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E 10-3 p.450
Income Statements; Variable and Absorption Costing LO2
The following information pertains to Lextel, Inc., for 2008:
Beginning inventory in units —
Units produced 25,000
Units sold 23,000
Ending inventory in units 2,000
Variable costs per unit:
Direct materials $ 8.00
Direct labor 3.00
Variable overhead 1.80
Variable selling expenses 4.00
Fixed costs per year:
Fixed overhead $107,500
Fixed selling and administrative 26,800
There are no work-in-process inventories. Normal activity is 25,000 units. Expected and actual overhead costs are the same.
- Without preparing an income statement, indicate what the difference will be between variable-costing income and absorption-costing income.
- Assume the selling price per unit is $26. Prepare an income statement (a) using variable costing and (b) using absorption costing.
P 10-23 p.458
ROI Calculations with Varying Assumptions
White Mountain Products is a division of Parker Textiles, Inc. During the coming
year, it expects to earn an operating income of $310,000 based on sales of $3.45
million; without any new investments, the division will have average net operating
assets of $3 million. The division is considering a capital investment project—
adding machinery to produce gaiters (tubular coverings that extend from the ankle
of a ski boot to just below the knee to keep snow out of the boot)—that requires an
additional investment of $600,000 and increases operating income by $57,500
(sales would increase by $575,000). If made, the investment would increase beginning
net operating assets by $600,000 and ending net operating assets by $400,000.
Assume that the minimum rate of return required by the company is 7 percent.
- Compute the ROI for the division without the investment.
- Compute the margin and turnover ratios without the investment. Show that
the product of the margin and turnover ratios equals the ROI computed in
- Compute the ROI for the division with the new investment. Do you think the
divisional manager will approve the investment?
- Compute the margin and turnover ratios for the division with the new investment.
Compare these with the old ratios.
- Assume that a JIT purchasing and manufacturing system is installed, reducing
average operating assets by $800,000. Compute the ROI with and without the
investment under this new scenario. Now do you think the divisional manager
will accept the new investment? Should he accept it? Explain your answer.
- Refer to Requirement 5. Compute the margin and turnover ratios without the
Weighted Average Cost of Capital; EVA LO4
Donegal, Inc., has decided to use EVA to evaluate its performance. Last year, Donegal
had after-tax operating income of $350,000. Two sources of financing were used by
the company: $3 million of mortgage bonds paying 6 percent interest and $9 million
in common stock, which was considered to be relatively more risky than other
stocks, and had a risk premium of 8 percent. The rate on long-term treasury bonds
is 3 percent. Donegal, Inc., has $4,000,000 in operating assets and pays a marginal
tax rate of 40 percent.
- Calculate the weighted average cost of capital for Donegal, Inc.
- Calculate EVA for Donegal. Is Donegal creating wealth or not?
Now suppose that Donegal, Inc., is considering borrowing $2,000,000 in unsecured
bonds at a rate of 9 percent. The money will be used to purchase additional operating
assets of $1,000,000 (making total operating assets of $5,000,000). This added
investment will enable the company to manufacture products that are budgeted to
increase after-tax operating income by $80,000. (Total after-tax operating income
will be $430,000.)
- Calculate the new weighted average cost of capital for Donegal, Inc.
- Calculate the EVA for Donegal, Inc., including the new products. Is the new
investment a good idea?
Transfer Pricing with Idle Capacity LO5
GreenWorld, Inc., is a nursery products firm. It has three divisions that grow and sell
plants: the Western Division, the Southern Division, and the Canadian Division.
Recently, the Southern Division of GreenWorld acquired a plastics factory that manufactures green plastic pots. These pots can be sold both externally and internally.
Company policy permits each manager to decide whether to buy or sell internally.
Each divisional manager is evaluated on the basis of return on investment and EVA.
The Western Division had bought its plastic pots in lots of 100 from a variety of
vendors. The average price paid was $75 per box of 100 pots. However, the acquisition
made Rosario Sanchez-Ruiz, manager of the Western Division, wonder whether
a more favorable price could be arranged. She decided to approach Lorne Matthews,
manager of the Southern Division, to see if he wanted to offer a better price for an
internal transfer. She suggested a transfer of 3,500 boxes at $70 per box.
Lorne gathered the following information regarding the cost of a box of 100 pots:
Direct materials $35
Direct labor 8
Variable overhead 10
Fixed overhead* 10
Total unit cost $63
Selling price $75
Production capacity 20,000 boxes
*Fixed overhead is based on $200,000/20,000 boxes.
- Suppose that the plastics factory is producing at capacity and can sell all that it
produces to outside customers. How should Lorne respond to Rosario’s request
for a lower transfer price?
- Now assume that the plastics factory is currently selling 16,000 boxes. What are
the minimum and maximum transfer prices? Should Lorne consider the transfer
at $70 per box?
- Suppose that GreenWorld’s policy is that all transfer prices be set at full cost
plus 20 percent. Would the transfer take place? Why or why not?
P12-25 p. 554
Accept or Reject a Special Order LO2, LO3
Steve Murningham, manager of an electronics division, was considering an offer by
Pat Sellers, manager of a sister division. Pat’s division was operating below capacity
and had just been given an opportunity to produce 8,000 units of one of its products
for a customer in a market not normally served. The opportunity involves a product
that uses an electrical component produced by Steve’s division. Each unit that
Pat’s department produces requires two of the components. However, the price the
customer is willing to pay is well below the price usually charged; to make a reasonable
profit on the order, Pat needs a price concession from Steve’s division. Pat had
offered to pay full manufacturing cost for the parts. So that Steve would know that
everything was aboveboard, Pat had supplied the following unit-cost and price information
concerning the special order, excluding the cost of the electrical component:
Selling price $ 32
Direct materials (17)
Direct labor (7)
Variable overhead (2)
Fixed overhead (3)
Operating profit $ 3
The normal selling price of the electrical component is $2.30 per unit. Its full
manufacturing cost is $1.85 ($1.05 variable and $0.80 fixed). Pat had argued that
paying $2.30 per component would wipe out the operating profit and result in her
division showing a loss. Steve was interested in the offer because his division was
also operating below capacity (the order would not use all the excess capacity).
- Should Steve accept the order at a selling price of $1.85 per unit? By how much
will his division’s profits be changed if the order is accepted? By how much will
the profits of Pat’s division change if Steve agrees to supply the part at full cost?
- Suppose that Steve offers to supply the component at $2. In offering the price,
Steve says that it is a firm offer not subject to negotiation. Should Pat accept this
price and produce the special order? If Pat accepts the price, what is the change
in profits for Steve’s division?
- Assume that Steve’s division is operating at full capacity and that Steve refuses to
supply the part for less than the full price. Should Pat still accept the special
Cost-Based Pricing Decision LO5
Last year, Bagger Company had sales revenue of $1,250,000, direct materials of
$240,000, direct labor of $310,700, and overhead of $449,300. Bagger calculates
sales price using a markup on cost of goods sold.
- Calculate the markup Bagger will use.
- If a job has manufacturing cost of $43,000, what is Bagger’s price?
Associated Media Graphics (AMG) is a rapidly expanding company involved in the mass reproduction of instructional materials. Ralph Boston, owner and manager of AMG, has made a concerted effort to provide a quality product at a fair price with delivery on the promised due date. Expanding sales have been attributed to this philosophy. As the business grows, however, Ralph is finding it increasingly difficult to personally supervise the operations of AMG. As a result, he is beginning to institute an organizational structure that would facilitate management control.
One recent change was to designate the operating departments as cost centers, with control over departmental operations transferred from Ralph to each departmental manager. However, quality control stills reports directly to Ralph, as do the finance and accounting functions. A materials manager was hired to purchase all materials and oversee inventory handling (receiving, storage, and so on) and record keeping. The materials manager is also responsible for maintaining an adequate inventory based upon planned production levels.
The loss of personal control over the operations of AMG caused Ralph to look for a method to evaluate performance efficiently. Dave Cress, a new cost accountant, proposed the use of a standard costing system. Variances for materials, labor and overhead could then be calculated and reported directly to Ralph.
- Assume that AMG is going to implement a standard costing system and establish standards for materials, labor, and overhead.
- Who should be involved in setting the standards for each cost component?
- What factors should be considered in establishing the standards for each cost component?
- Describe the basis for assignment of responsibility under a standard costing system. (CMA adapted).
Investigation of Variances LO3
Ellerbee Cable Company uses a standard costing system to control the labor costs
associated with cable installation and repair. Ellerbee uses the following rule to
determine whether the labor efficiency variance should be investigated: a labor efficiency
variance will be investigated when the amount exceeds the lesser of $2,100 or
5% of standard cost. The company collected reports for the past four months to provide
the following information:
Month LEV Standard Labor Cost
1 $2,280 F $45,000
2 2,000 U 50,000
3 1,900 F 48,000
4 3,050 U 60,000
- Using the rule provided, identify the cases that will be investigated.
- Suppose investigation reveals that the cause of an unfavorable labor efficiency
variance is the hiring of a number of new workers who worked more slowly
while they were being trained. Who is responsible? What corrective action
would likely be taken?
Functional versus Flexible Budgeting LO3, LO4
Amy Bunker, production manager, was upset with the latest performance report, which indicated that she was $100,000 over budget. Given the efforts that she and her workers had made, she was confident that they had met or beat the budget. Now, she was not only upset but also genuinely puzzled over the results. Three items—direct labor, power, and setups—were over budget. The actual costs for these three items follow:
Direct labor $ 210,000
Amy knew that her operation had produced more units than originally had been budgeted, so that more power and labor had naturally been used. She also knew that the uncertainty in scheduling had led to more setups than planned. When she pointed this out to Gary Grant, the controller, he assured her that the budgeted costs had been adjusted for the increase in productive activity. Curious, Amy questioned Gary about the methods used to make the adjustment.
Gary: If the actual level of activity differs from the original planned level, we adjust
the budget by using budget formulas—formulas that allow us to predict the costs for
different levels of activity.
Amy: The approach sounds reasonable. However, I’m sure something is wrong here.
Tell me exactly how you adjusted the costs of direct labor, power, and setups.
Gary: First, we obtain formulas for the individual items in the budget by using the
method of least squares. We assume that cost variations can be explained by variations
in productive activity where activity is measured by direct labor hours. Here is
a list of the cost formulas for the three items you mentioned. The variable X is the
number of direct labor hours.
Direct labor cost  $10X
Power cost  $5,000 $4X
Setup cost  $100,000
Amy: I think I see the problem. Power costs don’t have a lot to do with direct labor
hours. They have more to do with machine hours. As production increases, machine
hours increase more rapidly than direct labor hours. Also. . . .
Gary: You know, you have a point. The coefficient of determination for power cost is
only about 50 percent. That leaves a lot of unexplained cost variation. The coefficient
for labor, however, is much better—it explains about 96 percent of the cost
variation. Setup costs, of course, are fixed.
Amy: Well, as I was about to say, setup costs also have very little to do with direct
labor hours. And I might add that they certainly are not fixed—at least not all of
them. We had to do more setups than our original plan called for because of the
scheduling changes. And we have to pay our people when they work extra hours.
It seems like we are always paying overtime. I wonder if we simply do not have enough people for the setup activity. Also, there are supplies that are used for each
setup, and these are not cheap. Did you build these extra costs of increased setup
activity into your budget?
Gary: No, we assumed that setup costs were fixed. I see now that some of them could
vary as the number of setups increases. Amy, let me see if I can develop some cost
formulas based on better explanatory variables. I’ll get back with you in a few days.
Assume that after a few days’ work, Gary developed the following cost formulas,
all with a coefficient of determination greater than 90 percent:
Direct labor cost  $10X, where X  Direct labor hours
Power cost  $68,000 0.9Y, where Y  Machine hours
Setup cost  $98,000 $400Z, where Z  Number of setups
The actual measures of each of the activity drivers are as follows:
Direct labor hours 20,000
Machine hours 90,000
Number of setups 110
- Prepare a performance report for direct labor, power, and setups using the directlabor-
- Prepare a performance report for direct labor, power, and setups using the
multiple-cost-driver formulas that Gary developed.
- Of the two approaches, which provides the more accurate picture of Amy’s performance?
Sumber: Hansen, DR. and Mowen, MM.(2007). Managerial Accounting 8th Edition. Mason: Thompson Southwestern