Acc 206 week 3 assignment (PLEASE DO NOT CHANGE THE PRICE, I ALREADY PAID SOMEONE TO DO THESE AND THEY DID NOT SEND THEM TO ME).

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Week Three Assignment

  1. Listen to the following videos and then complete the assignments using the changed numbers on the guidance report.  Place your answers on the guidance report.
  2. Open the Guidance Report and rework the problem with the changed numbers and place your answers on the guidance report. Do not alter the guidance report.
  3. Submit the guidance report using the Assignment Submission tab below.

    Complete the following problems and exercises:

    • Chapter Four Exercise 4  http://ashford.mediaspace.kaltura.com/media/ACC206A+Chapter+4+Exercise+4/0_urxlae4s
    • Chapter Four Problem 2  http://ashford.mediaspace.kaltura.com/media/ACC206A+Chapter+4+Problem+2/0_aiu417g2
    • Chapter Five Problem 2    http://ashford.mediaspace.kaltura.com/media/ACC206A+Chapter+5+Problem+2/0_ei3lxc86
    • Chapter Five Problem 3   http://ashford.mediaspace.kaltura.com/media/ACC206A+Chapter+5+Problem+3/0_avqkqrs3
    • Chapter Five Problem 4   http://ashford.mediaspace.kaltura.com/media/ACC206A+Chapter+5+Problem+4/0_6q4jspa1

    Week Three Guidance Report

Acc 206 week 3 assignment (PLEASE DO NOT CHANGE THE PRICE, I ALREADY PAID SOMEONE TO DO THESE AND THEY DID NOT SEND THEM TO ME).
chapter 4 Costing Methods Learning Objectives • Understand the ethical duty of managerial accountants to provide proper costing information. • Apply concepts and techniques that are used to fairly measure and report job costs. • Be able to track job costs, including overhead, through a typical accounting system. • Understand alternative costing concepts, such as process costing and activity-based costing. istockphoto waL80281_04_c04_083-112.indd 1 9/25/12 1:02 PM 84 Chapter Outline Chapter Outline 4.1 Job CostingJob Costing and the Ledger Actual Overhead Differences Between Actual and Applied Overhead Mandatory Reporting of Overhead Job Costing Is Not Only for Manufacturing 4.2 Process Costing Environments Cost of Production Report Case Study in Process Costing 4.3 Activity-Based Costing ABC Modeling ABC Example W hat is the cost of producing a product or service? To the untrained accountant, this question seems simple enough. But, the more you learn about accounting, the more difficult this question becomes to answer. How does one identify all of the necessary ele – ments that are needed to produce an output? The answer to this question necessarily includes direct material and direct labor. But you are also very familiar with other factory and nonfactory-related costs that must be incurred before a product may be produced. Typically, accountants will devise schemes by which costs are captured and assigned to products. When an accountant reports on the cost of a product or service, he or she is really reporting on measurements based on systematic processes for cost assignment. Accountants should not be flippant in developing their costing procedures. Key busi- ness decisions that impact the allocation of business resources, and ultimately peoples’ livelihoods, are at stake. As such, accountants have a high ethical duty to develop and correctly deploy fair and defensible models for product costing. This chapter provides insight into costing techniques that offer general acceptability in arriving at an answer to the all-important question about the cost of a product or service. Several methods can be used for costing purposes. They are somewhat dependent on the nature of the product that is being produced and/or the process by which production occurs. One such method is job costing, which is best suited to those situations in which goods and services are produced upon receipt of a customer order, according to customer specifications, or in separate batches. For example, a home builder woul d likely accumulate costs for each unique house that it produces. Materials and labor can be readily identified with each house, and the costing method will accumulate costs accordingly. In contrast, process costing captures costs for each process or department. It is applicable to homog- enous goods that are produced in batches or continuous processes. An example is the pro – duction of candy. Candy might be produced in stages such as mixing, cutting, and cooking. Within the mixing department, the cost of all ingredients and labor is accumulated and divided across the total pounds of finished goods to find a per-pound (or other measure) cost for the mixed material. Similar cost assignment processes are followed within each department to arrive at the cost of a final box of candy. The bulk of the remainder of this chapter will introduce you to the key components in job and process costing techniques. waL80281_04_c04_083-112.indd 2 9/25/12 1:02 PM CHAPTER 4 85 Section 4.1 Job Costing Accountants have long thought about costing methods and have challenged the basic assumptions on which costing decisions are made. There is considerable literature on this subject, and alternative models have been proposed. One model that has a strong group of proponents is activity-based costing. This chapter will close with a brief introduction to this alternative approach to answering questions about what a product or service costs. 4.1 Job Costing Job costing entails the development of a tracking system or database by which costs are matched to jobs. This generally entails specifically identifying the a mount of direct labor and direct material that is used on a specific job. The other overhead costs are then assigned to a job by reliance on a predetermined overhead allocation formula. One com – mon approach is to take the period’s total anticipated overhead and divide it by the antici – pated labor hours to arrive at an amount of overhead that is expected to be incurred “per labor” (overhead can be applied on other application bases, such as material usage; the goal is to try to closely associate overhead to jobs based on consumption of overhead). A logical starting point for costing a job is to determine the amount of direct labor that is attributable to a specific job. Employees typically complete reports (via a time card, electronic clock, spreadsheet, etc.) indicating the amount of time they worked. From the employees’ perspective, these time reports are important because they may be used to establish how much they are owed (i.e., how many hours they worked). However, in addi – tion to hours worked, time reports usually have codes to identify the work performed. These codes can be matched to specific tasks on specific jobs, but they will also include time spent on travel, breaks, job setups, and other work-related tasks that do not track to a specific product that is being produced. By querying the company’s accounting system, it then becomes possible to determine all of the direct labor time that was spent on a specific job. The indirect labor costs not traced to a specific job become part of the overhead cost pool, which is allocated across all jobs using the overhead application rate. Direct materials are assigned to jobs in a manner very similar to direct labor. It is very important that material that is used on a specific job be matched to the job. Just as employees are expected to maintain time records, they should also complete materials requisition forms. These forms are used to pull raw materials from inventory and transfer them into work in process. A very detailed coding system must be established that allows tracking of material from inventory into a specific job. Sometimes, a materials requisition form will only show inventory by part number and not identify the cost of the mate rial. When this is the case, additional systems must be put in place to subsequently all ow the company to identify the cost of the materials. Great care must always be taken to match the right cost to the right item and the right item to the right job. Indirect materials, such as tape, screws, and touch-up paint, are not traced to a specific job. These costs should instead be contemplated in the overhead cost pool that is allocated among all jobs. Previously, it was mentioned that a predetermined overhead rate is used to assign over – head to a particular job. It has likely already occurred to you that there can be differences between the actual overhead incurred and the amount applied to production via the pre – determined overhead application rate. This difference cannot be ignored indefinitely, and you will soon see how it is to be processed. For the moment, let’s not be concerned with those potential differences and instead focus on a job cost sheet (Exhibit 4.1) that sum- marizes direct labor, direct material, and overhead cost that is applied to a particular job: waL80281_04_c04_083-112.indd 3 9/25/12 1:02 PM CHAPTER 4 86 Section 4.1 Job Costing Exhibit 4.1 Direct Labor Source Code Rate Hours Qty Total Total Cost Pe r Unit Qty Basi sT otal Rate Direct Material Applied OverheadTotal No v. 15, 20X7 Bob Thurman Susan Mar key Steel Wheels No v. 16, 20X7 Bob Thurman Ravi Rajnar No v. 17, 20X7 Bob Thurman Susan Mar key Glass Applied Overhead Time Card #6573 Time Card #6998 Materials Req. A56 Materials Req. B17 Time Card #6573 Time Card #7002 Time Card #6573 Time Card #6998 Materials Req. B24 Totals 8.00 6.00 6.00 8.00 2.00 8.00 38.00 $12 $18 $12 $15 $12 $18 $ 96.00 $ 108.00 $ 72.00 $ 120.00 $ 24.00 $ 144.00 $ 564.00 400 lbs 6 units 25 sq ft $ 2.00 $15.00 $ 3.00 $800.00 $ 90.00 $ 75.00 $965.00 38.00 $11 $ 96.00 $ 108.00 $ 800.00 $ 90.00 $ 72.00 $ 120.00 $ 24.00 $ 144.00 $ 75.00 $ 418.00 $1,947.00 $418.00 $418.00 Turnkey Enterprises JOB COST SHEET Labor Hours waL80281_04_c04_083-112.indd 4 9/25/12 1:02 PM CHAPTER 4 87 Section 4.1 Job Costing Exhibit 4.1 is quite typical. The direct labor hours are drawn from the employee time cards and associated with each employee’s wage rate. The direct materials are drawn from the materials requisition forms (or similar documents) and associated with the cost of specific inventory items, and the overhead is applied based on the predetermined rates. Be aware that technology can greatly facilitate preparation of job cost sheets. For instance, materials can be automatically tracked to jobs by scanners and radio frequency identifica- tion chips. Furthermore, the job cost sheet is really just a compilation of data into a use- ful report format. The data may be mined from within a sophisticated database. Beyond this summarized data, you also need to recognize that information must be captured by a company’s general ledger system and lead to the preparation of aggregated data for reporting purposes. Job Costing and the Ledger The data, which are foundational for the preceding job cost sheet, must also be transferred to a company’s general ledger system. A robust information system will do this quite easily and automatically. However, it is necessary for you to see the debit/credit process to fully comprehend the cost flow through an accounting system and into the resulting financial statements. Let’s begin by considering the cost flows for the various factors of production. The typical sequence of steps for direct materials entails the purchase of raw materials from a sup – plier, a transfer of raw materials into work in process as production occurs, the transfer of the cost of completed goods into finished goods inventory, and finally the transfer of inventory to cost of goods sold when products are sold and delivered to a customer. Direct labor is slightly simpler because the first step is essentially not appl icable. As wages are incurred, those costs are accumulated straight into Work in Process. Upon completion, the labor cost is transferred to Finished Goods Inventory and then on to Cost of Goods Sold at the time of sale. The factory overhead items, such as factory depreciation, main – tenance, supplies, indirect labor, and indirect material, are not directly added to Work in Process. Instead, these costs are introduced into Work in Process based on the predeter – mined application base; if overhead is applied based on labor hours, it may well be that overhead is attached concurrent with direct labor costs. The following entries illustrate the full process for assigning job costs. Carefully review each entry, taking special note of the related journal entry description: 10-1-X2 Raw Materials Inventory 965 Accounts Payable 965 To record purchase of materials, placing costs into raw materials inventory 10-15-X2 Work in Process Inventory 1,947 Raw Materials Inventory 965 Salaries Payable 564 Factory Overhead 418 To transfer raw materials to production, record direct labor costs on job, and apply overhead at the predetermined rate of $11 per direct labor hour waL80281_04_c04_083-112.indd 5 9/25/12 1:02 PM CHAPTER 4 88 Section 4.1 Job Costing 10-24-X2Finished Goods Inventory 1,947 Work in Process Inventory 1,947 To transfer total cost of a completed unit to finished goods inventory 10-28-X2 Accounts Receivable 2,500 Sales 2,500 To record sale of finished for $2,500 Cost of Goods Sold 1,947 Finished Goods Inventory 1,947 To remove cost of sold unit from the finished goods inventory Actual Overhead Students are sometimes slightly confused by their first exposure to the accounting for factory overhead. In previous chapters, you saw how salaries, utilities, depreciation, the consumption of supplies, and similar costs were charged (i.e., debited) directly to vari – ous expense accounts. The accounting for these types of costs in a manufacturing envi – ronment now gets a slight twist. In the preceding entries, we credited an account titled “Factory Overhead” for the allocated amount of overhead cost. What is the nature of this overhead account? It clearly is not Cash, Accounts Payable, or some other familiar account that would ordinarily be related to an expenditure. Instead, it is a unique account that is used to accumulate and allocate the actual overhead costs. The credit you witnessed was the allocation effect. The accumulation of the actual costs results in a debit to Factory Overhead as follows: 10-XX-X2 Factory Overhead 450 Salaries Payable 150 Supplies 75 Accumulated Depreciation 100 Utilities Payable 125 To record actual factory overhead costs The previous credits are those customarily associated with incurring salaries, using sup – plies, recording depreciation, and utilizing utilities. However, instead of debiting the cus – tomary expense accounts, the costs are charged to Factory Overhead. The net result of this process is to debit Factory Overhead for the actual costs incurred and credit Factory Over – head as these costs are allocated to Work in Process (which eventually gets transferred to expense as Cost of Goods Sold as shown via the preceding entries). You may be wonder – ing what happens if the amount of overhead actually incurred differs from the amount allocated, and that question is answered in the following discussion. waL80281_04_c04_083-112.indd 6 9/25/12 1:03 PM CHAPTER 4 89 Section 4.1 Job Costing Differences Between Actual and Applied Overhead An actual company would, of course, have many jobs in process, so the preceding journal entries for only one job present a very simple picture of costs flows within the organiza- tion. Nevertheless, it is a realistic portrait. Notice that assigned costs totaled $1,947 (pro – ducing a $553 profit: $2,500 sales price 2 $1,947 of goods sold), including allocated over – head of $418. However, the actual overhead was $450. The fact that actual overhead was more than the amount assigned to production represents underapplied overhead. This is indicative of an unfavorable outcome. More was actually spent than was anticipated based on the application rate. This amount cannot be ignored. Based on the previous journal entries, the Factory Overhead account contains a net debit of $32 ($450 in debits and $418 in credits). Accountants dispose of this balance by one of several processes. A popular approach is to adjust cost of goods sold as follows: 10-31-X2 Cost of Goods Sold 32 Factory Overhead 32 To transfer underapplied overhead to cost of goods sold This entry causes an increase in cost of goods sold for the excess overhead spending. Alternative methods for clearing the Factory Overhead account are usually covered in advanced accounting classes. What is most important for you to note at t his time is that the Factory Overhead is indeed zeroed out. It is not a financial statement account. Rather, it is a temporary account for accumulating and transferring overhead costs into produc- tion. If applied overhead had exceeded the actual amount, overhead would have been overapplied. Overapplied overhead would be cleared in just the opposite manner of that illustrated for underapplied overhead. Mandatory Reporting of Overhead Although managerial accounting information is generally viewed as for in ternal use only, be mindful that many manufacturing companies do prepare external financial statements. Also, generally accepted accounting principles (GAAP) dictate the form and content of those reports. GAAP requires that underapplied overhead relating to idle facilities, wasted material, the allocation of fixed production overhead, and so forth be charged to current period income by means similar to those just illustrated. Job Costing Is Not Only for Manufacturing Most textbook illustrations tend to demonstrate job costing in the context of a product- manufacturing scenario. However, at least in the United States, most employees now work in the service sector. This includes the fields of accounting, sales, law, food service, elec – tronic information, and transportation. In addition, the not-for-profit and governmental sectors are significant components of the economy. Activities relate to education, health care, fire protection, law enforcement, transportation, human services, and the like. The idea of a “job” can easily be expanded from a tangible product to a particular activity. In health care, a job could be a surgical procedure. In accounting, a job could be preparation waL80281_04_c04_083-112.indd 7 9/25/12 1:03 PM CHAPTER 4 90 Section 4.2 Process Costing Environments of a tax return. In education, a job could be a particular course. Measuring the c ost of this output is equally important, and the job costing techniques remain fully applicable. For example, an architectural firm would likely track time (direct labor) devoted to each design. Direct materials can relate to printing of blueprints. Overhead allocations can become substantial, including the office costs, computers, software, and so forth. Success- ful management of a service-related entity requires careful attention to costing informa – tion. As you can imagine, it is easy to underestimate the full cost of providing services to customers; it is ultimately necessary to recover not only direct labor but also the other significant costs of operations. 4.2 Process Costing Environments S ometimes job costing techniques simply do not apply. Production may instead involve a continuous flow of raw materials through production departments. The output is not identifiable as discrete jobs. Rather, output consists of a homogenous product. Paint, petroleum distillates, paper products, steel, glass, and many other products display such attributes. It becomes virtually impossible to match direct labor and direct material to a particular gallon, pound, square foot, or other measure of final output. Nevertheless, it is vitally important for management to be able to assess the cost of production. Companies facing this challenge often turn to process costing. Process costing allocates the total cost of production across all units of output. This usually entails accumulation of costs for each stage (or department) of production and assigning those costs to all output from that stage. Process costing has certain attributes in common with job costing. Material, labor, and fac – tory overhead are all still assigned to work in process, and they are eventually transferred on to finished goods and then to cost of goods sold. In this respect, the journal entries are quite like those applicable to job costing. The main difference between job costing and process costing is that process costing captures costs by process or department rather than by specific job. If you consider a candy factory, three departments define the basic processes: mixing ingredients, cutting the ingredients into bite-sized pieces, and cooking. A separate Work in Process account will likely be used for each department. The Work in Process account for the mixing department will capture (i.e., be debited) the aggregate amount of direct material, direct labor, and allocated factory overhead incurred during a period. The accounts utilized in this entry would appear like the October 15 entry that was used for the job costing illustration. Assuming a weighted-average cost assumption (in contrast to FIFO or some other technique), the total dollar amount accu- mulated in this account would be divided by the total production (this could be pounds or some other measure) to find per-unit cost (e.g., dollars per pound). The per-unit cost can then be used to allocate cost between goods still in process and those that were completed and transferred to the cutting department. The journal entry to reflect a transfer out of cost from the mixing department to the cutting department would appear as follo ws: waL80281_04_c04_083-112.indd 8 9/25/12 1:03 PM CHAPTER 4 91 Section 4.2 Process Costing Environments 10-30-X2Work in Process Inventory 2 Cutting 50,000 Work in Process Inv. 2 Mixing 50,000 To transfer cost assigned to completed pounds of mixed candy to the cutting department The cutting department’s Work in Process account would therefore include the direct material, direct labor, and factory overhead generated directly within that department and also the carried forward cost from the preceding mixing department. A similar pro – cess would be used to transfer work completed by the cutting department to the cooking department. At the end of the production process, the Work in Process account of the final stage (cooking) would be cleared of the accumulated costs by a transfer of those costs to finished goods inventory. This entry would be just as the October 24 entry for the job cost – ing example. By carefully following this approach, the finished goods inventory will have completely captured the costs of production generated within each department. Cost of Production Report When process costing methods are used, management of each department will likely receive a cost of production report for each period. This report is very similar in purpose to a job cost sheet. It details the amount of direct material, direct labor, and factory overhead incurred by the department (rather than by job as with a job cost sheet). It then shows how those costs were allocated to total production and provides supporting documentation for the journal entries that were used to transfer costs to successive departments. To understand a cost of production report requires the introduction of one new dimen – sion, that of equivalent units. An equivalent unit is a physical unit expressed in terms of a finished unit. This is a relatively simple concept. As an example, assume that 100 pounds of candy was 40% complete within a particular department. Thi s is assumed to be equivalent to the production of 40 pounds (100 pounds 3 40% complete). Although none of the 100 pounds is complete, we can abstractly say that we produced the equiva – lent of 40 pounds. The concept of equivalent units is exceedingly important to grasp. It is rare that a com – pany will not have goods in production at the end of an accounting period. Accounting periods end on regular intervals, but there is no compelling business reason to cease pro – duction with the flip of a page on a calendar. Indeed, many production processes are dif – ficult to stop and restart effectively (e.g., heating a kiln). It is better to keep the production flow going. Thus, it is frequently necessary for managerial accountants to estimate the equivalent units under production. As you examine the example cost of production report that follows, you will see how this concept comes into play. The following example shows a simplified cost of production report for one department for 1 month. As you inspect this report, take special note that the ending work in process was assumed to be 40% complete. This report shows that of the total cost of $1,500,000, $1,250,000 was transferred to the next department, and $250,000 remained in work in pro – cess at the end of the month. waL80281_04_c04_083-112.indd 9 9/25/12 1:03 PM CHAPTER 4 92 Section 4.2 Process Costing Environments SWEET CANDY COMPANY Cost of Production Report for Mixing Department for the Month of October 20XX Total Pounds Percent Complete Equivalent Units Transferred to Cutting Department 500,000100%500,000 In production at end of month 250,00040% 100,000 Total equivalent units for the month 600,000 Cost Calculations Cost of beginning inventory $ 400,000 Additional costs during the month 1,100,000 Total costs to account for $1,500,000 Equivalent units from above ÷ 600,000 Per unit cost $ 2.50 Equivalent Units Per Unit Cost Cost Assignment Total pounds transferred to Cutting Department 500,000 $2.50$1,250,000 Equivalent units in ending work in process 100,000 $2.50 250,000 600,000 $1,500,000 The preceding cost of production report was simplified by an assumption that materials, labor, and overhead were all introduced into production uniformly. If you study more advanced cost accounting courses, you will learn how to account for scen arios where that assumption is violated. Essentially, it becomes necessary to separate the cost of materials, labor, and overhead so that you derive separate costs per equivalent for each component . waL80281_04_c04_083-112.indd 10 9/25/12 1:03 PM CHAPTER 4 93 Section 4.2 Process Costing Environments Case Study in Process Costing To further illustrate process costing, let’s focus on a comprehensive case study. Yum Gum produces chewing gum in a three-step process consisting of (a) blending ingredients, (b) cooking, and (c) cutting and packing. Each process involves a uniform incurrence and introduction of materials, labor, and overhead. Following are cost of production reports for each of the three departments for August. The amounts are all assumed, but do take note of how costs transferred out of one department are received into the next department. YUM GUM Cost of Production Report for Blending Department for the Month of August Total Pounds Percent Complete Equivalent Units Transferred to Cooking Department 300,000 100%300,000 In production at end of month 100,00025% 25,000 Total equivalent units for the month 325,000 Cost Calculations Cost of beginning inventory $ 80,000 Additional costs during the month 570,000 Total costs to account for $650,000 Equivalent units from above ÷ 325,000 Per unit cost $2.00 Equivalent Units Per Unit Cost Cost Assignment Total pounds transferred to Cooking Department 300,000 $ 2.00$600,000 Equivalent units in ending work in process 25,000 $ 2.00 50,000 325,000 $ 650,000 waL80281_04_c04_083-112.indd 11 9/25/12 1:03 PM CHAPTER 4 94 Section 4.2 Process Costing Environments YUM GUM Cost of Production Report for Cooking Department for the Month of August Total Pounds Percent Complete Equivalent Units Transferred to Cutting Department 250,000100%250,000 In production at end of month 60,00030% 18,000 Total equivalent units for the month 268,000 Cost Calculations Cost of beginning inventory $ 35,000 Costs transferred in from Blending Department 600,000 Additional costs during the month 236,000 Total costs to account for $ 871,000 Equivalent units from above ÷ 268,000 Per unit cost $ 3.25 Equivalent Units Per Unit Cost Cost Assignment Total pounds transferred to Cutting Department 250,000 $3.25$812,500 Equivalent units in ending work in process 18,000 $3.25 58,500 268,000 $871,000 waL80281_04_c04_083-112.indd 12 9/25/12 1:03 PM CHAPTER 4 95 Section 4.2 Process Costing Environments YUM GUM Cost of Production Report for Cutting Department for the Month of August Total Pounds Percent Complete Equivalent Units Transferred to Finished Goods 275,000100%275,000 In production at end of month 40,00060% 24,000 Total equivalent units for the month 299,000 Cost Calculations Cost of beginning inventory $ 260,000 Additional costs during the month 123,500 Costs transferred in from Cooking Department 812,500 Total costs to account for $1,196,000 Equivalent units from above ÷ 299,000 Per unit cost $ 4.00 Equivalent Units Per Unit Cost Cost Assignment Total pounds transferred to Finished Goods 275,000 $4.00$1,100,000 Equivalent units in ending work in process 24,000 $4.00 96,000 299,000 $1,196,000 The cost of production report for each department triggers information necessary to sup – port the following journal entries. Be sure to observe the unique entries where costs are handed off from one department to the next. waL80281_04_c04_083-112.indd 13 9/25/12 1:03 PM CHAPTER 4 96 Section 4.2 Process Costing Environments Journal entries related to blending: 8-31-XXWork in Process Inventory 2 Blending 570,000 Raw Materials Inventory 190,000 Salaries Payable 190,000 Factory Overhead 190,000 To transfer raw materials to production, record direct labor costs for blending, and apply overhead at the predetermined rate 8-31-XX Work in Process Inventory 2 Cooking 600,000 Work in Process Inventory 2 Blending 600,000 To transfer cost assigned to completed pounds of blended gum to cooking department Journal entries related to cooking: 8-31-XX Work in Process Inventory 2 Cooking 236,000 Raw Materials Inventory 78,667 Salaries Payable 78,667 Factory Overhead 78,6 66 To transfer raw materials to production, record direct labor costs for cooking, and apply overhead at the predetermined rate 8-31-XX Work in Process Inventory 2 Cutting 812,500 Work in Process Inventory 2 Cooking 812,500 To transfer cost assigned to completed pounds of cooked gum to cutting department Journal entries related to cutting: 8-31-XX Work in Process Inventory 2 Cutting 123,500 Raw Materials Inventory 41,167 Salaries Payable 41,167 Factory Overhead 41,16 6 To transfer raw materials to production, record direct labor costs for cutting, and apply overhead at the predetermined rate 8-31-XX Finished Goods Inventory 1,100,000 Work in Process Inventory 2 Cutting 1,100,000 To transfer cost assigned to completed pounds of cut gum to finished goods waL80281_04_c04_083-112.indd 14 9/25/12 1:03 PM CHAPTER 4 97 Section 4.3 Activity-Based Costing This comprehensive example shows how costs are monitored, accumulated, and assigned to finished goods. Bear in mind that the comingling of ingredients and involvement of numerous steps makes it exceedingly difficult to have an intuitive awareness of costs for goods that are produced via continuous processes. Process costing is essential for con- trolling costs and setting pricing in such environments. 4.3 Activity-Based Costing B oth job costing and process costing methods divide costs between product and period costs. As you know, period costs are charged against income as they occur, and they generally relate to selling, general, and administrative (SG&A) activities. In co ntrast, direct materials, direct labor, and factory overhead are assigned to inventory. One concep – tual shortcoming is that it becomes difficult to fully contemplate the true cost of a finished product. Arguably, the cost of producing a product should sometimes take into account a portion of the organization’s SG&A. For instance, buying raw materials is an adminis – trative task: Why is the cost of this activity not assigned to inventory ? Conversely, lawn maintenance for a factory is usually part of factory overhead: Why does the cost of that activity become assigned to inventory when the cost will be incurred no matter how many units are produced? Activity-based costing (ABC) attempts to overcome deficiencies such as those cited in the preceding paragraph. ABC requires a new mind-set as compared to traditional cost – ing methods. Some companies have embraced ABC, and others see it as too radical of a departure from traditional costing methods. Indeed, ABC is not acceptable for external reporting under GAAP. Thus, companies that implement aspects of ABC typically do so to supplement traditional costing information. ABC is normally for internal use only and is intended to facilitate internal decision-making processes by pinpointing actual (full) production costs more precisely. ABC requires one to abandon attempts to distinguish product and period costs. Instead, ABC is a costing model that divides production into core cost objects and activities, defines the costs for each, and then allocates activity costs to cost objects ba sed on how much of a particular activity is consumed by the cost object. This results in products absorbing costs of manufacturing and nonmanufacturing activities alike. Conversely, some manufactur – ing costs may not attach to any products. The driving principle of ABC is that a product’s cost is based only on the cost of capacity utilized in producing the product. Unused capac – ity is not assessed or allocated to production. Remember that traditional costing approaches usually allocate all manufacturing costs (via the overhead application rate), whether related to excess capacity or not, to the inven – tory actually produced. This has the potential to distort the measured cost of production, thereby limiting a manager ’s ability to make decisions about pricing and production. As you might suspect, important business decisions are based on assessment of product prof- itability. To the extent a product’s sales price is set by market conditions, and profit is seen as the sales price minus product cost, the determination of a product’s cost becomes criti- cal in deciding on its fate. waL80281_04_c04_083-112.indd 15 9/25/12 1:03 PM CHAPTER 4 98 Section 4.3 Activity-Based Costing ABC Modeling If you think about traditional costing, you will quickly conclude that t he cost object is normally a product or service. With ABC, the concept of a cost object is far more expan- sive. Cost objects expand to also include customers, markets, and similarly identifiable items or events that require activity to support. For example, a customer may receive a quarterly visit from a sales representative, no matter the level of purchasing activity. The customer would be a cost object, and activities to support the customer might include an airline ticket, hotel bill, and so forth. These activities have a cle ar cost that is traceable to the customer (i.e., the cost object) rather than the products produced/sold or period incurred. A business is apt to have many cost objects and hundreds of activities in sup – port thereof. Therefore, the first step in ABC implementation entails a detailed study of processes and costs. This study is usually supported by flowcharts and dia grams, and it may resemble something that looks more like it was developed by an engineer than a managerial accountant. In linking activities to cost objects, it is important to consider that activities occur at many levels. Some activities occur at the unit level. There is a one-to-one correspondence with a unit of output. Final inspection of each car for an automobile manufactu rer is an example. Other activities occur at a batch level. Global shipping of containers is an example; the same amount of effort must be expended to clear customs, regardless of the quantity of individual products within a container. Thus, shipping a container would be a batch-level activity. Other activities occur at much higher levels. Product-level activities include designing a new product. Customer-level activities include developing catalogs and sales calls; in other words, the amount of activity is dependent on the number of custom – ers. Some businesses even identify market-level activities (Asia, Europe, North America, etc.). At the highest level are entity-sustaining activities, such as the cost of a corporate audit. The identification of activities is unique to each company, and considerable study and thought is needed to properly map a company’s activities. Once all activities and cost objects have been identified, it next becom es necessary to study how the organization’s costs align with activities and objects. Basically, each cost is identified as one of three types. First, some costs are directly traceable to a specific cost object. Direct material is a clear example of a cost that is attributable to the “ product” cost object. You are quite familiar with this concept because this piece is the same under traditional costing and ABC. Moving to a less familiar concept, the cost of printing a cata – log would be traced to a “customer” cost object. Once all costs th at can be directly traced are determined, the second step is to attempt to allocate remaining costs to specific activi – ties. For some costs, this is very logical. The cost of a new product design team would be allocated to the product-level design activity. At other times, considerable judgment must be applied to make the allocation. Consider the light bill for the office space; perhaps 10% of this amount is for electricity usage within the design department’s space. You can see that ABC quickly entails a degree of complexity. Finally, some costs do not seem to match with any cost object or activity. This third grouping of costs is not assigned to any activity or cost object. The fact that a cost is not assigned to a cost object or activity does not mean that it is to be ignored; it is expensed but should be closely monitored by management. The final step in ABC requires that the cost of activities be allocated to cost objects. For example, the accumulated cost of the design activity must finally be all ocated to cost objects. If three new products were developed, it might be appropriate that the design activity’s total cost be shared one-third by each new product. waL80281_04_c04_083-112.indd 16 9/25/12 1:03 PM CHAPTER 4 99 Section 4.3 Activity-Based Costing Exhibit 4.2 is an attempt to recap the overall design of an ABC system: Exhibit 4.2 ABC Example Because of its complexity, it is easy to quickly lose sight of the purpose of ABC. ABC is intended to improve measures of cost. By introducing activity cost pools as an interme – diate step for selected costs (rather than allocating every cost directly to a product or period), we are much better able to allocate the costs to end objects (products, customers, etc.). Without activity cost pools, it becomes difficult to connect each cost with final cost objects. A simplified example should prove quite helpful in clarifying how ABC works. Hong sells three products. Each product generates exactly $1,750,000 in total sales. Two products (A and B) are manufactured internally, and one (C) is outsourced. A and C are sold via direct sales efforts, and B is sold only via a website. For simplicity, assume Hong has only four identifiable activities: manufacturing, direct sales, administration, and web sup – port. The cost of manufacturing ($1,000,000, excluding direct materials and direct labor) is allocated 50% to A and 50% to B. The study of the cost of direct sales ($800,000) revealed that it is attributable 70% to A and 30% to C. Administrative activities ($1,200,000) are found to be consumed 20% by A, 30% by B, and 50% by C. Finally, web support ($100,000) is 100% attributable to B. Let’s assume that there are no costs that cannot be traced to a particular cost object or activity. ASSIGN COSTS TO ACTIVITIES WHEN NOT TRACEABLE TO COST OBJECT ADOPT ALLOCATION SCHEME TO TRANSFER ACTIVITY COSTS TO COST OBJECTS CHARGED TO EXPENSE BUT MONITORED CLOSELY AS PA RT OF OVERALL FINANCIAL MANAGEMENT FINAL COST DETERMINATION FOR COST OBJECTS DETERMINECOSTS STUDY COSTS AND PROCESSES TRACE COSTS TO COST OBJECTS WHEN POSSIBLE COSTS THAT ARE NOT TRACEABLE OR ASSIGNABLE waL80281_04_c04_083-112.indd 17 9/25/12 1:03 PM CHAPTER 4 100 Section 4.3 Activity-Based Costing Table 4.1 reveals the ABC approach to assessing costs for each final product. Table 4.1: The ABC approach to assessing costs Product AProduct BProduct C Direct materials and labor (traceable) $500,000$750,000 Purchase of outsourced product (traceable) $900,000 Manufacturing activity (allocated activity) 500,000500,000 Direct sales (allocated activity) 560,000 240,000 Administration (allocated activity) 240,000360,000600,000 Web support (allocated activity) – 100,000 – Total cost assignment $1,800,000 $1,710,000 $1,740,000 The costs in the preceding table were either directly traceable to cost object A, B, and C or allocated based on the given percentages. The resulting total cost assignment shows that only products B and C are profitable (remember that each product had total sales of $1,750,000). A traditional costing model would not pinpoint these facts nearly so precisely. Why? The answer is that each product would have a high gross profit (sales minus cost of sales, based only on the traceable and allocated manufacturing costs). Furthermore, sell – ing and administrative costs would be deducted in the aggregate as follows: Product A Product BProduct C Total Sales $1,750,000$1,750,000$1,750,000$5,250,000 Cost of sales 1,000,000 1,250,000 900,000 3,150,000 Gross profit $750,000 $500,000$850,000$2,100,000 Sales (800,000) Administration (1,200,000) Web support (100,000) Net income – This quite simplified example of ABC is intended to show how alternative costing models can shed additional light on business operations and enable much better decision making. More advanced managerial accounting courses frequently go into ABC in much greater depth. The allocation tables are similar to those given here but will potentially encompass far more cost objectives, activities, and allocation steps. In business, ABC would become almost impossible to implement without modern information systems and so ftware that tracks and allocates complex cost arrays with relative ease. For now, your coverage of ABC is intended to make you aware of the limitations of traditional costing models and show an alternative thoughtful approach. Even ABC has its critics. It is no better than the processes used to identify activities and allocation waL80281_04_c04_083-112.indd 18 9/25/12 1:03 PM CHAPTER 4 101 Concept Check percentages, and these are inherently judgmental. Indeed, this facet of ABC underscores that an ethical manager must provide strong leadership to be sure that whatever cost- ing model is used, it must be thoughtfully designed and implemented. Without strong knowledge and leadership in costing, poor signals will be produced. Poor signals lead to bad decisions and wasted resources. This can be viewed as unethical from the per – spective of failing to discharge appropriate stewardship over company resources. Concept Check The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. ( The correct answers can be found at the end of your text.) 1. Which of the following businesses would be least likely to use a job cos ting system? a. Automobile r epair shop b. Custom home builder c. Cr ude oil refinery d. Motion pictur e producer 2. The journal entry to r ecord the use of indirect materials in production activities is a. debit W ork in Process; credit Raw Materials. b. debit Factory Over head; credit Raw Materials. c. debit Raw Materials; cr edit Work in Process. d. debit W ork in Process; credit Factory Overhead. 3. Dir ect materials, direct labor, and factory overhead applied are initially brought together in which of the following accounts? a. W ork in Process b. Finished Goods c. Cost of Goods Sold d. Income Summary 4. SR T Inc. applies factory overhead on the basis of direct labor cost. The company’s accountant has forecast $180,000 of factory overhead and $200,000 of direct labor for 20X5. Actual factory overhead and direct labor for 20X5 amounted to $185,000 and $210,000, respectively. Overhead for 20X5 is a. underapplied by $4,000. b. underapplied by $9,000. c. overapplied by $4,000. d. overapplied by $9,000. 5. In today’s modern manufacturing envir onment, many companies: a. ar e experiencing a decrease in overhead application rates. b. ar e experiencing a decrease in factory overhead and an increase in direct labor cost. c. can ignor e cost drivers because of a recent pronouncement from the Financial Accounting Standards Board. d. have a labor component that may be as low as 5% of total pr oduct cost. waL80281_04_c04_083-112.indd 19 9/25/12 1:03 PM CHAPTER 4 102 Critical Thinking Questions activity-based costing (ABC) A costing method typically reserved for internal use only, which is intended to facilitate internal decision-making processes by pinpointing actual (full) production costs more precisely. batch level Represents activity regarding a number of similar units. cost of production report A report that details the amount of direct material, direct labor, and factory overhead incurred by the department and then shows how those costs were allocated to total production and provides supporting documentation for the journal entries that were used to transfer costs to successive departments. customer-level Represents activity at the customer level, such as developing cata- logs or sales calls. entity-sustaining Represent the high- est level of activities, such as the cost of a corporate audit. equivalent unit A physical unit expressed in terms of a finished unit. job cost sheet A form that summarizes direct labor, direct material, and overhead cost that is applied to a particular job. job costing Used in situations in which goods and services are produced upon receipt of a customer order, according to customer specifications, or in separate batches. market-level Market-level activities repre- sent market-oriented actions. materials requisition A form that is used to pull raw materials from inventory and transfer them into work in process. process costing Allocates the total cost of production across all units of output and is applicable to homogenous goods that are produced in batches or continuous processes. product-level Represents high levels of activity, such as designing a new product. underapplied overhead A figure that results when the actual overhead is more than the amount assigned to production. unit level Represents a one-to-one corre- spondence with a unit of output. Key Terms Critical Thinking Questions 1. Briefly explain several of the pr oblems encountered when trying to compute the actual cost of a good or service. 2. Discuss the general featur es associated with a job order costing system. In what types of applications are job order systems used? 3. Explain how the flow of costs thr ough an accounting system parallels the flow of goods and materials through a manufacturing plant. 4. Contrast the pr oper accounting treatments of direct materials and indirect materials. 5. How does the use of a pr edetermined overhead rate smooth product costs over a period of time? 6. Explain how an over head application rate is developed and used to apply over – head to specific jobs. waL80281_04_c04_083-112.indd 20 9/25/12 1:03 PM CHAPTER 4 103 Exercises 7. List the characteristics of a good over head application base. 8. Ritten Company’s factory depr eciation for the year just ended totaled $40,000 and was recorded as follows: Depreciation Expense 40,000 Accumulated Depreciation: Factory 40,000 Comment on the appropriateness of Ritten’s journal entry. 9. Discuss the r elationship between the Work in Process account and individual job cost sheets. 10. If over head is underapplied, will the Factory Overhead account contain a debit or credit balance? What is the probable effect of the underapplication on the Work in Process balance (before adjustment) at the end of the accounting period? 11. What is pr obably the most popular application base for overhead? Can this base be criticized in light of today’s manufacturing environment? Briefly explain. 12. List several possible applications of job costing systems by service ent erprises. 13. Distinguish between a dir ect cost and an indirect cost. Exercises 1. Manufacturing journal entries The following selected transactions and events occurred at Pipeline Manufacturing during March: Mar. 3 Purchased $10,000 of direct materials and $7,300 of indirect materials on account from Sunbelt Distributors. 7 Issued $3,100 of direct materials and $700 of indirect materials from the storeroom. 14 Incurred $5,600 of direct labor and $3,400 of indirect labor. 17 Recorded $1,300 of overhead incurred on account. Mar. 20 Applied $2,800 of overhead to production. 23 Noted that $6,200 of production had been completed. 26 Sold goods on account at a profit of 30% of cost. The goods cost $5,000. Prepare journal entries to record the preceding transactions and events. waL80281_04_c04_083-112.indd 21 9/25/12 1:03 PM CHAPTER 4 104 Exercises 2. Analysis of job cost sheet Sumpter Manufacturing began job No. 587 in December 20X6 and recorded mate – rial, labor, and overhead charges of $38,800 through year-end. The bottom portion of page 2 of the job’s cost sheet is reproduced here: Summary of January charges Direct materials used $ 12,600 Direct labor (580 hours) 4,350 Factory overhead applied 6,728 Total $ 23,678 Job No. 587 was completed on January 30, 20X7. a. Determine Sumpter ’s overhead application rate, assuming the company uses direct labor hours for an application base. b. What is the total cost of job No. 587? c. Pr epare the journal entries recorded in January related to job No. 587. 3. Cost flows and over head application Cleveland Metals uses a job cost system and applies factory overhead to produc – tion at a predetermined rate of 180% of direct labor cost. Data pertaining to recent operations follow: • Job No. 636 was the only job in process on January 1 of the current year. The Work in Process account contained a $24,600 balance on this date. • Job Nos. 637, 638, and 639 were started during January. • Total direct material requisitions and direct labor incurred during January amounted to $89,200 and $114,500, respectively. • The only job that remained in process on January 31 was job No. 638, with costs of $15,000 for direct materials and $20,000 for direct labor. a. Compute the total cost of the work in pr ocess inventory on January 31. b. Compute the cost of jobs completed during January , and present the proper jour – nal entry to reflect job completion. 4. Job costing and over head application Uniflex applies overhead on the basis of direct labor cost. In December 20X4, the company’s cost accountant made the following predictions for 20X5 operations: direct labor cost, $620,000; factory overhead, $961,000. Uniflex worked on job Nos. 241 and 242 in January. The costs incurred and production status of these two jobs appear in the table that follows. waL80281_04_c04_083-112.indd 22 9/25/12 1:03 PM CHAPTER 4 105 Exercises Job No. 241Job No. 242 Direct materials $26,000$47,000 Direct labor 18,00024,000 Production status In processIn process By the end of 20X5, actual direct labor cost amounted to $612,500, and factory over – head incurred totaled $967,500. There was no work in process on January 1, 20X5. Compute the following: a. Uniflex’s over head application rate. b. The balance of the W ork in Process account on January 31, 20X5. c. The amount of over – or underapplied overhead for 20X5. Be sure to indicate whether overhead was overapplied or underapplied. 5. Job costing and over head application Oxford Enterprises uses a job costing system to accumulate manufacturing cost s. Overhead is applied to products on the basis of machine hours in the machining department and direct labor cost in the assembly department. The following esti – mates pertain to 20X4: Machining Assembly Machine hours 40,0005,000 Direct labor cost $270,000$800,000 Factory overhead 810,000960,000 Job No. 328 was the only job in process at the end of 20X4. Its cost sheet revealed the data that follow: Machining Assembly Machine hours 10010 Direct labor cost $1,100$3,500 Direct materials cost 1,9003,400 a. Compute Oxfor d’s overhead application rates in the machining department and the assembly department. b. Calculate the total amount of over head applied to job No. 328. c. Determine the total cost of job No. 328. waL80281_04_c04_083-112.indd 23 9/25/12 1:03 PM CHAPTER 4 106 Exercises 6. Overview of job costing and over head application Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why. a. A materials requisition forms the basis for the following journal entry: debit Work in Process, credit Raw Materials. b. The W ork in Process account normally contains the following costs for the jobs in production at year-end: direct materials used, direct labor, and actual factory overhead. c. Dir ect labor cost is a good overhead application base to use if a company is highly automated. d. The amount of over – or underapplied overhead at year-end is normally closed to the Work in Process account. e. An over head application rate is derived by the following computation: estimated factory overhead divided by an estimated application base. 7. Over head application: Working backward The Towson Manufacturing Corporation applies overhead on the basis of machine hours. The following divisional information is presented for your review: Division A Division B Actual machine hours 22,500? Estimated machine hours 20,000? Overhead application rate $ 4.50$ 5.00 Actual overhead $110,000? Estimated overhead ?$90,000 Applied overhead ?$86,000 Over- (under-)applied overhead ?$ 6,500 Find the unknowns for each of the divisions. 8. Dir ect costs and indirect costs Executive Airlines is studying whether to begin flight service from Chicago to St. Louis. Identify the following costs as a direct cost or an indirect cost of the Chicago/St. Louis flight segment, assuming the route would be serviced by aircraft that would continue to be flown throughout Executive’s extensive route system: a. Passenger beverage service b. Airport landing fees c. Monthly engine maintenance service d. Fuel consumed e. Commissions paid to travel agents on tickets sold f. Salary of Executive’s dir ector of route planning waL80281_04_c04_083-112.indd 24 9/25/12 1:03 PM CHAPTER 4 107 Problems 9. Cost drivers, service business Don’t Bug Me treats insect-infested homes and trees in Omaha, Nebraska. The company utilizes many liquid pesticides that are purchased in 55-gallon drums and later divided into 10-gallon containers for crew use. The pesticides are accounted for as indirect materials (i.e., supplies) in the firm’s job cost system. a. Why do you think the company tr eats pesticides as indirect materials (as op – posed to direct costs) of servicing a client? b. What is a cost driver? c. Management insists that cr ews estimate square footage and tree height, respectively, for homes and trees serviced. Why is this procedure necessary? Problems 1. Pr eparation of job cost sheet and journal entries Nycom Inc. manufactures items that are used in the electronics industry. The com – pany, which uses a job costing system, has two departments: machining and fi n – ishing. The machining department applies overhead to products at the rate of $15 per machine hour. Finishing, in contrast, uses an application rate of 250% of direct labor cost. On March 19, 20X3, Nycom received an order from Sensormatic for 225 photons, Model No. 116. Production began immediately, and the order (known as job No. 4155) was completed on March 31. Paperwork supporting the order revealed the following: Document* DateDepartment HoursAmount MR 1165 3/19Machining —$5,600 MR 1169 3/21Machining —3,500 TT 1450-52 3/23Machining 45400 MUR 46 3/23Machining 105— MR 4330 3/27Finishing —700 TT 1475-76 3/31Machining 30300 MUR 47 3/31Machining 50— TT 6608-13 3/31Finishing 2002,000 *MR, materials requisition; MUR, machine usage report; TT, time ticket. waL80281_04_c04_083-112.indd 25 9/25/12 1:03 PM CHAPTER 4 108 Problems Instructions a. Pr epare a job cost sheet for the Sensormatic order as of March 31. Use the following column headings: Direct Materials Direct Labor Machine Usage Factory Overhead Date Requisition AmountTicketHours Amount Report Hours Amount b. Pr epare journal entries to record (1) the issuance of direct materials, (2) direct labor incurred on the order, and (3) the application of factory overhead. All mate – rials requisitions should be combined in one entry, all time tickets in another, and so forth. c. If company policy is to sell goods at a pr ofit of 80% of total job cost, present the journal entries necessary to recognize completion and sale of the photons. 2. Computations using a job or der system General Corporation employs a job order cost system. On May 1, the following bal – ances were extracted from the general ledger: Work in process $ 35,200 Finished goods 86,900 Cost of goods sold 128,700 Work in Process consisted of two jobs, No. 101 ($20,400) and No. 103 ($14,800) . Dur – ing May, direct materials requisitioned from the storeroom amounted to $96,500, and direct labor incurred totaled $114,500. These figures are subdivided as follows: Direct Materials Direct Labor Job No. Amount Job No.Amount 101 $ 5,000 101$ 7,800 11 5 19,500 10320,800 11 6 36,200 11 542,000 Other 35,800 11 618,000 $96,500 Other 25,900 $114,500 Job No. 115 was the only job in process at the end of the month. Job No. 101 and three “other” jobs were sold during May at a profit of 20% of cost. The “other” jobs contained material and labor charges of $21,000 and $17,400, respectively. waL80281_04_c04_083-112.indd 26 9/25/12 1:03 PM CHAPTER 4 109 Problems General applies overhead daily at the rate of 150% of direct labor cost as labor summaries are posted to job orders. The firm’s fiscal year ends on May 31. Instructions a. Compute the total over head applied to production during May. b. Compute the cost of the ending work in pr ocess inventory. c. Compute the cost of jobs completed during May . d. Compute the cost of goods sold for the year ended May 31. 3. Job or der costing, overhead emphasis Toledo Company uses a job order system to accumulate manufacturing costs. On December 31, 20X1, the work in process inventory consisted of job No. 764, costed as follows: Direct materials $ 4,800 Direct labor 12,500 Applied overhead 10,000 $27,300 Because of changing plant conditions and labor markets, the cost account ing department calculated a new overhead application rate for use throughout 20X2. Estimated totals for direct labor cost and factory overhead for 20X2 amounted to $300,000 and $270,000, respectively. Actual results follow: Direct materials used $259,600 Direct labor 316,000 Indirect materials 23,700 Indirect labor 144,900 Factory depreciation 55,300 Factory taxes 12,700 Factory utilities 55,200 $867,400 All jobs were completed and sold by December 31, 20X2, except for job no. 821, which contained direct material costs of $10,900 and direct labor charges of $22,500. This job was still in production and was anticipated to be completed in early January. The company charges any under- or overapplied overhead to Cost of Goods Sold. waL80281_04_c04_083-112.indd 27 9/25/12 1:03 PM CHAPTER 4 110 Problems Instructions a. Determine the 20X2 over head application rate, using direct labor cost as the application base. b. Determine the total cost of the company’s work in pr ocess inventory as of Decem – ber 31, 20X2. Determine the amount of under- or overapplied overhead for the year. Be sure to indicate whether overhead was underapplied or overapplied. c. Compute the company’s cost of goods sold. T oledo had no finished goods inven – tory on January 1, 20X2. 4. Job costing in a service business Diego, Hyatt, and Stevens, a prestigious law firm located in San Antonio, uses a job order system to monitor the cost of servicing clientele. The office manager has prepared the following budget for 20X7: Client billings $11,520,000 Less: Professional staff costs (85%) $6,000,000 Administrative staff costs (75%) 2,000,000 Computer time (80%) 500,000 Photocopying (70%) 200,000 Other office costs (20%) 300,000 9,000,000 Net income $ 2,520,000 The numbers in parentheses indicate the percentage of cost that is directly traceable to client jobs. The remaining, nontraceable portion is charged to clients by using a predetermined overhead application rate. The office manager feels that total direct cost is the most appropriate overhead application base. In March, the firm completed work on a suit for Picante Foods. The following costs were directly chargeable to Picante: Professional staff $25,000 Administrative staff 6,400 Computer time 2,500 Photocopying 3,700 Other office costs 400 waL80281_04_c04_083-112.indd 28 9/25/12 1:03 PM CHAPTER 4 111 Problems Instructions a. Determine the firm’s total budgeted traceable and nontraceable cost s and the overhead application rate. b. Calculate the firm’s estimated income for the year as a per centage of traceable costs. c. Compute the total cost of the Picante job and the amount that Diego, Hya tt, and Stevens would bill the client. d. The office manager can acquir e new software that would allow the firm to increase the percentage of direct (as opposed to indirect) costs. Briefly explain why Diego, Hyatt, and Stevens would be interested in this software. waL80281_04_c04_083-112.indd 29 9/25/12 1:03 PM CHAPTER 4 waL80281_04_c04_083-112.indd 30 9/25/12 1:03 PM
Acc 206 week 3 assignment (PLEASE DO NOT CHANGE THE PRICE, I ALREADY PAID SOMEONE TO DO THESE AND THEY DID NOT SEND THEM TO ME).
chapter 5 Cost–Volume–Profit Analysis Learning Objectives • Extend your knowledge of fixed and variable costs, and be able to perform cost behavior analysis. • Understand the contribution margin, contribution margin ratio, and how knowledge of these concepts can be used to calculate breakeven and other performance measures. • Know the critical assumptions of cost–volume–profit analysis. • Understand variable versus absorption costing. • Be able to calculate residual income. istockphoto waL80281_05_c05_113-140.indd 1 9/25/12 1:03 PM 114 Section 5.1 Mixed Costs Chapter Outline 5.1 Mixed Costs 5.2 Cost–Volume–Profit AnalysisThe Algebra of Break-Even and Targeted Income Analysis Influence of Taxes Changing Costs Changing Revenues Multiple Products 5.3 CVP Assumptions Direct Costing Comprehensive Income Statements Under Variable and Absorption Costing Fluctuating Inventory 5.4 Evaluating Residual Income Y ou have previously learned about fixed and variable costs. Fixed costs are the same over the relevant range of expected production. Variable costs fluctuate in direct pro – portion to volume. You have seen how cost behavior influences measures of income, flex – ible budgeting, standard costing models, and so forth. Management must understand cost behavior to operate a successful business organization effectively. In this chapter, your knowledge of cost behavior will be extended to encompass techniques useful in studying a business’s break-even point and similar concepts. These techniques are com – monly referred to as cost–volume–profit analysis or just CVP. You will also apply your knowledge of cost behavior to understand alternative costing methods tha t are useful in managing business decisions. 5.1 Mixed Costs B efore diving into CVP and alternative costing models, one must give consideration to the prospect of a mixed cost. Mixed costs entail a fixed component and a variable component. They are actually quite common. If you have ever committed to a cell phone contract, it is very possible that you have some hands-on experience wit h mixed costs. Your monthly cellular bill may include both fixed and variable amounts. P erhaps there is a fixed charge for basic monthly service and variable charges related to Internet access, texting, and so forth. Mixed costs change in response to fluctuations in volume, but not in a way that is immediately apparent. Before a manager can study the effects of volume fluctuation on a business, it is first necessary to develop a model that separates mixed costs into their fixed and variable components. Assume that Charlie’s Restaurant receives a monthly electric bill. Charlie’s electricity use fluctuates significantly each month. The cause of the fluctuation relates mostly to seasonal differences in utility consumption, based on heating and air-conditioning needs. Charlie’s provides data about its monthly electric bill in Table 5.1. waL80281_05_c05_113-140.indd 2 9/25/12 1:03 PM CHAPTER 5 115 Section 5.1 Mixed Costs Table 5.1: Charlie’s electric bill data Total costKilowatts used January $1,95015,000 February 1,75013,000 March 1,65012,000 April 1,350 9,000 May 1,45010,000 June 1,75013,000 July 2,15017,000 August 2,05016,000 September 1,85014,000 October 1,350 9,000 November 1,55011,000 December 1,75013,000 At first glance, it may not be at all apparent how the total cost relates to the total usage. However, a graphical representation of this cost is quite revealing. Exhibit 5.1 is a chart with the total cost indicated along the vertical axis and the total usage along the horizontal axis. From this chart, you are able to see that fixed cost is the same, at $450, no matter the electricity consumed. Variable cost is rising at $0.10 per kilowatt hour. Exhibit 5.1 KILOWATTS USED TOT AL ELECTRICITY COST Va riable cost area Fixed cost area 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 $2,500 $2,000 $1,500 $1,000 $500 $0 waL80281_05_c05_113-140.indd 3 9/25/12 1:03 PM CHAPTER 5 116 Section 5.1 Mixed Costs Perhaps you are able to “eyeball” the data in the table and make a determination of the fixed and variable portions in the electric bill. However, what if the data set is much larger and more cryptic? How can you estimate the fixed and variable amounts? This problem is frequently encountered because many expenses contain both fixed and variable compo- nents. A simple (and sometimes imprecise) approach is the high–low method. With this technique, the highest and lowest levels of activity are identified and the difference in cost is deemed to be representative of the variable portion. The variable portion is divided by the difference in activity/consumption between the high and low activity levels to find the variable cost per unit. The fixed cost can be calculated by subtract ing variable cost from total cost. In Table 5.2 are calculations of the fixed and variable costs for Exhibit 5.1, determined by using the high–low method. Table 5.2: Fixed and variable costs for Charlie’s Restaurant Kilowatts Cost Highest level 17,000 $2,150 Lowest level 9,000 1,350 Difference 8,000 $800 Variable cost per unit $800/8,000 5 $0.10 High Low Total cost $2,150 $1,350 Less: Variable cost (kilowatts 3 $0.10) 1,700 900 Fixed cost $450 $450 Certainly, the high–low method is not the only technique that can be used to e stimate fixed and variable components. Also, if there are outlying data points (on the high or low end), the resulting estimates of fixed and variable components can be quite mislead ing. When data are not as linear as presented in the illustration, more precise tools are needed to separate costs into fixed and variable components. One such tool is regression analysis (also known as the method of least squares regression analysis), which defines a line that has a best fit to a set of data. The line is defined in terms of its intercept with the vertical axis and its slope. To better understand regression analy – sis, consider Exhibit 5.2 showing a line that intercepts the y axis at 2 and has a slope of 0.8. waL80281_05_c05_113-140.indd 4 9/25/12 1:03 PM CHAPTER 5 117 Section 5.1 Mixed Costs Exhibit 5.2 In the diagram, note that the line is rising consistently upward to the right as it moves out along the x axis. The rate of rise is called the slope of the line, and it is occur ring at the rate of 0.8 along the y axis for every 1 unit increase along the x axis. It is said that one picture is worth a thousand words, and the same can be true of some mathematical equations. You should be able to close your eyes and imagine the same line based on knowledge of its mathematical formula: Y 5 2 1 0.8X where a is the intercept on the y axis, b is the slope of the line, and X is the position on the x axis. This conventional mathematical formulation of a line can be translated t o a discussion of fixed and variable costs in an accounting context. In other words, the formula can also be used to describe a mixed cost that consists of $2 of fixed cost and an a dditional variable component of $0.80 per unit. For example, if five units were produced, total costs would be $6 (see the circle in Exhibit 5.2), consisting of $2 fixed and $4 variable (5 units 3 $0.80). Given a large historical data set about a mixed cost over time, how can regression analysis be used to analyze the data and find the formula for the line that best passes through the data? In a precise context, regression provides a mathematical model that processes the data set to find a line where the cumulative sum of the squared distances between the points and the line is minimized (hence the name “least squares”). You might actually learn to do these calculations in an advanced statistics class. Fortunat ely, however, elec – tronic spreadsheets include built-in functions that do these calculations for you. Exhibit 5.3 is an example of a spreadsheet plotting hypothetical cost data against hypothetical production data for a series of years: 20 2 0 4 6 8 10 12 4681 012 X Run = 10 Rise = 8 Y SLOPE = 0.8 waL80281_05_c05_113-140.indd 5 9/25/12 1:03 PM CHAPTER 5 118 Section 5.2 Cost–Volume–Profit Analysis Exhibit 5.3 In the spreadsheet, column C includes annual production data, whereas column D identi- fies total cost. The formula included in cell C16 (=INTERCEPT(D5:D13,C5:C13)) serves to calculate the intercept for the cost plotted against the volume. The indicated value of approximately $250,000 suggests fixed costs of approximately that level for each year. The slope reported in cell C17 (5SLOPE(D5:D13,C5:C13)) can be interpreted to mean that variable cost is $2.63 per unit of production. The accompanying graph shows the indi- vidual points and the resulting line defined by this formula: Y 5 $250,044 1 $2.63X This line resulting under regression analysis produces the best fit line, such that the verti – cal distance, squared, between each point and the resulting line is minimized. This line is deemed to be the best fit line, and it gives the best indication of the fixed and variable costs over time. A simple approach to regression is to simply “eyeball the points” and draw a line through them. You would then estimate the slope and intercept of this estimated line. This approach is not as precise as regression analysis, but it can get you in the right ball – park for a quick estimate. 5.2 Cost–Volume–Profit Analysis A good manager must understand an organization’s variable and fixed cost components. That is why it is essential to perform analysis such as that just illust rated to discern the precise nature of a company’s cost behavior. Knowledge about the cost structure is essen – tial for cost–volume–profit (CVP) analysis. CVP is helpful in assessing the relationships between costs, business volume, and profitability. These relationships take into account variables pertaining to pricing, volume, variable and fixed costs, and p roduct mix. $0 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 20,000 40,000 60,000 80,000 TOT AL COST 100,000 120,000 Year Production Total cost 20X1 20 X2 20 X3 20 X4 20 X5 20 X6 20 X7 20 X8 20 X9 100,000 90,000 75,000 110,000 70,000 105,000 95,000 60,000 85,000 $500,000 $480,000 $465,000 $550,000 $440,000 $535,000 $485,000 $399,500 $475,000 Intercept (spreadsheet cell C16) = 250044.335 Slope (spreadsheet cell C17) = 2.631773399 waL80281_05_c05_113-140.indd 6 9/25/12 1:03 PM Column C Column D CHAPTER 5 119 Section 5.2 Cost–Volume–Profit Analysis The goal of CVP is to provide a foundation for pricing decisions, product offerings, and management of an organization’s cost structure. In the following discussion, you will learn how to calculate a company’s break-even point as well as the volume level neces- sary to achieve a targeted amount of income. The core of CVP analysis is the contribution margin or revenues minus all variable expenses: Contribution Margin 5 Revenues 2 Variable Expenses Some of these variable costs are product costs and some relate to selling and administra- tive activities. The contribution margin should not be confused with gross profit (revenues minus cost of sales). Gross profit would be calculated after deducting all manufacturing costs associated with sold units, whether fixed or variable. Furthermore, gross profit is calculated before considering selling, general, and administrative costs. Thus, the cont ribu – tion margin and gross profit are two entirely different concepts. The contribution margin is a calculated value for internal analysis, but it is ordinarily not reported to parties external to the firm. Assume that Mustang Corporation manufactures and sells fishing boats. Each boat sells for $10,000, and variable manufacturing costs are $6,000 per boat. In addition, the boats are only sold through commissioned agents who receive $1,500 for each boat sold. Mus – tang’s per-unit contribution margin is $2,500 ($10,000 2 ($6,000 1 $1,500)). Mustang incurs $2,500,000 of fixed costs, no matter how many boats are produced and sold. The company must sell 1,000 units to break even, as shown in Table 5.3. Table 5.3: Breaking even Total Per boat Ratio Sales (1,000 3 $10,000) $10,000,000 $10,000100% (or 1.00) Variable costs (1,000 3 $7,500) 7,500,000 7,500 75% (or 0.75) Contribution margin $ 2,500,000 $ 2,500 25% (or 0.25) Fixed costs 2,500,000 Net income $ 0 In reviewing Table 5.3, you likely noticed that the contribution margin can be reflected in the aggregate, on a per-unit basis, or on a ratio basis. The ratios may be expressed as percentages or fractional amounts (e.g., 50% or 0.50). These data were designed to reflect a break-even outcome of 1,000 units. In the following paragraphs, you will l earn how to determine, in advance, the sales that are necessary to break even. Before looking at those formulations, let’s first consider what would happen to Mustang if sa les were 1,500 units. Logic suggests that the company will be profitable. If 1,000 units are first needed to break even, then selling an additional 500 units should produce profits equivalent to the added contribution on those 500 units (500 3 $2,500 5 $1,250,000). The calculations in Table 5.4 prove this logic: waL80281_05_c05_113-140.indd 7 9/25/12 1:03 PM CHAPTER 5 120 Section 5.2 Cost–V olume–Profit Analysis Table 5.4: Logic of being profitable Total Per boat Ratio Sales (1,500 3 $10,000) $15,000,000 $10,000100% (or 1.00) Variable costs (1,500 3 $7,500) 11,250,000 7,500 75% (or 0.75) Contribution margin $ 3,750,000 $ 2,500 25% (or 0.25) Fixed costs 2,500,000 Net income $ 1,250,000 The changes in volume only impacted the total column in Table 5.4. Volume changes do not change the per-unit or ratio effects. This will be important to remember in the ensuing formulas that you will learn for break-even calculations. Break-even analysis can also be presented in a graphical manner as in Exhibit 5.4. Exhibit 5.4 A break-even chart, such as the one shown for Mustang, is intended to allow the user to observe the unit sales volume (as revealed along the horizontal axis in Exhibit 5.4) that is necessary for a company to break even. In other words, it is the point where the amount of sales in dollars equals the total cost in dollars. Total sales are portrayed by the line starting at zero and sloping upward at $10,000 per unit. In contrast, total costs start at $2,500,000 (the amount of fixed costs) and rise more slowly at $7,500 per unit (the amount of variable cost per unit). TO TAL UNITS CVP ANALY SIS Variable cost area Pr ofit area Loss area Total cost line Break-ev en point Total sales line Fixed cost area 2,000 1,500 1,000 500 0 0 20,000,000 10,000,000 2,500,000 waL80281_05_c05_113-140.indd 8 9/25/12 1:03 PM CHAPTER 5 121 Section 5.2 Cost–V olume–Profit Analysis Some companies utilize graphs such as that shown in Exhibit 5.4 to keep an eye on their margin of safety. The margin of safety is simply the amount by which sales exceed the break-even sales level. If Mustang’s actual sales were $15,000,000, their margin of safety would be $5,000,000 ($15,000,000 2 $10,000,000 break-even sales). Operating leverage is a related CVP term that is often used. It refers to the amount of increase in income associ – ated with an increase in sales. This concept is based on the differences in slope between the total revenue line and the variable cost line; in essence, it reflects the contribution mar – gin rate. Some businesses refer to the process of evaluating margin of safety and operating leverage as tools in “sensitivity” or “scalability” analysis . Basically, it is perspective on how changes in volume impact changes in income. The Algebra of Break-Even and Targeted Income Analysis The preceding graphical representation can be converted to algebraic formulas. Consider the following relationships: Break-Even Sales 5 Total Variable Costs 1 Total Fixed Costs Mustang’s 10,000 units in sales to break even is confirmed via the following: (Units 3 $10,000) 5 (Units 3 $7,500) 1 $2,500,000 Solving: (Units 3 $10,000) 2 (Units 3 $7,500) 5 $2,500,000(Units 3 $2,500) 5 $2,500,000Units 5 1,000 The 1,000 units, at $10,000 each, translate into total sales of $10,000, 000. The preceding relationships can be algebraically modified to formulate a calculation of breakeven by reference to the contribution margin ratio: Break-Even Sales = Total Fixed Costs / Contribution Margin Ratio $10,000,000 5 $2,500,000/0.25 Utilization of this ratio-based approach is helpful for multiproduct companies as long as all products have a consistent contribution margin. As yet another modification to the algebra, consider that total fixed co sts can simply be divided by the contribution margin per unit: Break-Even Point in Units = Total Fixed Costs / Contribution Margin Per Unit 1,000 Units 5 $2,500,000/$2,500 waL80281_05_c05_113-140.indd 9 9/25/12 1:03 PM CHAPTER 5 122 Section 5.2 Cost–V olume–Profit Analysis Of course, businesses are not in business just to break even. They likely have targeted income levels and desire to know the amount of sales that will be needed to reach those goals. The determination of sales necessary to achieve a targeted amount of income is a very easy modification of the break-even calculations. All that is required is to treat the desired income in a manner similar to the amount of fixed costs that must be covered by the margin: Sales to Achieve Targeted Income 5 Total Variable Costs 1 Total Fixed Costs 1 Target Income If Mustang desired to earn $1,000,000 of income, the following calculations would be appropriate: (Units 3 $10,000) 5 (Units 3 $7,500) 1 $2,500,000 1 $1,000,000 Units 3 $2,500 5 $3,500,000 Units 5 1,400 If you want to know the dollar level of sales to achieve this targeted income, you could multiply the 1,400 units by the $10,000 selling price per unit, or $14,000,000 5 (Total Fixed Costs 1 Target Income) / Contribution Margin Ratio $14,000,000 5 $3,500,000/0.25 Influence of Taxes Taxes are a significant cost of doing business. Some taxes are fixed in amount, such as property taxes. They are easily factored into CVP by increasing the total fixed cost pool. However, taxes based on income present a slight complication to CVP. Income taxes are nonexistent up to the break-even point (i.e., you do not pay income taxes until you turn profitable) and then kick in based on a predetermined rate. The effect of an income tax essentially means that you have two different contribution margin rates—one based on sales minus variable expenses (without taxes) up to the break-even point and another based on sales minus variable expense and income taxes once the break-even point is exceeded. The preceding discussion points to the rather obvious need to modify the algebra associ – ated with profitability analysis. First, income taxes will not modify the break-even cal – culations. However, sales necessary to achieve target income level calculations must be amended. One simple way to perform this analysis is in two stages. The f irst stage is to calculate the break-even point. The second stage is to calculate the additional sales ne eded to reach the target income. In the second stage, it is important to remember that fixed costs have already been covered at the break-even point, but the contribution margin is reduced because of the income taxes. To illustrate, assume the Go for Gold Mining faces the following facts: Fixed costs $2,000,000 waL80281_05_c05_113-140.indd 10 9/25/12 1:03 PM CHAPTER 5 123 Section 5.2 Cost–Volume–Profit Analysis Variable mining costs $ 750 per ounce Income tax rate 50% If gold is selling for $1,500 per ounce (giving rise to a pretax contribution margin of 50%), and Go for Gold desires to reach an after-tax income level of $1,000,000, how much gold must be sold? The first step is to calculate break-even sales: $2,000,000 (fixed costs)/0.50 contribution margin ratio 5 $4,000,000 in sales The second step is to calculate the additional sales to earn a $1,000,000 profit: $1,000,000 (target inc ome)/0.25 revised cont ribution margin rati o 5 $4,000,000 in sales. Note: 50% contributio n plus 50% tax on that same 50% gives us 75% in cont ribution margin plus t axes. Combining the sales to reach breakeven plus the additional sales to reach the target income level reveals that Go for Gold must sell $8,000,000 to achieve the desired income level. You likely noticed that the contribution margin in the second step was only 25% instead of 50%. The reason is that any profits had to be shared 50:50 with the government (given the assumed 50% income tax rate). This means that the company’s contribu tion was reduced in half for all sales above the break-even point! Changing Costs Costs can naturally be expected to shift over time. These changes will i mpact the struc – tural relationships between fixed and variable components. Management must be able to contemplate how cost shifts will impact the business. For instance, an i ncrease in fixed costs, without a change in per-unit variable costs and revenues, will obviously increase the break-even point. The proper analysis for an increase in fixed cost requires that the new total fixed cost be divided by the contribution margin. Suppose Mustang’s total fixed costs increased from $2,500,000 to $3,000,000. What sales level is now necessary to break even? Recall that the break-even point in sales can be derived by dividing total fixed costs by the contribution margin ratio. Thus, the new calculation of breakeven is as follows: $12,000,000 5 $3,000,000/0.25 The $500,000 additional fixed cost requires an additional $2,000,000 in sales. As you can see, the revisions in fixed costs are relatively simple to incorporate into the break-even framework with which you are already familiar. However, what about changes in variable costs? What if a new environmental regulation required that an additional $500 be spent on each boat to use a safer fiberglass handling process? Now, the contribution margin is only $2,000 per unit ($10,000 2 ($7,500 1 $500)). Assuming the added cost cannot be passed through, how will this impact the break-even point? The revised break-even point (let’s assume fixed costs are still $2,500,000 for this illustration) is now calculated as follows: $12,500,000 5 $2,500,000/0.20 waL80281_05_c05_113-140.indd 11 9/25/12 1:03 PM CHAPTER 5 124 Section 5.2 Cost–V olume–Profit Analysis Of course, a business sometimes must choose between adding either a fixe d or a vari – able cost. Suppose the per-unit increase in variable cost associated with a safer fiberglass handling process could be avoided by instead incurring a $500,000 increase in fixed cost. If you review the two preceding examples, you can see that breakeven is lower with the added fixed cost, and you might jump to the conclusion that it would be the preferred option. However, if the business’s sales fail to reach even the break-even level, there is a point at which the added fixed cost would become disadvantageous. For ex ample, if sales reached only $8,000,000, Table 5.5 reveals that the loss is less for the case in which the increased fixed cost was avoided. Table 5.5: Loss is less With increased fixed cost Without increased fixed cost Sales $8,000,000 $8,000,000 Less: Fixed costs ($3,000,000) ($2,500,000) Less: Variable costs (800 , $7,500) ($6,000,000) Less: Variable costs (800 , $8,000) ($ 6,400,000) Net loss ($1,000,000)($ 900,000) Changing Revenues Changes in per-unit revenue, without changes in total fixed costs or per-unit variable cost, can sometimes cause dramatic impacts on firm profits. This is especially true for busi – nesses with a low variable cost structure. Consider the example in Table 5.6, in which firm profits are calculated before and after a $10 per-unit increase in selling price. Table 5.6: Calculating profits Before price increase After price increase Sales (5,000 units) $500,000$550,000 Variable costs ($40 per unit) 200,000 200,000 Contribution margin $300,000 $350,000 Fixed costs 275,000 275,000 Net income $25,000 $75,000 Notice that the $10 (10%) increase in selling price caused a tripling of profits from $25,000 to $75,000. This simple illustration shows the importance of small adjus tments in selling prices. Of course, markets are at times very sensitive to pricing. Customers may not be willing to pay the added $10, which can cause a reduction in per-unit sales. Management must be very careful in setting its pricing policies. waL80281_05_c05_113-140.indd 12 9/25/12 1:03 PM CHAPTER 5 125 Section 5.3 CVP Assumptions Multiple Products Most businesses offer more than one product. Each product may have a different selling price, contribution margin, and contribution margin ratio. This has the potential to com- plicate CVP analysis. Now, knowledge is also required about the proportion of total sales attributable to each product. To illustrate, assume that Infusion Technology sells hospital medication pumps and dis – posable cassettes that hold various medications. The pumps sell for $5,000 and have vari – able costs of $4,000. The contribution margin is therefore $1,000 per pump. The cassettes sell for $20 and have variable costs of $10, giving rise to a $10 per-unit contribution mar – gin. Infusion Technology sells 1,000 cassettes for each pump sold. How many pumps and cassettes must be sold to cover the business’s $1,100,000 of total fi xed costs? Consider that a product “unit” typically consists of one pump and 1,000 cassettes. T hus, the “unit” would have a contribution margin of $11,000, as shown in Table 5.7. Table 5.7: Contribution margin Contribution margin Pump 1 item at $1,000 Cassette 1,000 items at $10 5 $10,000 “Unit contribution” $11,000 To recover $1,100,000 of fixed cost requires sales of 100 “units” ($1,100,000/$11,000). This is equivalent to selling 100 pumps and 100,000 cassettes. Total break-even sales equal $2,500,000 (($5,000 3 100 pumps) 1 ($20 3 100,000 cassettes)). This break-even sales level would shift dramatically if the product mix is not as projected. Pumps have a much lower contribution margin than cassettes, and increasing their sales (without a corresponding increase in the high-margin cassettes) would cause a dramatic shift in the break-even level of sales. 5.3 CVP Assump tions T he CVP techniques illustrated in this chapter are simply models of cost behavior. Financial models are typically based on various assumptions. Violating an assump – tion can cause a model to produce misleading results. Therefore, it is very important for you to consider the assumptions of CVP in Table 5.8. waL80281_05_c05_113-140.indd 13 9/25/12 1:03 PM CHAPTER 5 126 Section 5.3 CVP Assumptions Table 5.8: Assumptions of CVP Inventory levelsConstant, with the number of units sold equaling the number of units produced. Fluctuations in inventory would result in a portion of the variable and fixed costs being transferred in and out of inventory rather than income. Identification of costs Costs can be clearly and reliably identified as fixed and variable in nature. Preservation of linearity Variable costs are constant per unit, and total fixed costs are stable and constant over the relevant range of activity. Revenues are constant per unit. Product mix ratios meet expectations Revenues are constant per unit, and multiple-product firms meet the expected product mix ratios. Direct Costing Now that you have examined the contribution margin and how it can be useful in corpo – rate analysis, it is time to expand upon the concept to see how it dovet ails with report – ing. Two general models can be used to measure and report income for a manufacturer. One is absorption (or full) costing. It is the model with which you ar e currently familiar, and it is required for external reporting purposes. There is an alternative model, accept – able only for internal use, called direct (or variable) costing. Each has its advantages and disadvantages. Absorption costing provided the basis for prior chapter illustrations. Under this tech – nique, all manufacturing costs are deemed to be product costs and are therefore included in inventory. When sold, the full cost of inventory is transferred to cost of goods sold. The result is that gross profit is reduced by all costs of manufacturing, including direct mate- rials, direct labor, and variable and fixed manufacturing overhead. Also recall that sell- ing, general, and administrative costs (SG&A) are classified as period expenses, whether fixed or variable in nature. Generally accepted accounting principles (GAAP) require this approach based on the premise that inventory should be measured and reported at its complete cost. There is obvious merit to this conclusion. A product could likely not be produced without a certain amount of fixed manufacturing overhead, and it seems inap – propriate to exclude such costs as one attempts to report on their manufacturing profits. Variable (direct) costing only assigns variable product costs to inventory and cost of goods sold. Thus, product costs are deemed to include direct materials, direct labor, and variable manufacturing overhead. The fixed manufacturing overhead is regarded as a period cost. Table 5.9 highlights the difference in perspective between absorption and variable costing. waL80281_05_c05_113-140.indd 14 9/25/12 1:03 PM CHAPTER 5 127 Section 5.3 CVP Assumptions Table 5.9: Absorption versus variable costing Absorption costingVariable costing Product cost Period costProduct cost Period cost Direct material ✔✔ Direct labor ✔✔ Variable manufacturing overhead ✔✔ Fixed manufacturing overhead ✔ ✔ Variable SG&A ✔✔ Fixed SG&A ✔✔ In light of GAAP’s requirement for absorption costing, and the associated arguments in support of this view, why might a company opt for variable costing for internal use? Regardless of the claims in support of absorption costing, it does suffer from some limita – tions that can impede appropriate management decisions. Absorption costing does not necessarily provide the best signals about product pricing, whether to continue to produce a product, whether to accept a special order, and similar decisions. With variable costing, fixed manufacturing costs are shifted from product costs to period costs because they will be incurred no matter the level of production. Simply stated, in many cases, a company should continue to produce a product that has a positive contribution margin, even if the overall results still appear to be producing a loss; the loss would be larger if the fixed costs were incurred and nothing was produced. Absorption costing does not illuminate this reality in a way that enables good decisions. Numerous similar situations can arise. This is a very important concept and bears much deeper analysis via a series of examples. Assume that Home Pride produces 500,000 loaves of bread per month, and per-unit costs are $0.45 for direct material, $0.30 for direct labor, and $0.25 for variable factory over – head. Total fixed factory overhead amounts to $250,000. Under absorption costing, a loaf of bread costs $1.50 to produce. This consists of variable costs ($0.45 1 $0.30 1 $0.25 5 $1) and fixed costs ($250,000/500,000 loaves 5 $0.50). Under variable costing, the prod- uct cost includes just the $1.00 of variable manufacturing components. I f Home Pride is approached by Super Grocery to produce a private-label bread product, and Super Gro – cery is willing to pay $1.25 per loaf, should Home Pride accept the deal ? Home Pride has evaluated the transaction and concluded that it will not result in any added variable or fixed SG&A costs, and it will not cause a reduction in sales of its own bread products. With absorption costing, it appears that the offer should be rejected. Why sell something for $1.25 when it costs $1.50 to produce? This seems obviously irrational. Conversely, vari – able costing suggests that a profit of $0.25 per loaf will result by accepting Super Grocery’s offer. Which decision is right? Management may well decide to accept the offer to enhance profits. It is important to recall that no other costs will be incurred. Reliance on absorption costing for decision making could have resulted in this opportunity having been missed. Very likely, you are now beginning to understand why some companies prefer a variable costing structure for internal measurement and decision-making purposes. waL80281_05_c05_113-140.indd 15 9/25/12 1:03 PM CHAPTER 5 128 Section 5.3 CVP Assumptions Comprehensive Income Statements Under Variable and Absorption Costing The preceding discussion focused on the general structure of income measurement under absorption and variable costing. The Home Pride example further assumed that SG&A was unaffected by the decision to sell to Super Grocery. That assumption would often not be valid. Variable SG&A typically increases along with rising sales, and this factor will be reflected in a variable costing income statement. Consider the following income statements for Garcia Company. Garcia does not maintain inventory, and it sells all that is produced each period. As a result, total income is the same, whether measured under absorption or variable costing. The difference, therefore, is only in how the data are pre- sented. Absorption costing will focus on an intermediate subtotal relating to gross profit. This is a different focus than with variable costing, in which the emphasis is on contri bu – tion margins. Begin by closely examining the absorption costing income statement shown in Exhibit 5.5, and then review the additional commentary that follows. Exhibit 5.5 Under absorption costing, assume the $500,000 cost of goods sold consists of direct mate – rials ($150,000), direct labor ($200,000), and variable ($50,000) and fixed manufacturing overhead ($100,000). Gross profit is reduced by SG&A, which is assumed to be $125,000 variable and $75,000 fixed. When these same factors are rearranged and presented as in a variable costing income statement format, you will first notice that all variable costs are subtracted from sales to arrive at the contribution margin. Garcia Company further divides the contribution margin between the manufacturing margin and the overall mar – gin, after subtracting variable SG&A (Exhibit 5.6). Sales Cost of goods sold Gross profit Less: Variable SG&A Fixed SG&A Net income $ 125,000 75,000 $1,000,000 500,000 $ 500,000 200,000 $ 300,000 GARCIA COMPANY Absorption Costing Income Statement For the Year Ending December 31, 20XX waL80281_05_c05_113-140.indd 16 9/25/12 1:03 PM CHAPTER 5 129 Section 5.3 CVP Assumptions Exhibit 5.6 Fluctuating Inventory You may be wondering what happens if inventory levels fluctuate. With absorption cost – ing, inventory will carry all manufacturing costs, whereas only variable manufacturing costs are assigned to inventory with variable costing. Generalizing, therefore, inventory is measured at a higher value with absorption costing; in other words, certain costs (a por – tion of the fixed manufacturing overhead) are placed in inventory that would otherwise be expensed immediately under variable costing. This means that income i s higher with absorption costing in those periods during which inventory levels are increasing. Let’s revisit Garcia Company, this time assuming that sales are 10% less, and the unsold units become part of ending inventory. The income statements (Exhibits 5.7 and 5.8) show how income is higher under absorption costing by $10,000. This is exactly as expected. In other words, 10% of the $100,000 of fixed manufacturing overhead is assigned to inventory under absorption costing versus what is expensed under variable costing. Sales Less: Variable product costs Manufacturing margin Less: Variable SG&A Contribution margin Less: Fixed factory cost Fixed SG&A Net income $ 100,000 75,000 $1,000,000 400,000 $ 600,000 125,000 $ 475,000 175,000 $ 300,000 GARCIA COMPANY Variable Costing Income Statement For the Year Ending December 31, 20XX waL80281_05_c05_113-140.indd 17 9/25/12 1:03 PM CHAPTER 5 130 Section 5.4 Evaluating Residual Income Exhibit 5.7 Exhibit 5.8 5.4 Evaluating Residual Income C omparing income measures under absorption and variable costing provides helpful clues to guide correct managerial decisions. However, these measures are not a pana- cea for management. Additional economic facets must be considered. For instance, neither measure adjusts income for the embedded amount of capital that must be deploye d to gen – erate the reported income numbers. In other words, the level of stockholder investments is not factored into the basic income calculations. If two businesses each generate i ncome of $1,000,000 but one of the businesses has stockholder investments of $5,000,000 and the other has stockholder investments of $10,000,000, it is apparent that the former business Sales Less: Variable product costs Manufacturing margin Less: Variable SG&A Contribution margin Less: Fixed factory cost Fixed SG&A Net income $ 100,000 75,000 $ 900,000 360,000 $ 540,000 112,500 $ 427,500 175,000 $ 252,500 GARCIA COMPANY Variable Costing Income Statement For the Year Ending December 31, 20XX Sales Cost of goods sold Gross profit Less: Variable SG&A Fixed SG&A Net income $ 112,500 75,000 $ 900,000 450,000 $ 450,000 187,500 $ 262,500 GARCIA COMPANY Absorption Costing Income Statement For the Year Ending December 31, 20XX waL80281_05_c05_113-140.indd 18 9/25/12 1:03 PM CHAPTER 5 131 Section 5.4 Evaluating Residual Income is generating a better rate of return on the amount of invested capital. Thus, not only is it important that a business have profitable operations to maintain long-run economic viabil- ity but also it must generate returns that are sufficient to justify the investment. In a later chapter, you will study many capital budgeting tools that aid in these evaluati ons. However, you are already in a position to consider the concept of residual income. Like vari – able costing, residual income is not a GAAP-based measure. Instead, it is another internal financial assessment technique. Residual income provides a scale of business success or fail- ure after adjusting for the presumed cost of capital. The cost of capital is the theoretical rate that funds could earn if invested in alternative use. The cost of capita l varies by firm and is based on general economic conditions. Although there are variations in the way in which residual income could be measured, one general approach is based on this formulation: Residual Income 5 Operating Income 2 (Operating Assets 3 Cost of Capital) To see how residual income can be used for business assessments, begin by looking at the data for two separate business segments in Table 5.10. Table 5.10: Data for two business segments Segment A Segment B Operating income $ 250,000 $500,000 Less: Cost of capital Segment A capital $3,000,000 3 5% cost of capital (150,000) Segment B capital $9,000,000 3 5% cost of capital (450,000) Residual income $ 100,000 $ 50,000 At first glance, it appears that Segment B is more successful because its operating income is twice that of Segment A. However, Segment B has much more capital invested in opera – tions ($9,000,000 for B vs. $3,000,000 for A). Assuming a 5% cost of capital, Segment A’s residual income is twice that of Segment B. This information casts the relative success of the two divisions in a completely different light. Thus, residual income can be a powerful tool for identifying and ranking the performance of segments, products, and other com – ponents of business activity. As with most analysis techniques, great care must be taken in interpreting residual income. Conclusions can be impacted by the assumption about the cost of capital and different rank – ings achieved by revisions in interest rates. In addition, management needs to understand the accounting principles that were used to measure operating income. For example, a unit may be spending heavily on developmental costs. Were these costs expensed? If so, then near-term income could be negatively impacted. In the long term, those same costs (having already been expensed) would be excluded from the calculation of invested capital and per – haps inflate the residual income in the latter stages of a project. Thus, management needs to be very careful in interpreting residual income. Nevertheless, when used appropriately, the technique is highly valuable in helping a business identify and rank products, segments, and business activities. It is crucial that business decisions about which products and ser – vices to offer, or cease to offer, be made with deliberate care and attention to detail. waL80281_05_c05_113-140.indd 19 9/25/12 1:03 PM CHAPTER 5 132 Concept Check Concept Check The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The correct answers can be found at the end of your text.) 1. V ariable costs (from the accountant’s viewpoint) a. ar e graphed by means of a curvilinear line. b. r emain constant in total through the relevant range. c. ar e constant on a per-unit basis through the relevant range. d. ar e commonly divided into committed and discretionary classifications. 2. The high–low method of analyzing cost behavior a. can be used to determine the variable and fixed components of a mixed cost function. b. uses the same number of data observations as a scatter graph. c. r elies on the following computation to figure the variable cost per unit (or hour): Change in activity between the high and low points / change in cost betw een the high and low points. d. r esults in different amounts of fixed cost at the high and low data points. 3. Foster Company has sales of $800,000, variable costs that total 60% of s ales, and fixed costs of $180,000. The firm’s break-even point is a. $140,000. b. $300,000. c. $450,000. d. $560,000. 4. The contribution mar gin a. is the amount that each unit contributes towar d covering variable costs and producing income. b. is the r esult of subtracting both the variable and fixed costs per unit from the selling price. c. may , in select cases, be less than net income. d. is the dif ference between a unit’s selling price and variable cost and, when divided into fixed costs, will produce the unit sales required to break even. 5. The cost–volume–pr ofit model a. can be used only by single-pr oduct companies. b. assumes that the sales mix will r emain as predicted. c. assumes that technology , efficiency, and costs can change. d. cannot be used to study operating changes of the firm. waL80281_05_c05_113-140.indd 20 9/25/12 1:03 PM CHAPTER 5 133 Critical Thinking Questions Critical Thinking Questions 1. Define the br eak-even point. 2. Define the contribution mar gin. What does the contribution margin represent, and how is it used in finding the break-even point? 3. Pr oduct A has a negative contribution margin. Explain how a negative contribution margin can arise, and determine whether product A should continue to be sold. 4. Discuss the benefits associated with using a br eak-even chart. 5. Determine the ef fect, if any, on the break-even point that each of the following events would have: a. An incr ease in sales price b. A decrease in fixed cost c. An incr ease in the number of units sold 6. W ill a change in a company’s sales mix likely affect the break-even point? Briefly explain. 7. What ar e the limiting assumptions of CVP analysis? absorption costing A technique by which all manufacturing costs are deemed to be product costs and are therefore included in inventory. break-even chart Used to allow the user to observe the unit sales volume that is necessary for a company to break even. contribution margin At the core of a CVP analysis, and it represents revenues minus all variable expenses. cost–volume–profit (CVP) analysis The process of providing a foundation for pricing decisions, product offerings, and management of an organization’s cost structure. high–low method A method of identify- ing the highest and lowest levels of activity and where the difference in cost is deemed to be representative of the variable portion. margin of safety The amount by which sales exceed the break-even sales level. mixed costs A type of cost that entails a fixed component and a variable component. operating leverage Refers to the amount of increase in income associated with an increase in sales, based on the differences in slope between the total revenue line and the variable cost line. residual income An internal financial assessment technique that provides a scale of business success or failure after adjust- ing for the presumed cost of capital. targeted income A measuring point for a company to pinpoint the amount of sales that will be required to reach financial goals. variable (direct) costing A method in which variable product costs are assigned to inventory and cost of goods sold. Prod- uct costs are deemed to include direct materials, direct labor, and variable manu- facturing overhead. Key Terms waL80281_05_c05_113-140.indd 21 9/25/12 1:03 PM CHAPTER 5 134 Exercises Exercises 1. High–low method The following cost data pertain to 20X6 operations of Heritage Products: Quarter 1 Quarter 2Quarter 3Quarter 4 Shipping costs $58,200$58,620$60,125$59,400 Orders shipped 120 140 175 150 The company uses the high–low method to analyze costs. a. Determine the variable cost per or der shipped. b. Determine the fixed shipping costs per quarter . c. If pr esent cost behavior patterns continue, determine total shipping costs fo r 20X7 if activity amounts to 570 orders. 2. Br eak-even and other CVP relationships Delta Gamma Upsilon sorority is in the process of planning its annual homecoming dinner and dance. The treasurer anticipates the following costs for the event, which will be held at the Regency Hotel: Room rental $300 Dinner cost (per person) 25 Chartered buses 500 Favors and souvenirs (per person) 5 Band 900 Each person would pay $40 to attend; 200 attendees are expected. a. W ill the event be profitable for the sorority? Show computations. b. How many people must attend for the sor ority to break even? c. Suppose the sor ority encouraged its members to drive to the hotel and did not charter the buses. Furthermore, a planned menu change will reduce the cost per meal by $2. If each member will still be charged $40, compute the contribution margin per person. 3. Br eak-even and other CVP relationships Cedars Hospital has average revenue of $180 per patient day. Variable costs are $45 per patient day; fixed costs total $4,320,000 per year. a. How many patient days does the hospital need to br eak even? b. What level of r evenue is needed to earn a target income of $540,000? c. If variable costs dr op to $36 per patient day, what increase in fixed costs can be tolerated without changing the break-even point as determined in part (a)? waL80281_05_c05_113-140.indd 22 9/25/12 1:03 PM CHAPTER 5 135 Exercises 4. CVP relationships: Working backward Determine the missing amounts in each of the independent cases that foll ow: Case Units sold Sales Variable costs Contribution margin per unit Fixed costs Net income A ?$70,000 $ ? $6$14,000$10,000 B 7,000 ? 42,000 5? 8,000 C 4,000 53,000 ? ? 21,000 (2,000) D 8,000 92,000 40,000 ? 24,000 ? 5. Dir ect and absorption inventory costing Milsap Industries began business on January 1 of the current year, manufacturing and selling a single product. Consider the data that follow: Units Variable cost per unit Fixed costs Production volume 80,000 Sales volume 72,000 Direct materials $1.30 Direct labor 2.80 Factory overhead 4.40$540,000 Selling expenses 0.20 180,000 a. Compute the cost of the company’s ending inventory by using dir ect costing. b. Compute the cost of the company’s ending inventory by using absorptio n costing. c. Suppose that Milsap’s accountant had accidentally excluded straight-l ine depr e – ciation on machinery from the data presented. Determine the effect of this error (overstate, understate, or no impact) on the company’s 1) dir ect costing ending inventory. 2) absorption costing ending inventory . 6. Dir ect and absorption income computations Crawford Company began operations on January 1 of the current year. The follow – ing information has been gathered from the accounting records: Variable costs per unitManufacturing: $12.50 Selling & administrative: $1.10 Fixed costs Manufacturing: $120,000 Selling & administrative: $60,000 waL80281_05_c05_113-140.indd 23 9/25/12 1:03 PM CHAPTER 5 136 Problems Production and sales amounted to 80,000 units and 75,000 units, respectively. The selling price is $17. a. Compute net income for the year just ended by using the dir ect costing method. b. Compute net income for the year just ended by using the absorption costi ng method. Problems 1. Cost behavior and analysis The chief accountant of Stevenson Corporation is studying certain costs (direct labor, plant security, utilities, and maintenance) in an effort to better control opera – tions. Normal production activity ranges from 7,500 to 8,000 units per month. In the past 3 months, the following cost behavior has been observed: Month 1 Month 2Month 3 Production (units) 7,540 7,950 7,680 Direct labor $18,850$19,875$19,200 Plant security 14,600 14,600 14,600 Utilities 28,044 29,520 28,548 In addition, maintenance costs have displayed the following step behavio r: Activity range (units) Cost Up to 7,600 $ 8,000 7,601–7,800 9,500 7,801–8,000 11,000 Stevenson uses the high–low method to analyze cost behavior. Instructions a. Pr oduction for next month is expected to total 7,850 units. Calculate the cost of direct labor, plant security, utilities, and maintenance for this level of activity. b. Comment on the cost-ef fectiveness of producing at a 7,850-unit level of activity with respect to maintenance costs. If you believe this is an ineffective production level, describe how effectiveness could be improved. c. Ther e is a high probability that Stevenson’s production volume will nearly double in forthcoming months because of a new customer. Can the data and methods used in part (a) for predicting the cost of 7,850 units be employed to estimate total costs for, say, 17,500 units? Why? waL80281_05_c05_113-140.indd 24 9/25/12 1:03 PM CHAPTER 5 137 Problems 2. Br eak-even and other CVP analysis Hodge and Best manufactures a single product. The information that follows relates to current operations: Sales (80,000 units , $15) $1,200,000 Less: Variable cost $720,000 Fixed cost 360,000 1,080,000 Net income $ 120,000 Instructions a. The sales outlook for next year is bleak. Calculate the number of units that must be sold to break even if current revenue and cost behavior patterns continue. b. If Hodge and Best wishes to earn a tar get income of $90,000 during the next accounting period, what level of dollar sales must be generated? c. Management is studying an incr ease in the selling price to $18 per unit. If con – sumers balk and volume drops, calculate the number of units that must be sold to earn the target income of $90,000. Should the change be implemented? Why? d. Hodge and Best’s pr ojected break-even point and target income are the result of interactions of numerous financial events and transactions. Determine the impact of the following operating changes by filling in the blanks below with “increase,” “decrease,” or “not affect.” 1) An incr ease in direct labor cost will _______________________ total variable costs, _______________________ the contribution margin, and _______________________ the break-even point. 2) An incr ease in plant insurance will _______________________ the break-even point and _______________________ the dollar sales level calculated in p art (b). 3. Straightforwar d CVP analysis FRB Inc. sells a single product for $40. The following costs and expenses were incurred at store No. 504: Variable costs per unit Annual fixed costs Invoice cost $24Salaries $60,000 Sales commission 4Advertising 14,000 Other 16,000 The company sold 8,200 units during 20X4. Instructions a. Compute the 20X4 br eak-even point in both dollar and unit sales. b. By how much will sales have to incr ease in 20X5 over 20X4 levels if management wishes to earn a target income of $14,400? waL80281_05_c05_113-140.indd 25 9/25/12 1:03 PM CHAPTER 5 138 Problems c. At pr esent, how much does each unit provide toward covering FRB’s fixed costs and generating income? Assume that management believes this amount is too low. What alternatives are available to FRB? d. What would be the ef fect on the break-even point if management reduced salary costs by $11,600 and increased the $4 sales commission by 20%? 4. Br eak-even and other CVP analysis Quebec Inc. manufactures and sells a single product. The information that follows relates to the year just ended, when 230,000 units were sold: Sales price per unit $ 10 Variable cost per unit 4 Fixed costs 930,000 Instructions a. Determine the number of units that Quebec sold in excess of its br eak-even point. b. If curr ent revenue and cost patterns continue, compute the dollar sales needed next year to produce a target income of $492,000. c. Assume that a dif ferent compensation plan was in effect during the current year. Rather than pay six salespeople an average salary of $36,000 each, manag ement has proposed that the salespeople receive a $10,000 base salary and a 6% commis- sion based on gross sales. 1) W ould the company have been better off financially if the new plan had been adopted for the year just ended? By how much? 2) What ef fect might paying a commission have on gross sales? Briefly explain. d. In addition to the compensation plan described in part (c), Quebec is studying the impact of other operating changes as well. State whether you agree or dis – agree with the following findings of a newly hired staff accountant: 1) A rise in property taxes will increase the break-even point. 2) A decrease in raw material cost will increase the contribution margin and decrease total fixed costs. 5. Dir ect and absorption costing The following information pertains to Turbo Enterprises for the year ended December 31, 20X8: Variable cost per unit:Direct materials $ 6 Direct labor 4 Factory overhead 9 Selling & administrative expense 3 Total $ 22 waL80281_05_c05_113-140.indd 26 9/25/12 1:03 PM CHAPTER 5 139 Problems Annual fixed costs:Factory overhead $600,000 Selling &. administrative expense 115,000 Total $715,000 Other data (units): Sales 21,000 Production 25,000 Inventory, 12/31/X8 11,000 The unit selling price is $62. Assume that costs have been stable in recent years. Instructions a. Compute the number of units in the beginning inventory on January 1, 20X 8. b. Calculate the cost of the December 31 inventory assuming use of 1) dir ect costing. 2) absorption costing. c. Pr epare an income statement for the year ended December 31, 20X8, by using direct costing. d. Pr epare an income statement for the year ended December 31, 20X8, by using absorption costing. 6. Dir ect and absorption costing The information that follows pertains to Consumer Products for the year ended December 31, 20X6: Inventory, 1/1/X6 24,000 units Units manufactured 80,000 Units sold 82,000 Inventory, 12/31/X6 ? units Manufacturing costs: Direct materials $3 per unit Direct labor $5 per unit Variable factory overhead $9 per unit Fixed factory overhead $280,000 Selling & administrative expenses: Variable $2 per unit Fixed $136,000 waL80281_05_c05_113-140.indd 27 9/25/12 1:03 PM CHAPTER 5 140 Problems The unit selling price is $26. Assume that costs have been stable in recent years. Instructions a. Compute the number of units in the ending inventory . b. Calculate the cost of a unit assuming use of 1) dir ect costing. 2) absorption costing. c. Pr epare an income statement for the year ended December 31, 20X6, by using direct costing. d. Pr epare an income statement for the year ended December 31, 20X6, by using absorption costing. waL80281_05_c05_113-140.indd 28 9/25/12 1:03 PM CHAPTER 5

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