QUESTIONS 3-1 Relevant cost information, including differential costs and opportunity costs, is
used in management planning and decision making. 3-2 Direct costs can be physically identified with and/or traced to the cost object
because there is a direct causal link between them. Indirect costs cannot be traced to each cost object. Direct costs for a manufactured product include the materials (called direct materials) which are part of the product and the labor (called direct labor) which is used to assemble the product. Indirect costs include the machinery, plant and other labor necessary to manufacture the product, but which is not directly traceable to the product, such as labor for inspection and supervision.
3-3 All direct costs are variable by definition since they can be directly traced to the
cost object, and thus must vary with the cost driver. 3-4 All fixed costs must be indirect, since the increase in the cost driver or volume of
output does not affect the level of fixed cost. 3-5 A cost driver is any activity that has the effect of changing the level of total cost. 3-6 Variable costs are those for which total cost changes with each change in the
cost driver. Fixed costs are the portion of total cost which remains constant as the cost driver changes.
3-7 A step-fixed cost varies with the cost driver, but in discrete steps. Costs remain
fixed over narrow ranges of the cost driver. However, total costs increase by a constant amount at set intervals. Examples of step-fixed costs are the costs for certain clerical tasks, order filling, and other administrative tasks. At specific levels of the cost driver, an additional clerk must be added. Therefore, total costs increase by a constant amount at these points.
3-8 The relevant range is the range of the cost driver for which total cost is
approximately linear. The relevant range is used to provide a useful range of activity for the cost driver in which it can be assumed that variable costs will be constant per unit of the cost driver. This is an assumption since the behavior of actual costs is likely to be non-linear (see Exhibit 3-5) over the range of the cost driver. The concept of the relevant range allows the management accountant to use the concept of constant unit variable cost for a defined range of operations, even though actual unit variable costs change over the entire range of the cost driver.
3-9 Conversion costs are the sum of direct labor and overhead costs. Prime costs are the sum of direct materials and direct labor.
3-10 Average cost can be misleading unless the activity level (denominator) is known.
Because average cost includes a fixed cost component, it will be different at each possible activity level. The term average cost is meaningless if the denominator is unknown.
3-11 Total variable costs increase as the cost driver increases.
Total fixed costs remain constant as the cost driver increases. Average variable costs remain constant as the cost driver increases. Average fixed costs decrease as the cost driver increases.
3-12 Marginal cost is the additional cost that is incurred as the cost driver increases by
one unit. 3-13 Product costs are costs which are capitalized as assets, or inventoried. They are
referred to as manufacturing costs in manufacturing firms and merchandise inventory in merchandising firms. Period costs are expensed as they are incurred because there is no expectation that they will provide any future benefit to the firm. Since period costs are not directly or indirectly related to the production process, they are sometimes called non-manufacturing costs.
3-14 Cost of goods manufactured is the cost of the units produced this period and
transferred into finished good inventory. Cost of goods sold is the cost of the units sold this period. Cost of goods sold will differ from cost of goods manufactured because of changes in finished goods inventory. If finished goods inventory is very nearly the same from the beginning to the end of the period, then cost of goods sold and cost of goods manufactured will be very nearly the same.
3-15 The types of inventory in manufacturing firms are:
1. raw materials inventory 2. work in process inventory 3. finished products inventory
3-16 Relevance is most crucial. Unless the information is relevant to the decision at
hand, it is not important how timely or accurate it might be. 3-17 A relevant cost is one that can help a decision maker distinguish the expected
utility of one option from another. A relevant cost must: 1. differ among the options 2. be incurred in the future
3-18 Opportunity cost: a benefit foregone, that is the difference between the value of the best option and that of the option chosen. Opportunity cost is used to measure the economic impact of decisions made on the basis of a non-quantifiable factor.
Sunk cost: a cost that has already been incurred. Therefore, it does not affect cash flows.
3-19 There are two views to this question:
1. Managers should only be responsible for the costs they can directly control. It would be unfair and unmotivating to hold managers responsible for costs they cannot control. For example, an incentive plan based on reducing total cost exposes the employee to risks that are beyond his control. For example, a poor economic climate may result in increases in certain costs regardless of the amount of effort exerted by the employee. 2. Managers should be responsible for all costs. Many uncontrollable costs are controllable by managers taken as a whole. If all managers work together to reduce these costs, the entity as a whole will benefit.
3-20 The answer depends on what you consider the cost object. Suppose we consider the flight as the cost object, then the variable costs should include fuel and, the flight team, and any meals or other products provided to passengers on the flight. If the object is the individual passenger, then the list of variable costs is shorter, since fewer costs are actually caused by the addition of another passenger – perhaps only beverages. While the cost of the aircraft and most airline staff would be clearly fixed costs for either type of cost object, some types of airline staff, such as baggage handlers and gate attendants might be variable with the flight.
3-21 We start with the cost object, which in this case could be the item of merchandise
sold. Then the variable costs are the cost of merchandise and the selling costs for the cashiers and restocking. For a large discount retailer, most other costs will be driven by the number of hours open each week, and the variety of merchandise handled. For other types of retailers (not discounters), sales commissions might be an applicable variable cost.
3-22 The cost object for a movie theater could be the number of films being shown, or
the number of screens. The cost of renting the movie from the film producer is the main cost. The key driver of revenue (not cost) is the number of ticket holders – for ticket revenue and also revenue from sales of food and beverages. Some costs will also be driven by the number of ticket holders, such as the cost of food and beverages. The cost of staff is likely to be a step cost, which depends on the expected number of ticket holders for each different day in the week, and time of day. Other facilities costs are likely to be fixed for the number of ticket holders, or number of films being shown.
3-23 The cost object here is more readily identified – the beer product, whether
measured in individual bottles or larger quantities. The variable costs will be significant here, including the ingredients that go into the brewing of beer. Other costs for the brewery are likely to be fixed for this cost object, but there are important activity costs which will vary with, for example, the number of customers/distributors (delivery and account management costs), the number of different types of beer, or the complexity of the brewing process for the brewery (A brewery that specializes in the more expensive beers require more costly ingredients, processing time, and different packaging).
3-24 Here it is plausible to consider the individual lesson as the cost object. Variable
costs would include that portion of the trainers pay which is based on each lesson (the salary portion of the trainers’ pay would be fixed for this cost object). Other variable cost could include any materials that are used for each lesson,
and perhaps the travel cost to each client, if the company reimburses the trainers for miles traveled.
3-25 The relevant costs are $13,500, $6,000 and $2,000. The $9,995 is a sunk cost,
and the $1,000 insurance will have to be paid irrespective of which cycle he owns, so it is also irrelevant.
3-26 As assistant manager, Toby is most likely to be able to control the efficiency of
the staff, thereby reducing the amount of waste and spoilage, and perhaps the cost of waiters by scheduling the waiters effectively to busier times. It is least likely he can control the heat and light which is driven by the number of hours the restaurant is open.
3-27 An opportunity cost 3-28 $400,000 + $1,600,000 - $200,000 = $1,800,000 cost of goods sold 3-29 Period cost includes interest, advertising, and office expense: $4,000 + $2,500 +
1. period 2. product and indirect 3. product and indirect 4. product and direct 5. period 6. period 7. product and direct 8. period 9. product and indirect (could be direct if electricity is metered and
measured for each product) 10. period 11. period 12. product and indirect 13. period 14. period
1. direct and variable 2. indirect and fixed 3. indirect and variable 4. indirect and fixed 5. direct and variable 6. indirect and fixed 7. indirect and variable 8. direct and variable 9. indirect and fixed
3-35 Application of the Direct Cost Concept in the Fashion Industry (15 min) It is always possible, by definition, to trace direct materials and direct labor costs to each unit produced. In some cases, as this one, the most practical approach is to trace the materials and labor costs directly to the batch. This is convenient both for cost management and pricing, since the batch is often for a single customer. This is a preview of job costing, which is the topic of the following chapter, chapter 4.
3-36 Complexity of Operations and the Effect on Cost (15 min) The observations made by the consultant show that the manufacturer was incurring large costs in operations, distribution, and administration due to the high level of complexity in its products. Maintaining relationships with 10 vendors for a single item contributed to high purchasing and stocking costs. Similarly, most of the firm’s volume was made up of products with five color combinations, with the result that manufacturing, warehousing, shipping and selling costs were high relative to fewer color combinations. Also, the high product variety required smaller batch production and more frequent set-ups, which caused increased manufacturing costs. And the variety of different customers, prices, and promotional programs created increased manufacturing, shipping and customer service costs as well as increased costs in accounting for the customers invoices and account balances. The solution? Reduce complexity. This was done by reducing the number of customers; the low value customers were reviewed and some were not continued. Also, a process of review was developed for the introduction of new products or new variations on existing products, to ensure the likely profitability of the new product. Further, the complexity of equipment set-ups was reduced so that the firm could meet the customer’s demands for smaller batch sizes without increasing overall costs. The result of the program was that overall profit margins improved. The firm had found a way to deal with the cost consequences of its strategic initiative. Also, the firm adopted new cost management practices that included new non-financial measures such as set-up time and frequency, percent of orders shipped on time, percent of orders on just-in-time, and number of vendors for the top 20 commodity raw materials items. In addition, the firm began to calculate and regularly review customer profitability, by type of market and customer size. Based on information in: “Managing Complexity Through Performance Measurement,” by Frank A. J. Gonsalves and Robert G. Eiler, Management Accounting, August 1996, pp 34-39.
$ 1,500 (fixed cost of night club) + 1,200 (variable cost of refreshments = $12 x 100) $ 2,700
Average cost: $2,700/100 people = $27.00 per person
2. Total cost:
$ 1,500 (fixed cost of night club) + 2,400 (variable cost of refreshments = $12 x 200) $ 3,900
Average cost: $3,900/200 people = $19.50 per person
3. Average costs decrease as attendance increases because the fixed cost component to total costs is now spread over 100 extra people.
Fixed cost per person: $1,500/100 people = $15 $1,500/200 = $ 7.50 Decrease in fixed cost per person $ 7.50 Average cost for 100 people $27.00 - Decrease per person in fixed costs 7.50 Average cost for 200 people $ 19.50
3-38 Cost Classification for Dance Studio (15 min) 1. While a variety of possible cost objects are possible for the dance studio, the most reasonable choice is the studio since management’s goal is to analyze the profitability of the studios. 2. Studios as the cost object
3-42 Military Downsizing and Direct vs. Indirect Costs (20 min)
In recognition of this problem, and of the large number of contract appeals it has caused, the various federal boards of contract appeals have ruled in favor of treating certain indirect costs as direct costs in these situations: 1) In an appeal filed by Fiesta Leasing & Sales, Inc., the board allowed depreciation on buses purchased for a bus leasing contract when the Defense Department terminated the contract. The board allowed depreciation costs because the costs were incurred for the contract and because these costs could not be discontinued after the contract was terminated. 2) In an appeal brought by Essex Electric Engineers, Inc., the Department of Transportation (DOT) Contract Appeals Board allowed recovery of the full cost of equipment remaining at a plant when the contract was terminated for the convenience of the DOT. The reason for the ruling is that the equipment purchased by Essex for the DOT contract was far beyond its needs for its other business. Source: Based on information from: Margaret M. Worthington, “As Military Downsizes, Contract Termination Becomes a Challenge,” Journal of Accountancy, March 1992, p88-90.
This question is based on a report by Paul Raeburn, “Hybrid Cars: Less Fuel but More Costs,” Business Week, April 15, 2002, p 107. The rapid increase of gasoline prices in 2004-2006 should enhance the interest in the issue discussed. The costs shown for each gallon of gasoline saved look much better in 2006 than in 2002 when the article was written; in 2002 the price of gas was about 40% of the 2006 price. The cost justification for higher fuel efficiency would be an easier case to make in 2006. The main point of this exercise is to have the students understand that the determination of an average cost, as in this report, requires a specification of the level of activity, or output, that drives costs. This is the reason the concept of average cost is often misunderstood and misused in practice. For example, since in this case total cost per gallon of gas depends on both variable costs (gasoline) and fixed costs (vehicle cost), the determination of an average cost requires an assumption of activity level. While variable costs (the price of gasoline) are constant per unit, for the number of gallons purchased, the average per-gallon fixed cost of purchasing the vehicle will depend on the number of miles traveled. Car owners who travel relatively few miles will have large average fixed costs in contrast to “road warriors” with many miles traveled. The Business Week report does a good job in this regard by reporting that the assumed activity was 12,000 miles per year for 12 years. This gives the reader a way to interpret the findings; those who drive more than this amount can expect lower “cost for each gallon of gas saved” from improvements in the vehicle, while those who drive fewer miles can expect higher costs than those reported. Instructors can start this exercise by asking the class how average cost is determined in this case. The key idea to bring out is that average fixed cost is determined by some pre-determined activity level.
This question is based upon an article in the January 1997, Journal of Accountancy, “How Does Your Finance Department Measure Up?” pp50-51. The main point of this exercise, as for 3-43 above, is to help the student understand the importance of taking activity levels into account when interpreting average cost information. The Journal of Accountancy article shows, as represented by the information presented in the exercise, that average fixed costs decline with higher levels of activity. Larger companies, with higher levels of transaction volume, will have higher total fixed costs, but average fixed costs should be lower due to economies of scale (as noted in the article, p50). Looked at another way, if a given firm were to grow, and its volume of transactions grew as well, then average fixed costs (or in this case the ratio of total accounting costs to total revenue) would have to fall. Average fixed cost would continue to fall with increasing numbers of transactions, until the firm felt it necessary to increase capacity in the accounting department, thereby increasing fixed costs. (Note there is a controversy in microeconomics about whether the long run average cost curve is flat or U-shaped. See Karl Case and Ray Fair, Principles of Microeconomics, Fourth Ed, 1996, page 239.) Thus, the data presented by the Journal is as we would expect – larger firms will have lower average costs. We would not expect otherwise. Average fixed costs should be lower for the larger firms.
First determine direct labor costs from total prime costs: Since: direct materials + direct labor = $180,000 Then: 95,000 + direct labor = $180,000 direct labor = $ 85,000 Next determine overhead costs from total conversion costs:
direct labor + overhead = $215,000 85,000 + overhead = $215,000 overhead = $130,000 Beginning work in process $ 75,000 Current costs: Direct materials used $95,000 Direct labor 85,000 Overhead 130,000 Total current manufacturing cost $310,000 Total manufacturing costs available $385,000 Less: Ending work in process 65,000 Cost of goods manufactured $320,000
2. a. All the additional costs are likely to be product costs except for the increase in advertising, which is a period cost. b. The baking facilities cost are not relevant since they will not change, but all the other costs are relevant (the increase in materials and labor; the increase in advertising and packaging; the increase in documentation and inspection costs).
3-47 Executional Cost Drivers: Internet Retailer (20 min)
The example of an internet retailer such as Bikes.com is a good example of the type of firm that must pay close attention to executional cost drivers. The reason is that its success depends on customer service – prompt response to customer requests, and prompt and accurate filling of customer orders. Customer loyalty is a key success factor for a firm such as this, and loyalty comes from superior customer service in all its dimensions. Amazon.com introduced the successful internet retailing business model, and has built a successful business on the basis of customer loyalty. This is the approach Bikes.com needs to follow – and this means execution, execution, execution. The fall off in sales growth could be an indication of problems in customer return sales, that is customer loyalty. Bikes.com can review sales records to investigate. Specific executional steps that Bikes.com can take include to look for possible improvements in the purchase and stocking of merchandise and the shipping of customer orders – the upstream and downstream activities that must work smoothly to get the orders to the customers quickly and accurately. Also, Bikes.com should consider the work flow in the company. Can it be streamlined? Are there non-value-adding activities that can be eliminated? What are the bottlenecks, if any, that slow the process of accurately filling a customer’s order? Also, are employees aware of the importance of executional issues? Are the employees working together to achieve the required speed and accuracy necessary for the firm’s success?
Executional cost drivers are important to Bikes.com in two ways. First, these are the executional issues which the firm must achieve in a superior way in order to compete effectively in internet retailing. And second, effective attention to the cost drivers and effective cost management can lower the costs of operation and speed the arrival of profits.
3-48 Structural Cost Drivers (25 min) Case A: A key structural issue for Food Fare is complexity. As the menu has changed, so will costs and service. More complexity means higher food purchasing costs, higher operating costs, and more complex operations. This will require new types of training for employees and perhaps additional employees. Moreover, it will be a challenge for Food Fare to continue to provide the speed of service that was possible with the shorter menu. The change will require careful attention to operations and to cost management issues for the firm to continue to be profitable. Employee training and new uses of technology to streamline the process of order taking and order filling are likely to be necessary. Scale might also be an important issue in this case – how large must each restaurant become, and how many restaurants must the chain have in order to justify the increased purchasing and stocking costs, and the new training and technology costs? Case B: A key issue in this case is the speed with which Gilman can provide customer service. The speed of service provides value to the customer and also increases profitability. In order to increase the speed of service, Gilman needs effective communication and coordination among the service teams. This is probably being accomplished now by cell phone. Gilman can research new and more effective ways to accomplish this, perhaps using hand-held internet access devices or modem-equipped notebook computers. The advantage of computer-based access is that computer based tools can be used in the scheduling and assignment of the service teams. Additionally, the computer can be used by each service team to quickly determine the availability of parts in the firm’s warehouse or in other service vehicles, thereby allowing faster service time. Also, the computer can be used to develop real time analyses of customer demand and profitability – in order to better understand which services and which types of customers are most profitable. Is it in installation or service, Brand X or Brand Y, residential or commercial, etc.? Scale is also an important cost driver for Gilman. To serve the large area it now serves, there should be a careful strategic analysis to get the right balance between order getting costs (advertising and promotion to obtain new customers) plus the costs of maintaining the
Total Factory Overhead + 132,000 Total Manufacturing Costs Incurred during year 222,000 Work-in-Process Inventory, Beginning + 33,000 Total Manufacturing Costs to Account for 255,000 Work-in-Process Inventory, Ending - 35,000 Cost of Goods Manufactured $220,000
Duvernoy CompanyIncome Statement
For the Year Ended December 31, 2007Sales Revenue $500,000Cost of Goods Sold
Finished Goods Inventory, Beginning $23,000Cost of Goods Manufactured 220,000 Total Goods Available for Sale 243,000 Finished Goods Inventory, Ending 20,000
Cost of Goods Sold 223,000 Gross Margin $277,000 Marketing Expenses $66,000
General and Administrative 55,000 Total Selling & Administrative Expenses 121,000 Net Income $156,000
Total Factory Overhead 286,000 Total Manufacturing Costs Incurred during year 921,000 Work-in-Process Inventory, Beginning 23,000 Total Manufacturing Costs to Account for 944,000 Work-in-Process Inventory, Ending 9,000 Cost of Goods Manufactured $935,000
Household Furnishings, IncIncome Statement
For the Year Ended December 31, 2007Sales Revenue $1,500,000Cost of Goods Sold
Finished Goods Inventory, Beginning $15,000Cost of Goods Manufactured 935,000 Total Goods Available for Sale 950,000 Finished Goods Inventory, Ending 38,000
Blue Water Equipment, IncStatement of Cost of Goods Manufactured
December 31, 2007Direct Materials Used Direct Materials Inventory, Beginning $33,000
Direct Materials Purchases 190,000 Total Direct Materials Available 223,000 Direct Materials Inventory, Ending $28,000
Direct Materials Used $195,000Direct Labor $345,000Factory Overhead
Insurance on Plant $44,000Supplies--Plant 21,000 Repairs on Plant Building 34,000 Depreciation Expense--Plant and Equip. 197,000 Heat and Light for Plant 23,000 Indirect Labor 128,000 Supervisor's Salary Plant 85,000
Total Factory Overhead 532,000 Total Manufacturing Costs Incurred during year 1,072,000 Work-in-Process Inventory, Beginning 14,000 Total Manufacturing Costs to Account for 1,086,000 Work-in-Process Inventory, Ending 11,000 Cost of Goods Manufactured $1,075,000
Blue Water Equipment, IncIncome Statement
For the Year Ended December 31, 2007Sales Revenue $1,675,000Cost of Goods Sold
Finished Goods Inventory, Beginning $66,000Cost of Goods Manufactured 1,075,000 Total Goods Available for Sale 1,141,000 Finished Goods Inventory, Ending 43,000
3-53 Cost of Goods Manufactured, Calculating Unknowns (40 min)
Case A 1. Direct materials used $18,000 + Direct labor 15,000 + Manufacturing overhead 20,000 Total manufacturing costs $53,000 2. Sales $100,000 - Cost of goods sold - ? = $75,000 Gross margin $25,000 3. Beginning finished goods $ 15,000 + Cost of goods manufactured + ? = $76,000 - Ending finished goods -16,000 Cost of goods sold 75,000 4. Beginning work in process ? = $30,000 + Total manufacturing costs +53,000 - Ending work in process - 7,000 Cost of goods manufactured $76,000 5. Gross margin $25,000 - Selling and administrative expenses - ? = $15,000 Operating income $10,000
Case B 1. Sales ? = $46,000 - Cost of Goods sold - 43,000 Gross margin $ 3,000 2. Finished goods inventory $ 8,000 + Cost of goods manufactured +45,000 - Finished goods inventory - ? = $10,000 Cost of goods sold $43,000
3. + Direct labor + 9,000 + Manufacturing overhead + ? = $ 18,000 Total manufacturing costs $35,000 4. Total manufacturing costs $35,000 + Work in process inv., Jan. 14,000 - Work in process inv., Dec. - ? = $4,000 Cost of goods manufactured $45,000
3-54 Cost of Good Manufactured and Income Statement (40 min)
Norton Industries Statement of Cost of Goods Manufactured
For the Month Ended May 31, 2007 ($000 omitted)
Direct materials Inventory of direct materials, April 30 $ 28 Purchase of direct materials 510 Freight-in 15 Total direct materials available for use $ 553 Inventory of direct materials, May 31 23 Direct materials used in production $ 530 Direct labor 260 Indirect factory labor $ 90 Utilities (135 x .8) 108 Property tax 60 Insurance (20 x .6) 12 Depreciation (20 + 30) 50 Manufacturing overhead $320 Total manufacturing costs $1,110 Plus: Inventory of WIP April 30 150 Less:Inventory of WIP May 31 220 Cost of goods manufactured $1,040
Sales $ 1,488 Less Sales discounts 20 Net Sales 1,468 Cost of Goods Sold Finished Goods Inventory, 4/30 $ 247 Cost of Goods Manufactured 1,040 Cost of Goods Available for Sale 1,287 Finished Good Inventory, 5/31 175 1,112 Gross Margin 356 General, Selling, and Administrative Expense Office Salaries $ 122 Sales Salaries 42 Insurance ($20 x .4) 8 Utilities ($135 x .2) 27 Rent 9 Depreciation 4 Interest 6 218 Income from operations $ 138 Other revenue 2
