to “global” maximization. Making each link in the value chain efficient does not
necessarily mean that the entire value chain will be efficient. For example, paying a pre-
mium for materials may in fact be the right thing to do to avoid more costly quality prob-
lems and waste in downstream manufacturing processes.
13.25 Rankings are only as good as the surveys they are based on. Every organization is unique
in some respect. Surveys can only compare organizations on a set of common criteria.
These criteria will suit some organizations well, and other organizations not so well. But
these organizations may actually be superior in certain chosen spheres of operations.
13.26 In principle, we can use a method similar to profit variance analysis to decompose a
summary metric into constituent parts. For example, suppose the firm believes that cus-
tomer satisfaction is a multiplicative function of price, delivery and quality relative to
competition. Then, just like we decomposed the overall materials cost variance into a
price and efficiency variance, we can decompose the difference between actual and ex-
pected customer satisfaction into pieces attributable to performance on price, delivery and
quality. Notice that having a underlying model (or production function) for the attribute is
a pre-requisite for performing such variance analysis
13.27 Conceptually, there is no barrier to using a balanced scorecard for non-profit organiza-
tions such as a municipality or a not-for-profit hospital. However, the components will
change to reflect the units’ missions. For example, a municipality might track measures
in categories such as financial, community, infrastructure and learning. These categories
broadly correspond to the financial, customer, processes and learning categories. Howev-
er, the measures will be quite different. For example, the financial measure might just be
breaking even rather than making a profit, and might include targeted amounts of grants
from the Federal government.
13.28 This question introduces a vexing issue confronting many firms that implement a bal-
anced scorecard. Ultimately, the firm has to combine the multiple measures in a balanced
scorecard into determining a manager’s overall performance. But, usually the manager
has exceeded expectations on some dimensions but has fallen short on others. How
should we average these factors out? The most common method (based on anecdotal evi-
dence) is that firms assign weights to different measures, with the weight reflecting the

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measure’s importance. The bonus also depends on meeting a minimum standard in every
measure so that there is some uniformity in performance. A maximum amount is also set
for each measure to avoid stellar performance in one measure driving the bonus. We
speculate that firms have resorted to such a formula based approach because a discretion-
ary bonus (based on a subjective combination of the multiple measures) might lead the
firm to systematically under-weight some measures and over-weight others. Research has
found that subjectivity leads to a focus on financial performance, which then results in
subordinate managers also focusing solely on financial measures, which is the antithesis
of the balanced scorecard philosophy.

EXERCISES

13.29
a.
While the end product is the same, the bundle of features offered differs greatly between
travel websites and travel agents. The former assumes considerable knowledge on the
part of the traveler and offers a way to quickly compare multiple fares. The aim is to pro-
vide a great deal of information and cheap fares. But, the responsibility is on you to un-
derstand the information being provided.

A travel agent provides considerably more hand-holding. The agent may well advise the
traveler on alternate modes of transportation, the best way to change currency, how to
find a package deal, and so on. The agent might even help with choice of a destination
(e.g., for a vacation). The value proposition is therefore not low cost but access to a
wealth of travel information. (Of course, the traveler has to pay for this information in
the form of the travel agent’s commission from ticket and other sales.)

b.
We find a similar tradeoff between discount traders such as Scottrade or Brown and
company. These services allow you to trade; they provide lots of information but little
advice. In contrast, a full-service brokerage such as AG Edwards will completely handle
all of the details (beginning with asset allocation and planning, down to executing indi-
vidual trades and providing tax advice). Here, the value proposition is advice and help ra-
ther than cost. Clearly, the clientele differs for each kind of firm. A person well-versed in
finance might choose a discount broker while persons with little idea about how to handle
money might (implicitly or explicitly) pay a full-service broker to handle the portfolio on
their behalf.

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13.30
a.
Competitive advantage could arise because of a number of reasons. Access to low-cost
inputs (e.g., labor or ore) or proximity to markets could be a source of advantage.
Somewhat less obvious, an ability to innovate could be a competitive advantage (e.g.,
3M). Firms with strong marketing programs, such as Coca Cola and P&G, derive an ad-
vantage from the “brand equity” (goodwill associated with brands) they have built up
over time. Toyota’s advantage arises from being able to manage its business processes,
particularly manufacturing processes, better than anyone else.

b.
A firm might choose to leverage access by lobbying regulators to prevent other firms
from accessing the same resources. A firm that relies on scale economies by aggressively
seeking market share so that it might increase its volume of operations, and thereby
lower costs. Innovation might be helped by allowing employees freedom (e.g., time off)
to experiment and try out different things. Classic innovators such as Google require em-
ployees to take time off from their regular work to think about new ideas and products.
Managing a business process requires consistent monitoring and effort. It requires a re-
lentless attention to detail and processes in place for identifying and eliminating waste.

c.
Management control systems reflect the different needs associated with the differing
strategies. A firm focused on volume places great emphasis on market-related data, par-
ticularly share and size. Such firms also are likely to be cost leaders, meaning that their
systems closely track and control costs. Innovative firms are more like differentiators that
we discussed in the text. These firms rely less on controls and more on price premiums.
While they may monitor the rate of innovation (e.g., % sales from new products), they
are usually less focused on intense cost control. Firms like Toyota that manage processes
pay intense attention to all aspects of cost. They have elaborate processes in place to
identify waste (no matter how small) and eliminate it. These firms therefore tend to have
intensive planning and control systems.

13.31
a.
Barriers to entry There are high barriers to entry because of the capital required and
because of the regulatory approvals needed.
Customer power Low because most customers really do not have viable alternatives.
Supplier power Again, low. For instance, there are many firms that sell coal or oil
to utilities. Fuel replenishment is a government-controlled activity
for nuclear powered plants.
Alternate sources One could think of solar / wind / geo-thermal sources of energy
that consumers could tap. Small generators also provide an alter-
nate source. However, power from these sources usually costs sub-
stantially more than obtaining power directly from the utility.

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Competition At the local level, there is very little competition as the utility tends
to be a monopoly with few substitutes. Nationally, utility firms
might compete with each other for select markets.

b.
As the analysis shows, a utility has considerable power over its customers. It delivers a
product with few substitutes and it is not easy for a competitor to enter. Individual cus-
tomers have low power over the firm. The cost advantages that come with producing
power in large quantities make firms in this industry into natural monopolies. Thus, op-
portunities to play favorites and price gouge abound. Naturally, the consumers wish the
government to step in and make sure that their interests are protected. Most utilities are in
fact rate regulated with the boards providing the firms with a “fair” return on capital. We
do note that, over the past 20 years, various jurisdictions (California is a prominent ex-
ample) have tried to deregulate this industry, with mixed success.

13.32
a.
Firm A Firm B
Contribution margin ratio 55% 40%
Sales / $ of fixed costs $2.86 $3.33
Profit margin ratio 20% 10%

The above results are obtained assuming that we compute the contribution margin ratio as
Contribution margin/sales, the profit margin ratio as profit/sales and the sales per $ of
fixed costs as sales/fixed costs.

b.
We believe that Firm A is following a differentiation strategy while Firm B appears to be
more focused on cost leadership. We base this conclusion on the higher CMR exhibited
by Firm A. Innovation allows a firm to command premium prices and earn more
contribution per sales $.

However, innovation is expensive. Notice that Firm A has a higher fixed cost for each
sales $.

The inference to be drawn from the higher profit margin ratio is unclear. In the long
run, we should not expect either strategy to significantly dominate the other. We do ex-
pect more variability in profit with an innovation-oriented strategy because innovation is
more risky than a steady grinding away at costs. This intuition is confirmed here -- Firm
A had a “good” year.

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13.33
a.

Total sales revenue 4,500 units × $5,000 per unit $22,500,000

Desired margin 5% 1,125,000
Allowable cost $21,375,000

b.
Current cost 4,500 × $4,900 $22,050,000
Allowable cost 21,375,000
Cost Gap $675,000

Thus, we need to reduce costs by $21,375,000 - $22,050,000 = $675,000 to achieve

the cost target.

13.34
a.
Total sales revenue 300,000 × $210 per unit $63,000,000
Desired margin 5% 3,150,000
Allowable cost $59,850,000

Current cost
Variable costs 300,000 × (80 + 75 +15) $51,000,000
Mfg. Overhead 300,000 × 40 12,000,000
Total $63,000,000

The product is making zero profit currently. Thus, we need to reduce costs by
$59,850,000 - $63,000,000 = $3,150,000 to achieve the cost target.

b.
Current variable manufac- $46,500,000 = 300,000 × ($80 +$75)
turing cost
Reduction possible 0.05×$46.50 million = 2,325,000
Current SG&A costs $4,500,000
Reduction possible 0.10 × $4,500,000 = 450,000
Total reduction possible $2,775,000

Even with this reduction, we are short by $375,000. This is a classic problem that firms
face all the time. A standard option is to revisit opportunities for cost cutting and to try to
“find” another $375,000. We note that fixed costs are not included in the estimate of the
cost gap. Surely, there are avenues to reduce this amount by 5%, which will give us more
than enough to meet the allowable cost. Notice that planning for cost savings through
continuous improvement (once the product goes into production) are not likely because
of the very short life cycle.

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13.35
a.
The following table provides the required information.

Price Expected Expected

volume Revenue
$89 450,000 $40,050,000
69 400,000 27,600,000
49 500,000 24,500,000
29 200,000 5,800,000
Total $97,950,000
b.
Many firms deal with uncertainty by considering multiple scenarios. A popular method is
to estimate benefits under the best case / worst case / most likely scenarios. More sophis-
ticated approaches include simulations.

13.36
a.
It is useful to compute the total cost as some of the costs are product-level, some are at
the batch-level and others are unit level costs.

Development given $1,650,000

Pre-production given 250,000
Manufacturing 40,000 × $250 10,000,000
Selling expenses $125,000 per year for 3 years 375,000
40,000 units × $200 per unit 8,000,000
Warranty (40,000/50) × 10 parts × $20 / part 160,000
(40,000/1,000) × 2 visits × $1,000 / visit 80,000
Total cost $20,515,000

b.
Now, let us compute the total cost with 50,000 units. We have:

Development given $1,650,000

Pre-production given 250,000
Manufacturing 50,000 × $250 12,500,000
Selling expenses $125,000 per year for 3 years 375,000
50,000 units × $200 per unit 10,000,000
Warranty (50,000/50) × 10 parts × $20 / part 200,000
(50,000/1,000) × 2 visits × $1,000 / visit 100,000
Total cost $25,075,000

Notice that the new cost is not 25% higher than the old cost. It is only 22% higher be-
cause of the presence of batch and product level costs.

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How should we compare the profit under the two scenarios? We know that the original
price is $600 per unit. Hence, the total revenue is $24,000,000 (= 40,000 units * $600 /
unit) yielding a profit of $3,485,000 ($24,000,000 - $20,515,000). With the price cut, to-
tal revenue is $27,000,000 and profit is $1,925,000 ($27,000,000 - $25,075,000). Imaging
should not cut its price.

13.37
a.
We would agree that the standard statistics are leading measures. As stated in the
problem, the measures provide a statistical profile of a player’s game. These measures
capture key ingredients for success, meaning that doing well on these measures is a good
predictor of future performance. Of course, it is possible to collapse a number of these
measures into a single statistic – the number of tournaments won or the number of top ten
finishes – that might be equally, if not more predictive of future success. Nevertheless,
the individual measures are useful as diagnostic measures of a player’s game. Players and
coaches can use these data to benchmark against the competition and figure out which ar-
eas need the most work.

b.
The discrepancy occurs because winning a tournament requires that the golfer deliver
on all of the standard measures. The golfer must be able to get the ball from the tee to
the putting green, navigate hazards such as bunkers, and effectively putt the ball. Being
an excellent putter (i.e., getting the ball into the hole) helps the score. But, the golfer wins
only if she can also get to the green in a few shots. A well-rounded game with very good
performance on all dimensions and excellence on a few seems to be the key for winning
in highly competitive environments such as USPGA tournaments.

In a business context, winning is delivering outstanding shareholder returns. However,

many pieces must fall into place for the desired outcome. The firm must be able to pro-
vide a value-adding product or service in a cost efficient fashion. Creating and sustaining
a competitive advantage requires that the firm manage its customers (external) and inter-
nal processes well, while investing in learning and growth.

c.
The design of a course affects the premium placed on a particular skill. Some courses
have narrow fairways, meaning that accuracy (landing on the fairway) has a greater
weight than getting a longer drive. The greens on some course test the putting skills of
even the best golfers on the planet. As an analogy, we can think of the golf course as the
external environment and the golfer’s skills on various dimensions as success factors.
Course design dictates the criticality of each success factor. The match between the
golfer’s ability on various success factors then determines the odds of success.

Note: Similar matching of skill sets occur in other sports as well. A grass court tennis
tournament (e.g., Wimbledon) places a greater emphasis on a serve-and-volley game rela-
tive to a tournament played on hard courts (e.g., the US open). A clay court tournament

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(e.g., French open) has entirely different requirements. In each instance, the court surface
affects the bounce and speed of the ball.

13.38
a.
Quality is perhaps the most critical success factor for Island Spices. Gourmet restaurants
and high-end cooperatives pride themselves on using the freshest, highest-quality ingre-
dients. Island Spices must deliver on this dimension if it is to survive. Many other factors
are also important, although these factors might take a back seat to quality. These factors
include range of product offering, price, delivery options, and attractiveness of packaging
(more important to retail stores than restaurants).

b.
As we learned in Chapter 8, variances help us develop a story as to the firm’s overall direction. In
this particular instance, one possible story is that Island Spices is moving away from offering a
high-quality, premium-price, differentiated product and toward offering a more commodity type
product. The cut in sales prices to boost volume is one indication that Island Spices might be
seeking to expand its customer base to include grocery shops that are likely much more price sen-
sitive than gourmet food stores. The purchase price variance also is cause for concern if the lower
price is due to trading off on product quality. The labor efficiency variances again support a story
of the firm stretching resources and cost cutting. All of these variances signal a pattern that does
not bode well for the firm.

Of course, management at Island Spices should monitor the trend in these variances. They also
should seek to corroborate the financial signals with other measures such as average outgoing
quality (e.g., number of external particles per packet of spices) and customer feedback. Any evi-
dence of a more permanent decline in quality would point to the need for quick and decisive cor-
rective action.

13.39
Management’s expectation is reasonable and fully justified. In today’s competitive
environment, customers base their choices on small differences in the value propositions
offered by different firms. A failure to deliver on a key dimension can, and often does,
negate the positive effects of other dimensions. In this case, the firm has identified three
attributes – cost, quality and time – perhaps because it is adopting a cost leadership strat-
egy, where it emphasizes the customer’s total cost of ownership. Thus, delivering on all
three dimensions is critical; all JHE is doing is to communicate this to its employees.

The point of this exercise is to demonstrate that it is not enough to rely on a single per-
formance measure. Sure, we can rely on profit. But in JHE’s case, cost of production,
quality, and time to delivery are the drivers of future profit, perhaps because the market
sets product prices. Thus, the firm needs to monitor all three dimensions and motivate its
employees to deliver continuing improvements on all three facets.

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13.40
a.
Tony’s pizza might consider the following measures when assessing itself from the cus-
tomer’s viewpoint:
 Percent of orders delivered within 30 minutes (target: 100%)
 Average price per delivered pizza (target: $12)
 Number of orders with extras such as drinks or breadsticks (target: 70%)
 Percent of orders for multiple pizzas (target: 60%)

The Gallery might track measures such as the following:

 Percent tip as proportion of billed amount (target 20 percent)

 Amount billed per patron (target $110)
 Number of dishes returned to the kitchen for rework (target: 0)
 Percent repeat customers in a month (target 70%)

b.
The measures differ because the two organizations target vastly different customer seg-
ments and offer differing value propositions. The value proposition for Tony’s Pizza is a
cheap, reliable source of filling food. The quality of the food, the ambience, and other
such factors are of secondary importance. Tony makes money by serving pizza on call
throughout the night, and via markups on ancillary items such as drinks and breadsticks.
His goal is to stay price competitive with the other pizza delivery chains.

Elegance and a wonderful evening out is the value proposition offered by the Gallery.
The overall ambience and the restaurant experience are central to this value proposition.
The food selection and quality must be top notch, and the customer must be showered
with attention, with no detail overlooked. The Gallery likely maintains an exclusive list
of its patrons, allowing it to discern individual tastes and offer suitable suggestions. (For
example, a patron may be partial to wines from Spain, and the wine steward can suggest a
bottle from a recent purchase.) The tracked measures therefore focus on the success of
this strategy. For example, a satisfied customer would leave a large tip. A large propor-
tion of repeat customers at a fancy restaurant are a sure sign that things are going well.

13.41
a.
Culinary’s value proposition is to provide a high quality and unique catering experience
that is stress free. The three major parts of this value proposition appear to be:
 Offer a wide range of themes that the customer could pick from or custom-
ize. This process forms the basis for Culinary’s sustainable competitive ad-
vantage. The firm might seek to retain this advantage by staying abreast of current
fashions and trends by attending trade shows and such.
 Deliver the arrangements and food on time and per the customer’s expecta-
tions. As the parent of any bride would tell you, waiting for a caterer to show up
when you expect 50 or more guests is a nerve racking experience. Culinary can

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manage this process and add value by communicating with the customer and mak-
ing sure that events occur per schedule without any hiccups.
 Provide excellent but unobtrusive service at the event. The final piece of the
puzzle is to offer exemplary service that anticipates every guest’s needs but does
not intrude. Wait staff must materialize, as if by magic, only when needed and not
be seen otherwise. This outcome is expected at up market, luxury events.

b.
Culinary needs to monitor these processes if it is to maintain its competitive advantage.
Some performance measures might be:

 Proportion of revenues from new themes.

Number of new themes added this year.
Number of events with fresh themes.
 Number of events with late deliveries
Percent of events contacted day before to appraise customer re schedule
Number of events with emergency purchase of food / supplies
 Number of customer complaints
Proportion of rehires (experienced staff are usually better).
13.42

MEMO
To: CEO, Robinsons Apparel
From: Student
Date: (Today)
Re: Quarterly Results: Analysis

Analysis of scorecard data for last quarter’s operations indicates that we might be head-
ing for trouble. Sales from new SKU’s are down, potentially indicating problems with
our selection of new products. We need to investigate our market intelligence regarding
future trends. Other evidence such as the average discounts corroborates.

Customer satisfaction seems to be the one bright spot in the overall picture. We did sig-
nificantly better on customer satisfaction scores. However, part of this might be price
driven. The price index relative to peers is only 94, and substantially below the target of
105. This is not good news. My concern is that our image might be shifting from a hip
place to shop to a value-place to shop.

Overall, a sustained pattern such as the one last quarter might lead to Robinson’s losing
its place and chic in the teen mindset. Indeed, we might already be late as evidenced by
the lower than expected ROI. Quick action is called for.

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13.43
For constructing such a balanced scorecard, it is useful to begin by considering that core
actions required for successful execution of the Eye Bank’s mission.
 At the first level, the Eye Bank needs to have the organizational capacity (both peo-
ple and infrastructure) to carry out its mission. This includes the prestige and contacts
of the boards of directors, and its contacts with key personnel in local hospitals.
 A related idea is to develop the operational processes for harvesting the corneas and
ensuring their timely transplantation. This set of activities includes educating the pub-
lic about the need and ease of eye donations, contacting and counseling families of
the recently deceased, harvesting the corneas, storing them, and making sure that they
get to the right place to be of use.
 A third aspect is the Eye Bank’s financial stability. Although it is a not-for-profit or-
ganization, the Eye Bank has to maintain and safeguard its assets. The organization
has to keep appropriate accounts and controls both from a fiduciary perspective and
from a sustainability perspective. The firm also needs to plan and monitor inflows
from donations and outflows because of operations.
 Finally, the Eye Bank needs to measure the outcomes of its actions. Outcomes obvi-
ously include the number of patients helped, the number of eye clinics held, the num-
ber of people contacted, and the volume of educational materials distributed.

The Eye Bank might do well by constructing appropriate performance measures and tar-
gets for each of these groups of related activities.

13.44
a.
Tim is following a niche strategy. He offers relatively high prices but also offers high
value. The value arises from the detailed information that customers can get at Tim’s
place. (Some technically-oriented customers might also get value from being able to “talk
shop” with the store personnel.)

In contrast, MegaLo Mart offers wide variety and low prices. Cost leadership, coupled
with an almost infinite selection, is the draw. However, a customer is unlikely to get the
same level of detailed information.

Thus, the average customers at MegaLo Mart know what they need or have simple in-
formation needs. Customers who need more hand holding will gravitate toward Tim’s
shop.

b.
Yes. Tim’s expenditures on resources are consistent with his strategy. He is willing to
pay a premium wage rate to attract and retain skilled employees who have vast
knowledge about hardware. The skill translates into higher sales per person, as well as
(we suspect) higher margin per sales $.

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c.
We expect considerable variation in management control systems. MegaLo Mart likely
has strict policies and exercises close (numbers-based) controls on sales per square foot,
sales by category, by sales-person, profit margins, and operating expenses. The store like-
ly has an extensive inventory control and tracking system.

Tim’s shop likely has far looser controls. Inventory controls are more likely to be in
someone’s head (“I think I have a unit in the back corner”) than computerized. The sales-
persons also have more leeway in terms of time spent with customers or authority to ac-
commodate special requests. Policies and procedures are likely more informal than those
at MegaLo Mart.

Some of these differences surely arise because of size. However, others, such as dele-
gating more authority are a function of strategic differences. This ambiguity high-
lights the difficulty in untangling the many factors that influence the evolution of a man-
agement control system.

13.45
a.
The incremental costs are as follows;

Development cost 0 - $18,000 ($18,000)

Cost of developing supplier $100,000 – $0 $100,000
Unit costs $8-$5 / unit $3 to $6 million

Thus, the total cost of using the new component ranges from a low of $3,082,000 to a
high of $6,082,000. Because Orange expects a volume of 1 to 2 million units, the cost
per unit is between $3 to $6. Essentially, the development and supplier certification costs
can be ignored. The debate will center on whether the extra 5% in battery life is “worth”
$3-$6 per unit. (Notice that the $750,000 of development cost is sunk and is not relevant
to the analysis).

b.
In our mind, the answer is clear: Orange should go with the new component. Its prod-
ucts sell because they are on the technological and design cutting edge. Both physical
(size, shape) and technological (battery life, software interface) features are key drivers of
product adoption. There is also considerable brand equity generated by these products,
which carries over to subsequent generations. Thus, sacrificing less than 5% of contribu-
tion to gain a significant but hard-to-quantify benefit seems worthwhile (Note that the
contribution margin is around $125 per unit, given a contribution margin ratio of 50% on
a selling price of $249 per unit. Thus, an additional cost of $3-$6 per unit constitutes less
than 5% of the contribution margin.)

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13.46
We begin by calculating the contribution margin at the different prices
Sales $199.00
- Contribution margin $79.60 (40% )
= Variable cost $119.40
- Variable selling costs ($199*0.1) 19.90
= Variable mfg. cost $99.50

We can plug these data in to the $174 price to get the contribution at that price.

Sales $174.00
Variable mfg. cost $99.50
Variable selling costs ($174 * 0.1) $17.40
= Contribution margin $57.10

We can now calculate expected profit under the two scenarios. Notice that the develop-
ment cost is sunk and is not relevant for the computations.

$199 price $174 price

Sales 2,000,000 3,000,000
Contribution margin $159.2 million $171.30 million
Cost of factory 140.0 million 160.0 million
Salvage value 25.0 million 30.0 million
Net factory cost 115.0 million 130 million
Net profit (= CM – net factory cost) $44.20 million $41.30 million

Based purely on financial considerations (and assuming accurate estimates), the firm
should go in for the high price - low volume niche. However, the differential is small
(less than 10% of the expected profit). The decision therefore has to turn on confidence in
our estimates. Typically, firms would run scenario analyses to estimate the variance in
profit. They also would consider the effect of this product’s pricing and volume on the
sales of future products (e.g., because of brand loyalty being built up). Overall, the deci-
sion is not clear cut.

Note: We would probably go with the larger market share strategy because we believe
that this market is likely to grow significantly. Getting our brand in front of consumers
might be the best long-run strategy.

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13.47
This problem highlights a classic issue that many firms face as they struggle to define
performance measures. The same construct, Quality, could mean very different things to
different persons within the organization as each person filters the construct via their own
tasks. Thus, a production manager might view quality as reducing scrap and increasing
outgoing quality, whereas an operations person might view quality as cycle time.

Ultimately, the firm has to decide on a single measure of quality that it publicizes and
tracks. This is because giving different messages to different people dilutes the message,
reducing its impact. However, it is extremely important to show how individual actions in
each department contribute to the overall performance.

One possible measure is a “Cost of Quality.” Traditional thought views costs relating to
quality as comprising four aspects: prevention, appraisal, internal failure and external
failure. Prevention costs include items such as vendor certification and worker training
that aim to prevent quality from slipping in the first place. Appraisal refers to activities
such as inspection that rely on assessing quality. Internal failure stems from excessive re-
jects and rework, as well as rescheduling of urgent jobs and so on. External failure costs
include the costs of warranties, penalty payments, and such.

The cost of quality is usually set as a percent of sales (say 8% as the target). This one
number has several advantages including highlighting the potential benefits from increas-
ing quality. The measure also allows management to consider actions that increase quali-
ty costs at some steps but reduce quality costs overall. For instance, investing in worker
training on process control charts could help reduce the overall defect rate and increase
outgoing quality. It is relatively easy then to use this overarching measure to induce co-
operation among the departments, as well as point out how each department’s actions
could affect this measure.

13.48
a.
The critical success factor in this case appears to be the product quality, or at least per-
ceived quality. Oliva’s product appeals to a small market segment that is likely not very
price sensitive. It is not unusual for an avid audio enthusiast to pay thousands of dollars
for a speaker system when most of us would not spend that much on an entire system.

The customers’ value propositions in this case come from two primary sources: Increased
audio quality and “status value.” The first is somewhat obvious but is often measured
subjectively. Beyond a certain point, better audio is in the ears of the listener. The second
attribute, one that few will agree to, is that often these fancy systems are bought equally
for show and as a status symbol. Those people that have become rich recently are particu-
larly susceptible to such purchases, going by the idea that they cannot have anything but
the best (as certified by experts).

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b.
From both of these dimensions, it appears that the number of five-star ratings from key
reviewers (stereo magazines, web sites, tech shows and so on) is the way to go. The mar-
ket is small and margins high. Thus, maintaining a mystique about the brand and promot-
ing its exclusivity and its documented superlative quality helps to sell the value proposi-
tion to the customer. This measure makes sure that the design and manufacturing process
focus on ensuring the best possible quality, both in terms of aesthetics and sound.

However, the volume projections give cause to revisit the above conclusion. New man-
agement appears to be expanding the brand umbrella to increase volume. In this case, it is
enough if the firm’s flagship product line obtains the best ratings. The other product lines
can shelter under this reputation and compete on price as much as quality. If such is the
new strategy, then a measure such as proposed by the CEO makes more sense. This
measure would induce the sales force to expand the number of stores carrying the product
(even if not the full range). The move could, however, dilute the prestige associated with
the brand….turning to automobiles, part of the mystique of a Ferrari is that we don’t see
one in every garage.

Ultimately, Oliva’s problem appears to be one of defining its strategy than picking the
performance measure. The firm has to choose between alternate strategies that deliver
differing value propositions to the customer. The choice of strategy then has to drive the
choice of the measure.

13.49
a.
We believe that course objectives can and do vary across classes. The objective for a
large-enrollment undergraduate class is to convey the concepts and ideas effectively.
There is little room for sustained arguments or for developing students’ oral communica-
tion skills. The objectives for a doctoral class are likely to understand and to evaluate crit-
ically current state of the art research. The goal here is to develop critical thinking skills
and the ability to perform independent research. The goal for master’s classes lies be-
tween the two, with mastery of the curriculum still looming large but with greater empha-
sis on softer skills such as written and oral communication, investigating professional is-
sues, and so on.

The key point is that course objectives systematically differ. Thus, we should expect per-
formance measures to differ systematically as well.

b.
As noted earlier, the objectives for this class are to convey a set of ideas to students.
The usual course introduces the students to a topic and gives limited exposure. The per-
formance measures therefore focus on whether the student has understood the con-
cepts. Multiple choice exams supplemented with word problems seem ideally suited for
this task. Many instructors also provide two or three exams so that the student can show
mastery of the subject in smaller pieces. In addition, as detailed below, instructors also

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provide incentives by putting points on items that foster a systematic steady approach to-
ward learning the materials.

c.
The measures complement each other by focusing on key aspects of the learning
process. The score on attendance motivates students to show up for class, a very im-
portant part of the experience. Equally important, the 20% for short-quizzes is a great
way to ensure that students have read and digested the reading material for the day. This
familiarity with the material then allows the instructor to build on the topics rather than
constantly dwell on foundational issues. The examinations, however, are the true test of
learning. A well-crafted exam does a good job of distinguishing among students who
have understood and mastered the material, who have merely followed the mechanics,
and those that need a bit more help in understanding the subject matter.

d.
Attendance and the performance on short quizzes are likely lead indicators. We sus-
pect that these scores would exhibit a strong positive correlation (not perfect though) with
the students’ performance on the examinations. Again, we expect this correlation because
these measures focus on the process of learning and the exams measure the outcomes
from this process. Exam scores would be lag indicators as they (presumably) measure
the outcome of the process.

13.50
a.
The critical success factors for Techno U. are its actual and perceived quality. As an
educational institution, the university’s quality is a function of both its students and its
faculty. The university’s reputation is central in drawing the best students and faculty to
its campus. Once there, it seems important to give faculty a free hand in designing the
best possible and most rigorous curriculum that will push these already excellent students
to a yet higher level.

Techno U.’s actions are consistent with this strategy. It draws from a worldwide pool of
applicants. It seeks not to limit applications to those that can afford it, seeking instead to
reach out to all that qualify. The school’s small size and focus on attracting the best facul-
ty (as evidenced by the high pay levels) also are consistent with this strategy of providing
an education characterized by exceptional rigor and quality.

b.
These changes likely weaken the core competency of the University. Surely not every school
can or should follow the strategy used by Techno U. However, it is difficult for the same univer-
sity to be all things to all people. Fostering an elite intellectual climate requires certain attributes
in terms of size and exclusivity. Diluting these attributes reduces the value that an elite program
can add to its students (and staff).

Nevertheless, even after they recognize the pitfalls of this strategy, administrators might engage
in such activities. This choice might result from the University administration seeking to satisfy

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multiple constituencies with potentially conflicting objectives. Unlike a for-profit organization, a

government-supported institution is subject to political pressures. These pressures could some-
times lead to sub-optimal action choices.

13.51
a.
George’s experience is not unusual in today’s corporate environment. George is follow-
ing the firm’s guidelines and is doing what he thinks is best for the firm. However, mis-
alignment between the firm’s rhetoric and its performance measurement system has land-
ed George into trouble. Due to this misalignment, George may no longer be motivated
to engage in future “soft” initiatives launched by the firm. In particular, the firm
seems not to “put its money where its mouth is.” Items such as diversity and building
employee skill levels are costly endeavors that have hard to measure payoffs. The belief
in such initiatives is that diversity encourages open thinking and leads to a more effective
workforce. In turn, the firm hopes to have more satisfied employees, with attendant fi-
nancial gains. Likewise, investing in training might help the firm by increasing the effi-
ciency and effectiveness of its workforce.

Unfortunately, many firms only recognize the costs of these initiatives in their perfor-
mance measurement systems. In particular, a focus on financial measures means that the
cost impact is recognized immediately. However, the revenue impact might not occur un-
til much later and may even occur elsewhere in the organization. This type of a mismatch
is particularly true for service departments that do not directly recognize revenue but en-
hance the revenue generation process in other departments and areas.

Nevertheless, a firm that does not foster and support such soft initiatives does so at
its own long-term peril. Academic research and business intuition suggest that these ini-
tiatives pay for themselves several times over in by improving the firm’s work environ-
ment.

b.
Effective firms recognize the long-term benefits and the short-term nature of the costs as-
sociated with many soft initiatives. Thus, these firms often set “quotas” for amounts to be
expended on training. Quantitative measures such as the number of new certifications
(e.g., in programming) might also be used. With respect to diversity, the firm might
measure the number and proportion of under-represented populations such as women,
Hispanics, and African-Americans.

Many people critique measures such as these by arguing that the measures force game
playing and that a focus on profit is enough. After all, these persons argue, if increased
diversity leads to greater profit, why would a manager not increase diversity voluntarily?
The answer lies in the mismatch between the timing and location of the costs and bene-
fits. The benefits of soft initiatives might occur much later and elsewhere in the firm. The
manager’s horizon, in contrast, might be much shorter, leading them to short-change
these initiatives. Firms can induce and encourage such behavior only by explicitly
promoting it, measuring outcomes, and linking the outcomes to incentive compensa-

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tion.

13.52
UCU’s primary strategy appears to be personalized service at mostly competitive prices.
The bank offers a range of convenience services and promotes local involvement. Thus, it
is important that the bank maintain a strong sense of community. At the same time, the
bank has to keep a sharp eye out for costs because depositors will flee if the bank be-
comes uncompetitive in its rate structure.

The following therefore appear to be key processes:

 Promote visibility among local organizations. Raise awareness via contests such
as “Kids Art Prize” and so on.
 Offer a wide range of convenience services such as safe deposit boxes, Certifi-
cates of Deposits, free checking, and so on.
 Use low-cost labor and management resources to offer the volume advantage
enjoyed by national banks.
 Build relations with national bank to outsource a potential demand for exotic
services.

The following table provides a possible balanced scorecard for UCU. Notice that each of
the measures corresponds to a critical process that UCU must execute to implement its
strategy.

Financial ROA

Deposit / Loan volume

Administrative costs as percent of deposits

External Number of local residents mentioning UCU as the first or

second bank when asked to name financial institutions

Customer retention rate

Number of services used by average member

Internal Deposit / lending rates as ratio of national rates

Hours of community service per employee

Number of public events with active participation by UCU

Learning and Number of new initiatives/products offered
Growth
Average wait time per transaction at branch

Percent of electronic transactions

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13.53
We would disagree that Rita’s performance should be based only on measures within her
control. The notion of local measures relies on controllability, the idea that managers
should be evaluated based on what they can control. However, local measures ignore the
process linkages among the various pieces of the organization. The effects of a decision
in one department could be felt elsewhere and much later in the organization. For exam-
ple, a decision to save on price by dealing with an unreliable vendor could prove expen-
sive because of unscheduled machine downtime.

Global measures seek to solve this problem by looking at the outcome of the entire pro-
cess. On time arrival requires Rita’s help because a plane needs to be available and ready
for flight to keep schedules. While the link is obvious with scheduled maintenance, the
link allows Rita to appreciate how much priority to give to unscheduled and unanticipat-
ed maintenance. Finally, global measures also emphasizes that individuals and teams are
part of a larger whole and that the ultimate outcome is what matters.

Global measures are not without problems, however. These measures dilute the link be-
tween individual actions and the outcome. Managers might easily argue that they exercise
little individual control over the outcome and that it is a lottery from their perspective.
The trick is to understand the process well enough to show how individual actions com-
bine into the global measure. It is equally important to link the global measure to local
measures at the level of the individual departments or processes.

Ultimately, many firms do a combination of both local and global measures, because
there are good theoretical and practical arguments for including both as performance
measures.

13.54
a.
This is a fun exercise for most people. As adults, well past the schooling age, we might
construct a scorecard such as the one listed below.
Personal characteristics
Education Number of non-fiction books read

Hours of educational TV

Hours of professional development seminars

Health Percent of days with active physical exercise

Key health indicators (weight, total cholesterol, and blood

pressure)
Emotional Number of times for losing temper
Development

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Hours spent in meditation / prayer / yoga

Organizational Time spent searching for misplaced items
skills
Number of emails pending in inbox
Number of rescheduled meetings per month
Potential to add value
Family # of times per week, dinner as a family
Time spent together on joint hobbies and sports

Hours spent helping children with their schoolwork

Number of new family friends made

Employer Sick days
Percent increase in total compensation
Community Service hours in community activities

Personal Goals
Monetary Net worth
Amount donated to charity
Non-monetary Percent of “happy’ days (subjectively measured)

b.
We visualize many links across the categories. For example, increasing organizational
skills potentially increases the value added you bring to interactions with your family,
employer, and community. In turn, this could lead to both monetary and non-monetary
gains. Likewise, improving your health via regular exercise benefits you, your family,
your employer and society (via lower health costs). The increased health also leads to a
greater feeling of happiness.
Why is this relevant to business? While the personal example shows “obvious” links, the
key idea is that we have to work on the underlying competencies and processes to pro-
gress toward our goals. For a firm, this might mean that they work on capacity building in
people, products, and systems (learning and growth). These capacities in turn lead to su-
perior organizational processes (internal processes). The finer execution adds greater val-
ue to external constituencies (customer), which translates into financial outcomes (finan-
cial). Indeed, many firms create strategy maps that outline the steps. The balanced score-
card is one way to communicate and measure progress.
Note: As an off-class exercise, set targets for yourself on key dimensions, and chalk out a
strategy for meeting these targets. Be sure to specify how you plan to procure needed re-
sources such as time, money, and effort.

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13.55
This problem serves to underscore the number of links between employee satisfaction
and profit, as well as the complexity of the relation. It is worthwhile to construct a table
that shows the change on a per employee basis:

Employee Customer Incremental Incremental Notes

skill satisfaction sales2 contribution3
1
Index index
86 92 --- ---- Current state of affairs
87 94 $1,000.00 $350.00
Incremental change in cus-
tomer satisfaction slows to
1% for each point change
88 95 1,000.00 350.00 in employee skill index
Incremental sales increases
to 0.75% for each point
increase in customer satis-
89 96 750.00 262.50 faction
90 97 750.00 262.50
Incremental change in em-
ployee skills is only ½
90.5 97.5 375.00 131.25 point for $200 in training
91 98 375.00 131.25
91.5 98.5 375.00 131.25
92 99 375.00 131.25
1
The change in customer satisfaction is twice the change in employee skills up to a score of 94. After that
level, a 1-point skill change leads to a 1-point change in customer satisfaction.
2
A 1-point change in customer satisfaction leads ½ the change in sales. Thus, $1,000 = 0.5 * (94-92) *
$100,000 per employee
3
35% of the incremental sales

These computations show that the firm would benefit from investing in skilling employ-
ees until the employee skill index reaches 90 points. After that level, additional invest-
ments cost more than they bring in additional profit.

13.56

a.
Answering this question requires that we understand that there are two sides to the rela-
tion between customer satisfaction and profitability. The first is the positive effect of
higher satisfaction on future sales, which should increase the firm’s ROA. However, in-
creasing customer satisfaction is costly. The additional costs depress the firm’s ROA by
lowering profit and increasing the asset base. The optimal level of customer satisfaction
is one where the incremental benefits equal the incremental costs of increasing satisfac-
tion.

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The pattern of data shows that increased satisfaction (from 85 points to 90 points) seemed
to lead to increased ROA. At this level, the additional benefits seem to outweigh the addi-
tional cost. However, past this level of satisfaction, it appears that costs increased more
rapidly than benefits. ROA actually dips as we move up the index. However, toward the
end of 2007, we see a marginal up tick in ROA.

We caution that these kinds of inferences also must account for the lead-lag relation be-
tween satisfaction and ROA. Increased satisfaction might take 2-4 quarters or more to re-
sult in higher ROA. Also, the relation might not be linear. Overall, Kozy Kitchens might
be wise to let its satisfaction scores stabilize at current levels (say 92-95%) and examine
the financial results before engaging in initiatives to further boost the satisfaction score.

b.
Not at all. As argued for part a, the lack of an apparent pattern could stem from several
causes.
 Ambiguity about the optimal level of satisfaction in terms of costs and benefits.
 Time lag between increased satisfaction and increased sales.
 A complex (but increasing) relation between satisfaction and sales.
 Moves by competition that increase the competition’s score. Kozy Kitchen might
have no choice but investing in increasing satisfaction.

Thus, Kozy Kitchen’s investment, at some level, has to be based on gut feel. The overall relation,
we would argue is positive. However, the return for an additional dollar of investment is unclear.
The decision has to turn on our current satisfaction levels, the cost to increased satisfaction, and
perception of the increased benefit. Perhaps equally important, we need to consider that the status
quo might not be the current sales. We might actually lose ground if we do nothing.

13.57
The following table provides the required computation.

Item Target Actual Raw Adjusted Category Weighted

Score Score Weight Total
ROA 18.50% 22% 118.92% 118.92% 0.40 47.57%
Customer satisfaction 85% 90% 105.88% 105.88% 0.30 31.76%
Discount per sales $ 5% 4.50% 110.00% 110.00% 0.15 16.50%
(reverse coded item)
Sales from new SKU’s 20% 26% 130.00% 120.00% 0.15 18.00%
Total 110.83%

It is useful to notice the following adjustments.

 The raw score is the actual score divided by the target, expressed as a percentage.
If the raw score is below 90% for any category, we can stop and no bonus is pay-
able. Notice that the raw score for the discount is the target / actual as the item is
reverse coded (lower values are better).
 We next adjust the raw score to 120% for values above 120% (sales from new
SKUs is the only affected category)

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 We next weight the totals per the instructions.

Based on this information, the manager for Joan’s Fabrics would receive a bonus of 30%
× 1.14 = 34.2%.

13.58
a.
By definition, insiders have greater information about a firm’s future prospects than ordi-
nary investors do. A firm’s CEO has access to information about the viability of new
product line, the success of efforts to contain costs, the probability of an impending mer-
ger and so on. If left unchecked, the insiders could use this informational advantage to
profit at the expense of the everyday shareholder. Thus, in most countries, strict rules
govern insider trading. In the United States, investors (legally defined by applicable laws)
must file a Form 4 that discloses all of their trades. Many websites collect and report this
information as well.

To the relevance of this information, notice that there are two reasons why an investor
may trade (consider a sale): obtain money for liquidity purposes (e.g., pay tuition for col-
lege) or lock in current prices because of a strong belief that future prices will be lower.
The second aspect obviously is useful to other investors because the insider’s belief is
based on specific non-public knowledge about the firm’s future prospects. In this way,
insider trading is a leading indicator of future performance. (Recent academic studies ev-
idence an association between insider trades and future returns.)
b.
Governments have an interest in maintaining an orderly and fair market place.
Such an institution allows for the free flow of capital and results in its efficient utiliza-
tion, increasing overall welfare. Insiders, in some sense, do not play in a level playing
field because of their access to privileged information. Thus, many Governments either
outright ban or severely regulate insider trading to increase the perception of market
transparency and fairness.
c.
This difficult question does not have a definitive answer. The cost of unregulated in-
sider trading includes an uneven trading advantage. This might raise the cost of capital as
more people become reluctant to trade for fear of taken advantage by an informed trader.
At an extreme, the market could collapse, leading to inefficient resource allocations. On
the other hand, many finance professionals and economists argue that the market will see
through such trades and that insider trading might be an efficient way of bringing relevant
information into the marketplace for securities. Whether the costs outweigh the benefits
is still open to debate.

13.59
Market participants consider numerous factors when valuing a security. Some of these
factors include:
 Customer satisfaction with the firm’s products and services. In some sense, the
buzz about the firm.

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 The depth of the firm’s product line and prospects for future growth.
 Emergence of new technologies that might threaten the firm’s business model
 The age and tenure of the firm’s CEO, particularly if the person is also the
firm’s founder.
 Weather, particularly if the firm is in a weather-sensitive industry such as trans-
portation or food processing.
 Interest rates and other indicators of macro economic performance
 Local and global political environment
All of these factors are likely informative about a firm’s future performance. For in-
stance, high customer satisfaction likely translates to good sales in the future, meaning
more profit. Likewise, the news that a founding CEO is departing often boosts a stock
price because of the belief that newer management might find better ways to add value.

The problem most investors face is that the set of potentially relevant factors is very large. More-
over, how any factor affects the stock price varies from firm to firm and from industry to indus-
try. Even within the same firm, the market’s general sentiment and current information might af-
fect how a recent news item affects prices. Thus, while one could make an argument that the
above factors are leading indicators of performance, the relation is likely very complex, rendering
them of limited use as lead indicators of future performance.

13.60
a.
Let us begin with the desired outcomes and work our way down. The following seem
consistent with RVS’ objectives.
Outcomes
Academic competence Students should be well versed in technical competence so that
they may do well in college.

Social awareness Students should graduate with a desire to put their education to
“good” uses. This awareness should be lifelong and broad in
scope.

Sense of community Students should feel a sense of loyalty to RVS and its alumni.
They should be proud to be a “Rishi.”

Processes
Curriculum This has to concern both the design and the delivery of the cur-
riculum. The program should challenge students to think and to
do so “outside the box.”

Extra-curricular A sound mind exists in a sound body. Thus, it is vital that RVS
have a strong program that encourages physical fitness. Facili-
ties for learning and practicing fine and performing arts (e.g.,
painting, music, drama) are required to create a humanist envi-
ronment. Finally, students should have opportunities to develop

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skills such as oral argumentation (e.g., debate clubs) that ena-

ble one to take on leadership roles.

Building team spirit A boarding school inherently leads to close friendships. How-
ever, it is important to provide additional opportunities. For in-
stance, a mentoring program could build bridges between older
and younger students. Having students interact with alumni
regularly could build inter-generational relations. Having inter-
house competitions on a number of dimensions could also
prove useful in building esprit de corps.

Social awareness Students must be exposed to ideas of social equity and justice
and entrepreneurship. They also should be provided with op-
portunities (and learn via examples set by the staff and alumni)
to engage in socially beneficial activities.

Resources
Students Admitting high quality students in a very important part of the
equation. Students are the raw materials that the school seeks
to transform into its “products.”

Faculty Much like machines shape steel, faculty and staff play a key
role in shaping student experiences and values. Faculty must be
of the highest moral fiber and lead via example. They also
should push students on all aspects of their performance.

Money Without funding, it is not possible to sustain the quality of the

faculty and the infrastructure needed to sustain excellence.
Primary sources of funding appear to be tuition fees, endow-
ment income and alumni contributions.

Parental involvement Even in boarding schools, parents play a critical role in a

child’s emotional development. It is important for parents to
demonstrate via words and actions that they too fully subscribe
to the school’s mission and values. Parents also play a vital role
as interested monitors of the entire process.

Alumni involvement Alumni need to be involved to provide both monetary and non-
monetary resources. They serve as the basis for the school’s
value lasting over time among its graduates.

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b.
The following table provides sample metrics that the Head Master may consider to assess
how RVS is doing.

Outcomes Academic % students admitted to first choice college

Median percentile score in standardized tests

Academic prizes won in select competitions

Social awareness Number of alumni serving on Boards of civic or-
ganizations

Percent of alumni belonging to social service ori-

ented groups such as the Rotary, Lions Club or
Jaycees
Sense of communi- % of recent alumni (2 years) donating to school
ty
% alumni with current contact information
Processes Curriculum Number of new courses

Number of courses revised this year, either for

content or for delivery

Number of academic competitions won

Extra-curricular Percent student body in school-level sports teams

Percent student body enrolled in fine arts programs

(drama club, jazz band,…)

Number of competitions won – Sports

Number of competitions won – Fine arts

Team spirit Percent student body participating in inter-house
sports / competitions

Number of dances and socials involving the entire

school

Number of disciplinary actions taken for disal-

lowed behavior (swearing, bullying etc)
Social Awareness Hours per student spent on social service activities.

Number of new projects initiated by students

Financial Fund balance

Donations as percent of last three year’s average

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Percent operating expenses covered by tuition rev-

enue
Stakeholder Students Average test scores of incoming students

Percent students on scholarships

Percent students who are children of alumni

Faculty Faculty salaries as percent of regional and national
averages

Percent with advanced degrees in teaching or their

subject

Turnover rate
Parents Percent parents attending parent-teacher confer-
ences

Number of volunteer hours

Alumni Percent alumni with current information in data-
base

Percent alumni donating to school

Number of alumni serving as mentors to students

Clearly, we have listed more performance measures than could be tracked meaningfully.
The next step in constructing a balanced scorecard requires that the school’s two key con-
stituencies – the faculty (represented by senior staff and the Head Master) and the alumni
(represented by the Board of Governors) – get together to pick a few key measures in
each category. Indeed, the instructor could use this list to generate discussion on the
“best” number of measures for a firm should track and how it should narrow the list of
possible measures. Unfortunately, we do not know a definitive answer to either question.

13.61
a.
Triple S-C’s strategy appears to rest on two pillars:

Cost Containment: This feature is essential in this commodity business. Triple S-C seeks
to contain costs in many ways.
 Reduce transactions costs via electronic processing of orders, coordination, bill-
ing and payment.
 Combine multiple orders to garner efficiencies in transportation and processing.
 Combine orders to get volume discounts with steel mills.
 Identify trends to engage in proactive hedging strategies.

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Differentiation: This feature is central for Triple S-C to maintain its competitive ad-
vantage. The firm appears to be engaging on the following to deliver value.
 The convenience of a one-stop shop that handles the entire chain from steel mill
to end-user
 Offer unparalleled flexibility in terms of configuring orders.
 Offer the entire range of alloys and processes at competitive prices

Naturally, the critical processes must support these value propositions. Thus, having a
clean user-friendly web site is important. It is also important that customers trust the web
site and rely on electronic coordination rather than pick up the phone. Triple S-C’s data
systems must allow it to identify and exploit opportunities for combining multiple orders
to save a few dollars. The system must allow for enough flexibility via signing pre-
negotiated orders with many mills, transporters and processors.

b.
The following table provides a possible BSC for Triple S-C. Notice that each of the
measures corresponds to a critical process that Triple S-C must execute to implement its
strategy. External growth has to rely on volume – both in terms of raw quantities as well
as available options. Triple S-C’s differentiator is the ability to flexibly offer the custom-
er a wide range of custom options all from a single one-shop vendor. Similarly, cost con-
tainment via electronic order processing and combining multiple orders is a key element.
Thus, it is important for Triple S-C to measure percent of orders with non-electronic con-
tract (reverse measure) and the percent of transactions handling multiple orders. Trust, a
central element in e-commerce, is a CSF as well and is measured by security breaches
(Target = 0). Likewise, growth has to come via the web design by increasing its ease and
attractiveness, as well as growing the variety of products handled.

Financial Cashflow

ROI

Sales growth
External Number of new customers

Average volume per deal

Percent revenue from alloy markets

Number unique visitors to website

Internal Number of new contracts (with mills, processors, transport-
ers) signed

Discount per purchase $ as ratio of industry average

Percent of orders with non-electronic contact

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Percent of processing / transportation transactions with more

than one customer order

Number of security incidents (rated on 1-5 scale for severity)

Learning and Growth New SKUs handled this year

New features in website

Number of customer complaints (on line and offline) re web

design

Percent uptime of servers

13.62
a.
Hercules appears to be following more of a differentiation strategy in that their core ad-
vantage is providing a personal touch and superior customer service. This service in turn
allows them to save a bit of money by not offering the latest equipment. Thus, their main
critical success factors is
1. Building and maintaining a high level of customer satisfaction. While personal atten-
tion increases satisfaction, poor facilities and high fees will reduce it.

The following two are less critical as they feed into the first factor (one positively and
one perhaps negatively).

2. Staying abreast of trends in fitness and offering facilities that are not much below that
offered by competition.
3. Keeping a tight lid on costs as there is considerable competitive pressure in this in-
dustry and entry barriers are not high.

b.
The following table provides a possible BSC for Hercules. Notice that each of the
measures corresponds to a critical process that Hercules must execute to implement its
strategy.

Financial Cashflow

ROI
External Churn (i.e., the turnover rate) among members

Number of new members

Customer satisfaction rate

Internal Number of member complaints (with a target of zero)

Number of machines not available on average day (because

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of maintenance etc)

Average wait time for a cardio machine during peak time

Learning and Growth Number of members enrolled in new classes

Number of new machines put into service

Number of staff gaining professional “personal trainer” certi-

fication

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 CHAPTER 14
Job Costing
Solutions

REVIEW QUESTIONS
14.1 (1) Discrete production of customized products (job shops), and (2) continuous produc-
tion of homogeneous products (process shops).
14.2 A job-costing system accumulates and analyzes costs separately for each product or small
batches of products. Examples of firms that use job-costing systems include law firms
and firms that build custom houses.
14.3 A process-costing system accumulates and analyzes costs by each process (or a depart-
ment) rather than by each job. Examples of firms that use process-costing systems in-
clude steel mills and paper companies.
14.4 Direct materials and direct labor are traced, and overhead is allocated.
14.5 Work in process inventory is the inventory of unfinished products at the start of a period.
Cost of goods manufactured is the cost of items finished and transferred from work in
process inventory to finished goods inventory. Cost of goods sold is the cost of products
sold in a period. It is the cost of items transferred from finished goods inventory to the in-
come statement.
14.6 A predetermined overhead rate equals expected overhead costs for the period divided by
the expected activity level.
14.7 Firms use predetermined overhead rates because actual overhead costs and activity vol-
umes frequently fluctuate.
14.8 A normal-costing system is a job-costing system that uses a predetermined overhead rate.
14.9 Underapplied overhead means that the overhead applied to jobs is smaller than the
amount actually spent on overhead. Overapplied overhead means that the overhead ap-
plied to jobs exceeds the amount spent on overhead.
14.10 False – if a firm has underapplied overhead, then the actual rate must have exceeded the
predetermined rate.
14.11 (1) correct rates are year end, (2) write off to cost of goods sold, and (3) prorate among
inventory accounts and cost of goods sold.
14.12 The adjustment will increase cost of goods sold and, in turn, decrease net income.
14.13 The proration method allocates the under- or overapplied overhead to WIP inventory, FG
inventory, and cost of goods sold in proportion to their unadjusted ending balances.
14.14 Three accounts will be affected: (1) WIP, (2) FG, and (3) COGS.
14.15 Income will be higher under the proration method because some of the adjustment will be
to the inventory account.

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DISCUSSION QUESTIONS
14.16 Job shops and process shops differ considerably in the extent to which we can trace costs
to individual units and jobs. A pure job shop makes custom products. Each unit is a sepa-
rate job and is unique. It is therefore possible to trace many costs directly to each job.
However, in process shops, it is not possible to trace most costs to individual units. Ra-
ther, we can trace the costs, even for direct materials and direct labor, only at the process
or departmental level.
14.17 Yes. Each patient’s care may be viewed as a job. Many of the costs, including the costs of
nurse care, attending physician’s time, medicines and drugs, and room occupancy can be
directly traced to the patient. Some indirect costs may still have to be allocated. However,
such a system also has elements of process costing in that we might use pre-determined
rates (e.g., $40 per hour of nursing or $100 per visit by a doctor) to determine costs rather
than use actual costs.
14.18 Business consulting firms are likely to have job-costing like systems. Fast food restau-
rants like McDonald’s have more of a process costing-type environment.
14.19 True. Batch size is one of the main differences that distinguish job shops from process
shops. Job shops can be viewed as having a production batch size of one with each batch
being unique. The batch size in process shops is typically large, with each batch consist-
ing of a large number of identical units.
14.20 A firm’s actual overhead cost and actual activity volume likely change from month to
month. Firms compute a predetermined overhead rate using expected overhead costs and
expected activity levels at the start of a plan period (usually a year), which provides a ba-
sis for computing overhead variances as the difference between actual overhead and ap-
plied overhead. These overhead variances can be potentially used for control purposes.
14.21 Using a higher predetermined overhead (for instance, using a smaller denominator vol-
ume to calculate the rate) tends to result in the overhead being overapplied. In this case,
the year-end adjustment would be income-increasing.
14.22 Assume that the budgeted overhead is $100,000 and that the normal volume is 10,000
units. Then, the predetermined overhead rate is $10 per unit. Let us say that the actual
volume is 9,500 units, and the actual overhead is also $100,000. Overhead would be un-
derapplied by $5,000 (9,500 × 10 - $100,000). The actual overhead rate is
$100,000/9,500. The error in the predetermined rate is $10 – ($100,000/9,500). Multiply-
ing this by the actual production units we get 9,500 × [$10 – ($100,000/9,500)] = -
$5,000, or $5,000 underapplied.
14.23 Yes, it will. Adjusting the income for the entire amount of the underapplied or overap-
plied, means that the entire amount is charged to COGS. With actual rates, the adjustment
will differ because some of the amount will go toward WIP and FG inventories. Indeed,
the amounts will not agree even with proration because we use unadjusted balances as the
allocation basis.
14.24 Yes it would. If the overhead is underapplied, the income would be higher when it is pro-
rated among work-in-process inventory, finished goods inventory, and cost of goods sold
rather than written off. If overhead is overapplied, the income would be lower when it is

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prorated among work-in-process inventory, finished goods inventory, and cost of goods
sold.
14.25 We would generally agree with this statement. We view the method for disposing of
overhead as an accounting exercise to balance the books and to zero out control accounts.
The specific method used does not affect the estimate of future capacity costs and thus is
not likely to be very useful from a decision making perspective.

EXERCISES
14.26
We can use the inventory equation for the WIP account to answer the question.

Beginning WIP + (materials + labor + applied overhead) = COGM + Ending WIP.

We know the items on the left hand side. But, we need to calculate Ending WIP, which
will be the costs charged to job 232.

Direct materials $4,250

Direct labor $2,500
Mfg. overhead $3,750 $2,500 × $1.50 per
labor $
Ending WIP $10,500

(We use the total amounts charged to WIP to calculate the overhead rate as $36,000 ap-
plied overhead /$24,000 labor $ = $1.50 per labor dollar.)

Thus, we have:

COGM = $22,500 + (25,000+24,000 + 36,000) - $10,500 = $97,000.

14.27
We need to work backwards to solve this problem.

First, we find COGM = $750,000 = $800,000 COGS + $75,000 FG(ending inventory) –

$125,000 FG(beginning inventory)

Next, we find materials usage = $340,000 = $750,000 COGM + $30,000 WIP(ending in-
ventory) – $220,000 OH – $160,000 DL – $60,000 WIP(beginning inventory)

Finally, we find materials purchases = $380,000 = $340,000 materials usage +

$120,000 Materials(ending inventory) – $80,000 Materials(beginning inventory)

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14.28
a.

First, we compute material usage as $80,000 = $30,000 (materials beginning inventory) +

$70,000 materials purchases – $20,000 materials ending inventory.

Next, let’s compute the overhead rate – we have: 125,000 OH/$250,000 total direct labor
cost = $0.50 OH rate per DL$

So, the overhead charged to M1 = $0.50 * 150,000 = $75,000

We now compute COGM = $295,000 = $15,000 beginning balance in WIP + $80,000

materials usage + $150,000 payments for direct labor + $75,000 overhead – $25,000 end-
ing balance in WIP.

Finally, we compute COGS = $290,000 = $45,000 beginning balance in FG + $295,000

COGM – $50,000 ending balance in FG.

b.

Because we don’t know materials usage, we will have to work backwards to find material
purchases.

We can find materials usage via the following equation:

Usage = WIPEI + COGM – DL – OH – WIPBI

= $25,000 + $260,000 – $120,000 – (.50 * $100,000) – $50,000
= $65,000

Substituting back…

Materials purchased = $40,000 = $30,000 + $65,000 – $45,000

14.29
a.
The expected fixed overhead is $500,000 out of a total overhead amount of $1,200,000.
Thus, the remaining $700,000 constitutes variable overhead. Given the expected activity
of 10,000 machine hours, we have:
$700,000
Variable overhead rate =  $70 per machine hour.
10,000
$500,000
Fixed overhead rate =  $50 per machine hour.
10,000

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$1,200,000
Total overhead rate =  $120 per machine hour.
10,000
b.
We compute the inventoriable cost of the job as:
Job cost = Cost of direct materials + cost of direct labor + allocated overhead.
Referring to the solution from part [a], we calculated the total overhead rate to be $120
per machine hour. Therefore, the cost of this job under the job-costing system is:
Job cost = $5,000 + $8,000 + ($120 per hour × 40 hours) = $17,800.
Price = $22,250 = $17,800 × 1.25 (for the 25% markup).

14.30
Overhead application rate = Budgeted overhead / Budgeted DL costs.
Thus, the pre-determined rate is $525,000 / $150,000 = $3.50 per labor dollar.
Applied overhead = predetermined overhead rate × Actual DL costs.
Thus, Applied overhead = $140,000 labor $ × $3.50 per labor $ = $490,000.
Under/Overapplied overhead = Actual overhead - Applied overhead.
Thus, $530,000 - $490,000 = $40,000 underapplied.

14.31

Since overhead was overapplied, the products’ cost for the period should decrease.

Because Ace uses the proration method, we should allocate the overapplied overhead
among the WIP, FG and COGS accounts.

The WIP account will decrease by

$10,000 × [$25,000 / ($25,000 + $75,000 + $100,000)]
= $10,000 × 0.125 = $1,250.
Thus, the adjusted balance is $25,000 - $1,250 = $23,750.

Alternatively, we could construct a table as follows:

Item Amount Percent Allocated Adjusted
Amount of Amount
$10,000
Cost of Goods Sold $100,000 50.0% $5,000 $95,000
Finished Goods Inventory $75,000 37.5% $3,750 $71,250
Work-in-process inventory $25,000 12.5% $1,250 $23,750
Total 200,000 100.0% 10,000 190,000

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14.32
We know that

Overhead rate = budgeted overhead / budgeted activity volume

$5 per machine hour = $25,000 / budgeted hours
Budgeted hours = 5,000.

Next, we know that

Applied overhead – actual overhead = under/overapplied overhead

In this case, applied overhead is smaller than actual overhead because overhead is under
applied. Thus,

Applied overhead = $26,000 -$6,000 = $20,000.

Furthermore,

Applied overhead = actual # of machine hours × rate per machine hour

Plugging in the relevant values, we have:

Actual number of machine hours = $20,000 / $5 per machine hour = 4,000 hours.

14.33
We need to use the inventory equation in the WIP account for this item.

Beginning WIP + (materials + labor + applied overhead) = COGM + Ending WIP.

Plugging in relevant data, we have:

Beginning WIP + ($90,000 +$107,000 + $113,000) = $313,000 + 0.4 × Beginning WIP.

Solving, we calculate Beginning WIP as $5,000.

We then calculate Ending WIP = 40% × Beginning WIP = 0.4 × $5,000 = $2,000.

14.34
We know that

Applied overhead – actual overhead = under/overapplied overhead.

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In this case, overhead is overapplied, meaning that applied overhead is larger than actual
overhead. Thus,

Applied overhead = $500,000 + $50,000 = $550,000.

Furthermore,

Applied overhead = actual # of labor hours × rate per labor hour

Plugging in the relevant values, we have:

Actual number of labor hours = $550,000 / $50 per labor hour = 11,000 hours.

14.35
We have to calculate this number indirectly as an input into the WIP account.

Beginning balance + (materials+ labor +applied overhead) – COGM =Ending balance.

We know the beginning and ending balances in this account. The inflows into this ac-
count are materials, labor (the answer), and applied overhead. We calculate the cost of
materials by applying the inventory equation to the raw materials inventory account.

Materials added to WIP account = $30,000 + $200,000 - $40,000= $190,000

We know applied overhead to be $150,000. The final item to calculate is COGM, which
we can do by applying the inventory equation to the finished goods account.

Beginning FG balance + COGM - COGS = Ending FG balance

$65,000 + COGM - $530,000 = $50,000, or COGM = $515,000.

Thus, $10,000 + ($190,000 + labor cost + $150,000) – $515,000 = $20,000

Labor cost = $185,000

14.36
We know that adjusted COGS is larger than the unadjusted amount. Hence, overhead is
underapplied. Further, the adjustment is $757,500 - $720,000 = $37,500.

However, this is not the entire amount of the underapplied overhead. This is only the por-
tion allocated to COGS. Under proration, COGS would have received
$720,000/($720,000 + $54,000 + $90,000) = 83.33% of the total underapplied overhead.

Thus, the total underapplied overhead is $37,500/0.83333 = $45,000 underapplied.

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14.37
a.
We have
Actual overhead $260,000
Applied overhead $280,000
Overapplied overhead ($20,000)

Closing the amount to the COGS give us an adjusted COGS of $200,000 - $20,000 =
$180,000.

Notice that we reduce the COGS because overhead is overapplied.

b.
The percentage of overapplied OH that should be prorated to COGS is

$200,000 / ($50,000 + $150,000 + $200,000) = 50%.

Thus, the adjustment amount that should be applied to COGS is $10,000.

The adjusted COGS is therefore $200,000 - $10,000 = $190,000

Alternatively, you could construct a table as follows:

Item Amount Percent Allocated Adjusted
amount Amount
Cost of Goods Sold $200,000 50.0% $10,000 $190,000
Finished Goods Inventory $150,000 37.5% $7,500 $142,500
Work-in-process inventory $50,000 12.5% $2,500 $47,500
Total $400,000 100.0% 20,000 380,000

14.38
a.
We can do this problem in two ways. The first way is to calculate the flow through the
WIP account. However, this method is tedious.

A shorter way, however, is to recognize that neither jobs J5-59 nor X9-60 are in the WIP
account. Only job T10-61 is left in WIP. This job has costs of:

Direct materials $37,000

Direct labor 35,000
Mfg. overhead 43,200 1,200 hours × $36 per machine hour
Total $115,200

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b.
The only job remaining in Finished Goods is X9-60. Using the same logic as in part (a),
the cost in the FG inventory is:
Beginning value $39,500
Direct materials 0 none were added
Direct labor $20,000
Mfg. overhead $ 7,200 200 hours × $36 per machine hour
Total $66,700

14.39
a.
The budgeted overhead rates for the most recent year are:
Variable overhead rate = $62 per rug,
Fixed overhead rate = $25 per rug,
Total overhead rate = $87 per rug.

Calculating applied overhead using the actual number of rugs produced, we find:

Variable overhead applied = $62 × 9,750 = $604,500

Fixed overhead applied = $25 × 9,750 = $243,750
Total overhead applied = $87 × 9,750 = $848,250

b.
Total overhead under- or overapplied
= Actual total overhead - Applied total overhead
= $848,250 – $848,250 = $0.

Thus, total overhead was neither under- nor overapplied.

Fixed overhead under- or overapplied

= Actual fixed overhead - Applied fixed overhead
= $603,250 – $604,500 = ($1,250) or $1,250 overapplied.

Fixed overhead under- or overapplied

= Actual variable overhead - Applied variable overhead
= $245,000 – $243,750 = $1,250 or $1,250 underapplied.

Notice that the amounts by which fixed and variable overhead are under- or overapplied
exactly offset each other. Such an exact offset is generally unlikely.

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14.40
a.
The total overhead rate at the beginning of the year is:

Total overhead rate = Fixed overhead rate + Variable overhead rate

$7,200,000
=  80 = $152 per labor hour.
100,000

b.
The applied overhead for the year = Actual direct labor hours × overhead rate.
= 120,000 hours × $152/hour = $18,240,000.

The actual overhead incurred was $18,000,000.

Thus, under- or overapplied overhead

= Actual overhead incurred – Applied overhead
= $18,000,000 – $18,240,000
= ($240,000), or $240,000 overapplied.

c.
Because the overhead is overapplied by $240,000, cost of goods sold is overstated.
Therefore, writing off the amount of cost of goods sold will decrease cost of good sold
and, in turn, increase income by $240,000.

14.41
a.
Manufacturing overhead rate = Budgeted overhead / Budgeted activity volume
= $275,000 / 20,000 Machine hours
= $13.75 per machine hour

b.
The ending balance of Finished Goods is Job no. 401:

Prior period’s production costs $211,250

Current period’s production costs:
Direct materials $33,000
Direct labor $15,200
Applied overhead $34,375
Total $293,825

Applied overhead = 2,500 machine hours × $13.75 per machine hour

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c.

Actual overhead
= $50,000 + $53,000 + $26,250 + $168,000
= $297,250.

Applied overhead = Total machine hours × $13.75 per machine hour

= (2,500 + 6,800 + 6,500 + 12,000) × $13.75 per machine hour
= $382,250.

Thus, overhead is under- or overapplied by

= 297,250 - $382,250 = ($85,000) or $85,000 overapplied.

14.42
a.
Lone Star Glassworks would apply factory overhead as:

Factory overhead applied =

Overhead rate per direct labor hour × actual direct labor hours.

Thus,

Factory overhead applied = $8 × 50,000 = $400,000.

b.
We calculate underapplied (overapplied) overhead as:

Underapplied (overapplied) overhead = Actual overhead incurred – Applied overhead

From part (a), we know factory overhead applied = $400,000.

Actual factory overhead for the year = $415,000

= $160,000 indirect labor + $75,000 depreciation on manufacturing equipment +
$60,000 factory fuel + $120,000 factory rent.

Note: We do not include sales commissions because, under GAAP, sales commissions are
a period cost and not an inventoriable product cost.

For Lone Star, overhead was underapplied by $15,000 = $415,000 – $400,000 for the
year.

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14.43
a.
Dept A overhead rate =Dept Budgeted OH / materials cost in department
= $ 9,000,000 / [($6,000 per unit × 4,000 units) + ($6,000 per unit × 2,000 units)]
=$9,000,000 / $36,000,000
= $ 0.25 per materials dollar

Dept B overhead rate = Dept Budgeted OH / (Machine hours in Dept)

= $3,000,000 / [(4,000 units × 40 hours per unit) + (2,000 units × 20 hours per unit)]
= $3,000,000 / 200,000 hours
= $15 per machine hour

b.
Inventoriable cost consists of materials, labor, and applied overhead.

Materials $6,000
Labor in department A 1,000
Labor in department B 750
Overhead in department A 1,500 $6,000× 0.25/material $
Overhead in department B 300 20 machine hours × $15 per machine hour
Total cost $9,550

14.44
a.

For the previous year, Reliable has total overhead of ($500,000 + $600,000) =
$1,100,000, and 10,000 budgeted machine hours. Thus, its total overhead rate is $110 per
machine hour.

Repeating the exercise for the current year, we calculate the total overhead rate as $100
per machine hour.

b.
The manufacturing cost for a product comprises the cost of materials, labor, and over-
head. Using the overhead rates from part (a), we calculate the allocated overhead per unit
as ($110 × .25 per unit) = $27.50, and ($100 × .25 per unit) = $25.00 for the previous and
current years, respectively. Adding these costs to the cost of materials and labor yields:

Previous Year Current Year

Materials + DL cost per unit $45.00 $45.00
Allocated overhead per unit $27.50 $25.00
Cost per unit $72.50 $70.00

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c.
The unit cost has come down by $2.50 per unit from the previous year to the current year.
However, this fact does not necessarily mean that the firm has reduced costs or increased
efficiency. In particular, each unit actually consumed 0.25 machine hours both last year
and this year. Thus, there is no gain in efficiency.

The decline in reported cost arises because the fixed overhead rate and, in turn, the total
overhead rate has changed.

The variable overhead rate has stayed the same because the total variable overhead has
increased in direct proportion to machine hours. In the prior year, Reliable budgeted
10,000 machine hours and, in the current year, Reliable budgeted 12,500 machine hours.
At a variable overhead rate of $60 per machine hour (=$750,000/12,500 hours), this in-
crease of 2,500 machine hours corresponds exactly to an increase in variable overhead of
$150,000.

On the other hand, the budgeted fixed overhead has stayed the same at $500,000. How-
ever, because budgeted machine hours have increased from 10,000 to 12,500, the fixed
overhead rate has declined from $50 per machine hour to $40 per machine hour.

This decline in fixed overhead rates is the only reason for the apparent decline in costs.
Stated differently, the firm was able to utilize its capacity better, resulting in less money
lost to idle capacity. We are not comfortable, however, terming this higher utilization as
reducing costs.

Note: In general, as the volume of activity increases but the fixed overhead stays the
same, the fixed overhead rate declines. However, the variable overhead rate stays the
same as long as the variable overhead increases in the same proportion. Thus, one way of
distinguishing fixed and variable overhead items is to look at the trend in the respective
rates over time as the volume of the allocation base fluctuates. Variable overhead rates
would remain relative stable, whereas fixed overhead rates would vary inversely with
volume.

14.45
a.
Let us begin by first calculating the amount of under- or overapplied overhead.

Underapplied (overapplied) overhead = Actual overhead incurred – Applied overhead.

For the labor-related pool, we have:

Underapplied overhead = $1,445,400 – ($0.80 × 1,800,000) = $5,400.

For the machine-related pool, we have:

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Overapplied overhead = $1,816,550 – ($22 × 84,000) = ($31,450).

Thus, the total under- or overapplied overhead is ($31,450) + $5,400 = $26,050 overap-
plied.

When we write off under- or overapplied overhead to COGS, net income decreases or in-
creases by a like amount. Overapplied overhead reduces COGS and increases net income.
Thus, the year-end adjustment increases Magenta’s net income to $471,330 = $445,280
+ $26,050.

b.
In part (a), the adjustment resulted in net income increasing by the entire amount of the
overapplied overhead. However, by definition, when we prorate (or allocate) overapplied
overhead among COGS and the inventory accounts, we allocate less than $26,050 to
COGS. Thus, the amount of decrease in COGS, and the corresponding increase in net in-
come, would be lower than that in Part (a). Thus, Magenta’s income would be lower
than the answer computed in part [a].

PROBLEMS
14.46
a.
Underapplied (Overapplied) overhead = Actual overhead – Applied overhead.

We know that actual overhead is $692,415. Further, applied overhead = $679,815, the
sum of the applied overhead amounts in WIP, FG, and COGS
(=$61,183.35+$95,174.10+$523,457.55, respectively). Thus,

$692,415 - $679,815 = $12,600 underapplied overhead.

b.
Closing out the underapplied overhead to COGS would increase COGS, thereby reducing
income. Thus, the adjustment for underapplied overhead would reduce Longhorn’s net
income by $12,600, from $122,342 to $109,742.

c.
Under proration, the underapplied overhead would be allocated among the WIP, FG, and
COGS accounts. No adjustment would be made to the Raw Materials account because no
overhead has been charged to this account in the first place. The adjustment in each ac-
count is proportional to the ending balances as shown below:

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Work in process Finished Goods Cost of Goods Sold Total

Unadjusted year-end value $143,516.50 $215,274.75 $1,076,373.75 $1,435,165
% of value in account 10% 15% 75% 100%
Allocation for underapplied
overhead $1,260.00 $1,890.00 $9,450.00 12,600
Adjusted balance $144,776.50 $217,164.75 $1,085,823.75 $1,447,765

We find that COGS increases by $9,450, meaning that net income decreases by a like
amount. We compute adjusted net income as $122,342 - $9,450 = $112,892.

d.
This requirement is similar to requirement [c] except that the allocation basis is different.
We now allocate based on the current period overhead, rather than the end of year bal-
ances, as shown below.

Work in process Finished Goods Cost of Goods Sold Total

Current period overhead 61,183.35 95,174.10 523,457.55 679,815
% of value in account 9% 14% 77% 100%
Unadjusted value at year end $143,516.50 $215,274.75 $1,076,373.75 $1,435,165
Allocation for underapplied
overhead $1,134.00 $1,764.00 $9,702.00 12,600
Adjusted balance $144,650.50 $217,038.75 $1,086,075.75 $1,447,765

Thus, we find that COGS increases by $9,702, meaning that net income decreases by a
like amount. We have the adjusted net income as: $122,342 – $9,702 = $112,640.

e.
The results differ because of the different allocations of the underapplied overhead of
$12,600. The methods in (b) – (d) use differing allocation basis: all to COGS, proportion-
al to ending balances, proportional to overhead applied during the year.

Intuitively, we might expect the answers for parts (c) and (d) to be the same as we are
prorating overhead in both instances to the same accounts. However, the amounts allocat-
ed differ the ratio of overhead to the ending balance would vary across the accounts. For
instance, for Longhorn, WIP comprises 10% of the total value but only 9% of the over-
head. Such a discrepancy might arise because we still have to perform some work on the
units in WIP (meaning that we would allocate more overhead to these units).

14.47

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a.
Manufacturing OH rate = $1,728,000 / (24 persons * 2,000 artisan hours per person)
= $36 per artisan hour

b.
The unadjusted balance of Cost of Goods Sold is the cost of Job no. 101:

Prior period’s production costs $200,000

Current period’s production costs:
Direct materials $160,000
Direct labor (1,000 DLHs × $50) $ 50,000
Overhead (1,000 DLHs × $36) $36,000
Total $446,000

c.
First, let us calculate the under- or overapplied overhead. We have:

Actual overhead = $187,500 + $50,000 + $30,000 + $108,500 = $376,000.

Applied overhead = $36 per artisan hour * (1,000 + 6,500 + 3,000) hours = $378,000.

Overapplied overhead = $378,000 - $376,000 = $2,000.

The adjusted cost of goods sold is therefore $446,000 - $2,000 = $444,000.

14.48
a.
Let us begin by calculating the overhead rate as
Total overhead / total machine hour
= $4,000,000 / 200,000 = $20 per machine hour.

Thus, the job’s total cost is:

Materials given $5,000

Labor 250 hours × $16 $4,000
Overhead 1,000 hours ×$20 $20,000
Total $29,000

Notice that we apply overhead based on the total machine hours, across both depart-
ments. Thus, 250 hours = 100 + 150 hours; 1,000 hours = 400 + 600 hours.

b.
Let us begin by calculating the overhead rates

Materials handling $1,500,000 / 150,000 = $10 per labor hour

Assembly $2,500,000 / 100,000 = $25 per machine hour

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Thus, the job’s total cost is:

Materials given $5,000

Labor 250 hours × $16 $4,000
Overhead 100 labor hours ×$10 $1,000
Overhead 600 machine hrs × $25 /hr 15,000
` Total $25,000

Notice that we apply materials handling overhead only on the labor hours in that de-
partment (100 hours), and the assembly department overhead only on the machining
costs in that department.

14.49
a.
The accounting equation for the raw materials account is:

Ending balance = Beginning balance + raw materials purchased – raw materials issued to
production. Thus,

$80,000 = $60,000 + raw materials purchased - $225,000.

Therefore, raw materials purchased = $245,000.

b.
Total costs charged to production = raw materials issued to production consumed
+ direct labor cost + (120% × direct labor cost) = $885,000.

$225,000 + direct labor cost + (1.2 × direct labor cost) = $885,000.

2.2 × direct labor cost = $885,000 - $225,000 = $660,000.

Therefore,
Direct labor cost charged to production = $300,000.

c.
The accounting equation for the work-in-process account is:

Ending balance = Beginning balance + costs charged to operations – cost of goods

manufactured.

$105,000 = $80,000 + $885,000 - Cost of goods manufactured.

Cost of goods manufactured = $860,000.

d.
Overhead applied during the period = 120% × direct labor cost

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= 1.2 × $300,000 = $360,000.

Actual overhead incurred is $400,000.

Underapplied (overapplied) overhead = Actual overhead incurred – Applied overhead

= $400,000 - $360,000 = $40,000,
= $40,000 underapplied.

e.
We can express cost flows through the finished goods account using the following ac-
counting equation:

Ending balance = Beginning balance + Cost of goods manufactured – Cost of goods sold.

$320,000 = $300,000 + $860,000 – Cost of goods sold.

Cost of goods sold = $840,000

[Alternatively, we can calculate cost of goods sold as cost of goods available for sale less
ending balance in finished goods, or $1,160,000 less $320,000, to get $840,000.]

Therefore, the balance in cost of goods sold after writing off the underapplied amount of
$40,000 is $840,000 + $40,000 = $880,000.

14.50
First, we compute COGS = $560,000 = $800,000 revenues × (1 – .30 gross margin %).
Next, we compute COGM = $585,000 = $560,000 COGS + $100,000 ending balance in
FG – $75,000 beginning balance in FG.

Next, we know that the beginning balance in WIP = $110,000

We also know that direct labor = $150,000
Further, materials usage = $225,000 = (.60 prime cost % × $150,000 DL)/(1-.60 prime
cost %)
And, OH = $240,000 = $150,000 DL × ($280,000 budgeted OH/$175,000 budgeted DL)

Combining this information, we determine that ending balance in WIP (unadjusted) =

$140,000 = $110,000 + $225,000 + $150,000 + $240,000 – $585,000

Next, we know that overhead is underapplied by $50,000 = $290,000 actual overhead –

$240,000 applied overhead.

Given the unadjusted balances in WIP, FG, and COGS (as per above), we compute the
final (adjusted) balance in WIP as:

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WIP (adjusted balance) = $148,750 = $140,000 unadjusted balance + [$50,000 ×

($140,000/($140,000 + $100,000 + $560,000))]

14.51
a.

Inventoriable cost = DM + DL + OH
For this particular shoe, we have inventoriable cost = $3,400 = $1,375 + $900 + (1.25 ×
$900)

b.

We have the following completed table:

Raw Work in Finished Cost of Goods

Materials Process Goods Sold Total
Materials $5,000 $14,250 $21,750 $84,000 $125,000
Labor $0 $7,000 $17,000 $56,000 $80,000
Allocated overhead $0 $8,750 $21,250 $70,000 $100,000
Ending balance $5,000 $30,000 $60,000 $210,000

First, we note that that raw materials account does not have any labor or overhead cost.
Next, we compute labor for WIP as $7,000 = $80,000 – $56,000 – $17,000.

Since allocated overhead = 1.25 × the associated direct labor cost, we compute allocated
overhead for WIP and FG as $8,750 and $21,250, respectively.

We solve for the remaining “?’s” by summing down or across.

c.

From the table above, we know that total applied overhead = $100,000. Additionally, the
problem text informs us that actual overhead = $92,000. So, overhead is overapplied by
$8,000.

d.

If we write-off the overapplied OH to COGS, the adjusted balance in COGS will be

$202,000 = $210,000 – $8,000.

e.

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The ending balances in WIP, FG, and COGS total to $300,000. Thus, 10%, 20%, and
70% of the overapplied OH will be subtracted from the unadjusted balances in WIP, FG,
and COGS, respectively. This gives us ending (adjusted) balances of:

WIP = $29,200 = $30,000 – .10 × $8,000

FG = $58,400 = $60,000 – .20 × $8,000
WIP = $204,400 = $210,000 – .70 × $8,000

14.52
a.
Given the unit data, we know total overhead = (4,800 × $48) + (3,200 × $72) = $460,800.

Variable overhead = 40% of direct labor $ = .40 × [(4,800 × $24) + (3,200 × $36)] =
$92,160.

Thus, fixed overhead = $460,800 – $92,160 = $368,640.

b.
We can calculate the total assembly hours required to make 4,800 units of Cavalier and
3,200 units of Classic as (4,800 × 0.80) + (3,200 × 2.40) = 11,520 assembly hours.

Total budgeted overhead = Budgeted fixed overhead + Budgeted variable overhead

= $368,640 + (0.40 × 230,400) = $460,800.

$460,800
Therefore, the new overhead rate =  $40 per assembly hour.
11,520

With this rate, each unit of Cavalier will be charged ($40 × 0.80) = $32 of overhead, and
each unit of Classic will be charged ($40 per assembly hours × 2.40 assembly hours) =
$96 per unit. Therefore,

Unit manufacturing cost of Cavalier = $20 + $24 + $32 = $76.

Unit manufacturing cost of Classic = $30 + $36 + $96 = $162.

Note: With this new allocation scheme, the Classic appears even more expensive. It takes
3 times as long to assemble each Classic compared to each Cavalier. In contrast, with la-
bor dollars as the allocation basis, the Classic attracted only 1.5 times the overhead as the
Cavalier because the labor content of the Classic was 1.5 times that of the Cavalier. The
question of which of these two allocation bases is more appropriate depends on which of

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these bases better captures the consumption of overhead resources. We addressed these
issues in detail in Chapter 10, Activity Based Costing.

14.53
a.
We can calculate the budgeted total overhead rate as:
Total budgeted overhead $600,000
Budgeted overhead rate =   $0.80 per labor hour.
Total budgeted labor cost $750,000

With this overhead rate, we can calculate applied overhead.

Applied overhead = $0.80 × Actual labor cost incurred.

= $0.80 × $900,000 = $720,000.
Therefore,

Underapplied (overapplied) overhead = Actual overhead – Applied overhead

= $640,000 - $720,000 = ($80,000), or
$80,000 overapplied.

b.

There are three jobs in work-in-process at the end of the year – Jobs 126, 130, and 137.
At the rate of $0.80 for every labor dollar, the overhead applied to these jobs would be:

Overhead applied to Job 126 = $25,000 × 0.80 = $20,000.

Overhead applied to Job 130 = $15,000 × 0.80 = $12,000.
Overhead applied to Job 137 = $40,000 × 0.80 = $32,000.

Therefore,
The cost of Job 126 = $10,000 + 25,000 + $20,000 = $55,000.
The cost of Job 130 = $8,000 + $15,000 + $12,000 = $35,000.
The cost of Job 130 = $38,000 + $40,000 + $32,000 = $110,000.

The ending balance in work-in-process (before year-end adjustments) is ($55,000 +

$35,000 + $110,000) = $200,000.

c.
The following table prorates the overapplied overhead of $80,000 to work-in-process,
finished goods, and cost of goods sold.

Unadjusted Allocation Adjusted

Account Proportion
balance of $80,000 balance
Work-in-process $200,000 20% $16,000 $184,000
Finished Goods $300,000 30% $24,000 $276,000

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Cost of Goods Sold $500,000 50% $40,000 $460,000

Total $1,000,000 100% $80,000 $920,000

d.
If the company had chosen to write off the entire $80,000 of overapplied overhead to cost
of goods sold, then income would have increased by $80,000. Because of proration, the
income only increases by $40,000. Therefore, income would be higher under the write
off approach by $40,000 (= $80,000 - $40,000).

14.54
a.
$600,000
Overhead rate for machine operations = = $80 per machine hour.
7,500

$300,000
Overhead rate for assembly = = $15 per labor hour.
20,000

b.
Applied overhead in Machine operations = $80 × 12,000 = $960,000.

Actual overhead in Machine operations = $650,000.

Therefore, overhead was overapplied in machine operations by $310,000.

Applied overhead in Assembly = $15 × 22,000 = $330,000.

Actual overhead in Assembly = $275,000.

Therefore, overhead was overapplied in assembly by $55,000.

c.
Cost of Job #C252 in work-in-process = $2,000 + $6,000 + ($80 × 40) + ($15 × 250)
= $14,950.

The following table pro-rates the total overapplied overhead of $365,000 ($310,000 +
$55,000) to work-in-process, finished goods, and cost of goods sold accounts.

Unadjusted Allocation Adjusted

Account Proportion
balance of $365,000 balance
Work-in-process $14,950 1.63% $5,950 $9,000
Finished Goods $150,000 16.39% $59,824 $90,176
Cost of Goods Sold $750,000 81.98% $299,226 $450,774
Total $914,950 100% $365,000 $549,950

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With pro-rating, income will rise by $299,226 for the year.

Clearly, in this case, McMaster has significantly over-estimated its overhead rate. In par-
ticular, the actual volume of operations is much higher (12,000 versus 7,500). Although
the overhead costs also increased, the actual overhead rate of $650,000/12,000 = $54.16
for machining is significantly lower than the budgeted rate of $80 per machine hour. This
error is the reason for the large overapplied overhead.

14.55
a.
We can add up the listed amounts for overhead to calculate the overhead as $350,000
for production and $250,000 for assembly. We then have:

$350,000
Overhead rate for Production = = $14 per machine hour.
25,000

$250,000
Overhead rate for Assembly = = $0.50 per labor dollar.
$500,000
b.
We know that the applied overhead in the production department is $322,000. Thus,

$322,000 = $14 × Actual machine hours worked, or

Actual machine hours worked = 23,000.

c.
Applied overhead in Assembly = $0.50 × actual direct labor cost
= $0.50 × $550,000 = $275,000.

d.
We first compute the amount by which overhead is under- or overapplied.

In Production, overhead is underapplied by $38,000 (= actual of $360,000 – applied

overhead of $322,000). In Assembly, overhead is overapplied by $50,000 (= actual of
$225,000 – applied overhead of $275,000). Combining the two departments, overhead is
overapplied by $12,000.

Since this overapplied amount is written off as an adjustment to cost of goods sold, its
balance decreases by $12,000 from $1,650,000 to $1,638,000.

The gross margin after adjustment would be $1,612,000 (= sales of $3,250,000 – cost
of goods sold of $1,638,000).

14.56
a.

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Using normal volume, the total overhead rate for the year is:

Total overhead rate = Fixed overhead rate + Variable overhead rate

$7,200,000
=  $80 = $128 per labor hour.
150,000

b.
Using the rate from part (a), applied overhead for the year = Actual direct labor hours ×
overhead rate = 110,000 × $128 = $14,080,000.

The actual overhead incurred was $16,000,000. Thus,

Underapplied (overapplied) overhead = Actual overhead incurred – Applied overhead

= $16,000,000 - $14,080,000 = $1,920,000, or $1,920,000 underapplied.

c.
Because the overhead was underapplied by $1,920,000, cost of goods sold is understated.
Therefore, writing off the amount of cost of goods sold will increase cost of good sold,
and decrease income.

d.
Using budgeted direct labor hours, we compute the total overhead rate as:

Total overhead rate = Fixed overhead rate + Variable overhead rate

$7,200,000
=  $80 = $152 per labor hour.
100,000

The applied overhead for the year = Actual direct labor hours × overhead rate
= 110,000 × $152 = $16,720,000.

The actual overhead incurred was $16,000,000. Thus,

Underapplied (overapplied) overhead = Actual overhead incurred – Applied overhead

= $16,000,000 - $16,720,000 = $720,000, or $720,000 overapplied.

If Hansen writes off this amount to cost of goods sold, the resulting adjustment will de-
crease cost of goods sold and increase net income.

e.
By allocating fixed costs using budgeted volume, Hansen charges all costs to the volume
budgeted for the year. Thus, last year, only 100,000 hours of direct labor were budgeted,
much below the normal volume of 150,000 labor hours, which indicates that the company
did not expect to utilize its capacity fully. Consequently, the fixed costs (including the

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costs of projected idle capacity of 50,000 labor hours) are spread over a smaller volume,
resulting in a higher fixed overhead rate ($24 per hour higher = $152 - $128).

In contrast, by allocating fixed costs using normal volume, Hansen does not charge all
costs to the volume budgeted for the year. This leads to stable product costs and can facil-
itate pricing and product emphasis decisions. On the downside, using normal volume can
lead to large underapplied overhead amounts, and income decreasing adjustments at year
end, when actual volume is consistently less than normal volume.

Most firms employ some variant of budgeted volumes to compute predetermined over-
head rates. Chapter 10 discussed in detail the merits of alternative volume basis.

Note: The accounting for unused capacity is an item that is under debate both in the pro-
fessional and practitioner communities.

14.57
a.
There could be legitimate disagreement about Jaiying’s profit. The item under dispute is
whether the profit computation should include the overhead charge. In other words,
should Jaiying take a short- or long-term view in computing the operating profit from the
job?

There is little dispute about Jaiying’s contribution margin from the job. It is $24,000 –
$7,200 – $8,000 = $8,800. It is not clear whether Jaiying’s expenditure on overhead
would increase by $500 (=$8,000 applied based on actual labor - $7,500 budgeted) be-
cause of the increased labor cost. After all, the overhead represents an allocation of ca-
pacity costs, which are fixed in the short term. While Jaiying needs to include an alloca-
tion for overhead in pricing (she does need to take a long-term view in pricing), it is not
clear that such an allocation is useful for assessing operational efficiency. Such a control
role is a key driver for computing job-level profits. For that purpose, Jaiying should focus
on contribution margin (as we detailed in Chapters 4-7).

b.
The following table provides the required analysis.

Bid Actual Variance

Revenue $24,250 $24,000 $250 U
Direct materials $7,000 $7,200 $200 U
Labor $7,500 $8,000 $500 U
Contribution margin $9,750 $8,800 $950 U

As detailed in Chapter 8, we could further decompose the labor variance of $500U into a
price and an efficiency portion. Using the columnar format, we have:

Budgeted As if budget Actual cost

500 × $15 = $7,500 550 × $15 = $8,250 $8,000

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Thus, the labor efficiency variance = $750 U ($7,500 - $8,250) and the labor price vari-
ance is $250 F ($8,250 - $8,000).

Note: we do not have enough information to decompose the materials variance into price
and efficiency components.

c.
The variance analysis does not include a flexible budget because there is no change in
output volume. That is, Jaiying budgeted costs for a certain amount of work (say a job
that delivered 10,000 units). Her actual costs would then be computed for the same
amount of work (after all, the customer will demand 10,000 units before payment).

14.58
a.
The firm’s total variable overhead is:
(10,000 × $1 per hour) + (20,000 × $5 per hour) = $110,000

The total fixed overhead is $400,000+ 630,000 = $1,030,000

Thus, total overhead is $1,140,000 = $110,000 + $1,030,000

The rate is $1,140,000/30,000 = $38 per labor hour.

b.
Machining OH Rate = [($1 × 10,000) + $400,000] / 10,000 hours = $41.00 per hour

Assembly OH Rate = [($5 × 20,000) + $630,000] / 20,000 hours = $36.50 per hour

c.
Ultimate Deluxe
Direct material $85.00 $60.00
Direct labor (1.5 hours at $25.00 per hour) 37.50 37.50
Mfg. overhead in machining 32.80 24.60
(@$41/ labor hour in machining)1
Manufacturing overhead in assembly 25.55 32.85
(@$36.50 / labor hour in assembly)2
Total $180.85 $154.95
1
$32.80 = $41 * 0.8 hours; $24.60 = $41 per hour *0.7 hours.
2
$25.55 = $36.50 * 0.6 hours; $32.85=$36.50 * 0.9 hours.

14.59
a.

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The firm’s total variable overhead is:

(30,000 hours × $20 per hour) + (30,000 hours × $6 per hour) = $780,000

The total fixed overhead is $115,000+ 230,000 = $345,000

Thus, the total overhead is $780,000 + $345,000 = $1,125,000

The rate is $1,125,000 / 60,000 hours = $18.75 per labor hour.

At this rate, each product gets an allocation of 12 hours × $18.75 per hour = $225 toward
its share of overhead costs.

b.
Dept. A OH rate = [(30,000 × $20) + $115,000] / 30,000 = $23.83per DLH

Dept. B OH rate = [(30,000 × $6) + $230,000] / 30,000 = $13.67 per DLH

c.
R1 R2
Direct material $ 200.00 $ 300.00
Direct labor $ 160.00 $ 160.00
Mfg overhead in dept A
(@$23.83 per hour)1 $ 214.47 $ 119.15
Mfg overhead in dept B
(@13.67 per hour)2 $ 41.01 $ 95.69
Total $ 615.48 $ 674.84
1
$214.47 = $23.83 *9 hours; $119.15 = $23.83 per hour *5 hours.
2
$41.01 = $13.67 * 3 hours; $95.69 = $13.67 * 7 hours.

14.60
a.
The problem appears to be the way National is allocating overhead costs when develop-
ing bids. To see this, notice that the regular jobs (using data from Year 1) have an over-
head rate of $100 per labor hour (= $20.5 million / 205,000 hours). The problem states
that National has a long history with such jobs, meaning that this overhead rate would
stay the same if National did not change its underlying characteristics.

However, the overhead rate has steadily increased over time. For Year 2, the rate was
$107.317 ($22 million/205,000 hours) and was $116.279 for Year 3. It is likely that such
dramatic increases in the overhead rate occur because of the addition of the new jobs,
which seem to be resource intensive.

Indeed, the data support this conjecture. Suppose National had not added “new” jobs in
Year 1. Then, for Year 2, we expect overhead of $19 million (190,000 hours × $100 per

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hour) from the regular jobs. If we believe that the remaining overhead is because of the
new jobs, we have the rate for new jobs as $200 per hour ($3 million/15,000 hours, where
$3 million = $22 million - $19 million). Naturally, the average rate increased from year 1
to year 2. An analysis of the change in costs from Years 2 to 3 yields the same estimates
for per hour rates for the two kinds of jobs.

This information clarifies why National’s job mix is changing. Because it uses an average
rate, and because it engages in cost based pricing, National is under-pricing the new jobs
(charging overhead at $107 and $116 instead of $200 per labor hour) and over-pricing
regular jobs (charging overhead at $107 and $116 instead of $100 per labor hour).

b.
Much like the EZ-rest case that we discussed in Chapter 10, National might be able to
improve its cost estimates if it moves to a two-pool system, with one pool for costs con-
nected with regular jobs and another pool for costs associated with new jobs.

14.61
a.
Total overhead rate = Fixed overhead rate + Variable overhead rate:

$1,000,000
Total overhead rate for year 1 =  0.40 = $1.65 per labor dollar.
800,000

$1,000,000
Total overhead rate for year 2 =  0.40 = $1.2333 per labor dollar.
1,200,000

We find that the overhead rate for year 2 is lower than for year 1 because the same fixed
overhead of $1,000,000 is spread over a larger base of direct labor.

b.
The total overhead rate computed using normal labor cost will be the same for each of the
next two years. It is:

$1,000,000
Total overhead rate =  0.40 = $1.40 per labor dollar.
1,000,000
c.
Projected application of overhead = Budgeted direct labor hours  overhead rate.

In year 1, the projected application of overhead = 800,000  $1.65 = $1,320,000.

Projected total overhead = $1,000,000 + (800,000  0.4) = $1,320,000

In year 2, the projected application of overhead = 1,200,000  1.2333 = $1,480,000.

Project total overhead = $1,000,000 + (1,200,000  0.4) = $1,480,000

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Therefore, Ricardo Windows does not expect to have any underapplied or overap-
plied overhead in either year.

Intuitively, this result makes sense. There is no “projected” underapplied or overapplied

overhead because we are applying overhead using the same volume that we used to cal-
culate the overhead rate in the first place.

d.
Projected application of overhead = Budgeted direct labor hours  overhead rate.

In year 1, the projected application of overhead = 800,000  $1.40 = $1,120,000.

Project total overhead = $1,000,000 + (800,000  0.4) = $1,320,000.

Therefore, there is underapplied overhead of $200,000 in year 1.

In year 2, the projected application of overhead = 1,200,000  $1.40 = $1,680,000.

Projected total overhead = $1,000,000 + (1,200,000  0.4) = $1,480,000

Therefore, there is overapplied overhead of $200,000 in year 2.

e.
Based on the overhead rate using the normal direct labor cost, the underapplied overhead
in year 1 indicates that Ricardo expects unused capacity costs of $200,000. We know that
in year 1, the budgeted volume is less than normal volume by $200,000. Therefore, we
can calculate the projected cost of unused capacity as:

Cost of projected unused capacity = $200,000  fixed overhead rate

= $200,000  1 = $200,000.

Notice that this matches the amount of the projected underapplied overhead exactly.

The overapplied overhead in year 2 indicates that the company expects to go beyond ca-
pacity by $200,000. We know that in year 2 the budgeted volume exceeds normal volume
by $200,000. Therefore, we can calculate the fixed cost of additional capacity as:
Fixed cost of additional capacity = $200,000  fixed overhead rate
= $200,000  $1 = $200,000
Notice that this matches the amount of the projected overapplied overhead exactly.

In sum, if budgets accurate depict reality, then the use of budgeted volumes to compute
predetermined overhead rates should lead applied overhead to mirror actual overhead. In
contrast, the use of “normal” volumes frequently leads to under/overapplied overhead
and, oftentimes, significant end-of-period adjustments. There are, of course, benefits to
using long-run normal volumes – we discussed these benefits in Chapter 10, when we
discussed ABC systems.

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MINI-CASES

14.62
a.
The total overhead rate is:

Total budgeted overhead

Total overhead rate =  $2.
Total budgeted labor cost

Total budgeted overhead

 $2.
$250,000

Thus, total budgeted overhead for the previous year = $250,000 × 2 = $500,000.

b.

We can calculate the budgeted variable overhead as

Budgeted variable overhead = Budgeted total overhead – Budgeted fixed overhead.

= $500,000 - $375,000 = $125,000.

c.

Budgeted variable overhead $125,000

Variable overhead rate =  = $0.50 per labor $.
Total budgeted labor cost $250,000

d.
We know that the total overhead rate is $2 per labor dollar. We can compute total over-
head applied the previous year using this rate and actual labor cost:

Total overhead applied = Total overhead rate × actual labor cost.

= 2 × $300,000 = $600,000.

e.
The actual overhead incurred was $ 630,000. Therefore,

Underapplied overhead = Actual overhead – Applied overhead.

= $630,000 - $600,000 = $30,000 underapplied.

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f.
We know that:

Budgeted fixed overhead rate = Budgeted total overhead rate

- Budgeted variable overhead rate

= $ 2 - $0.50 = $1.50 per labor $.

We therefore calculate applied fixed overhead as:

Applied fixed overhead = $1.50 ×$300,000 = $450,000.

Then,

Fixed overhead under- or overapplied

= Actual fixed overhead -Applied fixed overhead
= $475,000 - $450,000 = $25,000 or $25,000 underapplied.

g.
We can calculate the actual variable overhead incurred as:

Actual variable overhead = Actual total overhead – Actual fixed overhead.

= $630,000 - $475,000 = $155,000.

Because the variable overhead rate is $0.50 per direct labor dollar,

Applied variable overhead = $300,000 × 0.5 = $150,000.

Therefore,

Variable overhead under- or overapplied

= Actual variable overhead -Applied variable overhead

= $155,000 - $150,000 = $5,000, or $5,000 underapplied.

h.
We know that the total overhead rate is $2 per labor dollar. Therefore,

Overhead that would have been applied to Job 125 = $20,000 × 2 = $40,000.

Overhead that would have been applied to Job 178 = $13,000 × 2 = $26,000.

Accordingly,

The cost of Job 125 in the work-in-process inventory = $16,000+$20,000+$40,000

= $76,000.

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The cost of Job 178 in the work-in-process inventory = $18,000+$13,000+$26,000

= $57,000.

The total balance in the work-in-process account = $76,000 + $57,000 = $133,000.

i.
If Superior Auto Body & Paint Shop were to write off the entire underapplied amount of
$30,000 (=$25,000 underapplied fixed overhead + $5,000 underapplied variable over-
head) to the cost of goods sold account, the balance in this amount would increase by
$30,000 from $800,000 to $830,000, causing the income (before taxes) for the period to
decrease by $30,000.

j.
The following table computes the proportions and the allocation of the underapplied
overhead of $30,000 (computed earlier) to the three accounts:
Unadjusted Allocation Adjusted
Account Balance Proportion of $30,000 balance
Work-in-process $133,000 11.74% $3,522 $136,522
Finished Goods $200,000 17.65% $5,295 $205,295
Cost of Goods Sold $800,000 70.61% $21,183 $821,183
Total $1,133,000 100% $30,000 $1,163,000

k.
Referring to part (j), we see that the balance in the cost of goods sold account increas-
es by $21,183 if the underapplied overhead is prorated to work-in-process, finished
goods, and cost of goods sold. In contrast, we found in part (i) that cost of goods sold
would increase by $30,000 if the entire amount is written off.

Consequently, the income would be higher by $8,817 ($30,000 - $21,813) if the un-
derapplied were to be pro-rated instead of being written off fully to COGS.

14.63
a.

Let us begin by computing the ending balance in raw materials and supplies. We will use
the inventory equation to determine all ending balances. For the raw materials and sup-
plies inventory we have:

Beginning balance + purchases – issued out = ending balance.

Plugging in the numbers, we have:

Item Amount
Beginning balance $28,100
Purchases: RM 112,340

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Purchases: Supplies 26,430

Issued out to WIP1 (115,450)
Issued out to overhead control (22,000)
Ending Balance $29,420
1
$114,450= $22,000+$58,000+24,000+$11,450.

b.

We know that Divine uses a predetermined overhead rate, based on labor hours. From the
budget, we know that:

Budgeted overhead for the year = $1,688,400

Budgeted labor hours for the year = 80,400

Thus, overhead rate per labor hour = $21 per labor hour.

c.

We know that the WIP has several jobs. Let us first calculate the cost of each of the jobs
in WIP. Each job’s cost consists of the beginning value plus materials issued plus labor
costs plus overhead. We know the first three items for each job. We calculated the over-
head rate to compute the overhead charged to a job. In part (b), we calculated the over-
head rate. With this rate in hand, let us return to the valuation of individual jobs:

Job number X K L B Total

Model OO OI RO RI
Description Oval, Oval, Round, Round,
OTC in sink OTC in sink
Units 700 500 200 700
Labor hours 1,920 2,430 1,678 845 6,873

Beginning Balance $124,320 $124,320

Raw materials 22,000 $58,000 $24,000 $11,450 115,450
Labor 34,560 43,740 29,365 15,210 122,875
Overhead1 40,320 51,030 35,238 17,745 144,333
Total 221,200 152,770 88,603 44,405
Cost per unit $316 $305.54 $443.02 n/a
1
Overhead rate of $21 per labor hour * number of labor hours.

We can then summarize the information as in the following table:

Beginning Balance – WIP $124,320

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Raw materials 115,450

Labor 122,875
Overhead 144,333
Completed: X (221,200)
Completed: K (152,770)
Completed: L (88,603)
Ending balance – WIP $44,405

Notice that the value of the ending WIP is the value of job B, the only job that is incom-
plete at the end of September. The cost of goods manufactured is the total of the costs
of the jobs transferred to FG, which is ($221,200 + $152,770 + $88,603) = $462,573.

d.

Just as we did the detail for the WIP account, we need to compute the detail for the FG
account as well. We need this detail because the FG has several types of products. Let us
begin with the product level detail:

Model OO RI OI RO Total
Description Oval, Round, Oval, Round,
OTC In sink in sink OTC
Units
Beginning invento- 100 400 450 0
ry
Added this period 700 0 500 200
Sold in September 750 200 400 150
Ending inventory 50 200 550 50

Beginning Balance $32,000 $78,900 $134,100 0 $245,000

From WIP 221,200 0- 152,770 88,603 462,573
Sold (see detail) 237,400 39,450 119,200 66,452.25 462,502.25
Ending inventory 15,800 39,450 167,670 22,150.75 245,070.75

Notice two features of the above table. First, the detail in the FG inventory is by product
and not by batch. This is because there might be several batches of the same product in
store. Second, it is useful to keep track of the inventory both in units and in value, be-
cause we need to employ an inventory cost flow assumption to value the units, and dif-
ferent units of the same product might have different values because they are from differ-
ent batches.

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The following table computes the sales value of each of the products. Notice that we keep
track of the layers of inventory. Notice that the total corresponds to the Cost of Goods
Sold of $462,502.25 we computed earlier.

Model OO RI OI RO
Description Oval, Round, Oval, Round,
OTC In sink In sink OTC
Units
Beginning invento- 100 400 450 0
ry
Cost per unit (be- $320.00 $197.25 $298 N/A
ginning value /
number of units)
Sold from begin- 100 200 400 0
ning inventory
Value of units sold $32,000 $39,450 $119,200 0

Added this period 700 0 500 200

Cost per unit (job $316.00 $305.54 $443.02
cost / # of units)1
Sold from current 650 0 0 150
production
Value of units sold $205,400 $0

Total Sales $237,400 $39,450 $119,200 $66,452.25

1
$316 = $221,200/700.
e.
Answer computed as a piece of the answer to part c.

f.
Answer computed as a piece of the answer to part d.

g.

The final item we need to compute is the amount of under- or overapplied overhead. We
know:

Under/overapplied overhead = applied overhead – actual overhead.

Until September, we have

Actual overhead = $1,569,450

Applied overhead = $1,581,615 $21/labor hour × 75,315 labor hours
Overapplied OH = $12,165

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That is, Divine begins September with a credit balance of $12,165 in the overhead control
account.

Now, let us add the transactions for September in the overhead control account.

Item Amount
Beginning balance (September 1) (12,165)
Supplies $22,000
Indirect labor 32,000
Supervision 18,400
Depreciation 32,650
Utilities 8,900
Factory rent 15,400
Applied overhead
(see WIP detail) (144,333)
Ending balance ($27,148)

That is, Divine would have overapplied overhead of $27,148 as of September 30. An-
other way of computing the same answer is to compute the under/over applied overhead
for September.

Actual overhead for September $129,350

Applied overhead for September $144,333
Overapplied overhead ($14,983)

Added to the overapplied balance at the start of September, the total overapplied over-
head is $27,148 = $12,165 + $14,983.

14.64
a.
$544,000
Total overhead rate for year 1 = = $0.756 per labor dollar (rounded).
720,000

$562,000
Total overhead rate for year 2 = = $0.694 per labor dollar (rounded).
810,000

$530,000
Total overhead rate for year 3 = = $0.815 per labor dollar (rounded).
650,000

b.
Applied overhead = Overhead rate × Actual labor cost.

Overhead applied in year 1 = $0.756 × $725,000 = $548,100.

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Actual overhead in year 1 = $565,000.

Thus, overhead was underapplied in year 1 by $16,900.

Overhead applied in year 2 = $0.694 × $900,000 = $624,600.

Actual overhead in year 2 = $600,000.

Thus, overhead was overapplied in year 2 by $24,600.

c.

The total cost of Phoebe’s order in year 2 = $15,000 + $30,000 + ($30,000 × 0.694).
= $65,820.

The markup charged for each order is 50% of the total cost. Therefore:

Price charged for year 2 order = $65,820 + ($65,820 × 0.50).

= $98,730.

The total cost of Phoebe’s order in year 3 = $15,500 + $32,000 + ($32,000 × 0.815).
= $73,580.

Price quoted for year 3 order = $73,580 + ($73,580 × 0.50).

= $110,370.

d.
It is hard to disagree with Phoebe. From her point of view, both direct materials and di-
rect labor costs have not gone up by much. However, the overhead allocation rate is
much higher in year 3 than in year 2 (up from $0.694 to $0.815 per direct labor dollar).
The reason is that in year 3, the company’s fixed costs are the same as in year 2, but
Vanessa expects lower demand during the year -- the budgeted direct labor cost is down
from $810,000 in year 2 to $650,000 in year 3. One could argue that there is no reason
why Phoebe, as a customer, should pay a higher price just because things don’t look good
for Vanessa’s company.

e.
In suggesting any other method, there are at least two key issues to consider:

– Year 3 appears to be a “down” year for the company. In general, when demand
conditions are not favorable, most firms offer price cuts and discounts to stimulate
demand. The cost-plus pricing scheme that Noel Draperies has in place results in
a price increase, which is contrary to this common business intuition.

– It also does not seem intuitive that the cost of what is essentially the same job ap-
pears to be a function of outside demand conditions.

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Using normal volume to calculate the overhead rate addresses these issues because it will
not fluctuate as the volume of business fluctuates from period to period. Because Vanessa
believes the average of the actual direct labor cost over the previous two years is a fair
estimate of the normal volume of business, we have:

725,000  900,000
Normal volume of business in direct labor cost = = $812,500
2

530,000
Overhead rate in year 3 using normal volume = = $0.652 per direct labor dollar.
812,500

Using this rate, the corresponding price for year 3 is:

year 3
Direct materials $15,500
Direct labor 32,000
Applied overhead ($32,000 * 0.652) 20,864
Total cost $68,364
Markup (50%) 34,182
Order price $102,546

As we can see from these calculations and the price charged in year 2, the difference in
prices between the job in year 2 and year 3 is almost entirely due to the differences in ma-
terials and labor costs. Thus, the use of normal volume in the denominator to calculate
the overhead rate results in costing and pricing schemes that are more consistent over
time.

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 CHAPTER 15
Process Costing
Solutions

REVIEW QUESTIONS

15.1 Firms that mass produce relatively identical products.

15.2 In process costing, different units of the same batch might be at different stages of com-
pletion (either in WIP or FG), whereas in job costing a job is either in process or com-
pleted. This means that under process costing, we need to allocate the costs of a batch be-
tween completed and in-process units.

15.3 The amount of output stated in terms of completed units – e.g., 100 units that are 60%
complete represent 60 equivalent units.

15.4 It allows us to put units at different stages of completion on equal footing.

15.5 Because a job is either in process or fully completed. Thus, all of the units and the costs
stay in the WIP account until the job is complete. When the job is done, we transfer the
units (and the associated costs) to the FG inventory account.

15.6 (1) Track the physical flow, (2) compute equivalent units, (3) collect costs to allocate, (4)
calculate the rate per equivalent unit, and (5) allocate costs.

15.7 Because processes often require inputs at different stages. Materials may be added at the
beginning of the process, whereas conversion costs are incurred uniformly throughout the
process.

15.8 Depending on the stage of completion, equivalent units certainly could be different for
each cost pool. For example, units that are 50% complete would have 100% equivalent
units with respect to materials added at the start of the process and 0% complete with re-
spect to materials added at the end of the process.

15.9 Units that are finished during the period are fully complete with respect to every input –
thus, they are 100% equivalent.

15.10 By definition, units still in process are less than 100% complete. As such, they will not
contain materials added at the end of the process – thus, they will be 0% complete with
respect to this input.

15.11 Because of the presence of beginning inventory – the units in inventory produced in a
prior period might have different costs than units produced during the current period.

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15.12 Weighted average systems do not distinguish between the costs from the prior period and
the costs incurred during the current period.

15.13 Standard process costing uses predetermined rates for materials, labor, and overhead.

15.14 (1) record keeping is easier, and (2) the standard cost of work done provides a natural
benchmark for actual costs.

15.15 Standard costs provide benchmarks that firms could use to determine variances from ex-
pectations. Such information might lead to the efficient use of materials, labor, and over-
head.

DISCUSSION QUESTIONS

15.16 For a firm that makes luxury yachts, each yacht takes time to build. Most costs can be
directly traced to each yacht, with only few indirect costs requiring allocations. In con-
trast, making a soft drink is a continuous process. We can only track costs for the entire
batch, and we need to distribute the cost of making the batch to units in the batch that are
still in process (work-in-process or WIP inventory) and the portion that has been com-
pleted (cost of goods manufactured). Such allocations are typical of process costing.
15.17 In a JIT inventory environment which has minimal work-in-process inventory, there is
really no need to distribute the cost of production to work-in-process or WIP inventory.
Consequently, the cost accounting is much simpler than in process costing because there
is no need to define equivalent in-process units and so on. Nevertheless, we might still be
producing many identical units, which require that we allocate the costs among the com-
pleted units. This leads to a simple allocation of costs (total costs/total units = cost per
unit).
15.18 When goods are produced in large batches and these batches take a long time to process,
it is generally the case that a part of the batch is completed while work is still going on
another part of the same batch. Consequently, allocations are needed to spread the cost of
the batch in a proportionate manner to the completed and uncompleted portions. This is
what process costing does. In contrast, when batch sizes are small, each batch is either
work-in-process or finished, meaning that such allocations are not necessary.
15.19 The percentage-of-completion method of revenue recognition that you may have learned
in your financial accounting class is an example that is conceptually similar to process
costing. Under that method, revenues on a long-term project --that takes several fiscal pe-
riods to complete – are recognized in a fiscal period in proportion to the percentage of
work done on the project during that period. This percentage is usually calculated as costs
incurred on the project during the period as a fraction of the total expected cost of the
project.
15.20 The reason why we need to allocate even direct costs in process costing is that it is gener-
ally the case that a part of the batch is completed while work is still going on another part
of the same batch. Since directs costs can only be measured at the batch level, it must be

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allocated appropriately to the portion that is still in process and to the portion that is com-
pleted; otherwise the work-in-process and finished goods inventory accounts will not re-
flect the correct amounts.
15.21 This assumption makes sense because organizational resources are consumed only when
work gets done. For instance, direct material is requisitioned only when it is needed. La-
bor input and machine time are needed only when units are processed.
15.22 The production/line manager or the line supervisor will usually be best able to assess the
percent completion for work in process.
15.23 Let us say that there are X units in WIP. Then, we would say that WIP has 0.45X = ([0.20
× 0.50 + 0.70 × 0.50] X) equivalent completed units for work that is continuously done.
We might need to track these two pieces of WIP inventory separately if they involve ma-
terials added at specific points in the production process (e.g., if we add materials at the
50% completion stage, one part will have the materials and another will not).
15.24 We can add additional columns for each overhead rate, much like we add additional col-
umns for calculating equivalent units for different materials. We would not support using
multiple overhead rates in a process costing system. The primary purpose of the system is
to value inventory and not decision making.
15.25 We would consider each department as a separate process. The cost of the completed
parts from department 1 would be considered as material costs for department 2. The
work-in-process units in department 1 will reflect the percent completion in that depart-
ment. The work-in-process units in department 2 will reflect the completed part costs
transferred from department 1 plus the cost proportional to the percent completed in de-
partment 2.
15.26 In such settings, a batch of each product is a job. The costs of all processes required to
produce the product can be accumulated in a job cost sheet. But a process costing system
is required to accumulate the costs for the batch at each individual station or process be-
cause a part of the batch may still be in process at each station, and a part may be com-
pleted and transferred to the next station. Therefore cost systems in such settings do share
some characteristics with both job-costing and process-costing.
15.27 There are several reasons for the preference. First, the weighted average method is com-
putationally easier. This complexity is particularly salient in processes that involve many
departments. Second, the volume of inventory is usually small relative to the volume of
work done during a period, meaning that refinements such as FIFO have little gain in ac-
curacy relative to the weighted average method. Thus, firms usually use the weighted av-
erage method.
15.28 The difference in the value of the ending inventory (completed items) is a function of the
difference in costs between periods and the relative amounts in opening inventory and
throughput. The greater these differences, the more the numbers under FIFO will differ
from the numbers computed with the weighted average method. In practice, costs rarely
fluctuate dramatically across months and the throughput volume dwarfs inventory values.
Thus, the error from using the weighted average method is small.
15.29 As illustrated in the text, we can compare the standard costs of the work done this period
with actual costs to determine variances.
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Such variance analysis is likely to be more informative in a process-costing setting rela-

tive to a job-costing setting. The reason is that the firm is doing the same process over
and over, allowing it to establish meaningful standards. Such standards then become the
basis for judging actual performance (i.e., variances assume meaning).
15.30 Essentially, we will have to compute a process costing report (or at least establish rates)
for each of the processes. This part of the system looks like process costing. Then, for
each batch of items, we will track the processes that it consumes. We will add up all of
the costs of the processes to determine the cost of the batch. This part of the system looks
like job costing. Most real world systems have features of both process and job costing
systems, and are termed operations costing systems.

EXERCISES

15.31 We have the following report for Shalimar:

Total
Step 1: Track Physical Costs
Flow
Beginning inventory - April 0
1
Started during April 100,000
Total physical units to ac-
count for 100,000
Step 2: Compute Equivalent Units
Units completed during 75,000 75,000
April (100% of 75,000)
15,000
Units in process on April 30 25,000 (60% of 25,000)
Total physical units ac- 100,000 90,000
counted for

Step 3: Collect costs to al-

locate
Costs incurred during April $720,000 $720,000
Total costs to account for $720,000 $720,000

Step 4: Calculate the rate

per equivalent unit
Cost per equivalent unit $8.00
(720,000/90,000)

Step 5: Allocate Costs

Units completed during $600,000 $600,000
April (COGM) (75,000 × $8)
Units in process on April 30 $120,000 $120,000
(15,000 × $8)

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(EWIP)
Total costs accounted for $720,000 $720,000

Thus, the value of Shalimar’s COGM is $600,000 and the value of its ending WIP is
$120,000. The sum of these two amounts is $720,000, which corresponds exactly to
Shalimar’s total costs incurred during April.

15.32 We have the following for Orange:

Total Detail for each cost pool
Step 1: Track Physi- Materials Conversion
cal Flow
Beginning inventory - 0
June 1
Started during June 250,000
Total physical units to
account for 250,000
Step 2: Compute Equivalent Units
Units completed during 175,000 175,000
June 175,000 (100% of 175,000) (100% of 175,000)
Units in process on 75,000 75,000 30,000
June 30 (100% of 75,000) (0.40 × 75,000)
Total physical units 250,000 250,000 205,000
accounted for

Step 3: Collect costs

to allocate
Costs incurred during $26,540,000 $18,750,000 $7,790,000
June
Total costs to account $26,540,000 $18,750,000 $7,790,000
for

Step 4: Calculate the

rate per equivalent
unit
Cost per equivalent $75.00 $38.00
unit (18,750,000/250,000) (7,790,000/205,000)

Step 5: Allocate Costs

Units completed during $19,775,000 $13,125,000 $6,650,000
June (COGM) (175,000 × $75) (175,000 × $38)
Units in process on $6,765,000 $5,625,000 $1,140,000
June 30 (EWIP) (75,000 × $75) (30,000 × $38)
Total costs accounted $26,540,000 $18,750,000 $7,790,000
for

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Thus, the value of Orange’s COGM is $19,775,000 and the value of its ending WIP is
$6,765,000. The sum of these two amounts is $26,540,000, which corresponds exactly to
Orange’s total costs incurred during June.

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15.33 The process costing report offers a convenient way to answer the questions collectively,
as each question pertains to one of the steps in the template. Using the information pro-
vided, we have:

Total Detail
Step 1: Track Physical Flow
Beginning inventory – March 1 0
Started during March 125,000
Total physical units to account for 125,000
Step 2: Compute
Equivalent Units
Units completed during March 100,000 100,000
(125,000 – 25,000) (100% of 100,000)
Units in process on March 31 25,000 7,500
(30% of 25,000)
Total physical units accounted for 125,000 107,500

Step 3: Collect costs to allocate

Costs incurred during March $3,225,000 $3,225,000
Total costs to account for $3,225,000 $3,225,000

Step 4: Calculate the rate per

equivalent unit
Cost per equivalent unit $30.00
(3,225,000/107,500)

Step 5: Allocate Costs

Units completed during March $3,000,000 $3,000,000
(COGM) (100,000 × $30)
Units in process on March 31 $225,000 $225,000
(EWIP) (7,500 × $30)
Total costs accounted for $3,225,000 $3,225,000

Summarizing our answers:

a = 100,000
b = 100,000 and 7,500, respectively
c = $3,225,000
d = $30.00
e = $3,000,000 and $225,000, respectively.

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15.34 The process costing report offers a convenient way to answer the questions collectively,
as each question pertains to one of the steps in the template. Using the information pro-
vided, we have:

Total Detail for each cost pool

Step 1: Track Phys-
ical Flow Materials Conversion
Beginning inventory 0
– 12/1
Started during De- 645,000
cember
Total physical units
to account for 645,000
Step 2: Compute Equivalent Units
Units completed dur- 550,000 550,000
ing December 550,000 (100% of 550,000) (100% of 550,000)
Units in process on 95,000 95,000 19,000
12/31 (100% of 95,000) (0.20 × 95,000)
Total physical units 645,000 645,000 569,000
accounted for

Step 3: Collect costs

to allocate
Costs incurred during $2,959,200 $1,935,000 $1,024,200
Dec.
Total costs to ac- $2,959,200 $1,935,000 $1,024,200
count for

Step 4: Calculate
the rate per equiva-
lent unit
Cost per equivalent $3.00 $1.80
unit (1,935,000/645,000) (1,024,200/569,000)

Step 5: Allocate
Costs
Units completed dur- $2,640,000 $1,650,000 $990,000
ing December (550,000 × $3) (550,000 × $1.8)
(COGM)
Units in process on $319,200 $285,000 $34,200
December 31 (95,000 × $3) (19,000 × $1.8)
(EWIP)
Total costs accounted $2,959,200 $1,935,000 $1,024,200
for

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Summarizing our answers:

a = 550,000 (= 645,000 – 90,000)

b = Total of 645,000 for materials and 569,000 for conversion costs
c = $2,959,200
d = $3.00 and $1.80, respectively
e = $2,640,000 and $319,200, respectively.

Notice that the total of the costs allocated to the two cost objects (completed units and
units in ending WIP) sum to the total costs to account for. This equality holds both in the
aggregate and for each of the two cost pools (materials and conversion). Moreover, the
total costs in the cost pool only contain current period costs because there is no beginning
inventory.

15.35 Let us begin by using the data for finished items to calculate the cost per equivalent unit.

$162,000
Cost per equivalent unit of direct materials =  $1.80 .
90,000 EUs

$108,000
Cost per equivalent unit of conversion costs =  $1.20 .
90,000 EUs

The cost data are given and we know that finished items are 100% complete for all cost
categories.
Thus, the value of ending work in process inventory is:
= ($1.80 × 10,000 equivalent units) + ($1.20 × 7,000 equivalent units)
= $26,400.

15.36 The value of the ending WIP

= (Cost per equivalent unit of direct materials × equivalent units of direct materials
in ending inventory)
+ (Cost per equivalent unit of conversion costs × equivalent units of conversion
costs in ending inventory).
We can calculate the number of equivalent units of materials and conversion in the end-
ing WIP as:
20,000 units × 100% complete = 20,000 equivalent units of materials
20,000 units × 50% complete = 10,000 equivalent units of conversion.
We also know the cost per equivalent unit for conversion but not for materials. But, we
can back this number out using the data for the cost of goods manufactured.
We know:

$550,000 = 110,000 units

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× (Cost per equivalent unit of materials + $2.00 per equivalent of conversion)

Thus, the cost per Eq. Unit of materials = $3.00.
We can then calculate the cost of the ending WIP as:
(20,000 equivalent units of materials × $3.00)
+ (10,000 equivalent units of conversion × $2.00) = $80,000.

15.37 Igloo has only one cost pool because it only tracks conversion costs. Using the infor-
mation provided, Igloo’s standard process costing report for January is:

Total Detail
Step 1: Track Physical Flow
Beginning inventory – January 1 0
Started during January 150,000
Total physical units to account for 150,000
Step 2: Compute
Equivalent Units
Units completed during January 145,000 145,000
(100% of 145,000)
Units in process on January 31 5,000 1,500
(30% of 5,000)
Total physical units accounted for 150,000 146,500

Step 3: Collect costs to allocate Using predetermined rates –

go to step 4

Step 4: Calculate the rate per

equivalent unit
Predetermined standard rate per $15.00
equivalent unit

Step 5: Allocate Costs

Units completed during January $2,175,000 $2,175,000
(COGM) (145,000 × $15)
Units in process on January 31 $22,500 $22,500
(EWIP) (1,500 × $15)
Total costs allocated $2,197,500

Next, let us compare the actual and standard costs for the work done to compute the vari-
ance.

Item Total

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Allocated costs (from report presented above) $2,197,500

Actual Costs incurred this period (given) $2,270,750
Variance (Allocated per standard rates – Actual $73,250 U
costs)

Igloo’s conversion cost variance is unfavorable for January because actual costs exceeded
standard/budgeted costs by $73,250. Igloo has experienced a relatively large (almost 4%
of expected cost) unfavorable variance and should investigate the cause(s) for this vari-
ance and take suitable corrective actions.

15.38 Rhino’s process costing report for March is presented below:

Total Detail for each cost pool

Step 1: Track Phys-
ical Flow Materials Conversion
Beginning inventory 0
– 3/1
Started during March 74,500
Total physical units
to account for 74,500
Step 2: Compute Equivalent Units
Units completed dur- 63,250 63,250
ing March 63,250 (100% of 63,250) (100% of 63,250)
Units in process on 11,250 11,250 6,750
3/31 (100% of 11,250) (0.60 × 11,250)
Total physical units 74,500 74,500 70,000
accounted for

Step 3: Collect costs

to allocate
Costs incurred dur- $2,479,750 $782,250 $1,697,500
ing March
Total costs to ac- $2,479,750 $782,250 $1,697,500
count for

Step 4: Calculate
the rate per equiva-
lent unit
Cost per equivalent $10.50 $24.25
unit (782,250/74,500) (1,697,500/70,000)

Step 5: Allocate
Costs
Units completed dur- $2,197,937.50 $664,125 $1,533,812.50
ing March (COGM) (63,250 × $10.50) (63,250 × $24.25)
Units in process on $281,812.50 $118,125 $163,687.50

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March 31 (EWIP) (11,250 × $10.50) (6,750 × $24.25)

Total costs account- $2,479,750 $782,250 $1,697,500
ed for

Thus, Rhino’s COGM during March = $2,197,937.50 and its ending WIP inventory =
$281,812.50.

Notice that the total of the costs allocated to the two cost objects (completed units and
units in Ending WIP) sum to the total costs to account for. This equality holds both in the
aggregate and for each of the two cost pools (materials and conversion). Moreover, the
total costs in the cost pool only contain current period costs because there is no beginning
inventory.

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15.39
a.

Rhino’s standard process costing report for March is presented below:

Total Detail for each cost pool

Step 1: Track Physical
Flow Materials Conversion
Beginning inventory – 0
3/1
Started during March 74,500
Total physical units to
account for 74,500
Step 2: Compute Equivalent Units
Units completed during 63,250 63,250
March 63,250 (100% of 63,250) (100% of 63,250)
Units in process on 3/31 11,250 11,250 6,750
(100% of 11,250) (0.60 × 11,250)
Total physical units ac- 74,500 74,500 70,000
counted for

Step 3: Collect costs to Using predetermined rates – go to step 4

allocate

Step 4: Calculate the

rate per equivalent
unit
Cost per equivalent unit $10.00 $25.00

Step 5: Allocate Costs

Units completed during $2,213,750 $632,500 $1,581,250
March (COGM) (63,250 × $10) (63,250 × $25)
Units in process on $281,250 $112,500 $168,750
March 31 (EWIP) (11,250 × $10) (6,750 × $25)
Total costs allocated $2,495,000 $745,000 $1,750,000

Thus, using standard costing Rhino’s COGM during March = $2,213,750 and its end-
ing WIP inventory = $281,250.

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b.
Each variance equals the difference between the allocated costs and actual costs. A nega-
tive number indicates an unfavorable variance (because actual costs exceed standard
costs), whereas a positive number indicates a favorable variance (because actual costs are
less than standard costs). Using the standard cost data from part [a] and the actual cost
data from the previous problem, we have:

Item Total Materials Conversion

Actual Costs in- $2,479,750 $782,250 $1,697,500
curred this period
(from exercise
29)
Allocated costs $2,495,000 $745,000 $1,750,000
(from part [a])
Variance (Allo- $15,250 F $37,250 U $52,500 F
cated per stand-
ard rates – Actual
costs)

Rhino experienced a favorable variance for conversion costs because the actual expendi-
ture of $1,697,500 is $52,500 lower than the expected (or budgeted) expenditure for the
work done this period. In particular, the allocated amount is the flexible budget for the
conversion cost. Likewise, Rhino has an unfavorable variance of $37,250 for materials.
The net effect is relatively small $15,250 (or approximately 0.6% of total allocated costs)
indicating that the process appears to be reasonably well under control.

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15.40 Belle’s process costing report looks just like the regular report, except that Belle has three
cost pools – one for materials, one for conversion, and one for testing. Additionally, end-
ing WIP has 0% of the testing done as testing is the final step in the production process.

2) Compute Equivalent Units

Materials1 Conversion2 Testing3
1) Track physical flow
Units in beginning inventory 0
Started during July 4,000
Total units to account for 4,000

Units completed during July 3,500 3,500 3,500 3,500

Units in process on July 31 500 500 150 0
Total units accounted for 4,000 4,000 3,650 3,500

3) Collect costs to allocate

Costs incurred this period $2,307,500 $600,000 $1,095,000 $612,500

4) Calculate the rate per equivalent unit4

Cost per equivalent unit $625 $150 $300 $175

5) Allocate Costs5
Units completed during July $2,187,500 $525,000 $1,050,000 $612,500
(COGM)
Units in process on July 31 120,000 75,000 45,000 0
(Ending WIP)
Total costs accounted for $2,307,500 $600,000 $1,095,000 $612,500
1
100% of 3,500; 100% of 500.
2
100% of 3,500; 30% of 500.
3
100% of 3,500; 0% of 500.
4
$150 = $600,000/4,000; $300 = $1,095,000/3,650; $175 = $612,500/3,500.
5
$525,000 = 3,500 × $150; $1,050,000 = $300 × 3,500; $612,500 = 3,500 × $175; $75,000 = 500 × $150;
$45,000 = 150 × $300.

Thus, Belle’s COGM during July = $2,187,500 and its ending WIP inventory =
$120,000.

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15.41
a. Jogirushi’s process cost report has four cost pools – one for sheet metal (materials),
one for the heating element and other electrical items, one for conversion costs, and
one for packing materials. We note that units in ending WIP have 0% of the packing
done as packing is the final step in the production process. However, the heating ele-
ment and other electrical items would already have been added to these units as they
are past the point (40%) when they are added to the process.

Using the information provided, we calculate Jogirushi’s equivalent units for Febru-
ary as:

2) Compute equivalent units

Sheet Heating Conver-
Metal Element sion Packing
1) Track physical flow
Beginning inventory – 2/1* 0
Started during February 23,500
Total units to account for 23,500

Units completed during Feb-

ruary 21,200 21,200 21,200 21,200 21,200
Units in process on 2/28a 2,300 2,300 2,300 1,150 0
Total units accounted for 23,500 23,500 23,500 22,350 21,200

* There is no beginning inventory as Jogirushi launched the new model in February.

a
100% for sheet metal and the heating elements, 50% for conversion, and 0% for packing.

b. We can prepare the remainder Jogirushi’s process costing report as follows:

Sheet Heating
3) Collect costs to allocate Metal Element Conversion Packing
Costs incurred during Feb- ¥115,570,000 ¥10,575,000 ¥58,750,000 ¥33,525,000 ¥12,720,000
ruary

4) Calculate the rate per

equivalent unit
Cost/equivalent unit ¥5,050 ¥450 ¥2,500 ¥1,500 ¥600

5) Allocate costs
Units completed during
February (COGM) ¥107,060,000 ¥9,540,000 ¥53,000,000 ¥31,800,000 ¥12,720,000
Units in process on 2/28
(Ending WIP) ¥8,510,000 1,035,000 5,750,000 1,725,000 0
Total costs accounted for ¥115,570,000 ¥10,575,000 ¥58,750,000 ¥33,525,000 ¥12,720,000

Thus, Jogirushi’s COGM during February = ¥107,060,000 and its ending WIP inven-
tory = ¥8,510,000.

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15.42 This problem reinforces the mechanics of process costing and the linkages among the
steps in the process costing report. We first present Yum Yum’s process costing report
using the information available for June and then illustrate how we back out the required
information.

Total 2) Compute equivalent units

Berries1 Conversion2 Packing3
1) Track physical flow
Beginning inventory – June 1 0
Cases started during June 20,000
Total cases to account for 20,000

Cases completed during June 18,000 18,000 18,000 18,000

Cases in process on 6/30 2,000 2,000 1,600 0
Total units accounted for 20,000 20,000 19,600 18,000

3) Collect costs to allocate

Costs incurred this period $450,000

4) Calculate the rate per equivalent unit

Cost per equivalent case

5) Allocate costs
Cases completed during June $2,160,000 $450,000
(COGM)
Cases in process on June 30 $36,000 0
(EWIP)
Total costs accounted for
1
100% of 18,000; 100% of 2,000
2
1.0 × 18,000; 0.8 × 2000
3
1.0 × 18,000; 0 × 2,000

To determine the answers, we use the principle that the amount allocated to a cost object
equals the cost per equivalent unit times the number of equivalent units. This relation
holds for each cost pool and cost object. Thus,

For berries and sugar: Cost of completed units = $2,160,000, and there are 18,000 equiva-
lent units of material in COGM. Thus, the cost per equivalent unit is $2,160,000/18,000 =
$120. Multiplying this cost by the 20,000 equivalent units in total, Yum Yum must have
spent $2,400,000 on berries and sugar during June.

For conversion costs: Conversion cost in ending WIP = $36,000. There are 1,600 equiva-
lent units of conversion in ending WIP. Thus, the cost per equivalent unit of conversion is
$36,000/1,600 = $22.50. Then, because there are 19,600 equivalent units in total, Yum
Yum must have spent $441,000 on conversion costs during June.

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For packing costs: We know that the packing costs allocated to units in ending WIP is ze-
ro. (These units are yet to be packed). Thus, all packing costs must be allocated to com-
pleted units. Thus, total packing costs during June must be $450,000.

PROBLEMS

15.43 The process costing report offers a convenient way to answer the questions collectively,
as each question pertains to one of the steps in the template. Using the information pro-
vided, we have:

Total Detail
Step 1: Track Physical Flow
Beginning inventory – April 1 25,000
Started during April 125,000
Total physical units to account for 150,000
Step 2: Compute
Equivalent Units
Units completed during April 135,000 135,000
(150,000 – 15,000) (100% of 135,000)
Units in process on April 30 15,000 7,500
(50% of 15,000)
Total physical units accounted for 150,000 142,500

Step 3: Collect costs to allocate

Costs from beginning inventory $225,000 $225,000
Costs incurred during June 3,978,750 3,978,750
Total costs to account for $4,203,750 $4,203,750

Step 4: Calculate the rate per

equivalent unit
Cost per equivalent unit $29.50
(4,203,750/142,500)

Step 5: Allocate Costs

Units completed during March $3,982,500 $3,982,500
(COGM) (135,000 × $29.50)
Units in process on March 31 $221,250 $221,250
(EWIP) (7,500 × $29.50)
Total costs accounted for $4,203,750 $4,203,750

Summarizing our answers:

a = 135,000
b = 135,000 and 7,500, respectively
c = $4,203,750
d = $29.50
e = $3,982,500 and $221,250, respectively.

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Notice that data regarding the completion percentages in beginning inventory is not need-
ed to solve this problem. Likewise, we only need the total costs in a cost pool and do not
need to know whether the costs are from beginning inventory or were added the current
period. This simplification is possible because we use the weighted average method for
process costing (the most popular method). Other methods such as FIFO require details
not needed by the weighted average method.

15.44 Using the information provided, Orange’s process costing report for July is:

Total Detail for each cost pool

Step 1: Track
Physical Flow Materials Conversion
Beginning in- 75,000
ventory – July
1
Started during 150,000
July
Total physical
units to account 225,000
for
Step 2: Compute Equivalent Units
Units complet- 200,000 200,000
ed during July 200,000 (100% of 200,000) (100% of 200,000)
Units in pro- 25,000 25,000 12,500
cess on July 31 (100% of 25,000) (0.50 × 25,000)
Total physical 225,000 225,000 212,500
units accounted
for

Step 3: Collect
costs to allo-
cate
Costs from be- $6,765,000 $5,625,000 $1,140,000
ginning inven-
tory
Costs incurred 18,622,500 11,475,000 7,147,500
during July
Total costs to $25,387,500 $17,100,000 $8,287,500
account for

Step 4: Calcu-
late the rate
per equivalent
unit
Cost per equiv- $76.00 $39.00

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alent unit (17,100,000/225,000) (8,287,500/212,500)

Step 5: Allo-
cate Costs
Units complet- $23,000,000 $15,200,000 $7,800,000
ed during July (200,000 × $76) (200,000 × $39)
(COGM)
Units in pro- $2,387,500 $1,900,000 $487,500
cess on July 31 (25,000 × $76) (12,500 × $39)
(EWIP)
Total costs ac- $25,387,500 $17,100,000 $8,287,500
counted for

Thus, the value of Orange’s COGM is $23,000,000 and the value of its ending WIP is
$2,387,500.

15.45
a.
Units in beginning WIP = units in ending WIP
+ units completed and transferred out
– units started during the year

Thus,
Units in beginning WIP = 100,000 + 1,000,000 – 990,000 = 110,000 units.

b.
Total equivalent units = (100,000 × 80%) + (1,000,000 × 100%)
= 1,080,000 equivalent units with respect to conversion

c.
Cost per equivalent unit for materials
= ( $330,000 + $2,970,000) / (100,000 + 1,000,000)
= $3 per equivalent unit for materials

d.
Ending WIP inventory costs
= (100,000 × $3) + [100,000 × 80% × ($432,000 + $1,728,000)] / 1,080,000
= $460,000.

15.46
a.
Applying the inventory equation, we have:

900 units in Beginning WIP + 2,700 units started – 2,100 units completed

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= 1,500 units left in Ending WIP

b.
2,100 equivalent units completed and transferred out (2,100 × 100%)
+ 1,200 equivalent units left in Ending WIP (1,500 × 80%)
= 3,300 total equivalent units.

c.
Cost per equivalent unit = total cost / total equivalent unit:
Total Conversion cost
= $43,800 in Beginning WIP + $154,200 incurred throughout August
= $198,000.

$198,000 / 3,300 equivalent units = $60 per equivalent unit with respect to conversion
costs.

d.
For this item, we also need to compute the cost per equivalent unit of material. We have:

Total Direct Material cost

= $90,000 in Beginning WIP + $270,000 incurred throughout August
= $360,000.

Cost per equivalent unit with respect to material

= $360,000 / 3,600 equivalent unit = $100 per equivalent unit.

Then, we can calculate the WIP value as:

August 31st WIP =

($100 × 1,500 equivalent units of direct material)
+ ($60 × 1,200 equivalent units for conversion costs)
= $222,000.

15.47
a.
Applying the inventory equation, we have:

Beginning WIP + Started = completed + Ending WIP.

Beginning WIP + 2,200,000 = 1,800,000 + 600,000

Beginning WIP = 200,000

b.
(1,800,000 × 100%) + (600,000 × 60%)

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= 2,160,000 equivalent units with respect to conversion

c.
For this part, we will need the cost per equivalent unit of materials as well. We have:

Total materials costs = ($1,260,000 + $3,900,000) = $5,160,000.

Total equivalent units for materials = [(1,800,000 × 100%) + (600,000 × 100%)]

= 2,400,000

Cost per equivalent unit of direct materials = $2.15 per equivalent unit.

Likewise:

Total conversion costs = [($510,000+$170,000+5,500,000+16,500,000)] =

$22,680,000

Total equivalent units for conversion = 2,160,000

Cost per equivalent unit of conversion = $10.50 per equivalent unit.

We can now calculate the value of the goods completed.

(1,800,000 equivalent units of materials × $2.15 / equivalent unit)

+ (1,800,000 equivalent unit of conversion × $10.50 / equivalent unit )
= $22,770,000

15.48
a.
Units in ending WIP
= units in beginning WIP + units started during the month
- units completed and transferred out
= 80,000 + 100,000 – 120,000 = 60,000 units.

b.
Total equivalent units
= (60,000 × 60%) + (120,000 × 100%)
= 156,000 equivalent units with respect to conversion costs

c.
Cost per equivalent unit for materials = Total cost / total equivalent units for materials.

Total cost = $95,000 + $85,000 = $180,000

Total equivalent units for materials = (60,000 + 120,000) = 180,000 units
Cost per equivalent unit = $1 per equivalent unit for materials

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d.
Notice that only 110,000 units were sold and that all these units were manufactured this
period.

We also can calculate the cost per equivalent unit for conversion costs as
Total conversion cost = $112,000 + $200,000 = $312, 000
Total equivalent units for conversion = 156,000
Cost per equivalent unit of conversion costs = $2 per equivalent unit

COGS = 110,000 × [$1 + $2] = $ 330,000

e.
We now have two layers of inventory:
5,000 units @ $2.90
120,000 units @$3.00.

The older layer is sold first under FIFO. We therefore have:

COGS = (5,000 × $2.90) + (105,000 × $3) = $329,500.

15.49
a.
The inventory equation is:

Units in beginning WIP + Units started

= Units completed and transferred out + Ending WIP.

15,000 + Units started = 190,300 + 45,200.

190,300 + 45,200 – 15,000 = 220,500 units started in June.

b.
We have:

(190,300 × 100%) from units completed + (45,200 × 75%) from units in Ending WIP.

Thus, the total Eq. unit for conversion is 224,200 equivalent units with respect to conver-
sion.

We also know that the total cost is

$85,000 (Beginning WIP) + $311,834 (For June) = $396,834

Thus, the cost per Eq. unit is

$396,834/ 224,200 equivalent units
= $1.77 per equivalent unit with respect to conversion.

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c.
For this step, we need the cost per equivalent unit of materials. We have:

Total cost of materials = ($16,250 + $165,085) = $181,335.

Total equivalent units of materials = (190,300 + 45,200) = 235,500.

Cost per equivalent unit = $181,335/ 235,500 = $0.77.

Notice that we have 45,200 × 0.75 = 33,900 equivalent units of conversion. So, the value
of the ending WIP
= [45,200 equivalent units of DM × $0.77 / equivalent unit of materials]
+ [33,900 equivalent units of Conversion × $1.77 / equivalent unit of conversion]
= $34,804 + $60,003 = $94,807.

15.50 As with other problems, the process costing report offers a convenient way to answer the
questions collectively, as each question pertains to one of the steps in the template. Using
the information provided, we have:

Total Detail for each cost pool

Step 1: Track
Physical Flow Materials Conversion
Beginning inven- 95,000
tory – 1/1
Started during 600,000
January
Total physical
units to account 695,000
for
Step 2: Compute Equivalent Units
Units completed 640,000 640,000
during December 640,000 (100% of 640,000) (100% of 640,000)
Units in process 55,000 55,000 13,750
on 1/31 (100% of 55,000) (0.25 × 55,000)
Total physical 695,000 695,000 653,750
units accounted
for

Step 3: Collect
costs to allocate
Costs from be- $319,200 $285,000 $34,200
ginning inventory
Costs incurred $2,946,675 $1,869,500 $1,077,175
during Jan.

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Total costs to ac- $3,265,875 $2,154,500 $1,111,375

count for

Step 4: Calculate
the rate per
equivalent unit
Cost per equiva- $3.10 $1.70
lent unit (2,154,500/695,000) (1,111,375/653,750)

Step 5: Allocate
Costs
Units completed $3,072,000 $1,984,000 $1,088,000
during January (640,000 × $3.10) (640,000 × $1.70)
(COGM)
Units in process $193,875 $170,500 $23,375
on January 31 (55,000 × $3.10) (13,750 × $1.70)
(EWIP)
Total costs ac- $3,265,875 $2,154,500 $1,111,375
counted for

Summarizing our answers:

a = 640,000
b = Total of 695,000 for materials and 653,750 for conversion costs
c = $3,265,875
d = $3.10 and $1.70, respectively
e = $3,072,000 and $193,875, respectively.

15.51 Rhino’s process costing report for April is presented below:

Total Detail for each cost pool

Step 1:
Track Physi- Materials Conversion
cal Flow
Beginning 11,250
inventory –
4/1
Started during 80,000
April
Total physical
units to ac- 91,250
count for
Step 2: Compute Equivalent Units
Units com- 85,000 85,000
pleted during 85,000 (100% of 85,000) (100% of 85,000)
April
Units in pro- 6,250 6,250 4,375

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cess on 4/30 (100% of 6,250) (0.70 × 6,250)

Total physical 91,250 91,250 89,375
units account-
ed for

Step 3: Col-
lect costs to
allocate
Costs from $281,812.50 $118,125 $163,687.50
beginning in-
ventory
Costs in-
curred during 2,839,000.00 830,875 2,008,125.00
April
Total costs to $3,120,812.50 $949,000 $2,171,812.50
account for

Step 4: Cal-
culate the
rate per
equivalent
unit
Cost per $10.40 $24.30
equivalent (949,000/91,250) (2,171,812.5/89,375)
unit

Step 5: Allo-
cate Costs
Units com- $2,949,500 $884,000 $2,065,500
pleted during (85,000 × $10.40) (85,000 × $24.30)
April
(COGM)
Units in pro- $171,312.50 $65,000 $106,312.50
cess on April (6,250 × $10.40) (4,375 × $24.30)
30 (EWIP)
Total costs $3,120,812.50 $949,000 $2,171,812.50
accounted for

Thus, Rhino’s COGM during March = $2,949,500 and its ending WIP inventory =
$171,312.50.

15.52
a.
Rhino’s standard process costing report for April is presented below:

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Total Detail for each cost pool

Step 1: Track Physical
Flow Materials Conversion
Beginning inventory – 11,250
4/1
Started during April 80,000
Total physical units to
account for 91,250
Step 2: Compute Equivalent Units
Units completed during 85,000 85,000
April 85,000 (100% of 85,000) (100% of 85,000)
Units in process on 4/30 6,250 6,250 4,375
(100% of 6,250) (0.70 × 6,250)
Total physical units ac- 91,250 91,250 89,375
counted for

Step 3: Collect costs to Using predetermined rates – go to step 4

allocate

Step 4: Calculate the

rate per equivalent
unit
Cost per equivalent unit $10.00 $25.00

Step 5: Allocate Costs

Units completed during $2,975,000 $850,000 $2,125,000
April (COGM) (85,000 × $10) (85,000 × $25)
Units in process on $171,875 $62,500 $109,375
April 30 (EWIP) (6,250 × $10) (4,375 × $25)
Total costs allocated $3,146,875 $912,500 $2,234,375

Thus, using standard costing Rhino’s COGM during April = $2,975,000 and its ending
WIP inventory = $171,875.

b.
Each variance equals the difference between the allocated costs and actual costs. A nega-
tive number indicates an unfavorable variance (because actual costs exceed standard
costs), whereas a positive number indicates a favorable variance (because actual costs are
less than standard costs). We can use the actual cost data for April from the previous
problem.

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The costs allocated are a bit harder to compute. We need to figure out the standard cost
for the work done during April. This amount is the right benchmark for comparing the ac-
tual cost incurred during April. We compute the required amount by taking the total
standard costs and subtracting the standard cost of the units in beginning WIP. We have:

Item Total Materials Conversion

Cost of units in EWIP $3,146,875 $912,500 $2,234,375
and completed
- Standard cost of units 281,250 112,500 168,750
in beginning WIP1
Allocation for work $2,865,625 $800,000 $2,065,625
done this period
1
For materials: 11,250 units in beginning WIP × $10.00 = 112,500; Allocation for conversion is 11,250 ×
60% (completion percentage) × $25.00.

We now have enough information to compute the required variances:

Item Total Materials Conversion

Actual Costs in- $2,839,000 $830,875 $2,008,125
curred this period
(from problem
15.52)
Allocated costs $2,865,625 $800,000 $2,065,625
for work done in
April
Variance (Allo- $26,625 F $30,875 U $57,500 F
cated per stand-
ard rates – Actual
costs)

Rhino experienced a favorable variance for conversion costs because the actual expendi-
ture of $2,008,125 is $57,500 lower than the expected (or budgeted) expenditure for the
work done this period. In particular, the allocated amount is the flexible budget for the
conversion cost. Likewise, Rhino has an unfavorable variance of $30,875 for materials.
The net effect is relatively small $26,625 (or approximately 0.9% of total allocated costs)
indicating that the process appears to be well under control.

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15.53 Belle’s process costing report for August is:

2) Compute Equivalent Units

Materials1 Conversion2 Testing3
1) Track physical flow
Units in beginning inventory 500
Started during August 4,500
Total units to account for 5,000

Units completed during August 4,600 4,600 4,600 4,600

Units in process on August 31 400 400 160 0
Total units accounted for 5,000 5,000 4,760 4,600

3) Calculate total costs to account for

Costs from beginning invento- $120,000 $75,000 $45,000 $0
ry
Costs incurred during August 2,848,400 685,000 1,335,400 828,000
Total costs to account for $2,968,400 $760,000 $1,380,400 $828,000

4) Calculate the rate per equivalent unit4

Cost per equivalent unit $622 $152 $290 $180

5) Allocate Costs5
Units completed during August $2,861,200 $699,200 $1,334,000 $828,000
(COGM)
Units in process on August 31 $107,200 60,800 46,400 0
(EWIP)
Total costs accounted for $2,968,400 $760,000 $1,380,400 $828,000
1
100% of 4,600;100% of 400.
2
100% of 4,600; 40% of 400.
3
100% of 4,600; 0% of 400.
4
$152 = $760,000/5,000; $290 = $1,380,400/4,760; $180 = $828,000/4,600.
5
$699,200 = 4,600 × $152; $1,334,000 = $290 × 4,600; $828,000 = 4,600 × $180; $60,800 = 400 × $152;
$46,400 = 160 × $290.

Thus, Demski’s COGM during August = $2,861,200 and its ending WIP inventory =
$107,200.

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15.54
a.
The following table provides the equivalent unit computations.

2) Compute equivalent units

Sheet Met- Heating Conver-
al Element sion Packing
1) Track physical flow
Beginning inventory – May 1 2,300
Started during May 25,000
Total units to account for 27,300

Units completed during May1 25,100 25,100 25,100 25,100 25,100

Units in process on May 31 2,200 2,200 0 6602 0
Total units accounted for 27,300 27,300 25,100 25,760 25,100
1
25,100 = 27,300 – 2,200.
2
660 = 0.3 * 2,200.

The key point to note is that the ending inventory has 0 equivalent units for the heating
element and other electrical items. These units are only 30% complete and the heating el-
ements are added when the units are 40% complete.

b.
We can prepare the remainder of Jogirushi’s process costing report as follows:

Sheet Heating
3) Collect costs to allocate Metal element Conversion Packing
Costs in beginning invento- ¥8,360,000 ¥1,035,000 ¥5,600,000 ¥1,725,000 ¥0
ry
Costs incurred during May 122,220,000 11,523,000 55,895,000 39,491,000 15,311,000
Total costs to account for ¥130,580,000 ¥12,558,000 ¥61,495,000 ¥41,216,000 ¥15,311,000

4) Calculate the rate per

equivalent unit
Cost/equivalent unit ¥460 ¥2,450 ¥1,600 ¥610

5) Allocate costs
Units completed during
May (COGM) ¥128,512,000 ¥11,546,000 ¥61,495,000 ¥40,160,000 ¥15,311,000
Units in process on May 31
(EWIP) 2,068,000 1,012,000 0 1,056,000 0
Total costs accounted for ¥130,580,000 ¥12,558,000 ¥61,495,000 ¥41,216,000 ¥15,311,000

Thus, Jogirushi’s COGM during May = ¥128,512,000 and its ending WIP inventory =
¥2,068,000.

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15.55 Igloo has only one cost pool because it only tracks conversion costs. Using the infor-
mation provided, Igloo’s standard process costing report for February is:

Total Detail
Step 1: Track Physical Flow
Beginning inventory – February 1 5,000
Started during February 145,000
Total physical units to account for 150,000
Step 2: Compute
Equivalent Units
Units completed during February 148,000 148,000
(100% of 148,000)
Units in process on February 28 2,000 400
(20% of 2,000)
Total physical units accounted for 150,000 148,400

Step 3: Collect costs to allocate Using predetermined rates –

go to step 4

Step 4: Calculate the rate per

equivalent unit
Predetermined standard rate per $15.00
equivalent unit

Step 5: Allocate Costs

Units completed during February $2,220,000 $2,220,000
(COGM) (148,000 × $15)
Units in process on February 28 $6,000 $6,000
(EWIP) (400 × $15)
Total costs allocated $2,226,000

Igloo’s conversion cost variance for February equals the difference between the costs al-
located to work done in February and the actual costs incurred in February. A negative
number indicates an unfavorable variance (because actual costs exceed standard costs),
whereas a positive number indicates a favorable variance (because actual costs are less
than standard costs).

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 32

The actual conversion costs for February are given to us – they equal $2,245,000. The
costs allocated to work done in February are a bit harder to compute. We can compute
this amount by taking the total standard costs and subtracting the standard cost of the
units in beginning WIP. We have:

Item Total
Cost of units in EWIP and complet- $2,226,000
ed
- Standard cost of units in beginning 22,500
WIP1
Allocation for work done this period $2,203,500
1
5,000 physical units × 30% completion × $15 per equivalent unit.

We now have enough information to compute the required variance:

Item Total
Actual Costs incurred during February $2,245,000
Allocated costs for work done in February $2,203,500
Variance (Allocated per standard rates – $41,500 U
Actual costs)

Igloo experienced an unfavorable variance for February because the actual expenditure of
$2,245,000 is $41,500 higher than the expected (or budgeted) expenditure for the work
done this period. Moreover, Igloo should investigate the cause(s) for this variance and
take suitable corrective actions.

15.56
First, we compute the conversion costs for ending work in process inventory. This equals
$8,000 = ($30,000 conversion costs for finished units/15,000 finished units; note that this
gives us a rate of $2 per equivalent unit for conversion costs) × 4,000 equivalent units for
conversion costs in EWIP.

Next, we compute the container costs for cost of goods manufactured = $12,000 = 15,000
units × $0.80 per equivalent unit.

Next, we know the remaining costs to allocate = $10,000 = $60,000 total costs – $30,000
conversion for COGM – $8,000 conversion costs for EWIP – $12,000 container costs for
COGM.

Because materials are added at the start of the process, and COGM contains 15,000 units
and ending WIP contains 5,000 units, ¼ of the $10,000 or $2,500 will be allocated to
EWIP.

Adding the $2,500 for materials to the $8,000 for conversion costs gives us a value of

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$10,500 for EWIP.

MINI-CASES
15.57
a.
The wrinkle in this problem is that Shalimar has WIP inventory at two different stages of
completion: 50% and 98%. We can accommodate this change by adding another cost ob-
ject to the process costing report. Additionally, notice that the paint is canned at the 95%
point. Thus, there are zero equivalent units for this cost category for the WIP inventory
that is 50% is complete. In contrast, this category is 100% done for units that are 98%
complete.

With these changes, the following table provides Shalimar’s process costing report for
April.

2) Compute equivalent units

Materials Conversion Cans
1) Track physical flow
Beginning inventory – April
1 45,000
Started during April 145,000
Total units to account for 190,000

Units completed during April 185,000 185,000 185,000 185,000

Units in process on April 30
(98% complete) 1,000 1,000 980 1,000
Units in process on April 30
(50% complete) 4,000 4,000 2,000 0
Total units accounted for 190,000 190,000 187,980 186,000

3) Collect costs to allocate

Costs from beginning inven-
tory $280,350 $198,000 $82,350
Costs incurred during April 1,278,090 657,000 481,590 139,500
Total costs to account for $1,558,440 $855,000 $563,940 $139,500

4) Calculate the rate per

equivalent unit
Cost per equivalent unit $8.25 $4.50 $3.00 $0.75

5) Allocate costs
Units completed during April $1,526,250 $832,500 $555,000 $138,750
Units in process on April 30
(98% complete) 8,190 4,500 2,940 750
Units in process on April 30
(50% complete) 24,000 18,000 6,000 0
Total costs accounted for $ 1,558,440 $855,000 $563,940 $139,500

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 34

Thus, Shalimar’s costs of goods manufacturing for lilac paint for April = $1,526,250,
and the cost of its ending WIP inventory = $8,190 + $24,000 = $32,190.

b.
For each of the three cost categories (materials, conversion, cans), we need two pieces of
data to compute the required variance. First, we need to know the standard cost for the
work done in April. In other words, we need to calculate the cost applied to the work
done this period. Second, we need to know the actual amounts expended this period for
each cost category.

Calculating actual costs is straightforward as the firm’s accounting records contain this
data. The problem also provides these amounts for us.

Computing the standard cost of the work done this period is a bit trickier. We could value
the ending WIP inventory (both layers) and cost of goods completed at standard cost, us-
ing the provided standard costs per equivalent unit for each cost pool. However, this total
would overestimate the cost of work done because it includes the work contained in be-
ginning inventory (this work was done last period.)

Thus, we need to back out the work done in the prior period from our computations for
equivalent units and then apply the standard costs. This way, we can estimate the stand-
ard cost of the work done this period, which the appropriate benchmark for actual costs.
(In some sense, this adjustment is like a flexible budget that adjusts volume to correspond
to the actual volume.) For each cost category, we have:

Item Materials Conversion Cans

In EWIP and completed items 190,000 187,980 186,000
- Work in beginning WIP1 45,000 27,000 0
= Actual work done during April 145,000 160,980 186,000
× Standard rate per equivalent unit $4.40 $2.95 $0.78
= Standard cost of work done in April $638,000 $474,891 $145,080
- Actual cost of work done in April 657,000 481,590 139,500
Variance 19,000 U 6,699 U 5,580 F
1
Materials: 45,000 units at 100%; Conversion: 45,000 × 0.60; Cans at 0%.

Thus, in total Shalimar has an unfavorable variance of $20,119 U = $19,000 U +

$6,699 U – $5,580 F for April.

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 CHAPTER 16
Support Activity and Dual-Rate Allocations
Solutions

REVIEW QUESTIONS

16. 1 A line activity directly relates to producing services or products, whereas a support activi-
ty is not directly related to making or selling a product or service. Examples of a line ac-
tivity include engineering, machining, and assembly. Examples of a support activity in-
clude accounting and payroll.
16. 2 The reciprocity in consumption among support activities – such departments not only
provide services for line activities, but also for each other.
16. 3 (1) the direct method, (2) the step-down method, and (3) the reciprocal method.
16. 4 The direct method ignores reciprocity in consumption, whereas the step-method partially
accounts for it.
16. 5 Changing the order matters for the step-down method, but it does not for the direct and
reciprocal methods.
16. 6 We ignore such self-consumption.
16. 7 The step-method partially accounts for reciprocity in consumption, whereas the recipro-
cal method fully accounts for it.
16. 8 The dual-rate allocation method uses two pools, one for long-term or fixed costs and one
for short-term or variable costs, to allocate costs from a department. This dual-rate, or
two-factor, allocation informs managers about the different controllability of the costs.
16. 9 We allocate capacity costs using expected demand and operating costs using actual de-
mand.
16. 10 Using rates set on budgets instead of actual costs prevents cost inefficiencies being
passed on to user departments. Rather, they are isolated in the cost center, potentially
permitting superior control.

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2

DISCUSSION QUESTIONS
16. 11 When we allocate support activity costs, we are in essence assuming that the support re-
sources have positive opportunity costs over the relevant horizon. For short-term deci-
sions, we must include only those support costs that are controllable in the short term
(e.g., variable support costs). For long-term decisions such as product planning and ca-
pacity planning, it makes sense to allocate capacity costs of support activities as well un-
der the assumption that these costs are controllable over that horizon.
16. 12 We cannot say for sure. Allocating the support department of the largest size first -- or
the support department that provides the most support (transaction volume, support de-
partment involving expensive resources) first -- typically give rise to smaller errors be-
cause the cost of reciprocal services from other departments is likely to be less material.
16. 13 Predetermined overhead rates are based on budgeted usage. So they insulate each de-
partment from other departments’ actual usage patterns. They can be computed at the
time budgets are prepared. They are convenient to implement because each department is
charged for its requested usage for support department resources in a timely fashion,
much like a “transfer price.”
16. 14 Transfer price is a term used to refer to the price of internal transfers of goods and ser-
vices between two profit centers of a company. Service department cost allocations yield
cost rates charged to individual departments for using different services. From the per-
spective of a profit center using these services, there is not much difference between a
transfer price and allocated service department costs. Both in essence represent the
“price” for use of some input, whether it is a product or a service supplied by another
profit center, or by a service department. Allocating service department costs to a profit
center would induce its managers to use these services in effective and efficient ways.
16. 15 Use of actual usage and actual rates to allocate service department costs will result in one
department’s usage affecting the cost allocated to the other departments. To see why, as-
sume that all departments use the services of a service department as planned except one
department whose usage is far less than anticipated. Assuming that most of the service
department’s costs are fixed in the short run, a decline in usage increases the actual cost
rates, and the amounts allocated to other departments (even though as noted earlier their
usages have been as planned). This can be problematic, especially when the departments
are profit centers, and the profit of a department falls for no apparent reason.
16. 16 Yes, the use of predetermined overhead rates does solve the problem to an extent because
predetermined rates are based on budgeted, not actual, volume. So varying usage by one
department does not affect the costs allocated to other departments. However, the prob-
lem does not completely go away because budgeted volume can change from period to
period depending on business conditions. Predetermined rates can also fluctuate from pe-
riod to period. In other words, if a department budgets that its usage will be less for the
coming period, then all else equal, the predetermined overhead rate will increase, and
more of the service department’s costs will be distributed to other departments.
16. 17 With the use of practical capacity, the overhead rate is not only predetermined but it re-
mains stable over time. The use of practical capacity essentially commits each user de-

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partment to using a certain fraction of the service department’s resources over a longer
horizon. Therefore, any fluctuation in short-term business conditions will not affect the
cost rates.
16. 18 A natural incentive for managers of line activities is to under-report their demand so that
they are allocated less of the support department’s capacity costs. But, they risk having to
pay a premium for the services as and when demand outstrips their initial request for
support capacity resources.
16. 19 At a conceptual level, we can consider a single-rate allocation as viewing all costs being
allocated as being “variable” in the chosen cost driver. A dual rate allocation is then best
viewed as modeling the costs as fixed and variable costs, with separate drivers. Introduc-
ing product- and batch-level costs imposes a finer cost model. We can then use more
drivers that capture that consumption of batch- and product-level resources. That is, we
might have to resort to a system that has three or four-rates, one for each kind of cost.
16. 20 We argue that allocating facility level costs is not a useful exercise from a decision mak-
ing perspective because these costs are not controllable for decisions that view the busi-
ness as a going concern. Thus, the issue of how to allocate is moot. Nevertheless, many
firms do allocate facility level costs to make the allocation “complete.” In such cases,
separating facility level costs and allocating them as a lump-sum to the user divisions
(departments) is perhaps the best way to highlight the uncontrollable nature of these
costs.

EXERCISES
16. 21
The key idea in the direct allocation method is that we do not allocate costs from one
support department to another support department. Thus, we could think of the direct
method in two steps. First, compute the allocation percentages, ignoring the services pro-
vided to other support departments. Second, perform the allocations.
In this exercise, we have two support departments: Maintenance and Information Sys-
tems. Thus, for step 1, we have:

Human General
Resources Administration Shampoo Soap
Maintenance1 50% 50%
Services
Information
Provided by
Systems2 62.50% 37.50%
1
50% = (40/80) where 80 is the total of the support provided to non-service- pools/departments.
2
62.50% = (50/80) where 80 is the total of the support provided to non-service- pools/departments.

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4

We can now perform the second step: allocate costs. We know that Maintenance has
$800,000 and Information Systems has $500,000 in costs. Thus, we have:

Mainte- Information
nance Systems Shampoo Soap
Traced costs $800,000 $500,000 $2,000,000 $1,500,000
Maintenance1 (800,000) 400,000 400,000
Costs allo-
Information
cated from
Systems2 (500,000) 312,500 187,500
Total $0 $0 $2,712,500 $2,087,500
1
400,000 = 0.50 × $800,000.
2
$312,500 = 0.675 × $500,000.

After the allocation, we have $2,712,500 in Shampoo, and $2,087,500 in Soap. The total
amount in these two pools is $4,800,000 the total that we began with for the four cost
pools.

16. 22

The key idea in the step-down method is that we allocate costs from some support de-
partment to others. Thus, we could think of the step-down method in three steps. First, we
have to rank order the support departments on some basis (Maintenance, then Infor-
mation Systems in this case). Second, we compute the allocation percentages. For this
step, because we rank Maintenance first, we allocate Maintenance costs to all other de-
partments. For Information Systems, our computation ignores the services provided to
higher-ranked support departments. The final step is to perform the allocations.

In this problem, we have two support departments: Maintenance and Information Sys-
tems. We are asked to rank Maintenance first.

For step 2, we have:

Mainte- Information
nance Systems Shampoo Soap
Human
Services Resources1 20% 40% 40%
Provided by General
Administration2 62.50% 37.50%
1
No change in allocation percentages.
2
62.50% = (50/80) where 80 is the total of the support provided to non-service- pools/departments.

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 5

We can now perform the final step: allocate costs. We know that Maintenance has
$800,000 and Information Systems has $500,000 in costs. Thus, we have:

Mainte- Information
nance Systems Shampoo Soap
Traced costs $800,000 $500,000 $2,000,000 $1,500,000
Maintenance1 (800,000) 160,000 320,000 320,000
Costs allo-
Information
cated from
Systems2 (660,000) 412,500 247,500
Total $0 $0 $2,732,500 $2,067,500
1
$320,000 = 0.40 × $800,000.
2
$412,500 = 0.675 × $660,000.

Notice that the amount allocated from Information Systems includes the $500,000 origi-
nally traced to this cost plus the amount allocated from Maintenance ($160,000).

After the allocation, we have $2,732,500 in Shampoo and $2,067,500 in Soap. The total
amount in these two pools, $4,800,000, is the total that we began with for the four cost
pools.

16. 23
a.
The reciprocal method considers all interactions among support departments/cost pools.
As explained in the text, we perform this allocation in two steps. First, we set up the allo-
cation as a system of equations, and solve to find the amounts to be allocated. Second, we
perform the allocation using the amounts calculated in step 1 and the unadjusted con-
sumption percentages.

For step 1, we have:

Maintenance = $800,000 + 0.20 × Information Systems

Information Systems = $500,000 + 0.20 × Maintenance

Solving these two equations, we have:

Maintenance = $937,500
Information Systems = $687,500

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6

We can now perform step 2 of the allocation.

Maintenance Information
Systems Shampoo Soap
Traced costs $800,000 $500,000 $2,000,000 $1,500,000
Maintenace1 (937,500) 187,500 375,000 375,000
Costs allo-
Information
cated from
Systems2 137,500 (687,500) 343,750 206,250
Total $0 $0 $2,718,750 $2,081,250
1
$375,000 = 0.40 × $937,500.
2
$343,750 = 0.50 × $687,500

After the allocation, we have $2,718,750 in Shampoo and $2,081,250 in Soap. The total
amount in these two pools, $4,800,000, is the total that we began with for the four cost
pools.

16. 24
The key idea in the direct allocation method is that we do not allocate costs from one
support department to another support department. Thus, we could think of the direct
method in two steps. First, compute the allocation percentages, ignoring the services pro-
vided to other support departments. Second, perform the allocations.
In this exercise, we have two support departments: Human Resources and General Ad-
ministration. Thus, for step 1, we have:

Human General Parks and Facilities

Resources Administration Recreation Maintenance
Human
Services Resources1 50% 50%
Provided by General
Administration2 75% 25%
1
50% = (30/60) where 60 is the total of the support provided to non-service- pools/departments.
2
75% = (60/80) where 80 is the total of the support provided to non-service- pools/departments; likewise
for the FM department.

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 7

We can now perform the second step: allocate costs. We know that HR has $100,000 and
GA has $60,000 in costs. Thus, we have:

Human General Parks and Facilities

Resources Administration Recreation Maintenance
Traced costs $103,000 $60,000 $360,000 $450,000
Human
Costs allo- Resources1 (103,000) 51,500 51,500
cated from General
Administration2 (60,000) 45,000 15,000
Total 0 0 $456,500 $516,500
1
50,000 = 0.50 × $100,000.
2
$45,000 = 0.75 × $60,000.

After the allocation, we have $456,500 in P&R and $516,500 in the FM department. The
total amount in these two pools is $973,000, the total that we began with for the four cost
pools.

16. 25
a.
The key idea in the step-down method is that we allocate costs from some support de-
partment to others. Thus, we could think of the step-down method in three steps. First, we
have to rank order the support departments on some basis (HR, then GA in this case).
Second, we compute the allocation percentages. For this step, because we rank HR first,
we allocate HR costs to all other departments. For GA, our computation ignores the ser-
vices provided to higher-ranked support departments. The final step is to perform the al-
locations.

In this problem, we have two support departments: Human Resources and General Ad-
ministration. We are asked to rank HR ahead of GA.

For step 2, we have:

Human General Parks and Facilities
Resources Administration Recreation Maintenance
Human
Services Resources1 40% 30% 30%
Provided by General
Administration2 75% 25%
1
No change in allocation percentages.
2
75% = (60/80) where 80 is the total of the support provided to non-service- pools/departments.

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8

We can now perform the final step: allocate costs. We know that HR has $100,000 and
GA has $60,000 in costs. Thus, we have:

Human General Parks and Facilities

Resources Administration Recreation Maintenance
Traced costs $103,000 $60,000 $360,000 $450,000
Human
Costs allo- Resources1 (103,000) 41,200 30,900 30,900
cated from General
Administration2 (101,200) 75,900 25,300
Total $0 $0 $466,800 $506,200
1
$41,200 = 0.40 × $103,000.
2
$75,900 = 0.75 × $101,200.

Notice that the amount allocated from GA includes the $60,000 originally traced to this
cost plus the amount allocated from the HR department.

After the allocation, we have $466,800 in P&R and $506,200 in the FM department. The
total amount in these two pools, $973,000, is the total that we began with for the four cost
pools.
b.
In this problem, we have two support departments: Human Resources and General Ad-
ministration. Now we are asked to rank GA ahead of HR.
It is often useful to rearrange the rows and columns to correspond to the ranking of the
support departments. For step 2, we have:

General Human Parks and Facilities

Administration Resources Recreation Maintenance
General
Services Administration1 20% 60% 20%
Provided by Human
Resources2 50% 50%
1
No change in allocation percentages.
2
50% = (30/60) where 60 is the total of the support provided to non-service- pools/departments

We can now perform the final step: allocate costs. We know that HR has $103,000 and
GA has $60,000 in costs. Thus, we have:
GA HR Parks and Facilities
Recreation Maintenance
Traced costs $60,000 $103,000 $360,000 $450,000
General Admin-
Costs allo- istration (60,000) 12,000 36,000 12,000
cated from Human Re-
sources2 (115,000) 57,500 57,500
Total $0 $0 $453,500 $519,500
1
12,000 = 0.20 × $60,000.
2
$57,500 = 0.5 × $115,000.

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 9

Notice that the amount allocated from HR includes the $103,000 originally traced to this
cost plus the amount allocated from the GA department.

After the allocation, we have $453,500 in P&R and $519,500 in the FM department. The
total amount in these two pools, $973,000, is the total overhead that we began with for
the four cost pools.

The answers in parts (a) and (b) differ because of differences in the rank-ordering of
the support departments. The step-down method gives partial consideration to interac-
tion among cost pools (support departments), meaning that the rank ordering will change
the final answers.

16. 26
a.
The reciprocal method considers all interactions among support departments / cost pools.
As explained in the text, we perform this allocation in two steps. First, we set up the allo-
cation as a system of equations, and solve to find the amounts to be allocated. Second, we
perform the allocation using the amounts calculated in step 1 and the unadjusted con-
sumption percentages.

For step 1, we have:

HR = $103,000 + 0.20 × GA
GA = $60,000 + 0.40 × HR

Solving these two equations, we have:

HR = $125,000

GA = $110,000

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We can now perform step 2 of the allocation.

Human Re- General Parks and Rec- Facilities

sources Administration reation Maintenance
Traced costs $103,000 $60,000 $360,000 $450,000
Human
Costs allo- Resources1 (125,000) 50,000 37,500 37,500
cated from General
Administration2 22,000 (110,000) 66,000 22,000
Total $0 $0 $463,500 $509,500
1
$50,000 = 0.40 × $125,000
2
$22,000 = 0.20 × $110,000

After the allocation, we have $463,500 in P&R and $509,500 in the FM department. The
total amount in these two pools, $973,000, is the total overhead that we began with for
the four cost pools.

Of the solutions, the reciprocal method provides the conceptually accurate answer.
This method accounts for the interaction in services between the HR and GA depart-
ments. The direct method completely ignores this effect. The step-down methods account
for this effect only partially. However, the reciprocal method is perhaps the most com-
plex of the three methods.

16. 27
a.
We could compute the rate in the P&R department as $473,000/18,920 hours = $25 per
instruction hour. Notice that this cost includes the direct cost of the P&R department as
well as the amounts allocated to it from the two support departments, HR and GA.

b.
The City could use this information, for example, in pricing its classes. Suppose the PR
department is thinking about canceling a class with 100 hours of instruction. This move
would reduce total costs by $2,500 ($25/hour × 100 hours) in the medium-term.

16. 28

a.
The following table provides the required allocations, under the direct method.

Human General Indian Malaysian

Resources Administration Division Division
Traced costs $760,000 $1,460,000 $2,000,000 $3,000,000
Allocation Human
from Resources (760,000) 304,000 456,000

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General
Administration (1,460,000) 730,000 730,000

Total $0 $0 $3,034,000 $4,186,000

b.
The key is to realize that the step-down method will yield the same answers. Why? The
support departments do not provide services to each other.

c.
The answers do not depend on the method used because there the support departments
do not provide services to each other. Thus, the entire issue of support department allo-
cations is moot. This rather stark example underscores that the extent of interactions
among support departments is a key input into method choice. The more complex the in-
teraction pattern, the greater the benefit (in terms of better estimates of the cost of ser-
vices consumed) from a superior method for allocating costs.

16. 29
The key idea in the direct allocation method is that we do not allocate costs from one
support department to another support department. Thus, we could think of the direct
method in two steps. First, compute the allocation percentages, ignoring the services pro-
vided to other support departments. The second step is to perform the allocations.
In this problem, we have two support departments: IS and AS. Thus, for step 1, we have:

IS AS Government Corporate
1
Services IS 12.50% 87.50%
Provided by AS2 37.50% 62.50%
1
12.50% = (1,000/(1,000+7,000)) hours, where 8,000 hours is the total of the support provided to non-
service- pools/departments.
2
37.50% = (15/40) where 40 is the total numbers of person in the non-service- pools/departments.

We can now perform the second step: allocate costs. We know that IS has $1,020,000 and
AS has $600,000 in costs.

IS AS Government Corporate
Traced costs $1,020,000 $600,000 $2,400,000 $3,240,000
Costs allo- IS1 (1,020,000) 127,500 892,500
cated from AS2 (600,000) 225,000 375,000
Total $0 $0 $2,752,500 $4,507,5000
1
$127,500 = $1,020,000 × 0.125.
2
$225,000 = 0.375 × $600,000.

After the allocation, we now have $2,752,500 in Government and $4,507,500 in corpo-
rate. The total amount in these two pools $7,260,000 is the total that we began with for
the four cost pools.

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We can now compute the rate per hour in the two groups. We have:
Government Corporate
Total costs in cost pool $ 2,752,500 $4,507,500
# of hours worked 22,500 = 15×1500 37,500 = 25 × 1,500
Rate per hour $122.33 $120.20

16. 30
Let us first perform the required allocation and compute the profit realized by T3 Tech-
nologies.

The key idea in the step-down method is that we allocate costs from some support de-
partment to others. We can think of the direct method in three steps. First, we have to
rank order the support departments on some basis. Second, we compute the allocation
percentages. Third, we perform the allocations.

In this problem, we have two support departments: IS and AS. However, the Government
regulation is silent about the order for allocation to be used. Thus, we can try it out under
both sequences and see which one gives the higher profit.

Let us first perform the allocation, ranking IS ahead of AS. We have:

IS AS Government Corporate
Services IS1 20.00% 10.00% 70.00%
Provided by AS2 37.50% 62.50%
1
No change in allocation percentages. 20% = 2,000/ (2,000+1,000+7,000)
2
37.50% = (15/40) where 40 is the total of persons employed in non-service- pools/departments.

We can now perform the final step: allocate costs. We have:

IS AS Government Corporate
Traced costs $1,020,000 $600,000 $2,400,000 $3,240,000
Costs allo- IS1 (1,020,000) 204,000 102,000 714,000
cated from AS2 (804,000) 301,500 502,500
Total $0 $0 $2,803,500 $4,456,500
1
$102,000 = $1,020,000 × 0.10.
2
$301,500 = 0.375 × $804,000

Notice that the amount allocated from AS includes the $600,000 originally traced to this
cost plus the amount allocated from the IS department.

After the allocation, we now have $2,803,500 and $4,456,500 in the government and cor-
porate pools respectively. As shown in the table below, this gives us a cost of $143.29 per
hour for the government services and $118.84 per hour for the corporate client. We then
use these rates to compute the revenue realized and the profit from each group and in to-
tal.

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Government Corporate
Total costs in cost pool $2,803,500 $4,456,500
# of hours worked 22,500 = 15×1,500 37,500 = 25 × 1,500
Rate per hour $124.60 $118.84
Price charged $143.29 = 1.15 × $124.60 $125 (given)

A condensed income statement is as follows:

Government Corporate Total

Total hours 22,500 37,500 60,000
Revenue1 $3,224,025 $4,687,500 $7,911,525
Total costs 2,803,500 4,456,500 7,260,000
Profit from group $420,525 $231,000 $651,525

1
$3,224,025 = $143.29 * 22,500.

T3 Technologies realizes the potential to increase their profit by adjusting the allocation
mechanism. For instance, they can check to see if changing the order of allocation will al-
locate more costs to the Government. If so, the increased cost would contribute directly to
increasing profit. Let us check:

Let us first perform the allocation, ranking AS ahead of IS. We have:

IS AS Government Corporate
1
Services IS 12.50% 87.50%
Provided by AS2 20% 30% 50%

We can now perform the final step: allocate costs. We have:

IS AS Government Corporate
Traced costs $1,020,000 $600,000 $2,400,000 $3,240,000
Costs allo- AS2 120,000 (600,000) 180,000 300,000
cated from IS1 (1,140,000) 142,500 997,500
Total $0 $0 $ 2,722,500 $4,537,500
.

Notice that the amount allocated from IS includes the $1,020,000 originally traced to this
cost plus the amount allocated from the AS department.

After the allocation, we have $2,722,500 and $4,537,500 in the government and corpo-
rate pools respectively. As shown in the table below, this gives us a cost of $121 per hour
for the government services and $121 for the corporate client. Relative to the earlier allo-
cation, changing the order to allocate AS first lowers the cost per hour (and thus the re-
imbursable rate) for government services. Thus, we can stop here as allocating IS first is
the profit maximizing strategy.

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For completeness, let us verify our intuition.

Government Corporate
Total costs in cost pool $2,722,500 $4,537,500
# of hours worked 22,500 = 150×1500 37,500 = 25 × 1,500
Rate per hour $121 $121
Price charged $139.15 = 1.15 × $121 $125 (given)

A condensed income statement with the above rates follows:

Government Corporate Total
Total hours 22,500 37,500 67,500
Revenue $3,130,875 $4,687,500 $7,818,375
Total costs $2,722,500 $4,537,500 7,260,000
Profit from group $408,375 $150,000 $558,375

16. 31
a.
The reciprocal method considers all interactions among support departments / cost pools.
As explained in the text, we can perform this allocation in two steps. First, we set up the
allocation as a system of equations, and solve to find the amounts to be allocated. Second,
we perform the allocation using the amounts calculated in step 1 and the unadjusted con-
sumption percentages.

For step 1, we have:

IS = $1,020,000 + 0.20 × AS
AS = $600,000 + 0.20 × IS

Solving these two equations, we find IS = $1,187,500 and AS = $837,500. (Substitute the
expression for AS in the first equations, and solve to obtain the value for IS. Plug this
value into the second equation to get the value for AS.)

We can now perform step 2 of the allocation.

IS AS Government Corporate
Traced costs $1,020,000 $600,000 $2,400,000 $3,240,000
Costs allo- IS1 (1,187,500) 237,500 118,750 831,250
cated from AS2 167,500 (837,500) 251,250 418,750
Total $0 $0 $2,770,000 $4,490,000

With this, we have cost per hour for the government clients as $2,770,000/22,500 =
$123.11, and the rate as $141.57.

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16. 32
a.
The following table provides the required computations. As with any allocation, we pro-
ceed in two steps. We first compute the required rate and then we allocate to individual
divisions.

April May June

Actual costs $110,000 $123,000 $112,000
Total hours 4,200 5,200 4,800
Rate 26.19 23.65 23.33

We next compute the amount allocated to the various divisions for the three months. No-
tice that the total of the amounts allocated equal actual cost. This equivalence occurs be-
cause the total of the cost allocated equal the costs in the cost pool (used to compute the
rate).
April May June
Department 1 $52,380.96 $47,307.69 $46,666.67
Department 2 39,285.71 59,134.62 46,666.67
Department 3 18,333.33 16,557.69 18,666.66
Total $110,000.00 $123,000.00 $112,000.00

b.
The following table provides the required computations. As with any allocation, we pro-
ceed in two steps. We first compute the required rate and then we allocate to individual
divisions. Notice that we compute the flexible budget by adding together the fixed costs
and the variable costs for the given level of operations.

April May June

Fixed costs $40,000.00 $ 40,000.00 $ 40,000.00
Variable costs1 63,000.00 78,000.00 72,000.00
Total budgeted costs $103,000.00 $118,000.00 $ 112,000.00
Total hours 4,200.00 5,200.00 4,800.00
Rate 24.524 22.692 23.333
1
$63,000 = 4,200 hours * $15/unit.

We next compute the amount allocated to the various divisions for the three months.
April May June
Department 1 $49,047.62 $45,384.62 $46,666.67
Department 2 36,785.71 56,730.77 46,666.67
Department 3 17,166.67 15,884.62 18,666.67
Total $103,000.00 $118,000.00 $112,000.00

Notice that the amount allocated to the three departments equals the flexible budget cost.
This equivalence occurs because this is the amount we used to compute the rate. Compar-

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ing the allocated with actual cost yields the variance in spending (this is equivalent to the
under/overapplied overhead concept discussed in Chapter 14).

April May June

Allocated costs $103,000 $118,000 $112,000
Actual costs 110,000 123,000 112,000
Variance ($7,000) ($5,000) $0

Such a variance report is useful in identifying if the secretarial pool is expending more
resources than budgeted, for the actual amount of work done.

c.
Let us repeat the exercise using separate rates for fixed and variable costs. (Some refer to
this as long- and short-term rates as well.)

April May June

Fixed costs $40,000 $ 40,000 $ 40,000
Variable costs 63,000 78,000 72,000
Long-run hours 5,000 5,000 5,000
Actual hours 4,200 5,200 4,800
Fixed cost rate1 $8 $8 $8
Variable cost rate $15 $15 $15
1
$8 = $40,000/5,000 long-run hours. $15 = $63,000/4,200 actual hours.

Notice the rates do not fluctuate from month to month. The fixed cost rate is constant as
both the numerator (budgeted fixed cost) and the denominator (long-run volume) are the
same in the short-run. The VC rate is also constant because the flexible budget is propor-
tional to actual usage. Thus, we could have simply performed the rate computation for
one month and used the rates for all months.

We next compute the amount allocated to the various divisions for the three months. Note
that the total amount allocated to a department is the sum of the fixed cost and variable
cost allocated to it.

April May June

Department 11 $46,000 $46,000 $46,000
Department 2 38,500 53,500 46,000
Department 3 18,500 18,500 20,000
Total $103,000 $118,000 $112,000
1
$46,000=2,000 × $8 + 2000 × $15
2
$38,500=2,000 × $8 + 1,500 × $15
3
$18,500=1,000 × $8 + 700 × $15

Notice also that the amount allocated to the three departments equals the flexible budget
cost. Comparing the allocated with actual cost yields the variance in spending (this is
equivalent to the under/over applied overhead concept that we learned in Chapter 14).

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April May June

Allocated costs $103,000 $118,000 $112,000
Actual costs 110,000 123,000 112,000
Variance ($7,000) ($5,000) $0

Such a variance report is useful in identifying if the secretarial pool is expending more
resources than budgeted, for the actual amount of work done.
d.
We believe that the allocation is part (c) is the most meaningful. First, a department’s al-
located cost does not depend on the usage by other departments. Taking Department 1 as
an example, the cost is the same $46K a month, even though total usage varied. This al-
lows the department manager to plan operations better. Second, notice that each depart-
ment is charged both for its long-run estimated usage (which presumably dictates the to-
tal capacity cost for the secretarial pool) and for the actual usage. Thus, a department has
incentives to not over-estimate its long-run usage. Some might argue that the system now
provides incentives to under-estimate usage. This is a problem that firms tackle by using
penalty rates for usage over the estimated long-run consumption.

PROBLEMS

16. 33
a.
The key idea in the direct allocation method is that we do not allocate costs from one
support department to another support department. Thus, we could think of the direct
method in two steps. First, compute the allocation percentages, ignoring the services pro-
vided to other support departments. The second step is to perform the allocations.
In this problem, we have three support departments: cafeteria, janitorial and administra-
tion. Thus, for step 1, we have:

Cafeteria Janitorial Administration Machining Assembly

Services Cafeteria 50% 50%

Provided by Janitorial 60% 40%
Administration 25% 75%

We can now perform the second step: allocate costs.

Cafeteria Janitorial Admin-
istration Machining Assembly
Traced costs $100,000 $60,000 $360,000 $450,000 $ 560,000
From cafeteria (100,000) 50,000 50,000
From janitorial (60,000) 36,000 24,000
From admin (360,000) 90,000 270,000
$0 $0 $0 $626,000 $904,000

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After the allocation, we now have $626,000 in machining and $904,000 in assembly. The
total amount in these two pools $1,530,000 is the total that we began with for the five
cost pools.

b.
Ranking the support departments by size (initial costs in the pool), we have the following
– (1) administration, (2) cafeteria, and (3) janitorial. Given our rank ordering, we allocat-
ed administration costs to all other departments. We then allocate cafeteria costs to janito-
rial, machining and assembly. Finally, we allocate janitorial costs to machining and as-
sembly. Specifically, we have the following allocation sequence and percentages:

Administration Cafeteria Janitorial Machining Assembly

Administration 10% 10% 20% 60.00%
Services Cafeteria 25% 37.50% 37.50%
Provided by Janitorial 60% 40%

We can now allocate costs. We have:

Administration Cafeteria Janitorial Machining Assembly
Traced costs $360,000 $100,000 $60,000 $450,000 $560,000
Administration (360,000) 36,000 36,000 72,000 216,000
Services
Provided Cafeteria (136,000) 34,000 51,000 51,000
by Janitorial (130,000) 78,000 52,000
$0 $0 $0 $651,000 $879,000

After the allocation, we have $651,000 in machining and $879,000 in assembly. The total
amount in these two pools, $1,530,000 is the total that we began with for the five cost
pools.

c.
This part of the problem illustrates how the support department/activity allocations factor
into the computation of overhead rates.

For machining, the overhead rate would be $651,000/10,000 hours = $65.10/hour.

For assembly, the overhead rate would be $879,000/25,000 hours = $35.16/hour.

16. 34
a.
The key idea in the direct method is that we ignore consumption of services by other sup-
port departments. We can think of the direct method in two steps. First, we compute the
allocation percentage, ignoring the services provided to higher-ranked support depart-
ments. The second step is to perform the allocations.

For step 1, we have:

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Services Consumed by
Maintenance Administration Limo Shuttle

Services Maintenance 50% 50%

Provided by Administration 40% 60%

We can now perform the second step: allocate costs. We know that maintenance has
$94,000 and administration has $50,000 in costs. Thus, we have:

Maintenance Administration Limo Shuttle

Traced costs $94,000 $50,000 $240,000 $324,000
Services Maintenance (94,000) $47,000 $47,000
Provided by Administration (50,000) $20,000 $30,000
Total 0 0 $307,000 $401,000
Number of hours 10,000 20,000
Cost per hour $30.70 $20.05

After the allocation, we have $307,000 in the Limo service and $401,000 in the Shuttle
service. For completeness, we divide total costs by the number of hours to find the rates
per hour.

b.
The key idea in the step-down method is that we allocate costs from some support de-
partment to others. We can think of the step-down method in three steps. First, we have
to rank order the support departments (Maintenance and Administration in this case).
Second, we compute the allocation percentages. For this step, because we rank Mainte-
nance first, we allocate Maintenance costs to all other departments. For Administration,
our computation ignores the services provided to Maintenance, as it is a higher-ranked
support department. Third, we perform the allocations

In this part, we rank Maintenance ahead of Administration.

For step 2, we have:

Services Consumed by
Maintenance Administration Limo Shuttle

Services Maintenance 10% 45% 45%

Provided by Administration 40% 60%

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We can now perform the final step: allocate costs:

Maintenance Administration Limo Shuttle

Traced costs $94,000 $50,000 $240,000 $324,000
Services Maintenance (94,000) $9,400 $42,300 $42,300
Provided by Administration (59,400) $23,760 $35,640
Total 0 00 $306,060 $401,940
Number of hours 10,000 20,000
Cost per hour $30.61 $20.09

After the allocation, we have $306,060 in the Limo service and $401,940 in the Shuttle
service. Based on these totals, we compute the hourly cost rates as $30.61 and $20.09 for
the Limo and the Shuttle services respectively.

c.
Repeating part (b), but starting with Administration before Administration yields the fol-
lowing:

For step 2, we have:

Services Consumed by
Maintenance Administration Limo Shuttle
Maintenance 50% 50%
Services
Provided by Administration 10% 36% 54%

We can now allocate costs:

Maintenance Administration Limo Shuttle

Traced costs $94,000 $50,000 $240,000 $324,000
Services Maintenance (99,000) 49,500 49,500
Provided by Administration 5,000 (50,000) 18,000 27,000
Total $0 $0 $307,500 $400,500
Number of hours 10,000 20,000
Cost per hour $30.75 $20.03

After the allocation, we have $307,500 in the Limo service and $401,500 in the Shuttle
service. Based on these totals, we compute the hourly cost rates as $30.75 and $20.03 for
the Limo and the Shuttle services respectively.

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d.
The reciprocal method considers all interactions among support departments. As ex-
plained in the text, we can perform this allocation in two steps. First, we set up the alloca-
tion as a system of equations, and solve to find the amounts to be allocated. Second, we
perform the allocation using the amounts calculated in step 1 and the unadjusted con-
sumption percentages.

For step 1, we have:

M = $94,000 + 0.10 × A
A = $50,000 + 0.10 × M

Solving these two equations, we find M = $100,000 and A = $60,000. (Substitute the ex-
pression for A in the first equation, and solve to obtain the value for M. Plug this value
into the second equation to get the value for A.)

We can now perform step 2 of the allocation.

Maintenance Administration Limo Shuttle

Traced costs $94,000 $50,000 $240,000 $324,000
Services Maintenance (100,000) 10,000 45,000 45,000
provided Administration 6,000 (60,000) 21,600 32,400
by
Total $0 $0 $306,600 $401,400
Number of hours 10,000 20,000
Cost per hour $30.66 $20.07

Based on these totals, we compute the hourly cost rates as $30.66 and $20.07 for the Li-
mo and the Shuttle services respectively.

e.
Comparing our answers to parts (a) – (d), we see that the hourly rate estimates are very
close. This occurs because the proportion of services provided by Maintenance and Ad-
ministration to each other are relatively small – only 10% (i.e., the reciprocity in con-
sumption between service departments is low). We would observe more variation in our
estimates as this percentage increased.

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16. 35
a.
The following table provides the required allocations.
Admin- Tax Audit Client 1 Client 2
istration
Traced costs $22,500 $7,500 $15,000

Administration (22,500) $2,250 $2,250 $4,500 $13,500

Audit (9,750) 6,825 2,925
Services
Tax (17,250) 6,900 10,350
Provided by
Total 0 0 0 $18,225 $26,775
Notice that the total amount allocated to the clients, $45,000, equals the firm’s overhead
costs.

b.
The answer to part (a) would change if we used the direct method. This is because
the direct method ignores the consumption by the other support departments. Thus, no
costs from administration would be allocated to either tax or audit. For completeness, we
provide the direct allocation below:

Admin- Tax Audit Client 1 Client 2

istration
Traced costs $22,500 $7,500 $15,000
Administration (22,500) $5,625 $16,875
Tax (7,500) 5,250 2,250
Services
Audit (15,000) 6,000 9,000
Provided by
$0 $0 $0 $16,875 $28,125

c.
The answer to (a) depends on the order in which we allocate support departments.
For example, if we first allocated tax, then audit, and finally administration, the answer
would change relative to the direct method. The reason is that the step-down method ac-
counts for interactions, partially. In this case, the only links among support departments
are from administration to tax and audit. If we rank administration last, the step-down
method would ignore these links, making it equivalent to the direct method.

d.
The reciprocal method would lead to the same answer because this method accounts
for all linkages among support cost pools. However, the only links are from administra-
tion to audit and tax. The answer in part (a) accounts for these links because it ranks ad-
ministration ahead of audit and tax. Thus, the answers will coincide.

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16. 36
a.
The following table presents the required allocations.

Group Strategic Technology Cost Man- Marketing Personnel

Management Management agement Management Management

Staffing 25 45 12 50 18
Percent 16.67% 30.00% 8.00% 33.33% 12.00%
Allocation1 $ 2,041.67 $ 3,675.00 $980.00 $ 4,083.33 $ 1,470.00
1
$2,041.67 = $12,250 * 0.16666

Notice that we can perform the allocation in two steps. First, we compute a rate per per-
son as $12,250/150 persons = $81.66 per person per month. We then use this rate to allo-
cate the costs to the five cost objects. An equivalent method is to allocate the costs in
proportion to the percent of cost driver in each cost object, as shown in the table.
b.
We know that the current cost is $12,250 for 150 persons, and that costs would be
$12,875 for 175 persons. We could represent these cost estimates as:

$12,250 = Fixed Cost + (Variable Cost × 150)

$12,875 = Fixed Cost + (Variable Cost × 175)

Solving, we find that FC = 8,500 and VC = $25 per person.

Next, notice that staffing would have been 158 persons prior to the drop-off. The ex-
pected cost at that level of staffing would be:

$8,500 + ($25 × 158) = $12,450.

CCG would have computed a rate of $12,450/158 = $78.80 per person prior to the drop
off in volume. This rate leads to an allocation of ($78.80 per person × 25 persons) =
$1,969.94 to the Strategic Management Group. From part (a), we know this group was al-
located $ 2,041.67 (= $81.66 × 25 persons) after the drop-off in staffing. Thus, this group
has to bear more of the burden even though its own staffing level did not change.

c.
The SCG (Strategic Consulting Group) would naturally object to an increase in their allo-
cation because of events outside their control. The problem occurs because CCG is em-
ploying a single rate whereas the cost structure has both fixed and variable costs. A dual
rate allocation, one for fixed costs and one for variable costs, would address this
concern. That is, the fixed cost of $8,500 would be allocated based on the groups’ long-
run staffing. They would also get an allocation of $25 per person actually employed to
cover the variable costs connected with providing personnel services.

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The dual rate allocation would, therefore, insulate SCG from the actions of the CMG. All
that would happen is that the amount of idle capacity in personnel would increase by 8
persons.

16. 37
a.
Suppose the power were outsourced. Then, we could shutdown the power-generation de-
partment. However, our savings would be more than Rs. 3,000,000; notice that mainte-
nance now contributes 30% of its services to the power department. Thus, we could save
30% of the maintenance department’s Rs. 1,750,000, which is another Rs. 525,000 (= 0.3
* Rs. 1,750,000). Thus, total cost savings would be Rs. 3,525,000. In other words, this is
the cost of producing power internally.

Now, let us figure out the cost to outsource. We know that maintenance now consumes
20% of the power, or 240,000 KWh (= 1,200,000 * 0.20). With the power department
gone, its use will come down to 70% of current levels, or 168,000 KWh (= 240,000 *
0.7). We will not need 72,000 KWh currently used. Thus, total requirements would be
1,128,000 KWh. At a cost of Rs. 3.00 per KWh, the total cost to outsource is Rs.
3,384,000.

Comparing the amounts, it is cheaper to outsource at a cost of $3,384,000 than do it in-

ternally and spend Rs. 3,525,000 (for a net saving of Rs. 141,000).

b.
We would like to know the feasibility of saving the estimated amount. For instance, does
the amount included in the power department include allocations for space, management
and other overhead costs? If so, the savings are likely to be less. We are not likely to re-
duce management staff or gain more revenue from space (usually in a damp basement) if
we remove the power equipment. We also must consider the costs of dismantling and
selling the power equipment.

All of these refinements help improve the accuracy of estimated cost savings. The cost of
dismantling and salvage value, in particular, could become a make-or-break factor in
these calculations. (Chapter 11 discussed how to incorporate the time value of money into
such decisions.) Overall, it appears that management’s choice is not obvious.

16. 38
a.
The following table provides the resident’s allocated costs for the three months.
Month Total Total usage2 Cost / gal- Gallons Allocation
cost1 lon3 used
March $60,000 2,000,000 0.030 2,500 $75.00
May $75,000 3,000,000 0.025 2,500 $62.50
December $52,500 1,500,000 0.035 2,500 $87.50
1
30,000 + 0.015 × Total usage for month.

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2
Usage = Usage by residents + usage by P&R department.
3
0.030 = $60,000/2,000,000.

b.
The fixed cost rate is $0.01 per gallon, based on the monthly fixed cost of $30,000 and
total usage of 3,000,000 gallons. The variable cost is $0.015, leading to a total charge of
$0.025 per gallon. This means that the resident would be charged $62.50 = 2,500 ×
$0.025 for each of the three months.

c.
There is some appeal to the dual rate allocation, which does not lead to fluctuating usage
rates. The wide variation in part (a) arises because of variation in total usage, driven pri-
marily by variation in usage by the P&R department.

However, the allocation in part (b) is not justifiable. Because it is based on maximum us-
age, this allocation would lead to unallocated costs almost every month. The city would
have to find a way to charge users for this unused capacity. It might be more equitable to
add a “fixed” charge per account to deal with the cost of unused capacity. Alternatively,
the city could base the rates on average use. That is, calculate a fixed cost rate of $0.015
($30,000/2,000,000) and a total rate of $0.03. This way, the resident’s bill would be a
constant $75 per month (assuming equal usage of 2,500 gallons per month). Over the
year, the city would then recover all costs even though it would be over-allocating some
months and under-allocating during others. This mechanism is similar in concept to the
pre-determined overhead rate that was described in Chapter 14.

16. 39
a.
The required computations are presented below.

Total actual cost in proportion to actual use.

The clinic’s total cost is $8,000 + $10,720 = $18,720

Actual use was 240 + 240 = 480 exposures.
Thus, the rate per exposure is $18,720 / 480 = $39. Because each physician actually used
240 exposures, the amount to be allocated to each physician is (240 exposures × $39 per
exposures) = $9,360.

Total expected cost in proportion to actual use.

The clinic’s flexible budget for the actual volume is

$7,500 + (480 exposures × $20 / exposure) = $17,100.

Actual use was 240 + 240 = 480 exposures.

Thus, the rate per exposure is $35.625 (= $17,100/480 exposures). Because each physi-
cian actually used 240 exposures, the amount to be allocated to each of the physicians is

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(240 exposures × $35.625 per exposure) = $8,550. Under this scheme, notice that
($18,720 actual cost - $17,100 flexible budget) = $1,620 of cost is unallocated to the phy-
sicians.

Expected fixed cost allocated in proportion to expected use, expected variable cost allo-
cated in proportion to actual use.

This scheme uses separate pools (and drivers) for fixed costs and variable costs. Thus, we
have:

For fixed costs,

Total expected fixed cost $7,500

Total expected usage (long-term) 500 exposures (= 300 + 200)
Capacity cost / exposure $7,500 / 500 = $15 / exposure

Using this rate, we have the fixed cost allocated as:

Dr. Alpha 300 exposures × $15 / exposure $4,500
Dr. Beta 200 exposures × $15/ exposure $3,000

Next, the standard variable cost for each exposure is $20. Thus, we have:
Dr. Alpha 240 exposures × $20/exposure $4,800
Dr. Beta 240 exposures × $20/exposure $4,800
In total, we have:

Dr. Alpha: $4,500 + $4,800 $9,300

Dr. Beta: $3,000 + $4,800 $7,800
Total $17,100
Under this scheme also, notice that once again $1,620 of cost is unallocated to the physi-
cians.
b.
We believe that the dual rate systems (allocate fixed cost by long-run expected use and
variable costs by actual use, both at budgeted costs) is the superior way to allocate this
common cost between the physicians. This method effectively aligns the fixed and varia-
ble costs with their respective drives: long-run and actual volume.

16. 40
a.
As with all allocations, we perform this allocation in two steps. We first compute the al-
location rate. We then use this rate to allocate costs to the different programs.
The total cost is $24,000 + (0.03 × 1,500,000) = $69,000. The denominator volume is
1,000 students, meaning that the allocation rate is $69 per student. With this rate, the fol-
lowing amounts are allocated to each of the three programs:

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Daytime: 300 × $69 $20,700

Evening: 600 × $69 $41,400
EMBA 100 × $69 $6,900
b.
The allocation in part (a) appears faulty because the number of copies per student varies
widely across the programs. EMBA students are budgeted to consume 3,300 copies each
while the evening students only consume 900 or fewer copies. Thus, it seems fairer to al-
locate costs based on the actual number of copies consumed.

We have the rate as $69,000 / 1,500,000 = 0.046 / copy.

Daytime: 600,000 × $0.046 $27,600
Evening: 500,000 × $0.046 $23,000
EMBA 400,000 × $0.046 $18,400

Notice that the allocation to the EMBA program has increased dramatically to reflect its
much greater volume of copies per student.
c.
We could improve the system even further by separately allocating fixed and variable
costs. Ideally, we would want to compute the rates based on budgeted costs. (Here, we
only have the budget and no data on actual cost, so the choice is even easier.)

We have the fixed rate as $24,000/1,500,000 = $0.016/copy. The variable cost rate is the
flexible budget cost of $0.03 per copy. (Notice that the total is $0.046, equal to the com-
putation in (b). This equivalence is because the total actual number of copies and the
budgeted number of copies turned out to be the same.)

With this data, we have:

Program Total
Daytime1 Evening Executive
Most recent quarter
Actual # of copies 600,000 500,000 400,000 1,500,000
LT # of copies 720,000 450,000 330,000 1,500,000

Fixed cost allocated 11,520 7,200 5,280 $24,000

Variable cost 18,000 15,000 12,000 $45,000
Total cost $29,520 $22,200 $17,280 $69,000
1
$11,520 = 720,000 * 0.016; $18,000 = $0.03 * 600,000; Similarly for the other programs.

This allocation more appropriately captures the long-term and actual usage of the copy
center by the three programs. In particular, the long-term capacity costs for the copy cen-
ter are most likely correlated with long-term demand, and its variable costs with actual
demand. Separating the allocations into smaller pools provides a cleaner message to the
programs about the marginal costs of making copies (both in the short- and the long-
term). This superior information should lead to superior decision making.

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16. 41
a.
Currently, the firm pays the supplier to sequence 1.6 million base pairs (1,000,000 +
500,000 + 100,000). If the firm buys the machine, the cost would be
$550,000 + (0.10 × 1,600,000) = $710,000.

Thus, Morgan would save $10,000 (=$720,000 - $710,000) if she could get all the se-
quencing done internally.
b.
Morgan should of course consider quality when making the decision. She should also
note that the machine provides capacity for growth. In particular, consider a volume of 2
million base pairs. At this volume, the supplier cost is (0.45 × 2 million) = $900,000.
However, the internal cost is $550,000 + ($0.1 × 2 million) = $750,000, saving $150,000.
Thus, growth expectations are key. (Morgan could compute the crossover volume at
which the internal machine and out sourcing have the same cost) Finally, Morgan should
consider the intangible costs and benefits of owning her own machine. While it might
confer the benefits of greater access and control, it also results in lower flexibility (e.g., if
technology changes, it is easier to change suppliers than to replace your machine).

c.
This becomes a touchy issue in most corporations. Ideally, Morgan should allocate fixed
costs based on long-run usage and variable costs based on actual use. The fixed cost rate
is ($550,000 / 2 million base pairs) = $0.275 per base pair and the variable cost rate is
$0.10 per base pair. (This allocation assumes that current usage is a good estimate of
long-run usage.) The question is how Morgan should account for the cost of idle capacity
(400,000 pairs). If she uses practical capacity to estimate the allocation rates, the divi-
sions would be allocated:

Current & long- Fixed cost1 Variable cost Total

run usage
Wheat 1,000,000 $275,000 $100,000 $375,000
Corn 500,000 137,500 50,000 187,500
Soybean: 100,000 27,500 10,000 37,500
Idle capacity 400,000 110,000 - 110,000
Total 2,000,000 $550,000 $160,000 $710,000
1
$275,000 = $550,000 * (1,000,000 / 2,000,000)

However, a good argument could be made for not carving out the cost of idle capacity.
After all, if the long-run usage is 1.6 million pairs, the idle capacity is a consequence of
the combined demand and machine scale. Thus, it seems reasonable to divide the fixed
costs into the three divisions, as shown below:

Current & long- Fixed cost1 Variable cost Total

run usage
Wheat 1,000,000 $343,750 $100,000 $443,750
Corn 500,000 $171,875 50,000 $221,875

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Soybean 100,000 $34,375 10,000 $44,375

Idle capacity 400,000 $0 - 0
Total 2,000,000 $550,000 $160,000 $710,000
1
$343,750 = $550,000 * (1,000,000 / (1,000,000+500,000+100,000)

Notice that even with this allocation, each of the divisions is better off than contracting
with an outside supplier, although the “savings” for each division is lower.
d.
The firm’s expected cost without the soybean division is $550,000 + (1.5 million × 0.1) =
$700,000. The supplier’s cost is $0.45 × 1.5 million = $675,000. Thus, the soybean divi-
sion manager’s argument is not valid in this instance. All three divisions must use the tech-
nology for it to be cost effective. The situation would change if, for example, the corn divi-
sion were to increase its use to 600,000 or more base pairs.

The Soybean division manager’s argument is a classic that is often advanced by smaller
divisions. “Late comers” to the technology also argue that the fixed costs are sunk and
should not be allocated to them. We believe these arguments to be without merit. In partic-
ular, if the argument is adopted and no cost is allocated to “late comers,” no division has
incentives to move early. Avoiding this incentive means that we must allocate fixed costs
to all users of centralized capacity resources, regardless of timing or their criticality to the
coalition required to buy the machine.

Note: What a “best” allocation method would be in such settings is still the subject of much
debate. Thus, the arguments for (d) represent the authors’ judgment.

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