Prologue

Managerial Accounting and

the Business Environment

Study Suggestions

The prologue describes important aspects of the contemporary business

environment. While there are no written assignments, you should be
familiar with the major ideas as background for your study of managerial
accounting.

HIGHLIGHTS
A. In many industries, a company that does not continually improve will find itself quickly overtaken by
competitors. The text discusses four major approaches
to improvementJust-In-Time (JIT), Total Quality
Management (TQM), Process Reengineering, and the
Theory of Constraints (TOC). These approaches can
be combined.
B. The Just-In-Time (JIT) approach is based on the
insight that reducing inventories can be the key to improving operations. Work in process inventories (i.e.,
inventories of partially completed goods) create a
number of problems:
1. Work in process inventories tie up funds and
take up space.
2. Work in process inventories increase the
throughput time, which is the amount of time required
to make a product. If a company has two weeks of
work in process inventories, then it takes two weeks
longer to complete a unit than if there were no work in
process inventories. Long throughput time makes it
difficult to respond quickly to customers and can be a
major competitive disadvantage.
3. When work in process inventories are large,
partially completed products are stored for long periods of time before being passed to the next workstation. Therefore, defects introduced at a workstation
may not be noticed for quite some time. If a machine
is out of calibration or incorrect procedures are being
followed, many defective units will be produced
before the problem is discovered. And when the
defects are finally discovered, it may be very difficult
to track down the source of the problem.
4. Because of long throughput time, units may be
obsolete or out of fashion by the time they are finally
completed.
5. Large work in process inventories encourage
sloppy procedures and mask inefficiencies and problems in the production process. When inventories are
reduced, these problems are uncovered and can be
identified and dealt with.
C. Under JIT, inventories are reduced to the absolute
minimum levels possible.
1. Just in time means that raw materials are
received just in time to go into production, subassemblies are completed just in time to be assembled into
products, and products are completed just in time to be
shipped to customers.
2. In JIT, the flow of goods is controlled by a
pull approach; work is initiated only in response to

customer orders. In contrast, under conventional systems parts and material are pushed forward to the
next workstation regardless of need. There is also a
tendency in conventional systems to seek to keep
everyone busy. The result in both cases is a needless
buildup of inventory.
3. A JIT company should strive for zero defects.
If any units in an order are defective, the whole production process would have to be restarted to replace
the defective units. This would make it impossible to
deliver the order on time.
D. Many benefits result from a JIT system. The most
important are:
1. Funds that were tied up in inventories can be
used for more productive purposes.
2. Areas used to store inventories are made available for more productive uses.
3. Throughput time is reduced, resulting in
greater potential output and quicker response to customer needs.
4. Defect rates are reduced, resulting in less
waste and greater customer satisfaction.
E. Total Quality Management (TQM) is an approach
to continuous improvement that focuses on the customer and that involves systematic problem-solving
using teams of front-line workers. Specific TQM tools
include benchmarking and the Plan-Do-Check-Act
Cycle.
1. Benchmarking involves studying how a
successful world-class company runs a particular
operation. For example, a company trying to improve
its customer service might study how Disney trains its
employees.
2. The Plan-Do-Check-Act (PDCA) Cycle is a
systematic, fact-based approach to continuous
improvement. Exhibit 1 in the text illustrates the
PDCA Cycle.
a. In the Plan phase, the current process is
studied, data are collected, and possible causes of the
problem at hand are identified. A plan is developed to
deal with the problem.
b. In the Do phase, the plan is implemented
and data are collected. This is done on a small scale if
possible since at this point the team is rarely sure that
the plan will work.

Prologue
c. In the Check phase, the data collected in
the Do phase are analyzed to verify whether the
expected improvement actually occurred.

largely wasted if focused on areas that are not constraints.

H. Organizational Structure.

d. In the Act phase, the plan is implemented

on a large scale if it was successful. If the plan was not
successful, the cycle is started again with the Plan
phase.

1. Almost all organizations are decentralized.

Decentralization involves delegating decision-making
authority to lower levels in the organization.

3. Perhaps the most important characteristics of

TQM are that it empowers front-line workers to solve
problems and it focuses attention on solving problems
rather than on finger pointing.

2. An organization chart shows the levels of

responsibility and formal channels of communication
in an organization. It shows who reports to whom.
Exhibit 2 in the text provides an example of an organization chart.

F. Process Reengineering is a more radical approach

to improvement than TQM. It involves completely
redesigning business processes and it is often implemented by outside consultants.

3. A manager may occupy either a line position

or a staff position.

1. In Process Reengineering, all of the steps in a

business process are displayed as a flowchart. Many of
the stops are often unnecessary and are called nonvalue-added activities.
2. The process is then completely redesigned,
eliminating non-value-added activities.
3. Process Reengineering should result in a
streamlined process that uses fewer resources, takes
less time, and generates fewer errors.
4. However, some managers fall into a trap. If
Process Reengineering results in laying off workers
who are no longer needed, employees will resist further Process Reengineering efforts and morale will
suffer.
G. The Theory of Constraints (TOC) recognizes that
every organization has at least one constraint that prevents it from obtaining more of its objective. For
example, a machine that is slower than other machines
on an assembly line will prevent the company from
increasing its rate of output. To improve its rate of
output, the company must focus its improvement
efforts on the constraint. Improvement efforts will be

a. Line positions are directly related to

achieving the basic objectives of the organization.
b. Staff positions provide service, assistance,
and specialized support to the line positions. They do
not have direct authority over line positions.
Accounting is a staff position.
4. The controller is the manager of the accounting department and often acts as a key adviser to top
management.
I. Ethics plays a vital role in an advanced market
economy.
1. If people were generally dishonest, it would
become more difficult for companies to raise investment funds, the quality of goods and services would
decline, fewer goods and services would be available
for sale, and prices would be higher.
2. The Institute of Management Accountants has
issued the Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management. This is a useful, practical guide for general
managers as well as management accountants. The
Standards for Ethical Conduct are reproduced in
Exhibit 5 in the text.

Chapter 1
An Introduction to Managerial Accounting
and Cost Concepts

Chapter Study Suggestions

This chapter provides some general background discussion and introduces cost terms that will be used throughout the book. The chapter also
gives a broad overview of the flow of costs in a manufacturing company.
(Chapter 2 covers cost flows in more depth.) As you read the chapter,
note each new term and be sure you understand its meaning. It is important to keep in mind that costs are classified in many ways, depending on
how the costs will be used. This is the reason for so many different cost
terms. To fit the cost terms into a framework, you should frequently refer
to Exhibit 1-10 as you go through the chapter.
Exhibit 1-6 presents the schedule of cost of goods manufactured. You
should memorize the format of this schedule, as well as the material in
Exhibit 1-8. Learning this material will help you in Chapter 2 and will
also lay a foundation for many chapters that follow.

CHAPTER HIGHLIGHTS
A. An organization is a group of people united for a
common purpose. Organizations are run by managers
who carry out three major activities: planning, directing and motivating, and controlling.
1. Planning involves identifying alternatives and
selecting the alternative that best furthers the organizations objectives.
2. Directing and motivating involves mobilizing
people to carry out the plans and overseeing day-today activities.
3. Controlling involves obtaining feedback to
ensure that all parts of the organization are following
the plans.
B. Financial and managerial accounting differ in a
number of ways. In contrast to financial accounting,
managerial accounting:
1. Focuses on providing data for internal uses.
2. Places more emphasis on the future.
3. Emphasizes relevance and flexibility rather
than precision.
4. Emphasizes the segments of an organization,
rather than just looking at the organization as a whole.
5. Is not governed by Generally Acceptable
Accounting Practices.
6. Is not mandatory.
C. Manufacturing costs are the costs involved in
making a product. Manufacturing costs can be divided
into three basic elements: direct materials, direct labor,
and manufacturing overhead.
1. Direct materials are those materials that
become an integral part of a finished product and can
be conveniently traced into it.
a. An example of direct materials would be
the tires on a new Ford.
b. Small material items, such as glue, are
classified as indirect materials rather than as direct
materials. It is too costly and inconvenient to trace
such small costs to individual units.
2. Direct labor consists of labor costs that can be
easily traced to individual units of product. Direct
labor is sometimes called touch labor.
a. An example of direct labor would be a
worker on a manufacturing assembly line.

b. Other labor costs, such as supervisors and

janitors, are treated as indirect labor rather than as
direct labor. These costs cannot be traced to individual
units of product since these individuals do not directly
work on the product.
3. Manufacturing overhead consists of all manufacturing costs except direct materials and direct labor.
Manufacturing overhead includes indirect materials,
indirect labor, and other manufacturing costs such as
factory rent, factory utilities, and depreciation on factory equipment and facilities.
4. The terms prime cost and conversion cost are
also used to categorize manufacturing costs.
a. Prime cost consists of direct materials
plus direct labor.
b. Conversion cost consists of direct labor
plus manufacturing overhead.
D. Nonmanufacturing costs are those costs involved
with selling and administrative activities.
1. Selling, or marketing, costs include all costs
associated with marketing finished products such as
sales commissions, costs of delivery equipment, costs
of finished goods warehouses, and advertising.
2. Administrative costs include all costs associated with the general administration of an organization, including secretarial salaries, depreciation of
general administrative facilities and equipment, and
executive compensation.
E. For purposes of external financial reports, costs
can be classified as product costs or period costs.
1. Period costs are expensed on the income statement in the period in which they are incurred. (By
incurred, we mean the period in which the cost is
accrued, not necessarily when it is paid. For example,
remember from financial accounting that salaries are
counted as costs not when they are paid, but when
they are earned by employees. The cost is incurred in
the period in which it is earned. Just continue to use
the rules you learned in financial accounting.)
2. Product costs are matched with units of product and are recognized as an expense on the income
statement only when the units are sold. Until that time,
product costs are considered to be assets and are recognized on the balance sheet as inventory.
3. In a manufacturing company, product costs
include direct materials, direct labor, and manufacturing overhead. Thus, in a manufacturing company,

product costs and manufacturing costs are synonymous.

5. In a merchandising company such as Macys

or Wal-Mart, product costs consist solely of the costs
of products purchased from suppliers for resale to
customers. All other costs are period costs.

Synonymous Cost
Costs
Terms
Involved
...................................................................................
Manufacturing costs
Direct materials, direct
Product costs
labor, and manufactur Inventoriable costs
ing overhead
...................................................................................
Nonmanufacturing
Selling and
costs
administrative
Period costs
expenses

F. Income statements and balance sheets prepared by

manufacturing firms differ from those prepared by
merchandising firms.

H. Computation of cost of goods manufactured, cost

of goods sold, and preparation of the income statement.

1. The balance sheet of a manufacturing firm

contains three inventory accounts: Raw Materials,
Work in Process, and Finished Goods. By contrast, the
balance sheet of a merchandising firm contains only
one inventory accountMerchandise Inventory.

1. Computing the cost of goods sold for a manufacturing company involves a number of steps. These
steps rely on the following basic model that describes
flows into and out of any inventory account.

4. In a manufacturing company, period costs and

nonmanufacturing costs are synonymous terms. Thus,
the period costs are selling and administrative costs.

a. Raw Materials inventory consists of

materials on hand in stockrooms that will be used to
make products.
b.
products.

Work in Process consists of unfinished

c. Finished Goods consists of units of product that are completed and ready for sale.
2. The income statement of a manufacturing firm
contains an element termed cost of goods manufactured. You should study the schedule of cost of goods
manufactured in Exhibit 1-6 in the text very carefully.
If you have difficulty understanding this exhibit, look
at Exhibit 1-7, which shows the same information in a
different format.
G. Manufacturing costs (direct materials, direct
labor, and overhead) are also known as inventoriable
costs.
1. The term inventoriable costs is used since
direct materials, direct labor, and overhead costs are
assigned to Work in Process and Finished Goods
inventory accounts as they are incurred. If goods are
either not completed or not sold at the end of a period,
these costs will be included as part of these inventory
accounts on the balance sheet.
2. You should study Exhibit 1-8 in the text with
care. It shows the flow of manufacturing costs through
inventory accounts and the way these costs become an
expense (cost of goods sold) on the income statement.
This is a key exhibit for Chapter 1.
3. We can summarize manufacturing and nonmanufacturing cost terms as follows:

+
=

Basic inventory flows:

Beginning balance
Additions to inventory
Available
Ending balance
Withdrawals from inventory

2. To compute the raw materials used in production, this basic model is written as follows:
+
=

Beginning balance raw materials

Purchases of raw materials
Raw materials available for use
Ending balance raw materials
Raw materials used in production

The raw materials used in production could include

both direct materials and indirect materials. However,
unless otherwise stated in a problem, you can assume
that there are no indirect materials.
3. The next step is to compute the total manufacturing cost for the period. This is the sum of direct
materials, direct labor, and manufacturing overhead
costs:
Direct materials
+ Direct labor
+ Manufacturing overhead
= Total manufacturing cost
4. The next step is to compute the cost of goods
manufactured. This refers to the cost of the goods that
were finished during the period. To compute this figure, use the following version of the basic inventory
flow model:
Beginning balance, work in process
+ Total manufacturing cost
Ending balance, work in process
= Cost of goods manufactured

Chapter 1
Note: We dont have any name for the sum of the
beginning balance of the work in process inventory
and total manufacturing cost, so it has been left out of
the calculations.
5. The final step in the computation of cost of
goods sold is also based on the inventory flow model:
+
=

Beginning balance, finished goods

Cost of goods manufactured
Goods available for sale
Ending balance, finished goods
Cost of goods sold

6. The income statement in a manufacturing firm

may or may not show the computation of the cost of
goods sold as above. In the summary income statement below, it is assumed that the details of the cost of
goods sold computations are shown separately.

Sales
Cost of goods sold
Gross margin
Selling and administrative expenses
Net income

I. For purposes of describing how costs behave in

response to changes in activity, costs are often classified as variable or fixed. For example, one might be
interested in describing how the cost of admitting
patients to a hospital responds to changes in the number of patients admitted. Or, one might be interested in
how much it would cost for paint in a furniture factory
if the output of the factory were increased by 10%.
1. Variable costs are those costs that vary, in
total, in direct proportion to changes in the volume or
level of activity within the relevant range. Exhibit 1-11
illustrates variable cost behavior. Examples of variable
costs include direct materials, (usually) direct labor,
commissions to salespersons, and cost of goods sold in
a merchandising company such as a shoe store.
2. Fixed costs are those costs that remain constant in total amount within the relevant range. They
include, for example, depreciation, supervisory
salaries, and rent. Exhibit 1-11 illustrates fixed cost
behavior.

1. Managers often want to know how much

something (e.g., a product, a department, or a
customer) costs. The item for which a cost is desired is
called a cost object.
2. A direct cost is a cost that can be easily and
conveniently traced to the cost object under
consideration. For example, the salaries and
commissions of salespersons in a department stores
shoe department would be considered direct costs of
the shoe department.
3. An indirect cost is a cost that cannot be easily
and conveniently traced to the cost object. For
example, the salary of the manager of a department
store would be considered an indirect cost of the shoe
department and other departments.
K. For purposes of making decisions, the following
cost terms are often used: differential costs,
opportunity costs, and sunk costs.
1. Every decision involves choosing from among
at least two alternatives. A difference in cost between
two alternatives is called a differential cost. Only the
differential costs are relevant in making a choice
between two alternatives. Costs that are the same for
the two alternatives are not affected by the decision
and should be ignored.
2. An opportunity cost is the potential benefit
given up by selecting one alternative over another.
Opportunity costs are not recorded in accounting
records. They represent a lost benefit rather than an
out-of-pocket cost.
3. A sunk cost is a cost that has already been
incurred and that cannot be changed by any decision
made now or in the future. Sunk costs are never
differential costs and should always be ignored when
making decisions.
L. The term quality is used in many ways. It can
mean a luxurious product with many features or it can
mean a product that is free of defects. In this chapter,
we use quality in the latter sense. Quality of
conformance is the degree to which a product or
service meets its design specifications and is free of
defects or other problems that might affect appearance
or performance.

3. The relevant range is the range of activity

within which the assumptions about cost behavior can
be considered valid. If there is a big enough change in
activity (for example, a ten-fold increase in volume),
even the fixed costs are likely to change. A ten-fold
increase in volume would be outside the relevant
range.

M. Defects (i.e., poor quality of conformance) result

in costs that can be classified as prevention costs,
appraisal costs, internal failure costs, and external
failure costs.

J. For purposes of assigning costs to objects, costs

are classified as direct or indirect.

a. Internal failure costs result from

correcting defects in products before they are shipped

1. Internal failure costs and external failure costs

result from defects in products.

to customers. Internal failure costs include scrap,

reworking of defective units, and downtime.
b. External failure costs result when a
defective product is delivered to a customer. These
costs include warranty repairs, exchanges, returns, and
loss of future sales. These are the least desirable of all
quality costs. A dissatisfied customer will not buy
from the company in the future and is likely to tell
others of his or her dissatisfaction. It is generally
better to identify defects before they get into the hands
of customers.
2. Prevention costs and appraisal costs are
incurred to prevent defects and reduce the likelihood
of external failures.
a. Prevention costs are incurred to reduce or
eliminate defects. Prevention is often simple and
inexpensive. For example, a simple metal shield can
prevent drilling a hole in the wrong place. Prevention
costs include the costs of quality engineering and
quality improvement projects.

b. Appraisal costs are incurred to identify

defective products before the products are shipped to
customers. These costs include wages of inspection
workers and the costs of testing equipment.
N. In most companies, the total cost of quality (the
sum of prevention costs, appraisal costs, internal
failure costs, and external failure costs) decreases as
the defect rate improvesat least until very low levels
of defect rates occur. (A higher quality of conformance
means a lower defect rate.)
1. Reducing the defect rate (e.g., defects per
million parts) involves spending more on prevention
and appraisal. However, this additional spending is
usually more than offset by reductions in the costs of
internal and external failures caused by defects.
2. Most companies would benefit from putting
more effort into prevention. This reduces the need for
appraisal and decreases the incidence of internal and
external failures.

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.
___ 1. Raw materials consist of basic natural
resources, such as iron ore.
___ 2. A supervisors salary would be considered
direct labor if the supervisor works directly in the
factory
___ 3. Nonmanufacturing costs consist of selling
costs and administrative costs.
___ 4. All selling and administrative costs are
period costs.
___ 5. The terms product cost and manufacturing
cost are synonymous.
___ 6. The cost of goods manufactured is an
expense in a manufacturing firm.
___ 7. Part of a cost such as factory depreciation
may be on the balance sheet as an asset if goods are
uncompleted or unsold at the end of a period.
___ 8. Inventoriable costs and product costs are
synonymous terms in a manufacturing firm.
___ 9. Total variable cost will change
proportion to changes in the level of activity.

in

___ 10. A fixed cost is constant per unit of product.

___ 11. Manufacturing overhead is an indirect cost
with respect to units of product.
___ 12. Sunk costs can be either variable or fixed.
___ 13. Property taxes and insurance on a factory
building are examples of manufacturing overhead.
___ 14. A product containing defects has a poor
quality of conformance.
___ 15. The best quality systems are those that put
their emphasis on appraisal costs
Multiple Choice
Choose the best answer or response by placing the
identifying letter in the space provided.
___ 1. If the activity level increases, one would
expect the fixed cost per unit to: a) increase; b)
decrease; c) remain unchanged; d) none of these.

___ 2. Which of the following costs would not be

a period cost? a) indirect materials; b) advertising; c)
administrative salaries; d) shipping costs; e) sales
commissions.
___ 3. The term used to describe the cost of goods
transferred from work in process inventory to finished
goods inventory is: a) cost of goods sold; b) raw
materials; c) period cost; d) cost of goods
manufactured.
___ 4. Manufacturing cost is synonymous with all
of the following terms except: a) product cost; b)
inventoriable cost; c) period cost; d) all of the above
are synonymous terms.
___ 5. If the activity level drops by 5%, one
would expect the variable costs: a) to increase per unit
of product; b) to drop in total by 5%; c) to remain
constant in total; d) to decrease per unit of product.
___ 6. All of the following are considered to be
product costs for financial reporting except: a) indirect
materials; b) advertising; c) rent on factory space; d)
idle time; e) all of the above would be product costs.
___ 7. Walston Manufacturing Company has
provided the following data concerning its raw
materials inventories last month:
Beginning raw materials inventory .......... $80,000
Purchases of raw materials ...................... $420,000
Ending raw materials inventory ............... $50,000
The cost of the raw materials used in production for
the month was: a) $500,000; b) $450,000; c)
$390,000; d) $470,000.
___ 8. Juniper Company has provided the
following data concerning its manufacturing costs and
work in process inventories last month:
Raw materials used in production ............. $270,000
Direct labor ................................................ $140,000
Manufacturing overhead ........................... $190,000
Beginning work in process inventory ........ $50,000
Ending work in process inventory ............. $80,000
The cost of goods manufactured for the month was: a)
$730,000; b) $630,000; c) $600,000; d) $570,000.
___ 9. Vonder Inc. has provided the following
data concerning its finished goods inventories last
month:
Beginning finished goods inventory ......... $110,000
Cost of goods manufactured ...................... $760,000
Ending finished goods inventory ............... $70,000

Chapter 1
The cost of goods sold for the month was: a)
$800,000; b) $720,000; c) $950,000; d) $280,000.
___ 10. The cost of warranty repairs is an example
of a(n): a) prevention cost; b) appraisal cost; c)
internal failure cost; d) external failure cost.
___ 11. The cost of rework labor is an example of
a(n): a) prevention cost; b) appraisal cost; c) internal
failure cost; d) external failure cost.

___ 12. The cost of supplies used in testing and

inspection is an example of a(n): a) prevention cost; b)
appraisal cost; c) internal failure cost; d) external
failure cost.
___ 13. The cost of lost sales due to a reputation for
poor quality is an example of a(n): a) prevention cost;
b) appraisal cost; c) internal failure cost; d) external
failure cost.

Exercises
1-1.
Classify each of the following costs as either period costs or product costs. Also indicate whether the cost
is fixed or variable with respect to changes in the amount of output produced and sold.
Period Cost

Product Cost

Variable Cost

Fixed Cost

Example: Rent on a sales office ................

__X__

____

____

__X_

Example: Direct materials .........................

_____

__X_

__X_

____

a.

Sales commissions .....................................

_____

____

____

____

b.

Rent on a factory building .........................

_____

____

____

____

c.

Headquarters secretarial salaries ...............

_____

____

____

____

d.

Assembly line workers ..............................

_____

____

____

____

e.

Product advertising ....................................

_____

____

____

____

f.

Cherries in a cannery .................................

_____

____

____

____

g.

Top management salaries ...........................

_____

____

____

____

h.

Lubricants for machines ............................

_____

____

____

____

i.

Shipping costs via express service ............

_____

____

____

____

j.

Executive training program .......................

_____

____

____

____

k.

Factory supervisory salaries ......................

_____

____

____

____

1-2.
Using the following data and the form that appears below, prepare a schedule of cost of goods
manufactured.
Lubricants for machines ........................
Rent, factory building ............................
Direct labor ............................................
Indirect materials ...................................
Sales commissions .................................
Factory utilities ......................................
Insurance, factory ..................................
Purchases of raw materials ....................
Work in process, beginning ...................
Work in process, ending .........................
Raw materials, beginning ......................
Raw materials, ending ...........................
Depreciation of office equipment ..........

$ 4,500
16,000
90,000
2,000
24,600
5,800
2,000
120,000
16,000
11,500
15,000
5,000
4,000

Schedule of Cost of Goods Manufactured

(See Exhibit 1-6 in the text for the proper format)
Direct materials:
_________________________________.............................

$___________

_________________________________.............................

___________

_________________________________.............................

___________

_________________________________.............................

___________

_________________________________.............................

___________

Direct labor...................................................................................

___________

Manufacturing overhead:
_________________________________.............................

___________

_________________________________.............................

___________

_________________________________.............................

___________

_________________________________.............................

___________

_________________________________.............................

___________

_________________________________.............................

___________

_________________________________.............................

___________

_________________________________....................................

___________
___________

_________________________________....................................

___________

Cost of Goods Manufactured.......................................................

Chapter 1
1-3.
Harry is considering whether to produce and sell classic wooden surfboards in his spare time. He has a
garage that was constructed at a cost of $12,000 several years ago, and which could be used for production
purposes. The garage would be depreciated over a 20-year life. Harry has determined that each surfboard will
require $30 in wood. He would hire students to do most of the work and pay them $35 for each surfboard
completed. He would rent tools at a cost of $400 per month. Harry can draw money out of savings to provide the
capital needed to get the operation going. The savings are earning interest at 6% annually. An ad agency would
handle advertising at a cost of $500 per month. Harry would hire students to sell the surfboards and pay a
commission of $20 per board.
Required:
From the foregoing information, identify all the examples you can of the following types of costs (a single
item may be identified as many types of costs). A cost should be classified as variable in this case if it is variable
with respect to the number of surfboards produced and sold. A cost should be classified as a differential cost if it
differs between the alternatives of producing or not producing the surfboards.

Product
cost

Manuf.
ovhd.
cost

Sunk
cost

____

____

____

____

____

____

____

____

____

____

____

____

____

____

____

____

____

____

____

____

____

Student workers.............................

____

____

____

____

____

____

____

____

Tool rental......................................

____

____

____

____

____

____

____

____

Interest on savings..........................

____

____

____

____

____

____

____

____

Advertising costs............................

____

____

____

____

____

____

____

____

Sales commissions.........................

____

____

____

____

____

____

____

____

Variable
cost

Fixed
cost

Original cost of garage...................

____

____

Depreciation on the garage............

____

Wood for each surfboard................

Selling &
admin.
cost

Oppor- Differtunity ential

cost
cost

Answers to Questions and Exercises

True or False
1. F

Raw materials consist of any materials used

to make a product. The finished goods of
one company can be the raw materials of
another company.

2. F

Direct labor can be physically traced to

products in a hands on sense. Supervisors
do not work directly on products and
therefore are not direct labor.

3. T

Nonmanufacturing cost is synonymous with

selling and administrative costs.

4. T

Selling and administrative costs are period

costs because they are charged against
income in the period in which they are
incurred rather than being added to the cost
of manufactured or purchased goods.

5. T

These two terms are synonymous.

6. F

Cost of goods manufactured is not an

expense. It is the amount transferred from
work in process to finished goods inventory
when goods are completed. This is a subtle,
but important, point.

11. T

Manufacturing overhead cost is an indirect

cost; only direct materials and direct labor
are direct manufacturing costs.

12. T

A sunk cost is a cost that has already been

incurred and can be variable or fixed. If
obsolete materials have already been
purchased, for example, then the cost of the
materials is a sunk cost.

13. T

Manufacturing overhead consists of all

production costs except direct materials and
direct labor.

14. T

Quality of conformance indicates how well

a product meets its design specifications and
is free of defects.

15. F

The best quality

prevention costs.

systems

emphasize

Multiple Choice
1. b

The fixed cost per unit should drop since a

constant amount is spread over more units.

Manufacturing costs are assigned to units

during production. If these units are not
complete or not sold at the end of a period,
then the manufacturing costs incurred to
date are included as part of Work in Process
or Finished Goods inventories which are
assets on the balance sheet.

2. a

Indirect materials are part of manufacturing

overhead and thus are included in product
costs.

3. d

The cost of goods manufactured refers to the

costs of goods that are completed and ready
for sale during the period.

8. T

These two terms are synonymous.

4. c

9. T

Since a variable cost is constant per unit, it

will change in total in proportion to changes
in the level of activity. If activity increases
by 5%, then the total variable cost should
also increase by 5%.

A period cost represents a cost charged

against the period in which the cost is
incurred; it has nothing to do with the
manufacture of a product.

5. b

By definition, total variable cost changes in

proportion to changes in activity.

6. b

Advertising is a period cost, rather than a

product cost.

7. T

10. F

A fixed cost is constant in total amount; on a

per unit basis, it varies inversely with
changes in the level of activity.

7. b

The computations are as follows:

Beginning raw materials inventory ...........

Add: Purchases of raw materials ...............
Raw materials available for use .................
Deduct: Ending raw materials
inventory ....................................
Raw materials used in production .............
8. d

9. a The cost of goods sold is computed as follows:

$ 80,000
420,000
500,000
50,000
$450,000

The computations are as follows:

Raw materials used in production ........

Direct labor ..........................................
Manufacturing overhead ......................
Total manufacturing costs ....................
Add: Beginning work in
process inventory .......................
Deduct: Ending work in
process inventory ..................
Cost of goods manufactured ................

Beginning finished goods inventory .........

Add: Cost of goods manufactured .............
Goods available for sale ............................
Deduct: Ending finished
goods inventory ..........................
Cost of goods sold .....................................

70,000
$800,000

10. d

Warranty repairs occur after a product has

been released to customers and is therefore
an external failure cost.

11. c

50,000
650,000

Rework labor occurs as a result of a defect

that is discovered within the plant and is
therefore an internal failure cost.

12. b

Testing and inspection is part of the

appraisal process.

80,000
$570,000

13. d

Lost sales due to poor quality is an external

failure cost since it occurs as a result of
defective products getting into the hands of
customers.

$270,000
140,000
190,000
600,000

Exercises
1-1.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.

$110,000
760,000
870,000

Sales commissions ...............................................

Rent on a factory building ....................................
Headquarters secretarial salaries ..........................
Assembly line workers .........................................
Product advertising ..............................................
Cherries in a cannery ............................................
Top management salaries .....................................
Lubricants for machines .......................................
Shipping costs via express service .......................
Executive training program ..................................
Factory supervisory salaries .................................

Period
Cost
X

Product
Cost

Variable
Cost
X

Fixed
Cost
X
X

X
X

X
X

X
X
X

X
X

1-2.

Direct materials:
Raw materials inventory, beginning ............................
Add: Purchases of raw materials .................................
Raw materials available for use ..................................
Deduct: Raw materials inventory, ending ...................
Raw materials used in production ...............................
Direct labor .........................................................................
Manufacturing overhead:
Lubricants for machines ..............................................
Rent, factory building ..................................................
Indirect materials .........................................................
Factory utilities ............................................................
Insurance, factory ........................................................
Total overhead costs .................................................
Total manufacturing costs ...................................
Add: Work in process, beginning .......................................

$ 15,000
120,000
135,000
5,000
$130,000
90,000
4,500
16,000
2,000
5,800
2,000
30,300
250,300
16,000
266,300
11,500
$254,800

Deduct: Work in process, ending ........................................

Cost of Goods Manufactured ..............................................

Note: Sales commissions and depreciation on office equipment are not manufacturing costs.
1-3.
Variable
cost

Fixed
cost

Selling &
admin.
cost

Product
cost

Manuf.
ovhd.
cost

Original cost of garage ..................

Sunk
cost

Oppor- Differtunity ential

cost
cost

Depreciation on the garage ...........

(1)

Wood for each surfboard ...............

Student workers ............................

Tool rental .....................................

Interest on savings .........................

X
X

Advertising costs ...........................

Sales commissions ........................

X
X

(2)

(1) This is not a differential cost if the depreciation on the garage is the same regardless of whether it is used to
make surfboards or is used conventionally as a residential garage.
(2) This may be considered to be a differential cost, although some would say that it is not since it is a foregone
benefit rather than a cost per se..

Chapter 2
Systems Design: Job-Order Costing

Chapter Study Suggestions

This chapter expands on the concepts introduced in Chapter 1 and

provides more details concerning how product costs are determined. The
costing method illustrated in the chapter is known as job-order costing.
Exhibit 2-5 provides a overall view of the flow of cost and the documents
in a job-order cost system. Pay particular attention to the section in the
chapter titled Application of Manufacturing Overhead. Overhead
application is a key concept in the chapter.
Exhibits 2-6, 2-7, and 2-8 show how direct materials, direct labor, and
overhead costs are assigned to jobs. Study these exhibits with particular
carethe concepts they contain will show up often in the homework
material. Exhibits 2-10 and 2-11 summarize these concepts. Note
particularly the difference between the schedule of cost of goods
manufactured in Exhibit 2-11 and the schedule of cost of goods
manufactured in Chapter 1. Study and then restudy the section titled
Underapplied and Overapplied Overhead, paying particular attention to
how under- and overapplied overhead is computed.

Chapter 2

CHAPTER HIGHLIGHTS
A. Two basic costing systems are commonly used in
manufacturing and in many service organizations:
process costing and job-order costing.
1. Process costing is used in situations where a
single homogeneous product such as bricks is
produced for long periods of time.
2. Job-order costing is used in situations where
many different products or services are produced each
period. Examples include special order printing and
furniture manufacturing where products are typically
produced in small batches. For example, fifty units of
a particular type of sofa might be made in one batch.
Each batch is called a job. These concepts also
extend to service companies. For example, in a
consulting company, a job would be a particular
consulting project.
B. We will begin our discussion of job-order costing
with raw materials. When materials are purchased,
their costs are recorded in the Raw Materials inventory
account, which is an asset.
1. Materials are withdrawn from storage using a
materials requisition form as authorization. This form
lists all the materials required to complete a specific
job. The journal entry to record withdrawal of raw
materials from the storeroom for use in production is:
Work in Process (direct materials)
Manuf. Ovhd. (indirect materials)
Raw Materials

XXX
XXX
XXX

Materials that are traced directly to jobs are classified

as direct materials and are debited to Work in Process.
Any materials that are not directly traced to jobs are
classified as indirect materials and are debited to a
special control account called Manufacturing
Overhead.
2. When materials are placed into production,
they are recorded on a job cost sheet, which
summarizes all production costs assigned to a
particular job. Exhibit 2-2 in the text illustrates a job
cost sheet.
C. Labor costs are recorded on time tickets or time
sheets that are filled out by employees. These
documents list the amount of time each employee
works on specific jobs and tasks.
1. Labor time spent working directly on specific
jobs is termed direct labor. Labor time spent working
on supportive tasks (e.g., supervision, maintenance,
janitorial) is termed indirect labor. The entry to record
labor costs is:
Work in Process (direct labor)
Manuf. Ovhd. (indirect labor)

XXX
XXX

Salaries and Wages Payable

XXX
2. Direct labor costs are added to the individual
job cost sheets at the same time they are recorded in
the formal accounts.
D. As explained in Chapter 1, manufacturing
overhead is an indirect cost and therefore must be
allocated in order to be assigned to units of product.
This allocation is usually done with a predetermined
overhead rate.
1. The predetermined overhead rate is computed
before the year begins and is based entirely on
estimated data. Ordinarily, the rate is computed for an
entire year to eliminate seasonal fluctuations. The
formula is:

Estimated total manufacturing

overhead cost
Predetermined
overhead rate
Estimated total amount
of the allocation base
An allocation base is a measure of activity, such as
direct labor-hours, direct labor cost, or machine-hours.
The allocation base is something that all jobs have in
commonfor example, all of the jobs may require
direct labor-hours. Ideally, the allocation base should
actually cause the overhead cost, but in practice this
ideal is often ignored.
2. For example, suppose direct labor-hours is
used as the allocation base and that the estimated total
manufacturing overhead cost for next year is $400,000
and the estimated total number of direct labor-hours is
10,000. Then the predetermined overhead rate would
be $40 per direct labor-hour ($400,000 10,000 direct
labor-hours).
3. To assign overhead costs to a job, the
predetermined overhead rate is multiplied by the
amount of the allocation base incurred by the job. For
example, suppose that a particular job incurs 20 direct
labor-hours and the predetermined overhead rate is
$40 per direct labor-hour. Then $800 (20 direct laborhours $40 per direct labor-hour) of overhead cost
would be applied to that job. This $800 is called the
overhead applied. Note that this is not actual overhead
spending on the job. The $800 may have little to do
with any overhead that is actually caused by the job. It
is simply a way of distributing the overhead costs that
were estimated at the beginning of the year among the
jobs worked on during the year.
4. The overhead that is applied to a job is entered
on its job cost sheet and is recorded in the companys
formal accounts with the following journal entry:

Work in Process
XXX
Manufacturing Overhead
XXX
5. Turn to Exhibit 2-8 in the text to see how
overhead costs flow through the accounts and onto the
job cost sheets. Notice from the exhibit that applying
overhead to jobs and recording actual overhead costs
represent two separate and distinct processes. This is a
key concept that you must understand.

3. Under- or overapplied overhead can be

computed as follows:

6. Actual overhead costs are not charged to Work

in Process. Instead, they are charged to the
Manufacturing Overhead control account as we saw in
the entries for indirect labor and indirect materials
above. Note that actual overhead costs all appear as
debits to Manufacturing Overhead.

* Predetermined overhead rate Actual amount of the

allocation base incurred during the period.

E. When jobs are completed, their costs are

transferred from Work in Process to Finished Goods.
The journal entry is:
Finished Goods
Work in Process

XXX
XXX

When completed products are sold, their costs are

transferred from Finished Goods to Cost of Goods
Sold. The journal entry is:
Cost of Goods Sold
Finished Goods

XXX
XXX

F. Exhibits 2-10, 2-11 and 2-12 are key exhibits that

summarize much of the material in the chapter. Study
these exhibits with care. Note particularly how the
manufacturing overhead costs are handled.
G. Generally there will be a difference between the
amount of overhead cost applied to Work in Process
and the amount of actual overhead cost for a period.
This difference will be reflected in a debit or credit
balance in the Manufacturing Overhead account.
1. If less overhead cost is applied to Work in
Process than has actually been incurred, then overhead
has been underapplied and there is a debit balance in
the Manufacturing Overhead account.
2. If more overhead cost is applied to Work in
Process than has actually been incurred, then overhead
has been overapplied and the Manufacturing Overhead
account has a credit balance.

Actual overhead costs .................................. $XXX

Less: Overhead costs applied
to Work in Process* ............................... XXX
Underapplied (overapplied) overhead ......... $XXX

4. At the end of a period, under- or overapplied

overhead is closed out to Cost of Goods Sold
a. If overhead has been underapplied, the
entry would be:
Cost of Goods Sold
Manufacturing Overhead

XXX
XXX

This entry increases Cost of Goods Sold. If overhead

has been underapplied, not enough overhead cost was
applied to jobs during the period and therefore costs
are understated in the accounts. The journal entry
above adjusts Cost of Goods Sold so that it is no
longer understated.
b. If overhead has been overapplied, the
journal entry would be:
Manufacturing Overhead
Cost of Goods Sold

XXX
XXX

This entry decreases Cost of Goods Sold. If overhead

has been overapplied, too much overhead cost was
applied to jobs during the period and therefore costs
are overstated in the accounts. The journal entry above
adjusts Cost of Goods Sold so that it is no longer
overstated.
H. Largely for simplicity, the chapter assumes that a
single plant-wide overhead rate is used. Many
companies use multiple overhead rates rather than a
single plant wide rate. There may be a different
predetermined overhead rate for each processing
department or work center and there may be separate
overhead rates for activities such as processing
purchase orders that are caused by the job. These more
complex systems will be investigated in the chapter
dealing with activity-based costing.

Chapter 2

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.
___ 1. A company producing many different kinds
of furniture would probably use a job-order cost
system.
___ 2. Process costing systems are used in
situations where output is homogeneousthe
company makes a single product for long periods of
time.
___ 3. Most factory overhead costs are direct
costs and can be easily identified with specific jobs.
___ 4. The predetermined overhead rate is
computed using estimates of overhead cost and the
amount of the allocation base.
___ 5. The predetermined overhead rate is
generally computed on a monthly basis rather than on
an annual basis to increase the accuracy of unit costs.
___ 6. The cost of indirect materials used in
production is added to the Manufacturing Overhead
account rather than added directly to Work in Process.
___ 7. The job cost sheet is used to accumulate
the costs charged to a particular job.
___ 8. Actual manufacturing overhead costs are
charged directly to the Work in Process account as the
costs are incurred.
___ 9. Selling and administrative expenses are
charged to the Manufacturing Overhead account.
___ 10. If more overhead is applied to Work in
Process than is actually incurred, then overhead cost
will be overapplied.
___ 11. A debit balance in the Manufacturing
Overhead account at the end of a period would mean
that overhead was underapplied for the period.
___ 12. Under- or overapplied overhead is
computed by finding the difference between actual
overhead costs and the amount of overhead cost
applied to Work in Process.

Multiple Choice
Choose the best answer or response by placing the
identifying letter in the space provided.

___ 1. In a job-order costing system, the basic

document for accumulating costs for a specific job is:
a) the materials requisition form; b) the job cost sheet;
c) the Work in Process inventory account; d) the labor
time ticket.
___ 2. Suppose $30,000 of raw materials are
purchased. What account is debited? a) Work in
Process inventory; b) Raw Materials inventory; c)
Cost of Goods Sold; d) Manufacturing Overhead.
___ 3. Suppose $20,000 of raw materials are
withdrawn from the storeroom to be used in
production. Of this amount, $15,000 consists of direct
materials and $5,000 consists of indirect materials.
What account or accounts will be debited? a) Work in
Process $15,000 and Raw Materials $5,000; b) Raw
Materials $15,000 and Manufacturing Overhead
$5,000; c) Manufacturing Overhead $15,000 and Work
in Process $5,000; d) Work in Process $15,000 and
Manufacturing Overhead $5,000.
___ 4. Suppose $70,000 of wages and salaries are
earned by employees. Of this amount, $20,000
consists of direct labor; $10,000 consists of indirect
labor; and $40,000 consists of administrative salaries.
What account or accounts will be debited? a) Work in
Process $20,000 and Manufacturing Overhead
$10,000 and Administrative Salary Expense $40,000;
b) Direct Labor $20,000 and Indirect Labor $10,000
and Administrative Salary Expense $40,000; c) Work
in Process $20,000 and Manufacturing Overhead
$50,000; d) Direct Labor $20,000 and Manufacturing
Overhead $50,000.
___ 5. Suppose jobs are completed whose job cost
sheets total to $120,000. What account will be
debited? a) Manufacturing Overhead $120,000; b)
Cost of Goods Sold $120,000; c) Work in Process
$120,000; d) Finished Goods $120,000.
___ 6. Suppose a total of $30,000 of overhead is
applied to jobs. What account will be debited? a)
Manufacturing Overhead $30,000; b) Cost of Goods
Sold $30,000; c) Work in Process $30,000; d) Finished
Goods $30,000.
___ 7. Last year, a company reported estimated
overhead, $100,000; actual overhead, $90,000; and
applied overhead, $92,000. The companys overhead
cost for the year would be: a) underapplied, $10,000;
b) underapplied, $8,000; c) overapplied, $2,000; d)
overapplied, $10,000.

___ 8. Jurden Company bases its predetermined

overhead rates on machine hours. At the beginning of
the year, the company estimated its manufacturing
overhead for the year would be $60,000 and there
would be a total of 40,000 machine hours. Actual
manufacturing overhead for year amounted to $65,100
and the actual machine hours totaled 42,000.
Manufacturing overhead for the year would be: a)
underapplied by $2,100; b) overapplied by $3,000; c)
underapplied by $3,000; d) overapplied by $5,100.
___ 9. On January 1, Hessler Companys Work in
Process account had a balance of $18,000. During the
year, direct materials costing $35,000 were placed into
production. Direct labor cost for the year was $60,000.
The predetermined overhead rate for the year was set
at 150% of direct labor cost. Actual overhead costs for
the year totaled $92,000. Jobs costing $190,000 to

manufacture according to their job cost sheets were

completed during the year. On December 31, the
balance in the Work in Process inventory account
would be: a) $13,000; b) $18,000; c) $15,000; d)
$8,000.
___ 10. The Cost of Goods Manufactured
represents: a) the amount of cost charged to Work in
Process during the period; b) the amount transferred
from Work in Process to Finished Goods during the
period; c) the amount of cost placed into production
during the period; d) none of these.
___ 11. If overhead is overapplied for a period, it
means that: a) the predetermined overhead rate used to
apply overhead cost to Work in Process was too low;
b) the company incurred more overhead cost than it
charged to Work in Process; c) too much cost has been
assigned to jobs; d) none of these.

Chapter 2
Exercises
2-1.
Bartle Company uses a job-order cost system and applies overhead with a predetermined overhead rate
based on direct labor-hours. At the beginning of the year the estimated total manufacturing overhead for the year
was $150,000 and the estimated level of activity was 100,000 direct labor-hours. At the end of the year, cost
records revealed that actual overhead costs of $160,000 had been incurred and that 105,000 direct labor hours had
been worked.
a. The predetermined overhead rate for the year was $

b. Manufacturing overhead cost applied to work in process during the year was $

c. The amount of underapplied or overapplied overhead cost for the year was $

2-2. The following selected account balances are taken from the books of Pardoe Company as of January 1 of the
most recent year:

Cash
12,000

Accounts Receivable
48,000

Prepaid Insurance
8,000

Raw Materials
30,000

Work in Process
40,000

Accounts Payable
75,000

Finished Goods
100,000

Salaries and
Wages Payable
12,000

Accumulated
Depreciation
120,000

Manufacturing
Overhead

Sales

Cost of Goods Sold

Chapter 2
The following data relate to the activities of Pardoe Company during the year:
1. Raw materials purchased on account, $150,000.
2. Raw materials issued to production, $145,000 (all direct materials).
3. Advertising cost incurred for the year, $50,000 (credit accounts payable).
4. Utilities cost incurred for the factory, $35,000 (credit accounts payable).
5. Salaries and wages costs incurred: direct labor, $250,000 (30,000 hours); indirect labor, $75,000; selling and
administrative, $140,000.
6. Depreciation recorded for the year, $20,000, of which 75% related to the factory and 25% related to selling
and administrative functions.
7. Other factory overhead costs incurred for the year, $30,000 (credit accounts payable).
8. Other selling and administrative expenses incurred for the year, $25,000 (credit accounts payable).
9. Prepaid insurance of $4,000 expired during the year; all of this is related to the factory.
10. The company applies overhead on the basis of direct labor-hours at $5.50 per hour.
11. The cost of goods manufactured for the year totaled $550,000.
12. Goods that cost $540,000 according to their job cost sheets were sold on account for $800,000.
13. Collections on account from customers during the year totaled $790,000.
14. Cash disbursed during the year: on accounts payable, $300,000; for salaries and wages, $460,000.
Required:
a.
Post the above entries directly to Pardoe Companys T-accounts on the previous page. Key your entries with
the numbers 1-14.
b.
Compute the ending balance in each T-account.
c.
Is overhead underapplied or overapplied for the year? Close the balance to Cost of Goods Sold. (Key the
entry as #15.)
d.
Prepare an income statement for the year using the form that appears below.
PARDOE COMPANY
Income Statement
Sales.....................................................................................

Less cost of goods sold........................................................

Gross margin........................................................................
Less operating expenses:
..............................

..............................
..............................
..............................
Net Income .........................................................................

2-3.
The following data were taken from the Precision Milling Machine, Inc., cost records for the current year.
Compute the amount of raw materials used in production during the year:
Raw materials inventory, beginning ........................
Raw materials inventory, ending..............................
Purchases of raw materials.......................................

10,000
15,000
145,000

2-4.
Suppose all of the raw materials used in production by Precision Milling Machine in the preceding
exercise were direct materials. The company has supplied the following additional information:
Direct labor cost........................................................
Manufacturing overhead applied .............................
Work in process inventory, beginning .....................
Work in process inventory, ending...........................
Compute the cost of goods manufactured for the year.

$240,000
90,000
60,000
75,000

Chapter 2
2-5.
Precision Milling Machine company has supplied the following additional information. Use this data
together with your answer to exercise 2-4 above to compute the (adjusted) Cost of Goods Sold for the company.
Close out any balance in Manufacturing Overhead to Cost of Goods Sold.
Actual manufacturing overhead incurred ................
Finished goods inventory, beginning .......................
Finished goods inventory, ending ............................

88,000
120,000
145,000

Answers to Questions and Exercises

True or False

Multiple Choice

1. T

Job-order costing is used when many

different kinds of products are made.

2. T

Process costing is generally used when

output is homogeneous.

3. F

Only direct materials and direct labor are

direct costs; manufacturing overhead cannot
be easily identified with specific jobs.

4. T

Estimates are used since a rate must be

developed before the period begins.

5. F

The predetermined overhead rate is usually

computed on an annual basis in order to
smooth out month-by-month variations in
cost and activity.

6. T

Indirect costs are charged to

Manufacturing Overhead account.

7. T

A separate job cost sheet is prepared for

each job entered into production, and is used
to accumulate costs as they are charged to
the job.

8. F

9. F

the

Actual manufacturing overhead costs are

charged to the Manufacturing Overhead
accountnot to Work in Process.
Selling and administrative expenses are
period costs, not product costs; thus, they
are deducted as expenses on the income
statement in the period they are incurred.

10. T

This is true by definition.

11. T

A debit balance in Manufacturing Overhead

would mean that more overhead cost was
incurred than was applied to Work in
Process. Thus, manufacturing overhead
would be underapplied.

12. T

By definition, this is how under- or

overapplied overhead cost is computed.

1. b

The job cost sheet is used to accumulate

direct materials, direct labor, and overhead
costs.

2. b

The journal entry would be:

Raw Materials
Cash or Accounts Payable
3. d

30,000
30,000

The journal entry would be:

Work in Process
Manufacturing Overhead
Raw Materials
4. a

15,000
5,000
20,000

The journal entry would be:

Work in Process
Manufacturing Overhead
Administrative Salaries Expense
Wages and Salaries Payable
5. d

120,000
120,000

The journal entry would be:

Work in Process
Manufacturing Overhead
7. c

70,000

The journal entry would be:

Finished Goods
Work in Process
6. c

20,000
10,000
40,000

30,000
30,000

Under- or overapplied overhead represents

the difference between actual overhead cost
and applied overhead cost. The computation
in this case would be:
Actual overhead cost ..................... $90,000
Applied overhead cost ................... 92,000
Overapplied overhead cost ............ $(2,000)

8. a

The predetermined overhead rate is $60,000

40,000 hours = $1. 50 per hour.
Actual overhead cost ................. $65,100
Applied overhead cost
($1.50 42,000 hours) .........
63,000
Underapplied overhead cost....... $ 2,100

9. a

10. b

The cost of goods manufactured represents

the costs of goods completed during a
period; thus, it is the amount transferred
from Work in Process to Finished Goods.

11. c

If overhead is overapplied, then more

overhead cost has been added to jobs than
has been incurred. Therefore, too much
overhead cost will have been assigned to
jobs.

The solution would be:

Balance
Direct materials
Direct labor
Overhead applied*
Balance

Work in Process
18,000 190,000
35,000
60,000
90,000
13,000

Finished

*$60,000 150% = $90,000

Exercises
$150,000
$1.50 per DLH
100,000 DLHs

2-1. a.

2-2.
c.
d.

b.

105,000 DLHS $1.50 = $157,500 applied

c.

Actual overhead cost ..........................

Applied overhead cost ........................
Underapplied overhead cost ...............

$160,000
157,500
$ 2,500

The answers to parts (a) and (b) are on the following page.
Overhead is overapplied by $6,000.
PARDOE COMPANY
Income Statement
Sales ...............................................................................
Less cost of goods sold ($540,000 $6,000) ................
Gross margin .................................................................
Less operating expenses:
Advertising expense .............................................
Salaries expense ...................................................
Depreciation expense ...........................................
Other expenses .....................................................
Net Income ....................................................................

$800,000
534,000
266,000
$ 50,000
140,000
5,000
25,000

220,000
$ 46,000

2-2.

a. & b.
Cash
Bal. 12,000 760,000 (14)
(13) 790,000
42,000

Accumulated Depreciation
120,000 Bal.
20,000 (6)
140,000

Accounts Receivable
Bal. 48,000 790,000 (13)
(12a) 800,000
58,000

Manufacturing Overhead
(4) 35,000 165,000 (10)
(5) 75,000
(6) 15,000
(7) 30,000
(9) 4,000
(15) 6,000
6,000

Cost of Goods Sold

(12b) 540,000
6,000 (15)
534,000

Accounts Payable
(14) 300,000
75,000 Bal.
150,000 (1)
50,000 (3)
35,000 (4)
30,000 (7)
25,000 (8)
65,000

Advertising Expense
(3) 50,000

Prepaid insurance
Bal. 8,000
4,000 (9)
4,000
Raw Materials
Bal. 30,000 145,000 (2)
(1) 150,000
35,000
Work in Process
Bal. 40,000 550,000 (11)
(2) 145,000
(5) 250,000
(10) 165,000
50,000
Finished Goods
Bal. 100,000 540,000 (12b)
(11) 550,000
110,000

Salaries and Wages Payable

(14) 460,000
12,000 Bal.
465,000 (5)
17,000

Sales
800,000 (12a)

Salaries Expense
(5) 140,000

Depreciation Expense
(6) 5,000

Other Selling and

Administrative Expenses
(8) 25,000

2-3.

Raw materials inventory, beginning ........................

Add: Purchases of raw materials .............................
Total ..............................................................
Deduct: Raw materials inventory, ending ................
Raw materials used in production ............................

$ 10,000
145,000
155,000
15,000
$140,000

2-4.

Direct materials ........................................................

Direct labor ..............................................................
Manufacturing overhead applied .............................
Total manufacturing cost ...............................
Add: Beginning work in process inventory .............
Deduct: Ending work in process inventory .............
Cost of goods manufactured ....................................

$140,000
240,000
90,000
470,000
60,000
530,000
75,000
$455,000

Finished goods inventory, beginning .......................

Add: Cost of goods manufactured ...........................
Goods available for sale ...........................................
Deduct: Finished goods, ending ..............................
Unadjusted cost of goods sold .................................
Deduct: Overapplied overhead (see below) .............
Adjusted cost of goods sold .....................................

$120,000
455,000
575,000
145,000
430,000
2,000
$428,000

Actual manufacturing overhead cost incurred..........

Applied manufacturing overhead cost .....................
Overapplied overhead cost ......................................

$88,000
90,000
($ 2,000)

2-5.

Chapter 3
Systems Design: Activity-Based Costing

Chapter Study Suggestions

Activity-based costing is an extension of the product costing methods

described in Chapter 2. The only real difference between what you learned in
Chapter 2 and what you will learn in Chapter 3 is the use of more than one
overhead cost pool in activity-based costing. This means that instead of just
one predetermined overhead rate, a number of predetermined overhead rates
are used and each is keyed to a different allocation base. Study Exhibit 3-3
carefully; you must understand it thoroughly to do homework problems.

Chapter 3

CHAPTER HIGHLIGHTS
A. Overhead costs can be applied to products using a
plantwide overhead rate, departmental overhead rates, or
activity-based costing.
1. A plantwide overhead rate includes all the
manufacturing overhead costs in a factory and it is
typically based on direct labor-hours or machine-hours.
Such an overhead rate results in distorted product costs
when overhead costs arent really caused by direct laborhours or machine-hours. This is the method used in
Chapter 2.
2. Departmental overhead rates provide a slightly
more sophisticated approach than the plantwide
overhead rate. Each department has its own
predetermined overhead rate rather than having a single
predetermined overhead rate for the entire factory.
However, the allocation bases are usually still direct
labor-hours or machine-hours. So cost distortion can
occur if overhead costs are caused by factors other than
direct labor-hours or machine-hours. Activity-based
costing attempts to correct distortions in product costs by
allocating costs based on the activities that give rise to
costs.
3. In activity-based costing, each major activity that
causes overhead costs has its own activity cost pool, with
its own allocation base and its own predetermined
overhead rate.
a. An activity is any event or transaction that
causes the incurrence of overhead cost. For example, the
activity of setting up a machine causes setup costs,
which are considered part of overhead. The key concept
in activity-based costing is that products cause activities
that in turn consume resources and the consumption of
these resources causes costs.
b. An activity cost pool in activity-based
costing is an overhead pool containing all of the costs
associated with a particular activity.
c. Activity-based costing involves two stages
of allocation. In the first stage of the allocation process,
costs are assigned to the activity cost pools. This part of
the allocation process is not covered in the text.
c. In the second stage of the allocation process,
the costs in each activity cost pool are assigned to
products according to the amount of activity each
product requires. This is accomplished by computing an
activity rate (i.e., predetermined overhead rate) for each
activity cost pool. For example, the total cost in the
machine setup cost pool might be $150,000 and the total
activity might be 1,000 setups. In that case, the activity
rate would be $150 per setup and if a product requires
two setups, it would be charged $300 for setups.

B. To understand the implications of activity-based

costing, it is helpful to categorize activities into a
hierarchy consisting of unit-level, batch-level, productlevel, and facility-level activities.
a. Unit-level activities are performed each time
a unit is produced. An example would be processing time
on a milling machine.
b. Batch-level activities are performed each
time a batch is handled or processed. An example would
be setup time on a particular machine. Costs in a batchlevel cost pool depend on the number of batches run, but
not on the number of units in a batch.
c. Product-level activities are required to have
a product at all. An example would be maintaining an
up-to-date parts list and instruction manual for the
product. Costs in a product-level cost pool depend on the
number of products or their complexity, but not the
number of batches run or the number of units.
d. Facility-level activities sustain a facilitys
general manufacturing processes. An example would be
grounds maintenance for the factory.
C. Traditional allocation bases such as direct laborhours tend to allocate overhead costs to the highest
volume products simply because they are responsible for
the largest number of direct labor-hours. However, if
overhead costs are actually caused by batch-level or
product-level activities, allocating costs to the highest
volume products will create serious distortions in
product costs.
a. For example, batch-level costs are incurred
irrespective of how many units are in a batch.
Consequently, a batch with many units should be
charged the same amount as a batch with only one unit.
However, allocating the batch-level costs on the basis of
direct labor-hours or machine-hours will result in
inappropriately allocating most of the batch-level costs
to the high-volume product.
b. In general, traditional methods of allocating
overhead costs (including the use of departmental rates)
will distort product costs when products differ in
complexity, volume and how many units are in a batch.
D. Carefully study the example of activity-based
costing in Exhibit 3-3. Activity-based costing is just like
the methods for applying overhead to products as
described in Chapter 2. The only difference is that
activity-based costing uses many overhead cost pools
and rates rather than just one.
1. For each activity cost pool in turn:

a. Compute
the
activity
rate
(i.e.,
predetermined overhead rate) for the activity cost pool
by dividing the estimated overhead for the activity cost
pool by its expected activity.
b. Multiply the activity rate by the activity for
each product. This will determine each products share of
the activity centers overhead.
2. After all of the overhead has been allocated to
products, add all of the overhead together for a product
and then divide by the number of units of the product to
determine the unit overhead cost.
E. The flow of costs through Raw Materials, Work In
Process, and other accounts is basically the same under
activity-based costing as we saw in Chapter 2. The only
difference is that more than one overhead rate is used to
apply overhead to products under activity-based costing.
1. Using raw materials in production results in a
debit to Work in Process and a credit to Raw Materials.
Work in Process
Raw Materials

XXX
XXX

2. When direct labor costs are incurred, the debit is

to Work in Process.
Work in Process
Wages Payable

XXX
XXX

3. Actual manufacturing overhead costs are debited

to Manufacturing Overhead as they are incurred.
Manufacturing Overhead
Accounts Payable, Cash, etc.

XXX
XXX

4. Manufacturing overhead is applied to products

on the bases of the activities they require. If a product
requires three purchase orders and two machine set-ups,
it is charged for those purchase orders and machine setups based on the activity rates for those activity cost
pools. The manufacturing overhead applied is debited to
Work in Process and credited to Manufacturing
Overhead as they are incurred.
Work in Process
Manufacturing Overhead

XXX
XXX

5. At the end of the period, the total actual

manufacturing overhead incurred is compared to the
total manufacturing overhead applied. If the amount
applied exceeds the amount incurred, the overhead is
overapplied. If the amount incurred exceeds the amount
applied, the overhead is underapplied. Appropriate
adjustments are then made to Cost of Goods Sold as
discussed in Chapter 2.

Chapter 3

REVIEW AND SELF TEST

Questions and Exercises
True or False

Multiple Choice

For each of the following statements, enter a T or an

F in the blank to indicate whether the statement is true or
false.

Choose the best answer or response by placing the

identifying letter in the space provided.

___ 1. If direct labor is used as the allocation base

for assigning overhead costs to products and direct labor
does not cause overhead costs, the result will be distorted
product costs.
___ 2. The key concept underlying activity-based
costing is that products cause activities that consume
resources and consumption of resources results in costs.
___ 3. Batch-level activities would include issuing
purchase orders, issuing production orders, and performing machine setups.
___ 4. Maintaining parts inventories is a unit-level
activity.
___ 5. A company will have only one predetermined
overhead rate when activity-based costing is used.
___ 6. There will never be any under or overapplied
overhead when activity-based costing is used.
___ 7. Ordinarily, the unit product costs of highvolume products increase and the unit product costs of
low-volume products decrease when activity-based
costing replaces a traditional overhead costing systems
based on direct labor-hours.

___ 1. Issuing a purchase order is a: a) unit-level

activity; b) batch-level activity; c) product-level activity;
d) facility-level activity.
___ 2. Paying rent on a plant building is a: a) unitlevel activity; b) batch-level activity; c) product-level
activity; d) facility-level activity.
___ 3. Testing the prototype of a new product is a: a)
unit-level activity; b) batch-level activity; c) productlevel activity; d) facility-level activity.
___ 4. A company has two activity cost pools
machine setups and production orders. The total cost in
the machine setup activity cost pool is $200,00 and the
total cost in the production orders cost pool is $80,000.
The estimated activity is 20,000 setups and 5,000
production orders. What is the activity rate for the
machine setup activity cost pool? a) $16 per setup; b)
$10 per setup; c) $56 per setup; d) $14 per setup.
___ 5. A company that provides photocopying
services has an activity-based costing system with three
activity cost poolsmaking photocopies, serving
customers, and setting up machines. The activity rates
are $0.02 per photocopy, $2.15 per customer, and $0.75
per machine-setup. If a customer requires set-ups on two
different machines and makes 200 copies in total, how
much overhead cost would be assigned to the job by the
activity-based costing system? a) $4.00; b) $2.15; c)
$1.50; d) $7.65.

Exercises
3-1.
Listed below are activity cost pools that might be found in a company using activity-based costing. For each
activity, place an X under the proper heading to indicate whether the activity would be unit-level, batch-level, and so
forth.
Unit-Level
Batch-Level
Product-Level
Facility Level
Activity Cost Pool
Activity
Activity
Activity
Activity
a.

Parts inventory management

____

____

____

____

b.

Labor-related

____

____

____

____

c.

Plant occupancy

____

____

____

____

d.

Purchase orders

____

____

____

____

e.

Machine-related

____

____

____

____

f.

General factory

____

____

____

____

g.

Product prototype testing

____

____

____

____

h.

Production orders

____

____

____

____

i.

Product design

____

____

____

____

j.

Machine setup

____

____

____

____

k.

Personnel administration

____

____

____

____

Chapter 3
3-2.
Kozales Company uses activity-based costing to compute unit product costs for external financial reports. The
company manufactures two products, the Regular Model and the Super Model. During the coming year the company
expects to produce 20,000 units of the Regular Model and 5,000 units of the Super Model. Below are listed other
selected data relating to the coming year. Compute the overhead cost per unit for each product by filling in the missing
data in the schedules provided below.
Basic Data
Estimated
Overhead
Costs
$ 80,000
420,000
600,000
900,000
$2,000,000

Activity Cost Pool

(and Activity Measure)
Labor related (direct labor-hours)
Machine setups (number of setups)
Product testing (number of tests)
General factory (machine-hours)
Total cost

Total
10,000
1,400
8,000
45,000

Expected Activity
Regular
8,000
500
6,400
30,000

Super
2,000
900
1,600
15,000

Overhead Rates by Activity Center

Activity Center

(a)
Estimated
Overhead
Costs

(a) (b)
Predetermined
Overhead
Rate

Labor related ......................

$ 80,000

10,000 DLHs

$__________ per __________________

Machine setups....................

$420,000

1,400 setups

$__________ per __________________

Product testing ....................

$600,000

8,000 tests

$__________ per __________________

General factory....................

$900,000

45,000 MHs

$__________ per __________________

(b)
Expected
Activity

Overhead Cost per Unit

Regular Product
Activity
Amount

Super Product
Activity
Amount

Labor related, at __________________

_________

___________

________

___________

Machine setups, at __________________

_________

___________

________

___________

Product testing, at __________________

_________

___________

________

___________

General factory, at __________________

_________

___________

________

___________

_________

___________

________

___________

Number of units produced (b)

_________

___________

________

___________

Overhead cost per unit (a) (b)

_________

___________

________

___________

Total overhead cost assigned (a)

3-3.
Lawson Company uses activity-based costing to compute product costs for external reports. The company has
three activity centers and applies overhead using predetermined overhead rates for each activity center. Data for the
current year are presented below for the three activity centers:
Activity Cost Pools
(and Activity Measures)
Batch setups (setups)...........................
Material handling (loads)....................
General factory (DLHs)......................
Total..................................................
a.

Estimated
Overhead Cost
$ 52,900
100,800
65,000
$218,700

Expected
Activity
2,300
2,800
2,500

Actual
Activity
2,260
2,770
2,440

Determine how much total overhead was applied to products during the year by filling in the missing data in
the schedules that have been provided below.
Estimated
Overhead
Cost

Activity
Cost Pool

Expected
Activity

Predetermined
Overhead Rate

Batch setups......................

$ 52,900

2,300

Material handling..............

$100,800

2,800

General factory..................

$ 65,000

2,500

Actual
Activity

Overhead
Applied

Activity
Cost Pool

Predetermined
Overhead
Rate

Batch setups........................

______

2,260

__________

Material handling................

______

2,770

__________

General factory....................

______

2,440

__________

Total overhead applied ....

b.

Actual manufacturing overhead costs for the year were $216,860. Determine the overapplied or underapplied
overhead by filling in the missing data in the table provided below. (Be sure to clearly label whether the
overhead was overapplied or underapplied.)
Actual manufacturing overhead costs incurred.......................

__________

Manufacturing overhead costs applied...................................

__________

Manufacturing overhead ______applied................................

Answers to Questions and Exercises

True or False
1. T

If overhead is assigned based on direct labor

rather on the bases that actually cause the
overhead, product costs will be distorted.

Multiple Choice
1. b

See Exhibit 3-2.

This is the key concept underlying activitybased costing.

2. d

See Exhibit 3-2.

3. c

See Exhibit 3-2.

3. T

These activities are batch-level since they are

required every time a batch is initiated.

4. b

$200,000 20,000 setups = $10 per setup

4. F

This ordinarily a product-level activity.

5. d

The costs would be assigned as follows:

5. F

Under activity-based costing, a company will

have a predetermined overhead rate for each
activity center.

2. T

6. F

Actual manufacturing overhead will seldom

exactly equal manufacturing overhead applied
even under activity-based costing.

7. F

Ordinarily, activity-based costing shifts costs

from high-volume to low-volume products.

Making photocopies
(200 copies @ $0.02)............
Setting up machines
(2 set-ups @ $0.75)...............
Serving customers
(1 customer @ $2.15)...........
Total cost......................................

$4.00
1.50
2.15
$7.65

Exercises
3-1.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.

Unit-Level
Activity
Activity
Parts inventory management..........
Labor-related.................................. X
Plant occupancy.............................
Purchase orders..............................
Machine-related............................. X
General factory...............................
Product prototype testing...............
Production orders...........................
Product design................................
Machine setup................................
Personnel administration................

Batch-Level
Activity

Product-Level
Activity
X

Facility Level
Activity
X

X
X
X
X
X
X
X

3-2.
Overhead Rates by Activity Center
Estimated
Activity Cost Pool
Labor related ......................
Machine setups....................
Product testing ....................
General factory....................

(a)
(b)
Overhead
Costs
$ 80,000
$420,000
$600,000
$900,000

(a) (b)
Predetermined
Expected
Activity
10,000 DLHs
1,400 setups
8,000 tests
45,000 MHs

Overhead
Rate
$8.00 per DLH
$300.00 per setup
$75.00 per test
$20.00 per MH

Overhead Cost per Unit

Labor related, at $8 per DLH.........................
Machine setups, at $300 per setup.................
Product testing, at $75 per test.......................
General factory, at $20 per MH.....................
Total overhead cost assigned (a)................

Regular Product
Activity
Amount
8,000
$ 64,000
500
150,000
6,400
480,000
30,000
600,000
$1,294,000

Super Product
Activity
Amount
2,000
$ 16,000
900
270,000
1,600
120,000
15,000
300,000
$706,000

Number of units produced (b)........................

20,000

5,000

Overhead cost per unit (a) (b).....................

$64.70

$141.20

3-3.

a.

The first step is to compute the predetermined overhead rate for each activity center:
Activity Overhead
Center
Batch setups......................
Material handling..............
General factory..................

Estimated
Expected
Cost
$ 52,900
$100,800
$ 65,000

Predetermined
Activity
2,300 setups
2,800 loads
2,500 DLHs

Overhead Rate
$23 per setup
$36 per load
$26 per DLH

The amount of overhead applied to production is determined as follows:

Predetermined
Activity
Overhead
Center
Rate
Batch setups...................... $23 per setup
Material handling.............. $36 per load
General factory.................. $26 per DLH
Total overhead applied . .
b.

Actual
Activity
2,260 setups
2,770 loads
2,440 DLHs

Overhead was underapplied by $1,720.

Actual manufacturing overhead costs incurred............
Manufacturing overhead costs applied.........................
Manufacturing overhead underapplied.........................

$216,860
215,140
$ 1,720

Overhead
Applied
$ 51,980
$ 99,720
$ 63,440
$215,140

Chapter 4
Systems Design: Process Costing

Chapter Study Suggestions

The chapter is divided into four main parts. The first part is a comparison
of job-order and process costing. Exhibit 4-1, which outlines the
differences between the two costing methods, is the key item in this part.
The second part gives a perspective of cost flows in a process costing
system. Study Exhibit 4-3 carefully, as well as the journal entries that
follow. The third part deals with a concept known as equivalent units of
production. Pay particular attention to the computations in Exhibits 4-5
and 4-6.
The fourth part illustrates preparing a production report using the
weighted-average method. The production report is complex and you will
need to devote a large portion of your time to learning how it is
constructed. Exhibit 4-9 provides a detailed example of a production
report.

Chapter 4

CHAPTER HIGHLIGHTS
A. Process costing is used in industries that produce
homogeneous products such as bricks, flour, and
cement. It is also used in assembly-type operations, as
well as in utilities producing gas, water, and electricity.
B. Process costing is similar to job-order costing in
three ways:
1. Both systems have the same basic purposes,
which are to assign material, labor, and overhead costs
to products and to provide a mechanism for computing
unit costs.
2. Both systems use the same basic
manufacturing accounts: Manufacturing Overhead,
Raw Materials, Work in Process, and Finished Goods.
3. Costs flow through these accounts in basically
the same way in both systems.
C. Process costing differs from job-order costing in
four ways:
1. A single product is produced on a continuous
basis, and each unit is essentially the same.
2. Costs are accumulated by department, rather
than by job.
3. The department production report (rather than
the job cost sheet) is the key document showing the
accumulation and disposition of cost.
4. Unit costs are computed by department (rather
than by job). This computation is made on the
department production report.

G. Once costs have been totaled for a department, the

departments output must be determined so that unit
costs can be computed. Units that have only been
partially completed pose a problem. A unit that is only
10% complete should not count as much as a unit that
has been completed and transferred on to the next
department.
1. Equivalent units are the number of whole,
complete units one could obtain from the materials and
effort contained in completed and partially completed
units. Equivalent units are computed using the
following formula:

Number of
Equivalent
Percentage
partially completed
units
completion
units
2. The equivalent units of production is used to
compute the cost per equivalent unit. Under the
weighted-average method discussed in the chapter, the
equivalent units of production are determined as
follows:
Units completed and transferred out
+ Equivalent units of ending inventory
= Equivalent units of production

XXX
XXX
XXX

H. A separate cost per equivalent unit figure is

computed within each processing department for each
cost category. The cost categories may include:
1. Costs of prior departments associated with
units transferred into the department.
2. Materials costs added in the department.

D. A processing department is any work center

where work is performed on a product and where
materials, labor, or overhead costs are added.
Processing departments have two common features.
First, the activity carried out in the department is
performed uniformly on all units passing through it.
And second, the output of the department is basically
homogeneous.

4. Manufacturing overhead costs applied to the

department.

E. Less effort is usually required to use a process

costing system than a job-order costing system; costs
only need to be traced to a few processing departments
rather than to many individual jobs.

I. Note the following points concerning process

costing.

F. Exhibit 4-3 provides a T-account model of cost

flows in a process costing system. A separate work in
process account is maintained for each processing
department. Materials, labor, and overhead costs are
entered directly into each processing departments
work in process account.

3. Direct labor costs added in the department.

In process costing, direct labor costs and

manufacturing overhead costs are often combined into
one cost category called conversion costs.

1. A separate equivalent units of production

figure and a separate cost per equivalent unit must be
computed for each cost category.
2. Units transferred out of the department to the
next departmentor, in the case of the last
department, to finished goodsare considered to be
100% complete with respect to the work done by the
transferring department.

Chapter 4
3. The first processing department will not have
a cost category for the costs of units transferred in, but
subsequent departments will have such a cost category.
Units in process in a department are considered to be
100% complete with respect to the costs of the prior
department.
J. The purpose of the production report is to
summarize all of the activity that takes place in a
departments work in process account for a period. A
production report has three parts:
1. A quantity schedule, which shows the flow of
units through the department, and the computation of
equivalent units for each cost category for the period.
2. A statement showing computation of the cost
per equivalent unit for each cost category for the
period.
3. A reconciliation of all cost flows into and out
of the department during the period.
It would be a good idea to refer to Exhibit 4-9 as you
go through the explanation of the production report
below.
K. The purpose of the quantity schedule on the
production report is to show the flow of units through
a department. The schedule shows the number of units
to be accounted for in a department and it shows how
those units have been accounted for.
1. The format of the quantity schedule under the
weighted-average method is:
Units to be accounted for:
Work in process, beginning
Started into production
Total units

XXX
XXX
XXX

Units accounted for as follows:

Transferred out to the next
department or to finished goods
Work in process, ending
Total units

XXX
XXX
XXX

2. The equivalent units for the units transferred

out and for the ending work in process inventory are
listed next to the quantity schedule on the production
report.
L. The second step in preparing a production report
is to compute the cost per equivalent unit for each cost
category. Under the weighted-average method, this
involves summing the costs from the beginning
inventory with any costs added during the period to
arrive at total cost. This figure is then divided by the
equivalent units of production for the cost category to
determine the cost per equivalent unit.
M. The final step in a production report is to prepare
a reconciliation of all costs. Costs are accounted for as
either transferred out during the period or assigned to
the ending work in process inventory. Costs are
determined as follows:
1. Units transferred out. These units are
presumed to be 100% complete. (If they were not
complete with respect to the work done in the
department, they would not be transferred out.) The
costs of units transferred out are computed by
multiplying the number of units transferred out by the
cost per equivalent unit for each cost category. These
costs are then summed.
2. Units in ending work in process inventory.
Within each cost category, the number of equivalent
units is multiplied by the cost per equivalent unit for
that cost category. These costs are then summed.
N. Study Exhibit 4-9 carefully; it shows how the
weighted-average method works. Note that this
method combines costs from the beginning inventory
with costs from the current period. It is called the
weighted-average method because it averages together
costs from the prior period with costs of the current
period.

Chapter 4

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.
___ 1. A utility such as a water company would
typically use a process costing system.
___ 2. Under process costing it is important to
identify the materials, labor, and overhead costs
associated with a particular customers order just as
under job-order costing.
___ 3. In a process costing system, the production
report replaces the job cost sheet.
___ 4. Costing is more difficult in a process
costing system than in a job-order costing system.
___ 5. In a process costing system, a work in
process account is maintained for each processing
department.
___ 6. Since costs are accumulated by department
in a process costing system, there is no need for a
finished goods inventory account.
___ 7. In process costing, costs incurred in a
department are not transferred to the next department.
___ 8. If beginning work in process inventory
contains 500 units that are 60% complete, then the
inventory contains 300 equivalent units.

Multiple Choice
Choose the best answer or response by placing the
identifying letter in the space provided.
___
l. The mixing department of Deerdon
Company started 4,800 units into process during the
month. Five hundred units were in the beginning
inventory and 300 units were in the ending inventory.
How many units were completed and transferred out
during the month? a) 5,000; b) 4,600; c) 5,300; d)
5,100.
___ 2. Last month the welding department of
Eager Company started 8,000 units into production.

The department had 2,000 units in process at the

beginning of the month that were 60% complete with
respect to conversion costs, and 3,000 units in process
at the end of the month that were 30% complete with
respect to conversion costs. A total of 7,000 units were
completed and transferred to the next department
during the month. Using the weighted-average
method, the equivalent units of production for
conversion costs for the month would be: a) 7,900; b)
8,500; c) 9,200; d) 9,500.
___ 3. At the beginning of the month, 200 units
were in process in the stamping department of Farwest
Industrials Inc. and they were 70% complete with
respect to materials. During the month 2,000 units
were transferred to the next department. At the end of
the month, 100 units were still in process and they
were 60% complete with respect to materials. The
materials cost in the beginning work in process
inventory was $2,721 and $39,200 of materials costs
were added during the month. Using the weightedaverage method, what is the cost per equivalent unit
for materials costs? a) $19.06; b) $20.35; c) $20.42; d)
$19.60.
___ 4. The weaving department of Dolly
Company had $8,000 of conversion cost in its
beginning work in process inventory and added
$64,000 of conversion cost during the month. The
department completed 37,000 units during the month
and had 10,000 units in the ending work in process
inventory that were 30% complete as to conversion
cost. Using the weighted-average method, the amount
of cost assigned to the units in ending inventory would
be: a) $12,600; b) $4,800; c) $11,200; d) $5,400.
___ 5. The heat treatment department at Northern
Pipe is the third department in a sequential process.
The work in process account for the department would
consist of: a) costs transferred in from the prior
department; b) materials costs added in the heat
treatment department; c) conversion costs added in the
heat treatment department; d) all of the above.

Chapter 4
Exercises
4-1.
Diebold Company has a process costing system. Data relating to activities in the Mixing Department for
March follow:

Work in process, March 1

Units started into production
Work in process, March 31

Units
5,000
80,000
2,000

Percent Completed
Materials
Conversion
100%
60%
100%

50%

All materials are added at the start of processing in the Mixing Department.
Using the weighted-average method, fill in the following quantity schedule and a computation of equivalent
units for the month:
Quantity
Schedule
Units to be accounted for:
Work in process, beginning (all materials;
______% conversion cost added last month)
Started into production
Total units
Equivalent Units
Materials
Conversion
Units accounted for as follows:
Transferred out during the month
Work in process, ending (all materials;
______% conversion cost added this month)
Total units

Chapter 4
4-2.
Minden Company uses the weighted-average method in its process costing system. Complete the cost
reconciliation section of the production report below for the Welding Department, the first processing department
in the company.
Production Report, Welding Department
Quantity schedule and equivalent units
Quantity
Schedule

Units to be accounted for:

Work in process, beginning (all materials,
20% labor and overhead added
last month)
Started into production
Total units

5,000
75,000
80,000

Units accounted for as follows:

Transferred out
Work in process, ending (all materials,
75% labor and overhead added
this month)
Total units and equivalent
units of production

Equivalent Units
Labor
Overhead
72,000
72,000

72,000

Materials
72,000

8,000

8,000

6,000

6,000

80,000

80,000

78,000

78,000

Materials

Labor

Costs per equivalent unit

Total
Cost
Cost to be accounted for:
Work in process, beginning
Cost added by the department
Total cost (a)
Equivalent units of production(b)
Cost per equivalent unit (a)(b)
$6.00

9,500
460,500
$470,000

$ 4,500
75,500
$ 80,000
80,000
$1.00

3,000
231,000
$234,000
78,000
+ $3.00

Whole
Overhead Unit
$

2,000
154,000
$156,000
78,000
+ $2.00

Cost reconciliation
Materials
Cost accounted for as follows:
Transferred out
Work in process, ending:
Materials
Labor
Overhead
Total work in process, ending
Total cost $

470,000

Equivalent Units
Labor
Overhead

Answers to Questions and Exercises

True or False
1. T

2. F

Process costing is widely used by utilities

since their output (water, gas, electricity) is
homogeneous.
Since units are indistinguishable from each
other, there is no need to identify costs by
customer order.

3. T

See the discussion in Exhibit 4-1.

4. F

Costing is usually easier in a process costing

system since material and labor costs do not
have to be traced to individual jobs.

5. T

In a process costing system a work in

process inventory account is maintained for
each department. There is also a production
report for each department.

6. F

A finished goods inventory account is

needed in a process costing system for
unsold finished units, just as in a job-order
costing system.

7. F

As units move from one department to

another, the costs that have been incurred to
that point are transferred forward with the
units.

8. T

3. b

Beginning inventory
Add: Units started into process
Total units
Less ending inventory
Completed and transferred

Units completed and transferred

Work in process, ending:
3,000 units 30%
Equivalent units of production
Cost in beginning work
in process
Cost added during the month
Total cost (a)
Units transferred out
Equivalent units in ending
work in process inventory
(100 60%)
Equivalent units (b)
Cost per EU (a) (b)

4. d

Cost in beginning work

in process
Cost added during the year
Total cost (a)
Units transferred out
Equivalent units in ending
work in process inventory
(10,000 30%)
Equivalent units (b)
Cost per EU (a) (b)

500 units 60% = 300 equivalent units.

7,000
900
7,900
$ 2,721
39,200
$41,921
2,000
60
2,060
$20.35
$ 8,000
64,000
$72,000
37,000
3,000
40,000
$1.80

3,000 units $1.80 = $5,400.

5. d

Multiple Choice
1. a

2. a.

500
4,800
5,300
300
5,000

Costs in the departments work in process

inventory account include costs transferred
in from the previous department and any
costs added in the department itself
including materials, labor, and overhead.
Labor and overhead together equal
conversion cost.

Exercises
4-1.

Quantity
Schedule

Units to be accounted for:

Work in process, beginning (all materials; 60%
conversion cost added last month)
Started into production
Total units

5,000
80,000
85,000
Equivalent Units
Materials
Conversion

Units accounted for as follows:

Transferred out during the month
Work in process, ending (all materials;
50% conversion cost added this month)
Total units
4-2.
Cost accounted for as follows:
Transferred out: (72,000 units $6)
Work in process, ending:
Materials cost ($ 1 per EU)
Labor cost ($3 per EU)
Overhead cost ($2 per EU)
Total work in process, ending
Total cost

Total
Cost

83,000

83,000

83,000

2,000
85,000

2,000
85,000

1,000
84,000

Materials

$432,000

72,000

8,000
18,000
12,000
38,000
$470,000

8 ,000

Equivalent Units ________

Labor
Overhead
72,000

72,000

6,000
6,000

Chapter 5
Cost Behavior: Analysis and Use

Chapter Study Suggestions

Chapter 5 expands on the discussion of fixed and variable costs that was
started in Chapter 1. In addition, the chapter introduces a new cost
conceptmixed costsand shows how mixed costs can be broken down
into their basic fixed and variable elements. Focus the bulk of your study
time on the section titled The Analysis of Mixed Costs. Pay particular
attention to how a cost formula is derived and how a cost formula is used
to predict future costs at various levels.
Memorize the elements of the equation Y = a + bX. You need to
understand this equation to complete most of the homework exercises
and problems. At the end of the chapter, a new format for the income
statement is introduced that emphasizes cost behavior. Exhibit 5-11
illustrates the format of the contribution income statement. This format
should be memorizedyou will be using it throughout the rest of the
book.

Chapter 5

CHAPTER HIGHLIGHTS
A. A variable cost is a cost that varies, in total, in
proportion to changes in the level of activity. Variable
costs are constant on a per unit basis.
1. Activity is usually measured in terms of the
volume of goods produced or services provided by the
organization. However, other measures of activity may
be used for specific purposes such as patients admitted
to a hospital, number of machinery setups performed,
number of sales calls made, and so on.
2. A variable cost is shown graphically in Exhibit
5-1. Note that a variable cost is a straight line that goes
through zero (i.e., the origin) on the graph and slopes
upward to the right.
B. A fixed cost is a cost that remains constant in total
within the relevant range. Fixed cost per unit varies
inversely with changes in activity. As activity
increases, per unit fixed costs fall.
1. Fixed costs can generally be classified into
committed and discretionary fixed costs.
a. Committed fixed costs relate to
investments in facilities, equipment, and the basic
organization of a firm. These costs are difficult to
adjust.
b. Discretionary fixed costs result from
annual decisions by management to spend in certain
areas, such as advertising, research, and management
development programs. These costs are easier to
modify than committed fixed costs.
2. If there is a big enough change in activity,
even committed fixed costs may change. Exhibit 5-6
illustrates this idea. However, within the band of
activity known as the relevant range, total fixed cost is
constant.
C. A mixed cost (or semivariable cost) is a cost that
contains both variable and fixed cost elements. Exhibit
5-7 illustrates a mixed cost.
1. Examples of mixed costs include electricity,
costs of processing bills, costs of admitting patients to
a hospital, and maintenance.
2. The fixed portion of a mixed cost represents
the cost of providing capacity. The variable portion
represents the additional cost of using the capacity.
3. Several methods are available for breaking a
mixed cost down into its basic variable and fixed cost
elements using past records of cost and activity. These
methods are the high-low method, the scattergraph
method, and the least-squares regression method.

D. The relevant range and curvilinear costs.

1. For simplicity, a strict linear relation between
cost and volume is usually assumed. However, many
cost relationships are curvilinear, such as illustrated in
Exhibit 5-4.
2. The managers straight-line assumption is
reasonable since a straight line can approximate any
small portion of a curvilinear cost. The relevant range
is the range of activity within which a particular
straight line is a valid approximation to the curvilinear
cost.
E. Cost formula for a mixed cost.
1. The fixed and variable cost elements of a
mixed cost can be expressed in a cost formula, which
can be used to predict costs at all levels of activity
within the relevant range. This formula is expressed as
follows:
Y= a + bX
where:
Y = dependent variable (the total mixed cost)
a = vertical intercept (the total fixed cost)
b = slope of the line (the variable rate)
X = independent variable (the activity level)
2. Each of the methods discussed below can be
used to estimate the variable cost per unit (b) and the
total fixed cost (a). Then with the use of the cost
formula, the expected amount of total cost (Y) can be
computed for any expected activity level (X) within
the relevant range.
F. The high-low method bases its estimates of the
variable and fixed elements of a mixed cost on data at
the highest and lowest levels of activity.
1. The high-low method uses a variation of the
rise over run formula for the slope of a straight line.
The difference in cost observed between the two
extremes is divided by the change in activity to
estimate the amount of variable cost. The formula is:
Change in cost
Variable cost

per unit of activity Change in activity

2. The estimated variable cost per unit of activity

(i.e., variable rate) is then used to estimate the fixed
cost as follows:
Total cost at the high activity level ..............
Less variable portion:
Variable rate high activity level...........
Fixed portion of the mixed cost .............

$XXX
XXX
$ XXX

3. The high-low method is quick, but is not

reliable. It is based on costs and activity for only two
periodsthe periods with the highest and lowest
levels of activity. Other data are ignored and these two
periods tend to be unusual and may not be
representative of typical cost behavior.
G. In the scattergraph method, costs at various levels
of activity are plotted on a graph. A regression line is
then fitted to the plotted points using a ruler. This
requires judgment since there are no precise rules
concerning how to draw the line.
1. The slope of the regression line is the
estimated variable cost per unit of activity. The vertical
intercept is the estimated total fixed cost.
2. The scattergraph method is usually better than
the high-low method, since all the observed data
points can be taken into account when the straight line
is drawn. In contrast, the high-low method relies
entirely on just two data points.
3. However, the high-low method is subjective
and relatively imprecise.
H. The least-squares regression method fits a
regression line to past cost and activity data by means
of a formula. The formula results in straight line that
minimizes the sum of the squared errors from the
regression line. The computations are beyond the
scope of this book and are covered in more advanced
texts.
I. The contribution approach to preparation of an
income statement emphasizes cost behavior.
1. The traditional format for income statements
emphasizes the purposes for which costs are incurred
and groups expenses into functional categories:
Sales .........................................................
Less: Cost of Goods Sold ........................
Gross Margin ...........................................
Less: Admin. and Selling Expense ..........
Net Income ..............................................

$XXX
XXX
XXX
XXX
$XXX

2. The contribution approach, in contrast, groups

expenses according to their cost behavior.
Sales .........................................................
Less: Variable Expenses ..........................
Contribution Margin ................................
Less: Fixed Expenses ..............................
Net Income ..............................................

$XXX
XXX
XXX
XXX
$XXX

3. Note that the contribution margin is

determined by deducting variable expenses from sales.
4. The contribution approach is very useful to
managers for internal reports since it emphasizes the
behavior of costs. As you will see in later chapters,

this is very important in planning, budgeting,

controlling operations, and in performance evaluation.
However, in external reports the traditional format that
emphasizes cost by function must be used.

REVIEW AND SELF TEST

Questions and Exercises
True or False

Multiple Choice

Enter a T or an F in the blank to indicate whether the

statement is true or false.

Choose the best answer or response by placing the

identifying letter in the space provided.

___ 1. Variable costs are costs that change, in

total, in proportion to changes in the activity level.

___ 1. A companys cost formula for maintenance

is Y = $4,000 + $3X, where X is machine hours.
During a period in which 2,000 machine hours are
worked, the expected maintenance cost would be: a)
$12,000; b) $6,000; c) $10,000; d) $4,000.

___ 2. In cost analysis work, activity is known as

the dependent variable.
___ 3. Within the relevant range, the higher the
activity level, the lower the fixed cost per unit.
___ 4. Contribution margin and gross margin are
synonymous terms.
___ 5. Contribution margin is the difference
between sales and variable expenses.
___ 6. Discretionary fixed costs arise from annual
decisions by management to spend in certain areas.
___

7. Advertising is a committed fixed cost.

___ 8. A mixed cost is a cost that contains both

manufacturing and non-manufacturing costs.
___ 9. Within the relevant range, the relation
between cost and activity is approximately a straight
line.
___ 10. In order for a cost to be variable, it must
vary with either units produced or services provided.
___ 11. A cost formula produced by the high-low
method and a cost formula produced by the
scattergraph method would be the same except for
rounding error.
___ 12. The contribution approach to the income
statement organizes costs according to behavior, rather
than according to function.

___ 2. The costs associated with a companys

basic facilities, equipment, and organization are
known as: a) committed fixed costs; b) discretionary
fixed costs; c) mixed costs; d) variable costs.
___ 3. Last year, Barker Companys sales were
$240,000, its fixed costs were $50,000, and its
variable costs were $2 per unit. During the year,
80,000 units were sold. The contribution margin was:
a) $200,000; b) $240,000; c) $30,000; d) $80,000.
___ 4. An example of a discretionary fixed cost
would be: a) depreciation on equipment; b) rent on a
factory building; c) salaries of top management; d)
items a, b, and c are all discretionary fixed costs; e)
none of the above.
___ 5. In March, Espresso Express had electrical
costs of $225.00 when the total volume was 4,500
cups of coffee served. In April, electrical costs were
$227.50 for 4,750 cups of coffee. Using the high-low
method, what is the estimated fixed cost of electricity
per month? a) $200; b) $180; c) $225; d) $150.

Exercises
5-1.

Data concerning the electrical costs at Doughboy Company follow:

Week 1................
Week 2................
Week 3................
Week 4................
a.

Machine
hours
6,800 hrs.
6,000 hrs.
5,400 hrs.
7,900 hrs.

Electrical
cost
$1,770
1,650
1,560
1,935

Using the high-low method of cost analysis, what is the variable rate per machine hour?
Cost

Machine
Hours

High activity level ...........................................................

Low activity level ...........................................................
Change .........................................................................
Change in cost
__________________________
=
= $______________per machine hour
Change in activity
__________________________
b.

Using the high-low method of cost analysis, what is the total fixed cost?
Total cost at the high activity level....................................................
Less variable cost element:
__________________________________________......................
Fixed cost element ............................................................................

c.

Express the cost formula for electrical costs in the form Y = a + bX:

____________

5-2.
During July, Cramers, Inc., a wholesale distributor of a unique software product, sold 500 units. The
companys income statement for the month follows:
CRAMERS, INC.
Income Statement
For the Month Ended July 31
Sales ($100 per unit) ............................................
Less cost of goods sold ($60 per unit) .................
Gross margin ........................................................
Less operating expenses:
Commissions ($6 per unit) .................................
Salaries ...............................................................
Advertising .........................................................
Shipping ($2 per unit) ........................................
Net income ...........................................................

$50,000
30,000
20,000
$3,000
8,000
6,000
1,000

18,000
$ 2,000

Redo the companys income statement for the month in the contribution format. Assume that cost of goods sold,
commissions, and shipping expenses are variable costs and salaries and advertising expenses are fixed costs.
CRAMERS, INC.
Income Statement
For the Month Ended July 31
Sales .........................................................................

$___________

Less __________________________ :
__________________________.........................

$___________

__________________________.........................

___________

__________________________.........................

___________

Contribution margin .................................................

___________
___________

Less __________________________ :
__________________________.........................

___________

__________________________.........................

___________

Net income ...............................................................

___________
$

Answers to Questions and Exercises

True or False
1. T

This is the definition of a variable cost.

2. F

Activity is the independent variable.

3. T

Fixed costs vary inversely with changes in

activity when expressed on a per unit basis.

4. F

Contribution margin is sales less variable

expenses; gross margin is sales less cost of
goods sold.

5. T

This is true by definition.

6. T
7. F

Multiple Choice
1. c

Fixed cost ...................................... $ 4,000

Variable cost: $3 2,000 hours ....
6,000
Total cost ....................................... $10,000

2. a

Committed fixed costs relate to basic

facilities, equipment, and organization.

3. d

Sales .............................................. $240,000

Less variable costs:
$2 80,000 units ........................ 160,000
Contribution margin ...................... $ 80,000

Discretionary fixed costs are re-evaluated

each year by management.

4. e

All of the listed costs are generally

considered to be committed fixed costs.

Advertising is a discretionary fixed cost

since the advertising program is typically reevaluated on an annual basis.

5. b

8. F

Mixed costs contain both variable and fixed

cost elements.

9. T

By definition, a straight line is a reasonable

approximation to the real cost behavior
within a relevant range.

10. F

There can be many measures of activity

besides units produced and units sold. Other
measures include miles driven, number of
occupied beds in a hospital, and number of
flight hours.

11. F

The two methods are different and will

produce the same results only if the
regression line is drawn through the high
and low points when the scattergraph
method is used.

12. T

The contribution approach groups variable

costs together and fixed costs together; thus,
the income statement is organized according
to cost behavior.

High activity level ........

Low activity level .........
Change ........................

Cost
$227.50
225.00
$ 2.50

Cups
4,750
4,500
250

Change in cost
$2.50

$0.01 per cup

Change in activity
250

Total cost at the high activity......... $227.50

Less variable cost element:
4,750 cups $0.01 per cup .........
47.50
Fixed cost element......................... $180.00

Exercises
5-1.

a.

Variable cost per machine-hour:

Cost
High activity level .................................. $1,935
Low activity level .................................. 1,560
Change ................................................. $ 375

Machine
Hours
7,900
5,400
2,500

Change in cost
$375

$0.15 per machine hour

Change in activity
2,500 hours

b.

Total fixed cost:

Total cost at the high activity level...............................
Less variable cost element:
7,900 hours $0.15 per hour ....................................
Fixed cost element .......................................................

c.

$1,935
1,185
$ 750

Cost formula for electrical costs: $750 per period, plus $0.15 per machine hour, or
Y= $750 + $0.15X

5-2.
CRAMERS, INC.
Income Statement
For the Month Ended July 31
Sales ($100 per unit) ............................................
Less variable expenses:
Cost of goods sold ($60 per unit) ....................
Commissions ($6 per unit) ..............................
Shipping ($2 per unit) .....................................
Contribution margin .............................................
Less fixed expenses:
Salaries ............................................................
Advertising ......................................................
Net income ...........................................................

$50,000
$30,000
3,000
1,000
8,000
6,000

34,000
16,000
14,000
$ 2,000

Chapter 6
Cost-Volume-Profit Relationships

Chapter Study Suggestions

Chapter 6 is one of the key chapters in the book. Many of the chapters
ahead depend on concepts developed here. You should study several
sections in the chapter with particular attention. The first of these is the
section titled, Contribution Margin. Note how changes in the
contribution margin affect net income. The next section to be studied
with particular care is titled Contribution Margin Ratio. The
contribution margin ratio is used in much of the analytical work in the
chapter.
Another section to be given particular attention is titled Some
Applications of CVP Concepts. Much of the homework material is
drawn from this section. The section titled Break-Even Analysis also
forms the basis for much of the homework material. You should
memorize the break-even formulas in this section. Finally, the section
titled The Concept of Sales Mix shows how to use CVP analysis when
there is more than one product.
When studying the material in the chapter, try especially hard to
understand the logic behind the solutions.

Chapter 6

CHAPTER HIGHLIGHTS
A. The contribution margin is a key concept that will
be used throughout the chapter and in subsequent
chapters.

B. The contribution margin ratio (CM ratio), which

expresses the contribution margin as a percentage of
sales, is another very powerful concept.

1. The contribution margin is defined as the

difference between total sales and total variable
expenses:

1. The contribution
computed in two ways:

Sales .....................................................
Less variable expenses .........................
Contribution margin .............................

XXX
XXX
XXX

2. The unit contribution margin is defined as the

difference between the unit selling price and the unit
variable expenses:
Selling price per unit ............................
Less variable expenses per unit ............
Unit contribution margin ......................

XXX
XXX
XXX

3. The relation between the contribution margin

and the unit contribution margin is simple. The
contribution margin is equal to the unit contribution
margin multiplied by the number of units sold:
Unit contribution margin ......................
Unit sales ...........................................
Contribution margin .............................

XXX
XXX
XXX

The term total contribution margin is also

commonly used to refer to the contribution margin.
4. Net income is equal to the contribution margin
less fixed expenses.
Sales .....................................................
Less variable expenses .........................
Contribution margin .............................
Less fixed expenses ..............................
Net income ...........................................

XXX
XXX
XXX
XXX
XXX

5. The break-even point is the sales at which

profits are zero and the total contribution margin just
equals fixed expenses.
6. The relation between contribution margin and
net income provides a very powerful planning tool. It
gives the manager the ability to predict what profits
will be at various activity levels without the necessity
of preparing detailed income statements.
a. The contribution margin must first cover
fixed expenses. If it doesnt, there is a loss. Below the
break-even point, every unit sold reduces the loss by
the amount of the unit contribution margin.
b. Once the break-even point is reached, net
income will increase by the amount of the unit
contribution margin for each additional unit sold.

CM ratio =

CM ratio =

margin

ratio

can

be

Contribution margin
Sales

Unit contribution margin

Unit selling price

2. The contribution margin ratio is used to

predict the change in total contribution margin that
would result from a given change in dollar sales:
Change in dollar sales ..........................
CM ratio ............................................
Change in contribution margin .............

XXX
XXX
XXX

3. If fixed expenses do not change, any increase

(or decrease) in contribution margin will be reflected
dollar-for-dollar in increased (or decreased) net
income.
4. The CM ratio is particularly useful when a
company has multiple products since the CM ratio is
expressed in terms of total dollar sales, which provides
a useful common denominator in which all of the
products volumes can be measured.
C. Cost-volume-profit (CVP) concepts can be used
in many day-to-day decisions. Carefully study the
examples given under the heading Some Applications
of CVP Concepts in the early part of the chapter.
1. Notice that each solution makes use of either
the unit contribution margin or the CM ratio. This
underscores the importance of these two concepts.
2. Also notice that several of the examples
employ incremental analysis. An incremental analysis
is based only on costs and revenues that differ between
alternatives.
D. Two particular examples of CVP analysis, called
break-even analysis and target profit analysis, are
often used by managers. Break-even analysis is a
special case of target profit analysis, so target profit
analysis will be considered first.
1. Target profit analysis is used when a manager
would like to know how much the company would
have to sell to attain a specific target profit. The
analysis is based on the following equation:

Chapter 7
Profits = Sales Variable expenses
Fixed expenses

Margin of safety
Margin of safety

percentage
Total budgeted (or actual) sales

In CVP analysis, this equation is often rewritten in the

following format:
Sales = Variable expenses + Fixed expenses + Profits
All of the problems can be worked using this basic
equation and simple algebra. However, handy
formulas are available for answering some of the more
common questions. These formulas are discussed
below.
2. Target profit analysis is used in two basic
variations. In the first variation, the manager would
like to know how many units would have to be sold to
attain the target profit. In the second variation, the
manager would like to know how much total dollar
sales would have to be to attain the target profit. The
formulas are:

H. A companys cost structurethe relative

proportion of fixed and variable costs has an impact
on how sensitive the companys profits are to changes
in sales. A company with low fixed costs and high
variable costs will tend to have a lower CM ratio than
a company with a greater proportion of fixed costs.
Such a company will tend to have less volatile profits,
but at the risk of losing substantial profits if sales trend
sharply upward.
I. Operating leverage refers to the effect a given
percentage increase in sales will have on net income.
1. The degree of operating leverage is defined as
follows:

Degree of operating Contribution margin

leverage
Net income

Fixed expenses + Target profit

Units sold to

attain target profit

Unit contribution margin

2. A given percentage in sales is multiplied by

the degree of operating leverage to estimate the
resulting percentage change in net income.
Dollar sales to Fixed expenses + Target profit
attain target profit
Percentage change in dollar sales ......... XXX
CM ratio
Degree of operating leverage ............ XXX
E. Break-even occurs when profit is zero. Thus,
Percentage change in net income ......... XXX
break-even analysis is really just a special case of
3. The degree of operating leverage is not
target profit analysis in which the target profit is zero.
constant. It changes as sales increase or decrease. In
Therefore, the break-even formulas can be stated as
general, the degree of operating leverage decreases
follows:
the further a company moves away from its break-even
Fixed expenses
Breakeven point
point.
in units sold

Unit contribution margin

Fixed expenses
Breakeven point

in total sales dollars

CM ratio
F. CVP and break-even analysis can also be done
graphically. Exhibits 6-1 and 6-2 show how a CVP
graph is prepared and interpreted. A cost-volumeprofit graph shows the relations among sales, costs,
and volume throughout wide ranges of activity.
G. The margin of safety is the excess of budgeted (or
actual) sales over the break-even volume of sales. It is
the amount by which sales can drop before losses
begin to be incurred. The margin of safety can be
stated in terms of either dollars or as a percentage of
sales:
Total budgeted (or actual) sales ............
Less break-even sales ...........................
Margin of safety ...................................

XXX
XXX
XXX

J. When a company has more than one product, the

sales mix can be crucial. The sales mix is the relative
proportions in which the companys products are sold.
1. When CVP analysis involves more than one
product, the analysis is normally based on the overall
contribution margin ratio. This is computed exactly
like the CM ratio is computed in a single product
company except that overall figures are used for both
the contribution margin and sales:

Overall CM ratio =

Overall contribution margin

Overall sales

2. When there is more than one product, the

overall CM ratio is used in the target profit and breakeven formulas instead of the CM ratio.
3. As the sales mix changes the overall CM ratio
will also change. If the shift is toward the less
profitable products, then the overall CM ratio will fall;
if the shift is toward the more profitable products, then
the overall CM ratio will rise.

Chapter 6
K. CVP analysis ordinarily relies on the following
assumptions:

cost per unit is constant and the total fixed cost is

constant.

1. The selling price is constant; it does not

change as unit sales change.

3. In multi-product situations, the sales mix is

constant.

2. Costs are linear. Costs can be accurately

divided into variable and fixed elements. The variable

4. In manufacturing companies, inventories do

not change.

Chapter 7

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.
___ 1. If product A has a higher unit contribution
margin than product B, then product A will also have a
higher CM ratio than product B.
___ 2. The break-even point occurs where the
contribution margin is equal to total variable expenses.
___ 3. The break-even point can be expressed
either in terms of units sold or in terms of total sales
dollars.
___ 4. If the sales mix changes, the break-even
point may change.
___ 5. For a given increase in sales dollars, a high
CM ratio will result in a greater increase in profits than
will a low CM ratio.
___ 6. If sales increase by 8%, and the degree of
operating leverage is 4, then profits can be expected to
increase by 12%.
___ 7. The degree of operating leverage remains
the same at all levels of sales.
___ 8. Once the break-even point has been
reached, net income will increase by the unit
contribution margin for each additional unit sold.
___ 9. A shift in sales mix toward less profitable
products will cause the overall break-even point to
fall.
___ 10. Incremental analysis focuses on the
differences in costs and revenues between alternatives.
___ 11. If a companys cost structure shifts toward
greater fixed costs and lower variable costs, one would
expect the companys CM ratio to fall.
___ 12. One way to compute the break-even point
is to divide total sales by the CM ratio.
___ 13. When there is more than one product, a key
assumption in break-even analysis is that the sales mix
will not change.

unit. The companys fixed expenses are $200,000 per

month. What is the companys unit contribution
margin? a) $50; b) $30; c) $20; d) $80.
___ 2. Refer to the data for Lester Company in
question 1 above. What is the companys contribution
margin ratio? a) 0.60; b) 0.40; c) 1.67; d) 20.00.
___ 3. Refer to the data for Lester Company in
question 1 above. What is the companys break-even
in sales dollars? a) $500,000; b) $33,333; c) $200,000;
d) $400,000.
___ 4. Refer to the data for Lester Company in
question 1 above. How many units would the company
have to sell to attain target profits of $50,000? a)
10,000; b) 12,500; c) 15,000; d) 13,333.
___ 5. The following figures are taken from
Parker Companys income statement: Net income,
$30,000; Fixed costs, $90,000; Sales, $200,000; and
CM ratio, 60%. The companys margin of safety in
dollars is: a) $150,000; b) $30,000; c) $50,000; d)
$80,000.
___ 6. Refer to the data in question for Parker
Company in 5 above. The margin of safety in
percentage form is: a) 60%; b) 75%; c) 40%; d) 25%.
___ 7. Refer to the data for Parker Company in
question 5 above. What is the companys total
contribution margin? a) $110,000; b) $120,000; c)
$170,000; d) $200,000.
___ 8. Refer to the data for Parker Company in
question 5 above. What is the companys degree of
operating leverage? a) 0.25; b) 0.60; c) 1.25; d) 4.00.
___ 9. If sales increase from $400,000 to
$450,000, and if the degree of operating leverage is 6,
net income should increase by: a) 12.5%; b) 75%; c)
67%; d) 50%.
___ 10. In multiple product firms, a shift in the
sales mix from less profitable products to more
profitable products will cause the companys breakeven point to: a) increase; b) decrease; c) there will be
no change in the break-even point; d) none of these.

Choose the best answer or response by placing the

identifying letter in the space provided.

___ 11. Herman Corp. has two products, A and B,

with the following total sales and total variable costs:
Product A Product B
Sales ..............................
$10,000
$30,000
Variable expenses .........
$4,000
$24,000

___ 1. Lester Company has a single product. The

selling price is $50 and the variable cost is $30 per

What is the overall contribution margin ratio? a) 70%;

b) 50%; c) 30%; d) 40%.

Multiple Choice

Chapter 6

Exercises
6-1.
Hardee Company sells a single product. The selling price is $30 per unit and the variable expenses are $18
per unit. The companys most recent annual contribution format income statement is given below:
Sales ...................................................
Less variable expenses .......................
Contribution margin ...........................
Less fixed expenses ............................
Net Income .....................................

$135,000
81,000
54,000
48,000
$ 6,000

a.

Compute the contribution margin per unit. $__________

b.

Compute the CM ratio. _________%

c.

Compute the break-even point in sales dollars. $__________

d.

Compute the break-even point in units sold. __________ units

Chapter 7
e.

How many units must be sold next year to double the companys profits? __________ units

f.

Compute the companys degree of operating leverage. ___________

g.

Sales for next year (in units) are expected to increase by 5%. Using the degree
of operating leverage, compute the expected percentage increase in net income. __________%

h.

Verify your answer to part g above by preparing a contribution format income statement showing a 5%
increase in sales.
Sales .........................................................................

$_______________

Less variable expenses .............................................

_______________

Contribution margin .................................................

_______________

Less fixed expenses .................................................

_______________

Net income ...............................................................

Chapter 6
Using the data below, construct a cost-volume-profit graph like the one in Exhibit 6-2 in the text:
Sales: 15,000 units at $10 each.
Variable expenses: $6 per unit.
Fixed expenses: $40,000 total.
$180
.

$160

Dollars (in thousands)

6-2.

$140
$120
$100
$80
$60
$40
$20
$0

10

12

14

Units (in thousands)

What is the break-even point in units? ______________________.

What is the break-even point in total sales dollars? ______________________

16

18

20

Chapter 7
6-3.

Seaver Company produces and sells two products, X and Y. Data concerning the products follow:
Selling price per unit ..............................
Variable expenses per unit .....................
Contribution margin per unit .................

Product X
$10
6
$ 4

Product Y
$12
3
$ 9

In the most recent month, the company sold 400 units of Product X and 600 units of Product Y. Fixed
expenses are $5,000 per month.
a.

Complete the following contribution format income statement for the most recent month (carry
percentages to one decimal point):
Product X
Amount
%

Product Y
Amount
%

Total
Amount

Sales.............................................

$__________ _____

$__________ _____

$________ ___

Less variable expenses ................

__________ _____

__________ _____

________ ___

Contribution margin ....................

Less fixed expenses .....................

Net income (loss) ........................

________
$

b.

Compute the companys overall monthly break-even point in sales dollars. $ ________

c.

If the company continues to sell 1,000 units, in total, each month, but the sales mix shifts so that an equal
number of units of each product is being sold, would you expect monthly net income to rise or fall?
Explain.

Chapter 6

d.

Refer to the data in part c above. If the sales mix shifts as explained, would you expect the companys
monthly break-even point to rise or fall? Explain.

Answers to Questions and Exercises

True or False
1. F

2. F

2. b

The CM ratio is the unit contribution margin

divided by the unit selling price. One
product might have a higher unit
contribution than another, but its selling
price may be lower.
The break-even point occurs where profit is
zero and the contribution margin is equal to
fixed expenses.

3. T

The break-even point can be computed in

terms of units sold or sales dollars.

4. T

A change in sales mix usually results in a

change in the overall CM ratio. If the overall
CM ratio changes, the break-even point will
also change.

5. T

Profits should increase by 32% = 4 8%.

7. F

The degree of operating leverage decreases

as a firm moves further and further from its
break-even point.

8. T

At the break-even point all fixed costs have

been covered. All contribution margin
generated from that point forward increases
net income.
The reverse is truethe overall break-even
point will rise since the average CM ratio
will be lower as a result of selling less
profitable products.

10. T

By definition, incremental analysis deals

only with differences between alternatives.

11. F

The reverse is trueone would expect the

companys CM ratio to rise. Variable costs
would be lower and hence the CM ratio
would be higher.

12. F

The break-even point is computed by

dividing total fixed costs by the CM ratio.

13. T

This is a key assumption since a change in

the sales mix will change the break-even
point.

Multiple Choice
1. c

Fixed expenses
Breakeven point

in total sales dollars

CM ratio

4.

Unit selling price ..............................

Less unit variable expenses ..............
Unit contribution margin ..................

$50
30
$20

$200, 000
= $500,000
0.40

Units sold Fixed expenses + Target profit

to attain
Unit contribution margin
target profit

The CM ratio measures how much of a sales

dollar is translated into increased
contribution margin and profit.

6. F

9. F

3.

Unit contribution margin .................. $ 20

Unit selling price .............................. $ 50
Contribution margin ratio ................. 0.40

5.

$200,000 + $50,000
= 12,500 units
$20

$90,000
= $150,000 Breakeven sales
0.60
Margin of safety = $200,000 $150,000 = $50,000
6. d

$50,000 $200,000 = 25%

7. b

Sales ...................................
CM ratio .............................
Contribution margin ...........

$200,000
0.60
$120,000

8. d

Contribution margin ...........

Net income .........................
Operating leverage .............

$120,000
$30,000
4.0

9. b

The computations are:

$450,000 $400,000
Percentage

12.5%
change in sales
$400,000

Percentage change in dollar sales .........

Degree of operating leverage ...............
Percentage change in net income .........

12.5%
6.0
75.0%

10. b

A shift to more profitable products would

result in an increase in the overall CM ratio.
Thus, fewer sales would be needed to cover
the fixed costs and the break-even point
would therefore decrease.

11. c
Sales
Variable expenses
Contribution margin

Product A Product B
$10,000
$30,000
4,000
24,000
$ 6,000
$ 6,000

Total
$40,000
28,000
$12,000

Overall CM ratio = $12,000 $40,000 = 30%

Exercises
6-1.

a.
Selling price
Less variable expenses
Unit contribution margin
b.

CM ratio =

c.

Sales =
X=
0.40X =
X=
X=

Per Unit
$30
18
$12

100%
60
40%

Contribution margin
$54,000

40%
Sales
$135,000

Variable expenses + Fixed expenses + Profits

0.60X + $48,000 + $0
$ 48,000
$48,000 0.40
$ 120,000

Alternate solution:
Fixed expenses $48,000
Breakeven point

$120,000
in total sales dollars
CM ratio
0.40
d.

Sales =
$30Q =
$12Q =
Q=
Q=

Variable expenses + Fixed expenses + Profits

$18Q + $48,000 + $0
$48,000
$48,000 $12
4,000 units

Alternate solution:
Fixed expenses
$48,000
Breakeven point

4,000 units
in units sold
Unit contribution margin
$12 per unit

e.

Sales =
$30Q =
$12Q =
Q=
Q=

Variable expenses + Fixed expenses + Profits

$18Q + $48,000 + $12,000
$60,000
$60,000 $12
5,000 units

Alternate solution:
Fixed expenses Target profit
$46,000 $12,000
Units sold to

5,000 units
attain target profit
Unit contribution margin
$12 per unit

f.

$54,000
Degree of operating Contribution margin

9.0
leverage
Net income
$6,000

g.

Percentage change in dollar sales .................

Degree of operating leverage ........................
Percentage change in net income ..................

5%
9.0
45%

h.

New sales volume: 4,500 units 105% = 4,725 units

Sales (4,725 @ $30) .........................................
Less variable expenses (4,725 @ $18) .............
Contribution margin .........................................
Less fixed expenses ..........................................
Net income ........................................................

$141,750
85,050
56,700
48,000
$ 8,700

Present net income ............................................

Expected increase: $6,000 45% ....................
Expected net income (as above) .......................

$
$

6,000
2,700
8,700

The completed CVP graph:

$180

Total revenues

$160

Dollars (in thousands)

6-2.

$140

Break-even point

$120

Total expenses

$100
$80
$60

Fixed expenses
.

$40
$20
$0

10

12

14

Units (in thousands)

The break-even point in units is 10,000 units and in dollars is $100,000.

16

18

20

6-3.

a.

The completed income statement:

Product X
Amount
%

Amount
%
Sales .......................................
Less variable expenses ...........
Contribution margin ...............
Less fixed expenses ...............
Net income .............................
b.

$4,000
2,400
$1,600

100
60
40

Product Y
$7,200
1,800
$5,400

Total
100
25
75

$11,200
4,200
7,000
5,000
$ 2,000

100.0
37.5
62.5

Fixed expenses $5,000

Breakeven point

$8,000
in total sales dollars
CM ratio
0.625

c.

Monthly net income will fall. The shift in sales mix will mean that less of Product Y is being sold and
more of Product X is being sold. Since Product Y has a higher contribution margin per unit than
Product X, this means that less contribution margin in total will be available, and profits will therefore
fall.

d.

The monthly break-even point will rise. As explained above, the shift in sales mix will be toward the
less profitable Product X, which has a CM ratio of only 40% as compared to 75% for Product Y. Thus,
the companys overall CM ratio will fall, and the break-even point will rise since less contribution
margin will be available per unit to cover the fixed costs.

Chapter 7
Profit Planning

Chapter Study Suggestions

Carefully study the flow of budget data in Exhibit 7-2. This exhibit
provides a good overview of the chapter and the budgeting process.
Notice particularly how nearly all budgets eventually impact on the cash
budget. As suggested by this exhibit, the cash budget is a key budget that
serves to tie together much of the budget process. Schedule 8 in the text
contains an example of a cash budget.
Schedules 1 and 2, containing the sales and production budgets, are
also very important and your homework assignments are very likely to
concentrate on these two budgets. As you proceed through the chapter,
you will see that all other budgets depend in some way on the sales
budget in Schedule 1. Notice that a schedule of expected cash collections
accompanies the sales budget. Make sure you understand how the
production budget is put together based on the sales budget and desired
inventory levels.

Chapter 7

CHAPTER HIGHLIGHTS
A. Profit planning is accomplished in most
organizations with budgets. A budget is a detailed plan
for the acquisition and use of financial and other
resources over a specified time period.
1. The master budget is a summary of the
companys plans and goals for the future. It sets
specific targets for sales, production, and financing
activities and indicates the resources that will be
supplied to meet those targets. The master budget
culminates with a cash budget and a projected income
statement and projected balance sheet.
2. There are two steps in the budgeting process
planning and control.
a. Planning involves developing objectives
and formulating steps to achieve these objectives.
b. Control involves the steps taken by
management to increase the likelihood that the
objectives set down at the planning stage are attained.
3. Budgeting provides a number of benefits:
a The budget communicates managements
plans throughout the entire organization.
b. The budgeting process forces managers to
think ahead and to formalize their planning efforts.
c. The budgeting process provides a means
of allocating resources to those parts of the
organization where they can be used most effectively.
d. Budgeting uncovers potential bottlenecks
before they occur.
e. The budget coordinates the activities of
the entire organization by integrating the plans and
objectives of the various parts.
f. The budget provides goals and objectives
that serve as benchmarks for evaluating subsequent
performance.
B. This chapter and the next three chapters are
concerned with responsibility accounting. The basic
idea behind responsibility accounting is that each
managers performance should be judged by how well
he or she manages those itemsand only those items
under his or her control. Each manager is assigned
responsibility for those items of revenues and costs in
the budget that the manager is able to control to a
significant extent. The manager is then held
responsible for deviations between budgeted goals and
actual results.

C. Budget preparation is a complex task requiring the

cooperative effort of many managers.
1. Operating budgets (the budgets discussed in
this chapter) ordinarily cover a one-year period
divided into quarters and months.
2. Managers should be involved in setting their
own budgets rather than having the budgets imposed
from above or by the accounting staff. There are two
reasons for this. First, managers are likely to have the
best information concerning their own operations.
Second, a manager is more likely to be committed to
attaining the budget if he or she plays a major role in
developing his or her own budget.
D. The master budget consists of a number of
separate but interdependent budgets. Exhibit 7-2
provides an overview of the master budget and shows
how the parts of the master budget are linked together.
Study this exhibit carefully.
1. The sales budget (Schedule 1 in the text) is
the beginning point in the budgeting process. It details
the expected sales, in both units and dollars, for the
budget period. The sales budget is accompanied by a
Schedule of Expected Cash Collections, which shows
the anticipated cash inflow from sales and collections
of accounts receivable for the budget period.
2. In a manufacturing firm, the sales budget is
followed by the production budget (Schedule 2 in the
text), which shows what must be produced to meet
sales forecasts and to provide for desired levels of
inventory.
a.

The production budget has the following

format:
Budgeted unit sales ......................................
Add desired ending inventory .....................
Total needs ...................................................
Less beginning inventory ............................
Required production ....................................

XXX
XXX
XXX
XXX
XXX

b. Study Schedule 2 in the text carefully. Note

that the Year column is not simply the sum of the
figures for the Quarters in Schedule 2. The desired
ending inventory for the year is the desired ending
inventory for the 4th Quarter. And the beginning
inventory for the year is the beginning inventory for
the 1st Quarter. Warning: Students often overlook this
important detail.
3. In a merchandising firm such as a clothing
store, the sales budget is followed by a merchandise
purchases budget instead of a production budget. This

budget details the amount of goods that must be

purchased from suppliers to meet customer demand
and to maintain adequate stocks of ending inventory.
a. The format for the merchandise purchases
budget is (in units or dollars):
Budgeted cost of goods sold ...........................
Add desired ending inventory .........................
Total needs ......................................................
Less beginning inventory ................................
Required purchases .........................................

XXX
XXX
XXX
XXX
XXX

b. Note the similarity between the

production budget in a manufacturing company and
the merchandise purchases budget in a merchandising
company.
4. In a manufacturing firm, the direct materials
budget follows the production budget. It details the
amount of raw materials that must be acquired to
support production and to provide for adequate
inventories.
a.

The format for the direct materials budget

is:
Raw materials required for production ...........
Add desired ending inventory..........................
Total raw materials needs ................................
Less beginning inventory ................................
Raw materials to be purchased .......................

XXX
XXX
XXX
XXX
XXX

b. The direct materials budget should be

accompanied by a Schedule of Expected Cash
Disbursements for raw materials.
c. An example of the direct materials budget
appears in Schedule 3 in the text. Note that the Year
column is not simply the sum of the figures for the
Quarters.
5. In a manufacturing firm, a direct labor budget
(Schedule 4 in the text) also follows the production
budget.
6. In a manufacturing firm, a manufacturing
overhead budget (Schedule 5 in the text) also follows
the production budget and details all of the production
costs that will be required other than direct materials
and direct labor.

7. In a manufacturing firm, the ending finished

goods inventory budget (Schedule 6 in the text)
provides computations of unit product costs and of the
carrying value of the ending inventory.
8. In all types of companies, a selling and
administrative expense budget (Schedule 7 in the text)
is prepared that lists expenses falling under the selling
and administrative categories.
9. The cash budget (Schedule 8 in the text)
summarizes all of the cash inflows and cash outflows
appearing on the various budgets. In many companies
the cash budget is the single most important result of
the budgeting process because it can provide critical
advance warnings of potential cash problems. The
cash budget allows managers to arrange for financing
before a crisis develops. Potential lenders are more
likely to provide financing if managers appear to be in
control and looking ahead rather than simply reacting
to crises.
a.

The cash budget has the following format:

Cash balance, beginning .................................

Add receipts ....................................................
Total cash available before
current financing ..........................................
Less disbursements .........................................
Excess (deficiency) of cash available
over disbursements .......................................
Financing .........................................................
Cash balance, ending ......................................

XXX
XXX
XXX
XXX
XXX
XXX
XXX

b. Study Schedule 8 with care, noting

particularly how the financing section is handled.
c. As with the production budget and the
direct materials budget, the Year column in
Schedule 8 is not simply the sum of the figures for the
Quarters. The beginning cash balance for the year is
the beginning cash balance for the 1st Quarter. And the
ending cash balance for the year is the ending cash
balance for the 4th Quarter.
10. The budgeting process culminates with the
preparation of a budgeted income statement (Schedule
9 in the text) and a budgeted balance sheet (Schedule
10 in the text.)

Chapter 7

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.
___ 1. The usual starting point in budgeting is to
make a forecast of sales.
___ 2. A self-imposed budget is one prepared by
top management and imposed on other management
levels as it is passed downward through an
organization.
___ 3. Budgets are planning devices rather than
control devices.
___ 4. The basic idea behind responsibility
accounting is that each managers performance should
be judged by how well he or she manages those items
directly under his or her control.
___ 5. Ending inventories occur because an
organization is unable to sell all that it had planned to
sell during a period.
___ 6. The required production in units for a
budget period is equal to the expected unit sales for the
period.
___ 7. Because of the technical nature of
budgeting, it is best to leave budgeting entirely in the
capable hands of the accounting staff.

Multiple Choice
Choose the best answer or response by placing the
identifying letter in the space provided.
___ 1. Actual sales in Ward Company were
$30,000 in June, $50,000 in July, and $70,000 in
August. Sales in September are expected to be
$60,000. Thirty percent of a months sales are
collected in the month of sale, 50% in the first month
after sale, 15% in the second month after sale, and the
remaining 5% is uncollectible. Budgeted cash receipts
for September should be: a) $60,500; b) $62,000; c)
$57,000; d) $70,000.
___ 2. Beecher Inc. is planning to purchase
inventory for resale costing $90,000 in October,
$70,000 in November, and $40,000 in December. The
company pays for 40% of its purchases in the month
of purchase and 60% in the month following purchase.
What would be the budgeted cash disbursements for
purchases of inventory in December? a) $40,000; b)
$70,000; c) $58,000; d) $200,000.
___ 3. Archer Company has budgeted sales of
30,000 units in April, 40,000 units in May, and 60,000
units in June. The company has 6,000 units on hand on
April 1. If the company requires an ending inventory
equal to 20% of the following months sales,
production during May should be: a) 32,000 units; b)
44,000 units; c) 36,000 units; d) 40,000 units.
___ 4. Refer to the data for Archer Company in
question 3. Each unit requires 3 pounds of a material.
A total of 24,000 pounds of the material were on hand
on April 1, and the company requires materials on
hand at the end of each month equal to 25% of the
following months production needs. The company
plans to produce 32,000 units of finished goods in
April. How many pounds of the material should the
company plan to purchase in April? a) 105,000; b)
19,000; c) 87,000; d) 6,000.
___ 5. If the beginning cash balance is $15,000,
the required ending cash balance is $12,000, cash
disbursements are $125,000, and cash collections from
customers are $90,000, the company must borrow: a)
$32,000; b) $20,000; c) $8,000; d) $38,000.

Exercises
7-1.
Billings Company produces and sells a single product. Expected sales for the next four months are given
below:
April
May
June
July
Sales in units ............................. 10,000
12,000
15,000
9,000
The company needs a production budget for the second quarter. Experience indicates that end-of-month
inventories should equal 10% of the following months sales in units. At the end of March, 1,000 units were on
hand. Complete the following production budget for the quarter:
April

May

June

Quarter

Budgeted sales .................................................... _________

_________

_________

_________

Add desired ending inventory ............................ _________

_________

_________

_________

Total needs ....................................................... _________

_________

_________

_________

Less beginning inventory ................................... _________

_________

_________

_________

Required production ...........................................

7-2.

Dodero Companys production budget for the next four months is given below:
July
Required production .................. 15,000

August
18,000

September
20,000

October
16,000

Each unit of product uses five ounces of raw materials. At the end of June, 11,250 ounces of material were on
hand. The company wants to maintain an inventory of materials equal to 15% of the following months production
needs.
Complete the following materials purchases budget for the third quarter:
July

August

September

Quarter

Required production (units) ................................ _________

_________

_________

_________

Raw material needed per unit (ounces) .............. _________

_________

_________

_________

Production needs (ounces) .................................. _________

_________

_________

_________

Add desired ending inventory (ounces) .............. _________

_________

_________

_________

Total needs (ounces) ........................................ _________

_________

_________

_________

Less beginning inventory (ounces) ..................... _________

_________

_________

_________

Raw materials to be purchased (ounces) ............

Chapter 7
7-3.
Whitefish Company budgets its cash two months at a time. Budgeted cash disbursements for March and
April, respectively, are: for inventory purchases, $90,000 and $82,000; for selling and administrative expenses
(includes $5,000 depreciation each month), $75,000 and $70,000; for equipment purchases, $15,000 and $6,000;
and for dividend payments, $5,000 and $-0-. Budgeted cash collections from customers are $150,000 and
$185,000 for March and April, respectively. The company will begin March with a $10,000 cash balance on hand.
There should be a minimum cash balance of $5,000 at the end of each month. If needed, the company can borrow
money at 12% per year. All borrowings are at the beginning of a month, and all repayments are at the end of a
month. Interest is paid only when principal is being repaid.
Complete the following cash budget for March and April:
March

April

Two
Months

Cash balance, beginning ............................................

__________

__________

__________

Add collections from customers ................................

__________

__________

__________

Total cash available ....................................................

__________

__________

__________

_______________________________......................

__________

__________

__________

_______________________________......................

__________

__________

__________

_______________________________......................

__________

__________

__________

_______________________________......................

__________

__________

__________

Total disbursements ............................................

__________

__________

__________

__________

__________

__________

Borrowings (at beginning)......................................

__________

__________

__________

Repayments (at ending) .........................................

__________

__________

__________

Interest (12% per year) ...........................................

__________

__________

__________

Total financing ....................................................

__________

__________

__________

Less disbursements:

Excess (deficiency) of cash available over

disbursements .........................................................
Financing:

Cash balance, ending .................................................

Answers to Questions and Exercises

True or False
1. T

2. F

A forecast of sales forms the basis for the

companys sales budget. The sales budget,
in turn, is the basis for most of the other
parts of the master budget.
A self-imposed budget is one in which a
manager prepares his or her own budget
estimates.

3. F

Budgeting involves both planning and

control. Once a budget is set, it then
becomes a control device. It is the
benchmark for assessing actual results.

4. T

This is a clear, straightforward statement of

the purpose of responsibility accounting.

5. F

Ending inventories are carefully planned if a

company is following good budget
procedures.

6. F

Production requirements are determined by

the level of beginning inventory and the
desired level of ending inventory as well as
by the expected unit sales.

7. F

The accounting staff may provide help in

preparing budgets, but the underlying
estimates and data must come from
operating managers. There are two reasons
for this. First, the operating managers
generally have better information about their
own operations than the accounting staff.
Second, the operating managers must be
involved in preparing their own budgets or
they will not be committed to them.

Multiple Choice
1. a

The computations are:

September sales, ($60,000 30%) ..............

August sales, ($70,000 50%) ...................
July sales, ($50,000 15%) ........................
Total cash receipts .......................................
2. c

The computations are:

November purchases ($70,000 60%) .......

December purchases ($40,000 40%) ........
Total cash disbursements .............................
3. b

40,000
12,000
52,000
8,000
44,000

The computations are:

Required production ....................................

Material per unit ..........................................
Production needs .........................................
Desired ending inventory
(25% 44,000 3 lbs) ..............................
Total needs ...................................................
Less beginning inventory
(25% 96,000 lbs) ....................................
Required purchases .....................................
5. a

$42,000
16,000
$58,000

The computations are:

Budgeted sales ...............................................

Desired ending inventory (20% 60,000).....
Total needs ....................................................
Less beginning inventory (20% 40,000).....
Required production ......................................
4. a

$18,000
35,000
7,500
$60,500

32,000
3 lbs
96,000
33,000
129,000
24,000
105,000

The computations are:

Beginning cash balance ............................... $ 15,000

Cash receipts ...............................................
90,000
Cash available ............................................. 105,000
Cash disbursements ..................................... 125,000
Deficiency of cash ....................................... $(20,000)
Since the company desires an ending cash balance of
$12,000, the company must borrow $32,000 to make
up for the cash deficiency of $20,000.

Chapter 7
Exercises
7-1.
Budgeted sales ....................................
Add desired ending inventory ............
Total needs .......................................
Less beginning inventory ...................
Required production ...........................

April
10,000
1,200
11,200
1,000
10,200

May
12,000
1,500
13,500
1,200
12,300

Required production (units) ..............................

Raw material needs per unit (ounces) ..............
Production needs (ounces) ................................
Add desired ending inventory (ounces) ............
Total needs (ounces) ......................................
Less beginning inventory (ounces) ...................
Raw materials to be purchased (ounces) ..........

July
15,000
5 oz
75,000
13,500
88,500
11,250
77,250

August
18,000
5 oz
90,000
15,000
105,000
13,500
91,500

June
15,000
900
15,900
1,500
14,400

Quarter
37,000
900
37,900
1,000
36,900

7-2.
September
20,000
5 oz
100,000
12,000*
112,000
15,000
97,000

Quarter
53,000
5 oz
265,000
12,000
277,000
11,250
265,750

*16,000 units for October 5 oz = 80,000 oz; 80,000 oz 15%= 12,000 oz

7-3.
Cash balance, beginning ........................................................
Add collections from customers ............................................
Total cash available .....................................................
Less disbursements:
Inventory purchases ..........................................................
Selling and admin. expenses (net of depreciation)............
Equipment purchases ........................................................
Dividends ..........................................................................
Total disbursements .....................................................
Excess (deficiency) of cash available over
cash disbursements ...............................................................
Financing:
Borrowings (at beginning) ................................................
Repayments (at ending) ....................................................
Interest (12% per year) ......................................................
Total financing .............................................................
Cash balance, ending ..............................................................
* $25,000 12% 2/12 = $500

March
$ 10,000
150,000
160,000

April
$ 5,000
185,000
190,000

Two
Months
$ 10,000
335,000
345,000

90,000
70,000
15,000
5,000
180,000

82,000
65,000
6,000

153,000

172,000
135,000
21,000
5,000
333,000

(20,000)

37,000

12,000

(25,000)
(500)*
(25,500)
$ 11,500

25,000
(25,000)
(500)
(500)
$11,500

25,000

25,000
$ 5,000

Chapter 8
Standard Costs

Chapter Study Suggestions

The first part of the chapter covers setting standard costs. Exhibit 8-1
presents a standard cost card, which is the final product of the standard
setting process. You will be using a standard cost card in the homework
assignments in both this chapter and in the next chapter, so be sure you
understand what a standard cost card contains and how it is constructed.
The second part of the chapter covers standard cost variance analysis.
Exhibit 8-2 provides an overall perspective of variance analysis, and
Exhibits 8-3 through 8-6 give detailed examples of the analysis of
materials, labor, and variable overhead. Notice that the data from the
standard cost card in Exhibit 8-1 are used in Exhibits 8-3, 8-4, and 8-5.
As you study, follow the data from Exhibit 8-l into the following exhibits.
This will help you tie the various parts of the chapter together into one
integrated whole.

CHAPTER HIGHLIGHTS
A. A standard is a benchmark or norm for evaluating
performance. Manufacturing firms commonly set
exacting standards for materials, labor, and overhead
for each product. Some service companies, such as
auto repair shops and fast food outlets also set
standards.
1. Standards are set for both the quantity and the
price (cost) of inputs.
2. Actual quantities and prices of inputs are
compared to the standards. Differences are called
variances. Only the significant variances are brought
to the attention of management. This is called
management by exception.

4. Direct labor price and quantity standards are

usually expressed in terms of labor rate and labor
hours.
a. The standard direct labor rate per hour
should include not only wages but also fringe benefits,
employment taxes, and other labor related costs.
b. The standard labor-hours per unit should
include allowances for rest breaks, personal needs of
employees, clean-up, and machine down time.

B. Setting accurate quantity and price standards is a

vital step in the control process.

5. As with direct labor, the price and quantity

standards for variable overhead are generally
expressed in terms of a rate and hours. The rate
represents the variable portion of the predetermined
overhead rate. The quantity is usually expressed in
terms of direct labor-hours.

1. Many persons should be involved in setting

standards: accountants, purchasing agents, industrial
engineers, production supervisors, and line managers.

6. The price and quantity standards for materials,

labor, and overhead are summarized on the standard
cost card.

2. Standards tend to fall into two categories

either ideal or practical.

a. Study the standard cost card in Exhibit 81 and trace the figures in it back through the examples
on the preceding pages in the text.

a. Ideal standards are those that can be

attained only by working at top efficiency 100% of the
time. They allow for no machine breakdowns or lost
time.
b. Practical standards, by contrast, allow for
breakdowns and normal lost time (such as for rest
breaks). Practical standards are standards that are
tight, but attainable.
c. Most managers feel that practical
standards provide better motivation than ideal
standards. The use of ideal standards can easily lead to
frustration.
3. Direct material standards are set for both the
price and quantity of inputs that go into units of
product.
a. Price standards should reflect the final,
delivered cost of materials. This price should include
freight, handling, and other costs necessary to get the
material into a condition ready to use. It should also
reflect any cash discounts allowed.
b. Quantity standards should reflect the
amount of material that is required to make one unit of
product, including allowances for unavoidable waste,
spoilage, and other normal inefficiencies.

b. Essentially, the standard cost per unit

represents the budgeted variable production cost for a
single unit of product.
C. The General Variance Model. A variance is a
difference between standard prices and quantities on
the one hand and actual prices and quantities on the
other hand. The general model in Exhibit 8-2 is very
helpful in variance analysis. Study this model with
care.
1. A price variance and a quantity variance can
be computed for each of the three variable cost
categoriesmaterials, labor, and overhead.
2. Variance analysis is a form of input/ output
analysis. The inputs are materials, labor, and overhead;
the output is the units produced during the period.
3. The standard quantity allowed for the output
represents the amount of inputs that should have been
used in completing the output of the period. This is a
key concept in the chapter!
D. Direct Materials Variances. Exhibit 8-3 illustrates
the variance analysis of direct materials. As you study
the exhibit, notice that the center column (Actual
Quantity of Inputs, at Standard Price) plays a part in
the computation of both the price and quantity
variances.

1. The materials price variance can be expressed

in formula form as:
Price variance = (AQ AP) (AQ SP)
or
Price variance = AQ (AP SP)
where:
AQ = Actual quantity of inputs purchased
AP = Actual price of inputs purchased
SP = Standard price of inputs
An unfavorable materials price variance has many
possible causes including excessive freight costs, loss
of quantity discounts, improper grade of materials
purchased, rush orders, and inaccurate standards.
2. The materials quantity variance can be
expressed in formula form as:
Quantity variance = (AQ SP) (SQ SP)
or
Quantity variance = SP (AQ SQ)
where:
AQ = Actual quantity of inputs used
SQ = Standard quantity of input allowed
for the actual output
SP = Standard price of inputs
Possible causes of an unfavorable materials quantity
variance include untrained workers, faulty machines,
low quality materials, and inaccurate standards.
3. The materials price variance is usually
computed when materials are purchased, whereas the
materials quantity variance is computed when
materials are used in production. Consequently, the
price variance is computed based on the amount of
material purchased whereas the quantity variance is
computed based on the amount of material used in
production.
E. Direct Labor Variances. Exhibit 8-5 shows the
variance analysis of direct labor. Notice that the format
is the same as for direct materials, but the terms rate
and hours are used in place of the terms price and
quantity.
1. The price variance for labor is called the labor
rate variance. The formula is:
Rate variance = (AH AR) (AH SR)
or
Rate variance = AH (AR SR)
where:
AH = Actual labor hours
AR = Actual labor wage rate
SR = Standard labor wage rate

Possible causes of an unfavorable labor rate variance

include poor assignment of workers to jobs, unplanned
overtime, pay increases, and inaccurate standards.
2. The quantity variance for labor is called the
labor efficiency variance. The formula is:
Efficiency variance = (AH SR) (SH SR)
or
Efficiency variance = SR (AH - SH)
where:
AH = Actual labor hours
SH = Standard labor hours allowed
for the actual output
SR = Standard labor wage rate
Possible causes of an unfavorable labor efficiency
variance include poorly trained workers, low quality
materials, faulty equipment, poor supervision,
insufficient work to keep the everyone busy, and
inaccurate standards.
F. Variable Manufacturing Overhead Variances.
Exhibit 8-6 illustrates the variance analysis of variable
manufacturing overhead. Notice that the format is the
same as for direct labor.
1. The price or rate variance for variable
manufacturing overhead is called the variable
overhead spending variance. The formula for this
variance is:
Spending variance = (AH AR) (AH SR)
or
Spending variance = AH (AR SR)
where:
AH = Actual hours (usually labor hours)
AR = Actual variable manufacturing
overhead rate
SR = Standard variable manufacturing
overhead rate
2. The quantity, or efficiency, variance for
variable manufacturing overhead is called the variable
overhead efficiency variance. The formula for this
variance is:
Efficiency variance = (AH SR) (SH SR)
or
Efficiency variance = SR (AH SH)
where:
AH = Actual hours (usually labor hours)
SH = Standard hours allowed for
the actual output
SR = Standard variable manufacturing
overhead rate

G. Not all differences between standard costs and

quantities and actual costs and quantities warrant
management attention. The manager should be
interested only in the differences that are significant.
Statistical control charts, such as is illustrated in
Exhibit 8-8, can be used to identify the variances that
are worth investigating.
H. There are some potential problems with the use of
standard costs. Most of these problems result from
improper use of standard costs and the management by
exception principle or from using standard costs in
situations in which they are not appropriate.
1. Standard cost variance reports are usually
prepared on a monthly basis and may be released too
late to be really useful. Some companies are now
reporting variances and other key operating data daily
or even more frequently.
2. Managers must avoid using variance reports as
a way to find someone to blame. Management by
exception, by its nature, tends to focus on the negative.
Managers should remember to reward workers for a
job well done.
3. If labor is fixed, the only way to avoid an
unfavorable labor efficiency variance is to keep labor
busy all the time producing outputeven if there is no
demand. This can lead to excess work in process and
finished goods inventories.
4. A favorable variance may not be good. For
example, Pizza Haven has a standard for the amount
of mozzarella cheese on a 9-inch pizza. A favorable
materials quantity variance means that less cheese was
used than the standard specifies. The result is a
substandard pizza.
5. There can be a tendency with standard cost
reporting systems to emphasize meeting the standards
to the exclusion of other important objectives such as

maintaining and improving quality, on-time delivery,

and customer satisfaction.
6. Just meeting standards may not be sufficient;
continual improvement may be necessary.

Appendix 8A: General Ledger Entries to Record

Variances
A. Many companies carry inventories at standard
cost and record standard cost variances in the general
ledger. This simplifies bookkeeping.
B. Favorable variances are recorded as credits, and
unfavorable variances are recorded as debits.
1. The entry to record an unfavorable material
price variance upon purchase of materials on account
would be:
Raw Materials
Materials Price Variance (U)
Accounts Payable

XXX
XXX
XXX

2. The entry to record a favorable material

quantity variance would be:
Work in Process
Materials Quantity Variance (F)
Raw Materials

XXX
XXX
XXX

3. The entry to record an unfavorable labor

efficiency variance and a favorable labor rate variance
would be:
Work in Process
Labor Efficiency Variance (U)
Labor Rate Variance (F)
Wages Payable

XXX
XXX
XXX
XXX

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.

hours allowed; b) the actual hours worked; c) the

budgeted hours allowed; d) none of these.

___ 1. Practical standards are generally viewed as

better than ideal standards for motivating employees.

___ 2. If inferior-grade materials are purchased,

the result may be: a) an unfavorable materials price
variance; b) a favorable materials price variance; c) an
unfavorable labor efficiency variance; d) a favorable
labor efficiency variance; e) responses b and c are both
correct; f) responses a and d are both correct.

___ 2. Ideal standards allow for machine

breakdown time and other normal inefficiencies.
___ 3. In determining a material price standard,
any freight or handling costs should be excluded.
___ 4. The standard rate for variable overhead
consists of the variable portion of the predetermined
overhead rate.
___ 5. Raw materials price variances should be
computed and reported only when materials are placed
into production.
___ 6. Variances similar to price and quantity
variances can be computed for materials, labor, and
overhead.
___ 7. Waste on the production line will result in a
materials price variance.
___ 8. If the actual price or quantity exceeds the
standard price or quantity, the variance is unfavorable.
___ 9. Labor rate variances are largely out of the
control of management.
___ 10. Managers should thoroughly investigate all
differences (variances) between standard cost and
actual cost.
___ 11. In a company with fixed labor, an undue
focus on labor efficiency variances may result in the
production of needless inventories.
___ 12. (Appendix 8A) The use of standard costs
simplifies bookkeeping.
___ 13. (Appendix 8A) An unfavorable variance
would be recorded as a debit in the general ledger.

Multiple Choice
Choose the best answer or response by placing the
identifying letter in the space provided.
___ 1. The labor rate variance is determined by
multiplying the difference between the actual labor
rate and the standard labor rate by: a) the standard

___ 3. During June, Bradley Company produced

4,000 units of product. The standard cost card
indicates the following labor standards per unit of
output: 3.5 hours @ $6 per hour = $21. During the
month, the company worked 15,000 hours. The
standard hours allowed for the month were: a) 14,000
hours; b) 15,000 hours; c) 24,000 hours; d) 18,000
hours.
___ 4. Refer to the data in question 3 above. What
is the labor efficiency variance for June? (F indicates a
Favorable variance and U indicates an Unfavorable
variance.) a) $1,000 F; b) $1,000 U; c) $6,000 F; d)
$6,000 U.
___ 5. Refer to the data in question 3 above. The
total labor cost during June was $88,000 for the
15,000 hours that were worked. What is the labor rate
variance for June? a) $6,000 F; b) $6,000 U; c) $2,000
F; d) $2,000 U.
___ 6. During July, Bradley Company produced
3,000 units of product. The standard cost card
indicates the following materials standards per unit of
output: 2 pounds @ $0.50 = $1. During July, 8,000
pounds of material were purchased at a cost of $3,900.
The materials price variance for July is: a) $100 F; b)
$100 U; c) $4,100 F; d) $4,100 U.
___ 7. Refer to the data in question 6 above. 6,100
pounds of material were used in July to produce the
output of 3,000 units. The materials quantity variance
for July is: a) $1,550 F; b) $1,550 U; c) $50 F; d) $50
U.
___ 8. During August, Bradley, Inc. produced
3,500 units of product using 12,750 labor hours. The
standard cost card indicates the following variable
manufacturing overhead standards per unit of output:
3.5 labor hours @ $2 per labor hour = $7. During the
month, the actual variable manufacturing overhead
cost incurred was $25,000. The variable overhead
spending variance was: a) $500 U; b) $500 F; c)
$24,500 U; d) $24,500 F.

___ 9. Refer to the data in question 8 above. The

variable overhead efficiency variance was: a) $7,000
F; b) $7,000 U; c) $1,000 F; d) $1,000 U.

___ 10. The price variance for variable overhead

is called a: a) rate variance; b) spending variance; c)
budget variance; d) none of these.

Exercises
8-1.

Selected data relating to Miller Companys operations for April are given below:
Number of units produced ......................................................
Number of actual direct labor hours worked .........................
Total actual direct labor cost ..................................................

500 units
1,400 hours
$10,850

The standard cost card indicates that 2.5 hours of direct labor time is allowed per unit, at a rate of $8 per hour.
a.

Complete the following analysis of direct labor cost for the month:
Actual Hours of Input,
at the Actual Rate
(AH AR)

Actual Hours of Input,

at the Standard Rate
(AH SR)

Standard Hours Allowed

for Output, at the
Standard Rate
(SH SR)

____________________

____________________

____________________

____________________

____________________

____________________

____________________

____________________

____________________

b.

Redo the above analysis of direct labor cost for the month, using the following formulas:
Labor Rate Variance = AH (AR SR)

Labor Efficiency Variance = SR (AH SH)

8-2.

The following activity took place in Solo Company during May:

Number of units produced ......................................................
Material purchased .................................................................
Material used in production ...................................................
Cost per foot for material purchased ......................................

450 units
1,500 feet
720 feet
$3

The standard cost card indicates that 1.5 feet of materials are allowed for each unit of product. The standard cost
of the materials is $4 per foot.
a.

Complete the following analysis of direct materials cost for the month:
Actual Quantity of
Inputs, at Actual Price
(AQ AP)

Actual Quantity
of Inputs,
at Standard Price
(AQ SP)

Standard Quantity
Allowed for Output,
at Standard Price
(SQ SP)

____________________

____________________

____________________

____________________

____________________

____________________

____________________

____________________

____________________

(A total variance cant be computed in this situation, since the amount of materials purchased differs from the
amount of materials used in production.)
b.

Redo the above analysis of direct materials cost for the month, using the following formulas:
Materials Price Variance = AQ (AP SP)

Materials Quantity Variance = SP (AQ SQ)

8-3.
(Appendix 8A) Refer to the data for Solo Company in exercise 8-2 on the previous page. Prepare journal
entries to record all activity relating to direct materials for the month:
Debit

Credit

Answers to Questions and Exercises

True or False

Multiple Choice

1. T Practical standards provide better

motivation because they are attainable by workers.
2. F

Ideal standards do not allow for either

machine breakdowns or other normal
inefficiencies.

3. F

Freight and handling costs should be

included in the material price standard since
the purchasing manager should be
responsible for the total cost of acquiring
materials.

4. T

This statement is true by definition.

5. F

The purchasing manager is responsible for

the materials price variance. This variance
should be computed when the purchasing
manager does his or her worknot when
the materials are put into production.

6. T

This point is illustrated in Exhibit 8-2.

7. F

Waste will result in a materials quantity

variance.

8. T

This statement is true by definition.

9. F

Labor rate variances can arise from how

labor is used, and the use of labor is within
the control of management.

1. b

This point is illustrated in Exhibit 8-5.

2. e

The materials price variance will probably

be favorable, since the inferior grade
materials probably will cost less. The labor
efficiency variance will probably be
unfavorable, since the inferior grade
materials will probably require more work.

3. a

The computation is: 4,000 units 3.5 hours

per unit = 14,000 standard hours.

4. d

Efficiency variance = SR (AH - SH)

= $6 (15,000 - 14,000)
= $6,000 U

5. c

Rate variance = (AH AR) - (AH SR)

= ($88,000) - (15,000 $6)
= $2,000 F

6. a

Price variance = (AQ AP) - (AQ SP)

= ($3,900) - (8,000 $0.50)
= $100 F

7. d

Quantity variance = SP (AQ - SQ)

= $0.50 (6,100 - 2x3,000)
= $50 U

8. b

Spending
variance = (AH AR) - (AH SR)
= ($25,000) - (12,750 $2)
= $500 F

10. F

Managers
should not
waste
investigating insignificant variances.

time

11. T

When labor is fixed, the only way to

generate a more favorable labor efficiency
variance is to keep everyone busy producing
outputeven if there is no demand.

9. d

Efficiency
variance = SR (AH - SH)
= $2 (12,750 - 3.5 3,500)
= $1,000 U

12. T

The use of standard costs simplifies the

bookkeeping process since standards permit
all units to be carried at the same cost.

10. b

This point is illustrated in Exhibit 8-2.

13. T

Unfavorable variances have the effect of

decreasing income. Therefore, they are debit
entries just as an expense is a debit entry.

Exercises
8-1.

a.
Actual Hours of Input,
at the Actual Rate
(AH AR)

Actual Hours of Input,

at the Standard Rate
(AH SR)

Standard Hours Allowed

for Output, at the
Standard Rate
(SH SR)

$10,850

1,400 hrs. $8.00 per hr.

= $11,200

1,250 hrs.* $8.00 per hr.

= $10,000

Labor Rate Variance,

$350 F

Labor Efficiency Variance,

$1,200 U

Total Variance, $850 U

*500 units 2.5 hrs. = 1,250 hrs.
b.

AR = $10,850 1,400 hrs. = $7.75 per hr.

Labor Rate Variance = AH (AR - SR)
= 1,400 hrs. ($7.75 per hr. - $8.00 per hr.) = $350 F
Labor Efficiency Variance = SR (AH - SH)
= $8.00 per hr. (1,400 hrs. - 1,250 hrs.) = $1,200 U

8-2.

a.
Actual Quantity of
Inputs, at Actual Price
(AQ AP)

Actual Quantity
of Inputs,
at Standard Price
(AQ SP)

Standard Quantity
Allowed for Output,
at Standard Price
(SQ SP)

1,500 ft. $3.00 per ft.

= $4,500

1,500 ft. $4.00 per ft.

= $6,000

675 ft.* $4.00 per ft.

= $2,700

Materi al s Pri ce Vari ance,

$1,500 F
720 ft. $4.00 per ft.
= $2,880

Materi al s Quanti ty Vari ance,

$180 U
*450 units 1.5 ft. = 675 ft.
b.

Materials Price Variance = AQ (AP - SP)

= 1,500 ft. ($3.00 per ft. - $4.00 per ft.) = $1,500 F
Materials Quantity Variance = SP (AQ - SQ)
= $4.00 per ft. (720 ft. - 675 ft.) = $180 U
Note that a different quantity of materials was purchased (1,500 ft.) than was used in production (720 ft.).
When computing the price variance, use the quantity of materials purchased. When computing the
quantity variance, use the quantity of materials used in production.

8-3.

Raw Materials
Materials Price Variance
Accounts Payable
Work in Process
Materials Quantity Variance
Raw Materials

6,000
1,500
4,500
2,700
180
2,880

Chapter 9
Flexible Budgets and Overhead Analysis

Chapter Study Suggestions

The chapter is divided into three parts. The first part covers flexible
budgets, with Exhibit 9-3 providing a comprehensive example of how a
flexible budget is prepared. Pay close attention to the differences between
a flexible budget and a static budget.
The middle part of the chapter expands on the variance analysis of
variable overhead that was introduced in Chapter 8. Exhibits 9-and 9-7
are the key exhibits here.
The last part of the chapter covers fixed overhead analysis. Three
things in this part deserve special attention. First, be sure you understand
fully what the denominator activity is, and how it is used. Second, be
sure you understand the difference between a normal-cost system and a
standard-cost system, as illustrated in Exhibit 9-9. Third, be sure you
understand the variance analysis of fixed overhead illustrated in Exhibit
9-10.
The chapter concludes with a detailed example of flexible budgets
and fixed overhead analysis. Follow the example through step by step
before attempting the homework material.

Chapter 9

CHAPTER HIGHLIGHTS
A. The sales budgets, production budgets, and cash
budgets in Chapter 7 are static budgets. They are static
in the sense that they are geared toward a single level
of activity. The static budget cant be used to assess
how well individuals were able to control costs, since
actual activity will rarely coincide with the original
activity level assumed in the static budget. If, for
example, activity is higher than was assumed in the
original budget, variable costs should be higher than
originally budgeted.

for the actual level of activity, the variance is

favorable.

B. A flexible budget is geared to a range of activity,

rather than to a single level. This can be seen from the
flexible budget presented in Exhibit 9-3. Notice
especially how a cost formula is used in the flexible
budget for the variable costs.

b. For example, the cost of heating and

lighting an administrative office is fixedit does not
depend upon how many goods or services the
company sells. Nevertheless, this cost can change
from period to period due to seasonal factors, how
conscientious people are in turning off lights, the
thermostat setting they use, and so on.

1. The flexible budget is a dynamic tool. It can

be used to quickly develop a budget for any level of
activity within the relevant range. The variable costs
are adjusted by multiplying the cost per unit by the
activity level. Fixed costs remain unchanged within
the relevant range.
2. The activity base underlying the flexible
budget must be carefully chosen. Three general criteria
are used in selecting an activity base:
a. The flexible budget assumes that the
variable costs change in proportion to changes in the
activity base, so the activity base should actually drive
the variable costs.
b. The activity base should not be expressed
in dollars. For example, direct labor cost should not be
used as an activity base. A change in the labor wage
rate would change the measure of activity, but may
have little real effect on the costs in the flexible
budget.
c. The activity base should be simple and
easy to understand.
C. A flexible budget performance report can be
easily constructed to evaluate how well costs were
controlled.
1. Compute the amount for each variable cost in
the flexible budget by multiplying its cost per unit by
the actual level of activity for the period.
2. If the actual activity is within the relevant
range, the fixed cost amounts are constant and can be
copied from the static budget.
3. Variances are computed for each of the costs.
If the actual cost exceeds the flexible budget cost for
the actual level of activity, the variance is unfavorable.
If the actual cost is less than the flexible budget cost

4. Fixed costs can have variances. There can be a

difference between budgeted fixed costs and actual
fixed costs.
a. A cost is fixed if it does not depend on the
level of activity. However, that does not mean a fixed
cost cannot change for other reasons or that it cannot
be controlled.

c. It is often easier to control fixed costs

than variable costs. Many fixed costs involve
discretionary activities such as travel costs,
entertainment, and executive seminars.
D. The middle portion of the chapter focuses on
variable manufacturing overhead. Two types of
variable overhead performance reports are illustrated
for variable manufacturing overhead. One type of
report shows just a spending variance. The other type
of report shows both a spending and an efficiency
variance. This is a review of material from Chapter 8.
1. If the flexible budget allowances in the
performance report are based on the actual number of
hours worked during the period, then there will be just
a spending variance.
a. In preparing a performance report under
this approach, the cost formulas in the flexible budget
are applied to the actual number of hours worked for
the period.
b. The budget allowances computed in a
above are then compared to actual costs of the period
and a spending variance results. Exhibit 9-6 illustrates
this procedure.
c. The
overhead
spending
variance
combines both price and quantity variances. An
unfavorable variance could occur because the standard
is in error, prices paid for overhead items were too
high, or too many overhead resources were used.
2. If the flexible budget allowances in the
performance report are based on both the actual
number of hours worked and the standard hours
allowed for the output of the period, there will be both
a spending and an efficiency variance.

Chapter 9
a. Exhibit 9-7 contains a performance report
using this approach. Study the column headings in this
exhibit carefully.
b. The term variable overhead efficiency
variance is a misnomer. This variance has nothing to
do with how efficiently or inefficiently variable
overhead resources were used. The inefficiency is
really in the base underlying the application of
overhead. For example, if direct labor-hours are used
as the activity base, there will be an unfavorable
variable overhead efficiency variance if the actual
direct labor-hours exceed the standard number of
direct labor-hours allowed for the actual output. The
assumption is that the excessive use of direct labor
will have the indirect effect of increasing the spending
on variable overhead.
E. The flexible budget often serves as the basis for
computing predetermined overhead rates for product
costing purposes. The formula is:

the predetermined overhead rate by the standard hours

allowed for the output of the period. As in Chapter 8,
the standard hours allowed for the output is computed
by multiplying the standard hours per unit of output by
the actual output of the period.
G. The last part of the chapter is concerned with
fixed manufacturing overhead variances. Two
variances are computed for fixed overheada budget
variance and a volume variance.
1. The fixed overhead budget variance, or simply
budget variance, is the difference between actual
fixed overhead costs and budgeted fixed overhead
costs. The formula for the variance is:

Flexible budget
Budget Actual fixed
overhead fixed overhead
variance
cost
cost
The flexible budget fixed overhead cost refers to
how much the fixed overhead cost should be for the
actual level of activity during the period, according to
the flexible budget.

Overhead from the

flexible budget for the
Predetermined denominator level of activity
2. The formula for the fixed overhead volume
overhead
Denominato
r
level
of
activity
variance,
is:
rate
1. The denominator level of activity is whatever
level of activity (usually in direct labor-hours or
machine-hours) that is assumed when the
predetermined overhead rate is computed. The
numerator in the rate is the amount of manufacturing
overhead for that level of activity.
2. The predetermined overhead rate can be
divided into two parts, one for the variable overhead
costs and the other for the fixed overhead costs.

Fixed
Standard
Volume overhead Denominator hours
variance
hours

rate
allowed

The fixed overhead rate is the fixed portion of the

predetermined overhead rate. The volume variance
does not measure how well spending was controlled. It
is completely determined by the relation between the
denominator hours and the standard hours allowed for
the actual output.

a. The fixed portion of the predetermined

overhead rate depends on the level of the denominator
activity that is chosen. The larger the denominator
activity, the lower the rate will be.

a. If the denominator activity is greater than

the standard hours allowed for the output of the
period, then there is an unfavorable volume variance.

b. Most managers want stable unit costs, so

the denominator activity is usually changed no more
frequently than once a year.

b. If the denominator activity is less than the

standard hours allowed for the output of the period,
then the volume variance is favorable.

F. Exhibit 9-9 is an extremely important exhibit. It

shows that overhead is applied to work in process
differently under a standard cost system than it is
under a normal cost system.

I. In a standard cost system, the amount of overhead

applied to products is determined by the standard
hours allowed for the actual output.

1. We studied normal cost systems in Chapter 2.

There we learned that overhead is applied by
multiplying the predetermined overhead rate by the
actual hours of activity for a period.
2. In contrast, under a standard cost system
overhead is applied to work in process by multiplying

1. As in Chapter 2, if the actual overhead cost

exceeds the amount of overhead cost applied to units
of product, then the overhead is underapplied. If the
actual overhead cost incurred is less than the amount
of overhead cost applied to units, then the overhead is
overapplied.

Chapter 9
2. In a standard cost system, the sum of the
overhead variances equals the amount of under- or
overapplied overhead.
Overhead under- or overapplied =
Variable overhead spending variance

+ Variable overhead efficiency variance

+ Fixed overhead budget variance
+ Fixed overhead volume variance
If the sum of the variances is unfavorable, the
overhead is underapplied. If the sum of the variances
is favorable, the overhead is overapplied.

Chapter 9

REVIEW AND SELF TEST

Questions and Exercises
True or False

Multiple Choice

Enter a T or an F in the blank to indicate whether the

statement is true or false.

Choose the best answer or response by placing the

identifying letter in the space provided.

___ 1.

A budget prepared for a single level of

activity is called a static budget.

___ 2.

Fixed costs are not controllable and

therefore should be omitted from
performance reports.

___ 1. In a standard cost system, overhead is

applied to production on the basis of: a) the actual
hours required to complete the output of the period; b)
the standard hours allowed to complete the output of
the period; c) the denominator hours chosen for the
period; d) none of these.

___ 3.

A manger should be judged on the basis of

how well he or she is able to keep costs to
their originally budgeted levels.

___ 4.

Direct labor cost would generally be a better

base to use in preparing a flexible budget
than direct labor hours.

___ 5.

A variable overhead spending variance is

affected by waste and excessive usage as
well as price differentials.

___ 6.

The term overhead efficiency variance is

really a misnomer since this variance has
nothing to do with efficiency in the use of
overhead.

___ 7.

If overhead is applied to production on the

basis of direct labor hours, the labor
efficiency variance and the overhead
efficiency variance will always be favorable
or unfavorable together.

___ 8.

___ 9.

The fixed overhead volume variance

measures how well fixed overhead spending
was controlled.
If the denominator activity level exceeds the
standard hours allowed for the output, the
volume variance will be favorable.

___ 10. In a standard cost system, if overhead is

overapplied, then the sum of the four
manufacturing overhead variances will be
favorable.

___ 2. If the standard hours allowed for the output

of a period exceed the denominator hours used in
setting overhead rates, there will be: a) a favorable
budget variance; b) an unfavorable budget variance; c)
a favorable volume variance; d) an unfavorable
volume variance.
___ 3. Baxter Company uses a standard cost
system in which manufacturing overhead is applied to
units of product on the basis of direct labor hours. The
variable portion of the companys predetermined
overhead rate is $3 per direct labor hour. The standards
call for 2 direct labor hours per unit of output. In
March, the company produced 2,000 units using 4,100
direct labor hours and the actual variable overhead
cost incurred was $12,050. What was the variable
overhead spending variance? a) $250 U; b) $250 F; c)
$6,050 U; d) $6,050 F.
___ 4. Refer to the data in part (3) above
concerning Baxter Company. What was the variable
overhead efficiency variance for March? a) $6,300 F;
b) $6,300 U; c) $300 F; d) $300 U.
___ 5. Baxter Companys flexible budget for
manufacturing overhead indicates that the fixed
overhead should be $30,000 at the denominator level
of 3,000 standard direct labor hours. In March, the
actual fixed overhead cost incurred was $33,000.
Recall from the above data concerning Baxter
Company that the standards call for 2 direct labor
hours per unit of output and that in March, the
company produced 2,000 units using 4,100 direct
labor hours (DLHs). What is the fixed portion of the
predetermined overhead rate? a) $10 per DLH; b) $11
per DLH; c) $30 per DLH; d) $2 per DLH.

Chapter 9
___ 6. Refer to the data in parts (3) and (5) above
concerning Baxter Company. How much overhead
(both variable and fixed) was applied to units of
product during March? a) $12,000; b) $30,000; c)
$52,000; d) $42,000.

___ 8. Refer to the data in part (5) above

concerning Baxter Company. What was the fixed
overhead volume variance for March? a) $10,000 F; b)
$10,000 U; c) $3,000 U; d) $3,000 F.

___ 7. Refer to the data in part (5) above

concerning Baxter Company. What was the fixed
overhead budget variance for March? a) $10,000 F; b)
$10,000 U; c) $3,000 U; d) $3,000 F.

Exercises
9-1.

Herbold Corporation uses the following cost formulas in its flexible budget for manufacturing overhead:
Item
Utilities ..................................................
Supplies ..................................................
Depreciation ...........................................
Indirect labor ..........................................

Cost Formula
$ 6,000 per year, plus $0.30 per machine hour (MH)
$10,000 per year, plus $0.80 per machine hour
$25,000 per year
$21,000 per year, plus $0.40 per machine hour

Using these cost formulas, complete the following flexible budget:

Cost Formula
(per MH)

8,000

_________________

________

________

________

________

_________________

________

________

________

________

_________________

________

________

________

________

________

________

________

_________________

________

________

________

_________________

________

________

________

_________________

________

________

________

_________________

________

________

________

Total fixed costs

________

________

________

Overhead Costs
Variable overhead costs:

Total variable costs

Machine Hours____________
10,000
12,000

Fixed overhead costs:

Total overhead costs

Chapter 9
9-2.
Refer to the flexible budget data in Exercise 9-1. The standard time to complete one unit of product is 1.6
machine hours. Last year the company budgeted to operate at the 10,000 machine-hour level of activity. During
the year the following actual activity took place:
Number of units produced ............................
Actual machine hours worked ......................

5,000 units
8,500 hours

Actual overhead costs:

Variable
$2,600
6,700
3,300

Utilities ...............................
Supplies ..............................
Indirect labor ......................
Depreciation........................

Fixed
$ 5,900
10,300
21,700
25,000

Prepare a performance report for the year using the format that appears below. Do not compute efficiency
variances for variable overhead items.
Performance Report
Herbold Corporation
Budgeted machine hours .............................

___________

Actual machine hours ..................................

___________

Standard machine hours ..............................

___________

Cost
Formula
(per MH)

Actual
Costs
8,500 MHs

Budget
Based on
MHs

Spending
or Budget
Variance

_________________

________

________

________

________

_________________

________

________

________

________

_________________

________

________

________

________

________

________

________

_________________

________

________

________

_________________

________

________

________

_________________

________

________

________

_________________

________

________

________

Total fixed costs

________

________

________

Variable overhead costs:

Total variable costs

Fixed overhead costs:

Total overhead costs

Chapter 9
9-3.

The flexible budget for manufacturing overhead for Marina Company is given below:
MARINA COMPANY
Flexible Budget

Overhead Costs
Variable costs:
Electricity ...............................................
Indirect materials ...................................
Indirect labor ..........................................
Total variable costs .............................
Fixed costs:
Depreciation ...........................................
Property taxes ........................................
Insurance ................................................
Total fixed costs ..................................
Total overhead costs ..............................

Cost
Formula
(per DLH)

10,000

$0.15
0.50
0.25
$0.90

$ 1,500
5,000
2,500
9,000

$ 1,800
6,000
3,000
10,800

$ 2,100
7,000
3,500
12,600

11,500
8,500
4,000
24,000
$33,000

11,500
8,500
4,000
24,000
$34,800

11,500
8,500
4,000
24,000
$36,600

Direct Labor Hours_________

12,000
14,000

Marina Company uses a standard cost system in which manufacturing overhead is applied to units of product
on the basis of direct labor hours (DLHs). A denominator activity level of 12,000 direct labor hours is used in
setting predetermined overhead rates. The standard time to complete one unit of product is 1.5 direct labor hours.
For the companys most recent year, the following actual operating data are available:
Units produced .....................................................
Actual direct labor hours worked .........................
Actual variable overhead cost ..............................
Actual fixed overhead cost ...................................

9,000 units
14,000 hours
$12,880
$23,750

a. Compute the predetermined overhead rate that would be used by the company, and break it down into
variable and fixed cost elements:

b.

Predetermined overhead rate ................................

____________

Variable cost element ...........................................

____________

Fixed cost element ...............................................

____________

How much overhead would have been applied to work in process during the year? ___________

Chapter 9
c. Complete the following variance analysis of variable overhead cost for the companys most recent year
(see Chapter 10):
Actual Hours of Input,
at the Actual Rate
(AH AR)

Actual Hours of Input,

at the Standard Rate
(AH SR)

Standard Hours
Allowed for Output,
at the Standard Rate
(SH SR)

______________________

______________________

______________________

_____________

_______________

_______________

_______________ variance,

_______________ variance,

$ _____________

$ _____________

_______________ variance, $ _____________

d.

Complete the following variance analysis of fixed overhead cost for the companys most recent year:
Actual Fixed
Overhead Cost

Fixed Overhead
Cost Applied to
Work in Process

Flexible Budget
Fixed Overhead Cost

________________________
_____________

_______________

_______________

_______________ variance,

_______________ variance,

$ _____________

$ _____________

_______________ variance, $ _____________

Answers to Questions and Exercises

True or False
1. T

A static budget is prepared for only one

level of activity.

2. F

Many fixed costs are controllable and must

be on someones performance report or no
one will control them.

3. F

This may be true in government, but is not

true in commercial enterprises. Costs will be
higher or lower than budgeted simply due to
changes in activity. It is unreasonable to
expect , for example, that a production
manager will be able to make 10% more
units than budgeted (if requested by
marketing) without spending more than was
originally budgeted.

4. F

It is generally best to avoid using dollars in

the activity base.

5. T

The overhead spending variance contains

elements of both price and quantity
variances.

6. T

The overhead efficiency variance really

reflects efficiency in the base underlying the
application of overhead.

7. T

The reason for the close relationship is that

both variances are based on the difference
between the actual direct labor hours and the
standard direct labor hours allowed for the
actual output.

8. F

The fixed overhead volume variance results

from a difference between the denominator
level of activity and the standard hours
allowed for the actual output of the period.
It has nothing to do with spending.

9. F

The reverse is truethe volume variance

would be unfavorable.

10. T

Overapplied overhead is equivalent to

favorable variances and underapplied
overhead is equivalent to unfavorable
variances.

Multiple Choice
1. b

This point is illustrated in Exhibit 9-9.

2. c

The volume variance is favorable any time

the standard hours allowed for the actual
output of the period exceeds the
denominator level of activity.

3. b
Spending var.

= (AH AR) - (AH SR)

= ($12,050) - (4,100 $3)
= $250 F

4. d
Efficiency var. = (AH SR) - (SH SR)
= (4,100 $3) - (4,000* $3)
= $300 U
* 2,000 units 2 DLHs/unit = 4,000 DLHs
5. a

Fixed portion of
$30,000
the predetermined
3,000 DLHs
overhead rate
= $10 per DLH
6. c

Predetermined = $3 + $10
overhead rate
= $13 per DLH
Standard hours
allowed for = 2,000 x 2 DLH
units per unit
the output
= 4,000 DLHs
Overhead applied = $13 4,000
= $52,000

7. c

Flexible budget
Budget Actual fixed
overhead fixed overhead
variance
cost
cost
= $33,000 - $30,000
= $3,000 U
8. a

Fixed
Standard
Volume overhead Denominator hours
variance
hours

rate
allowed

= $10 (3,000 - 4,000) = $10,000 F

Exercises
9-1.
Overhead Costs
Variable overhead costs:
Utilities.....................................
Supplies....................................
Indirect labor............................
Total variable costs................
Fixed overhead costs:
Utilities.....................................
Supplies....................................
Depreciation.............................
Indirect labor ...........................
Total fixed costs.....................
Total overhead costs ................

Cost Formula
(per MH)

8,000

$0.30
0.80
0.40
$1.50

9-2.

Machine Hours _________

10,000
12,000

$ 2,400
6,400
3,200
12,000

$ 3,000
8,000
4,000
15,000

$ 3,600
9,600
4,800
18,000

6,000
10,000
25,000
21,000
62,000
$74,000

6,000
10,000
25,000
21,000
62,000
$77,000

6,000
10,000
25,000
21,000
62,000
$80,000

Performance Report
Herbold Corporation
Budgeted machine hours .........................
Actual machine hours ..............................
Standard machine hours ..........................

Variable overhead costs:

Utilities ........................................
Supplies .......................................
Indirect labor ...............................
Total variable costs ...................
Fixed overhead costs:
Utilities ........................................
Supplies .......................................
Depreciation ................................
Indirect labor ...............................
Total fixed costs .......................
Total overhead costs .........................

10,000
8,500
8,000

Cost
Formula
(per MH)

Actual
Costs
8,500 MHs

Budget
Based on
8,500 MHs

Spending
or Budget
Variance

$0.30
0.80
0.40
$1.50

$ 2,600
6,700
3,300
12,600

$ 2,550
6,800
3,400
12,750

$ 50 U
100 F
100 F
150 F

5,900
10,300
25,000
21,700
62,900
$75,500

6,000
10,000
25,000
21,000
62,000
$74,750

100 F
300 U
-700 U
900 U
$750 U

9-3.

a.

Predetermined overhead rate ($34,800 12,000 DLH)

Variable element ($10,800 12,000 DLH)
Fixed element ($24,000 12,000 DLH)

b.

Overhead applied:
9,000 units 1.5 DLHs per unit = 13,500 DLHs allowed
13,500 DLHs $2.90 per DLH = $39,150 overhead applied

c.

Variable overhead variance analysis:

Actual Hours of Input,
at the Actual Rate
(AH AR)
14,000 DLHs
$0.92 per DLH*
$12,880

$2.90 per DLH

$0.90 per DLH
$2.00 per DLH

Actual Hours of Input,

at the Standard Rate
(AH SR)
14,000 DLHs
$0.90 per DLH
$12,600

Spending variance,
$280 U

Standard Hours
Allowed for Output,
at the Standard Rate
(SH SR)
13,500 DLHs**
$0.90 per DLH
$12,150

Efficiency variance,
$450 U

Total variance, $730 U

* $12,880 14,000 DLHs = $0.92 per DLH
** 9,000 units 1.5 DLHs per unit = 13,500 DLHs
d.

Fixed overhead variance analysis:

Actual Fixed
Overhead Cost

Flexible Budget
Fixed Overhead Cost

$23,750

$24,000

Budget variance,
$250 F

Volume variance,
$3,000 F

Total variance, $3,250 F

Fixed Overhead
Cost Applied to
Work in Process
13,500 DLHs
$2.00 per DLH
$27,000

Chapter 10
Decentralization

Chapter Study Suggestions

This relatively brief chapter covers general concepts of decentralization

and return on investment (ROI) and residual income. Memorize the
formulas for ROI and residual income since they are used extensively in
the homework material.

Chapter 10

CHAPTER HIGHLIGHTS
A. A responsibility accounting system functions best
in a decentralized organization. A decentralized
organization is one in which decision making is spread
throughout the organization, with managers at all
levels making decisions. In a decentralized
organization the responsibility accounting system is
structured around cost centers, profit centers, and
investment centers.
1. A cost center is any responsibility center
where a manager has control over cost but not over
revenues or investments. A cost center manager is
usually held responsible for minimizing cost while
providing quality goods and services as requested.
2. The manager of a profit center has control
over both cost and revenue. A profit center manager is
usually held responsible for maximizing profit.
3. The manager of an investment center has
control over cost, revenue, and investments in
operating assets. An investment center manager is
ordinarily evaluated on the basis of return on
investment or residual income, as explained later.
B. Performance in an investment center is often
measured by return on investment (ROI), which is
defined as:
ROI

Net operating income

Average operating assets

You wont actually use the above formula very much.

Instead, you will use the following formula for ROI
that is expressed in terms of margin and turnover:
ROI = Margin Turnover
where:

Margin
Turnover

Net operating income

Sales

Sales
.
Average operating assets

1. Net operating income is income before interest

and taxes.
2. Operating assets include cash, accounts
receivable, inventory, and all other assets held for
productive use within the organization. Operating
assets do not include, for example, investments in
other companies and investments in undeveloped land.
Assets that are common to all divisions (such as assets
associated with corporate headquarters) should not be

allocated to the divisions when making ROI

computations.
3. A companys return on investment can be
improved by (1) increasing sales, (2) reducing
expenses, or (3) reducing assets, holding all other
things constant.
4. ROI is criticized for several reasons. One of
the most important criticisms is that a division
manager who is evaluated based on ROI will tend to
reject projects whose ROIs are less than the divisions
current ROI but greater than the companys minimum
rate of return. This would not be in the best interests of
the overall organization since a project whose rate of
return exceeds the minimum rate of return should
ordinarily be accepted.
C. Another approach to measuring performance in an
investment center is known as residual income.
1. Residual income is the net operating income
that an investment center earns above the minimum
required rate of return on operating assets.

Required Average
Net
Residual operating rate of operating

income
income return
assets
2. The residual income approach to performance
evaluation encourages investment in worthwhile
projects that would be rejected under ROI.
3. A major disadvantage of the residual income
approach is that it cant be easily used to compare
divisions of different sizes. Larger divisions naturally
tend to have larger residual incomes, all other things
the same.
D. It is fairly common for one part of a company to
provide goods or services to another part of the
company. For example, the General Motors truck
division sells delivery trucks to the Chevrolet
Division. The price that is charged for such a sale
inside a company is called a transfer price.
1. If the divisions are profit or investment
centers, then the selling division would like the
transfer price to be high and the purchasing division
would like the price to be low.
2. The objective in setting transfer prices should
be to encourage the managers to make decisions that
are in the best interests of the overall organization.

Chapter 10

REVIEW AND SELF TEST

Questions and Exercises
True or False

Multiple Choice

Enter a T or an F in the blank to indicate whether the

statement is true or false.

Choose the best answer or response by placing the

identifying letter in the space provided.

___ 1. A decentralized organization is one in

which decision making is confined to top
management.

___ 1. If the level of inventory in a company is

reduced, and if sales and expenses remain unchanged,
one would expect the companys ROI to: a) increase;
b) decrease; c) remain unchanged; d) it is impossible
to tell what would happen to ROI.

___ 2. Residual income is equal to the difference

between total revenues and operating expenses.
___ 3. Using ROI to evaluate managers may lead
managers to reject investment opportunities that would
be beneficial to the company as a whole.
___ 4. A profit center manager is responsible for
generating revenue, but is not responsible for
controlling costs.
___ 5. A reduction in operating assets will
increase a divisions ROI if sales and expenses remain
unchanged.
___ 6. In computing residual income, expenses
incurred in operating corporate headquarters should be
allocated to the separate divisions on the basis of the
contribution margins of the divisions.
___ 7. Under the residual income approach, the
manager seeks to maximize the rate of return on
operating assets.
___ 8. An increase in total sales would typically
increase the turnover of assets but it would have no
effect on the margin.

___

2. A company reported the following results:

Average operating assets ............. $ 45,000
Sales ............................................ 180,000
Contribution margin ....................
21,600
Net operating income ..................
9,000

The companys ROI would be: a) 48%; b) 12%; c)

20%; d) 30%.
___ 3. The purpose of the residual income
approach is to: a) maximize a segments overall rate of
return; b) maximize the ROI that a segment is able to
get on its operating assets; c) maximize the total
amount of the residual income; d) none of these.
___

4. A company reported the following results:

Average operating assets ........................ $300,000

Stockholders equity ..............................
50,000
Sales ....................................................... 900,000
Net operating income .............................
75,000
Minimum required rate of return ...........
18%
The companys residual income would be: a) $25,000;
b) $15,000; c) $21,000; d) 475,000.

Exercises
10-1.

Frankel Company has the following data for its Connectors Division for last year:
Sales ..........................................................
Net operating income ................................
Average operating assets ...........................
Minimum rate of return .............................

10-2.

$2,000,000
160,000
800,000
16%

a.

Compute the return on investment (ROI) for the Connectors Division, using margin and turnover.

b.

Compute the residual income for the Connectors Division.

Fill in the missing information for the three different companies below:
Company 1

Company 2

Company 3

Sales ..............................................................

$600,000

$600,000

$_______

Net operating income ....................................

60,000

_______

27,000

Average operating assets ...............................

300,000

200,000

_______

Margin ...........................................................

_______

7.5%

_______

Turnover ........................................................

_______

_______

1.8

Return on investment (ROI) ..........................

_______

_______

27%

Answers to Questions and Exercises

True or False
1. F

In a decentralized organization, decision

making is spread through all levels of
management.

2. F

Residual income is the difference between

net operating income and the minimum
return that must be generated on operating
assets.

3. T

This is a major criticism of the ROI method.

4. F

A profit center is responsible for controlling

costs as well as generating revenues.

5. T

A reduction in assets will result in an

increase in the turnover figure, and an
increase in the ROI.

6. F

Common expenses, such as those associated

with operating corporate headquarters,
should not be allocated to segments when
making either residual income or ROI
computations.

7. F

Under the residual income approach, the

manager seeks to maximize the residual
income figure.

8. F

The margin would also typically increase,

since the net operating income would
generally increase more rapidly than sales
due to the effects of operating leverage
discussed in an earlier chapter.

Multiple Choice
1. a

If the level of inventory is reduced, then

operating assets are reduced. The result will
be a higher turnover figure and an increase
in the ROI.

2. c

The computations are:

ROI

$9,000
$180,000

5% 4 20%
$180,000 $45,000

3. c

Residual income has nothing to do with

ROI; moreover, as residual income increases
ROI frequently decreases (as shown in
examples in the chapter).

4. c

The computations are:

Average operating assets ............... $300,000
Net operating income .................... $ 75,000
Minimum required return
(18% $300,000) ..................... 54,000
Residual income ............................ $ 21,000

Exercises

10-1.

a.

Net operating income

$160,000

8%
Sales
$2,000,000
Sales
$2,000,000
Turnover

2.5
Average operating assets
$800,000
Margin

ROI = Margin Turnover

= 8% 2.5 = 20%
b.

Average operating assets ........................

Net operating income .............................
Minimum required return
(16% $800,000) ...............................
Residual income .....................................

$800,000
$160,000
128,000
$ 32,000

10-2.
Sales ..............................................................
Net operating income ....................................
Average operating assets ...............................
Margin ...........................................................
Turnover ........................................................
Return on investment (ROI) ..........................
*Given

Company 1
$600,000*
60,000*
300,000*
10%
2
20%

Company 2
$600,000*
45,000
200,000*
7.5%*
3.0
22.5%

Company 3
$180,000
27,000*
100,000
15%
1.8*
27%*

Chapter 11
Relevant Costs for Decision Making

Chapter Study Suggestions

The concept of relevant costs is covered in the first few pages of the
chapter. Study these pages carefully, since this basic idea is used
throughout the chapter.
A number of specific decision-making situations are covered in the
chapter. The same principles are used in each situation to identify the
relevant costs.

Chapter 11

CHAPTER HIGHLIGHTS
A. Every decision involves a choice from among at
least two alternatives. A relevant cost or benefit is a
cost or benefit that differs between alternatives. If a
cost or benefit does not differ between alternatives, it
is not relevant in the decision and can be ignored.
Avoidable cost, differential cost, and incremental cost
are synonyms for relevant cost.
1. Two broad classifications of costs are
irrelevant in decisions: (a) sunk costs; and (b) future
costs that do not differ between alternatives. Sunk
costs are not relevant since they have already been
incurred and therefore cannot differ between
alternatives.
2. To make a decision, you should:
a. Eliminate the costs and benefits that do
not differ between alternatives. These irrelevant costs
consist of sunk costs and future costs that do not differ
between alternatives.
b. Make a decision based on the remaining
cost and benefit data. These data consist of the costs
and benefits that differ between alternatives.

2. Relevant costs should be isolated in cost

analysis for three reasons:
a. In any given situation, the irrelevant costs
greatly outnumber the relevant costs. Focusing just on
the relevant costs simply takes less time and effort.
b. The use of irrelevant costs intermingled
with relevant costs may draw the decision-makers
attention away from the really critical data.
c. People often make mistakes when they
include irrelevant costs in an analysis. They often
incorrectly calculate the amount of the irrelevant cost
under the alternatives and it may appear that the
amount of the irrelevant cost differs between the
alternatives when in fact it does not. It is particularly
easy to make this mistake when dealing with fixed
costs that are stated on a per unit basis. This makes the
fixed costs appear as if they are variable costs that
change if the number of units produced and sold
changes.

3. Costs that are relevant in one situation may not

be relevant in another situation.

D. Adding or dropping a segment such as a product

line is one of the decision-making situations covered
in the chapter. In making this decision, compare the
contribution margin of the segment to the fixed costs
that could be avoided by dropping the segment.

B. As stated above, sunk costs are never relevant

since they are not avoidable; that is, they can never
differ between alternatives.

1. If the contribution margin lost by dropping a

segment is greater than the fixed costs that can be
avoided, then the segment should be retained.

1. The book value of old equipment is a sunk

cost. Hence, it is not relevant in decision making.
Periodic depreciation based on the book value of old
equipment is also irrelevant.

2. If the contribution margin lost by dropping a

segment is less than the fixed costs that can be
avoided, then the segment should be dropped.

2. However, depreciation is a sunk cost only if it

relates to old equipment (e.g., equipment that has
already been purchased). Thus, depreciation on new
equipment would be a relevant cost.

3. Exhibit 11-3 illustrates an alternative approach

to deciding whether to retain or drop a product line or
other segment of a company. In this approach two
income statements are prepared one for each
alternative.

3. Even though the book value of old equipment

is not relevant in a decision, the resale value of old
equipment may be relevant. For example, if you are
considering whether to replace an old machine, its
resale value is relevant. If the machine were not
replaced, the resale value would not be realized.

4. The decision to keep or drop a product line or

other segment of a company is often clouded by the
allocation of common fixed costs, which are costs that
would not be avoided, in whole or in part, when a
segment is eliminated.

C. As stated above, future costs that do not differ

between alternatives are not relevant costs.
1. For example, maintenance costs are irrelevant
to the decision of which machine to purchase if
maintenance costs will be the same regardless of
which machine is purchased.

a. Allocations of common costs can make a

product line or other segment appear to be
unprofitable, when in fact the segment may be
contributing substantially to the overall profits of the
company.
b. Common fixed costs should never be
allocated to segments of a company; segments should
be charged only with those costs that are directly
traceable to them, as shown in Exhibit 11-4.

Chapter 11
E. A decision to produce a part internally rather than
to buy it from a supplier is called a make or buy
decision. The relevant costs in such a decision, as
always, are the costs that differ between the
alternatives.
1. Exhibit 11-5 contains an example of a make or
buy decision. Notice from the exhibit that the costs
that are relevant in a make or buy decision are the
costs that differ between the make or buy alternatives.
2. Opportunity cost may be a key factor in a
make or buy decision as well as in other decisions.
a. If there are no alternative uses of the
capacity that is currently being used to make a part or
a product, then the opportunity cost is zero and it does
not need to be considered.
b. On the other hand, if buying from outside
the company would release capacity that could be used
to produce something else, then there is an opportunity
cost involved in using that capacity to make parts
internally. This opportunity cost is the segment margin
that could be obtained from the alternative use of the
capacity. The opportunity cost should be included in
the analysis.
F. Another decision concerns special orders. A
company may have an opportunity to sell products
under special circumstances that dont affect regular
sales. For example, a company may receive an order
on a one-time basis from an overseas customer in a
market the company does not ordinarily sell in. Such a
special order should be accepted if the incremental
revenue from the special order exceeds the
incremental (i.e., avoidable) costs of the order. Any
opportunity costs should be taken into account.
G. A constraint is a scarce resource that limits
output. When the constraint is a machine or a
workstation, it is called a bottleneck. For example, a
company may be able to sell 1,000 units of a product
per week, but have a machine that is capable of only
producing 800 units a week. The machine would be a

bottleneck and time on the machine would be a scarce

resource that is a constraint.
1. When there is a production constraint, demand
exceeds capacity. In that case, managers must decide
what the company will not do since it cannot do
everything.
2. If the problem is how to best utilize a scarce
resource, fixed costs are likely to be constant and
therefore irrelevant. Maximizing the companys total
contribution margin is equivalent to maximizing the
companys profit. Given capacity and the companys
fixed costs, the problem is how to best use that
capacity to maximize total contribution margin and
profit.
3. The key to the efficient utilization of a scarce
resource is the contribution margin per unit of the
constrained resource. The products with the greatest
contribution margin per unit of the constrained
resource are the most profitable; they generate the
greatest profit from a given amount of the constrained
resource. These products should be emphasized over
products with a lower contribution margin per unit of
the constrained resource.
4. Since the constraint limits the output of the
entire organization, there can be a tremendous payoff
to increasing the amount of the available scarce
resource. This is called elevating the constraint and
can be accomplished in a variety of ways including
working overtime on the bottleneck, buying another
machine, subcontracting work, and so on.
5. The contribution margin per unit of the
constrained resource is also a measure of opportunity
cost. For example, when considering whether to accept
an order for a product that uses the constrained
resource, the opportunity cost of using the constrained
resource should be considered. That opportunity cost
is the lost contribution margin for the job that would
be displaced if the order were accepted.

Chapter 11

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.
___ 1. All costs are relevant in a decision except
costs that do not differ between alternatives.
___ 2. In a decision, variable costs are relevant
costs and fixed costs are irrelevant.
___

3. Sunk costs may be relevant in a decision.

___ 4. Depreciation is a relevant cost if it relates

to equipment that has not yet been purchased.
___ 5. Future costs are always relevant
decision-making.

in

___ 6. Costs that are relevant in one decision are

not necessarily relevant in another decision.
___ 7. If a company is able to avoid more in fixed
costs than it loses in contribution margin by dropping
a product, then it will be better off financially if the
product is eliminated.
___ 8. Allocation of common fixed costs to
product lines and to other segments of a company
helps the manager to see if the product line or segment
is profitable.
___ 9. If a product has a negative segment margin,
the product should be discontinued.
___ 10. Opportunity cost may be a key factor in a
make or buy decision.
___ 11. If there is a constrained resource, a
company should emphasize the product that has the
highest contribution margin per unit.

Multiple Choice
Choose the best answer or response by placing the
identifying letter in the space provided.
___ 1. All of the following costs are relevant in a
make or buy decision except: a) the opportunity cost
of space; b) costs that are avoidable by buying rather
than making; c) variable costs of producing the item;
d) costs that are differential between the make and buy
alternatives; e) all of the above costs are relevant.

___ 2. One of Simplex Companys products has a

contribution margin of $50,000 and fixed costs
totaling $60,000. If the product is dropped, $40,000 of
the fixed costs will continue unchanged. As a result of
dropping the product, the companys net operating
income should: a) decrease by $50,000; b) increase by
$30,000; c) decrease by $30,000; d) increase by
$10,000.
___ 3. Halley Company produces 2,000 parts each
year that are used in one of its products. The unit
product cost of this part is:
Variable manuf. cost ............ $ 7.50
Fixed manuf. cost .................
6.00
Unit product cost .................. $13.50
The part can be purchased from an outside supplier for
$10 per unit. If the part is purchased from the outside
supplier, two-thirds of the fixed manufacturing costs
can be eliminated. The effect on net operating income
from purchasing the part would be a: a) $3,000
increase; b) $1,000 decrease; c) $7,000 increase; d)
$5,000 decrease.
___ 4. Product A has a contribution margin of $8
per unit, a contribution margin ratio of 50%, and
requires 4 machine-hours to produce. Product B has a
contribution margin of $12 per unit, a contribution
margin ratio of 40%, and requires 5 machine-hours to
produce. If the constraint is machine-hours, then the
company should emphasize: a) Product A; b) Product
B.
___ 5. Sunderson Products, Inc. has received a
special order for 1,000 units of a sport-fighting kite.
The customer has offered a price of $9.95 for each
kite. The unit costs of the kite, at its normal sales level
of 30,000 units per year, are detailed below:
Variable production costs ..........................
Fixed production costs ..............................
Variable selling costs .................................
Fixed selling and admin. costs ..................

$5.25
2.35
0.75
3.45

There is ample idle capacity to produce the special

order without any increase in total fixed costs. The
variable selling costs on the special order would be
$0.15 per unit instead of $0.75 per unit. The special
order would have no impact on the companys other
sales. What effect would accepting this special order
have on the companys net operating income? a)
$1,850 increase; b) $1,850 decrease; c) $4,550
increase; d) $4,550 decrease.

Chapter 11
Exercises
11-1. The most recent income statement for the mens formal wear department of Merrills Department Store is
given below:
Sales .......................................................
Less variable expenses ...........................
Contribution margin ...............................
Less fixed expenses:
Salaries and wages ..........................
Insurance on inventories .................
Depreciation of fixtures ..................
Advertising .....................................
Net operating income (loss) ...................

$500,000
200,000
300,000
$150,000
10,000
65,000*
100,000

325,000
$ (25,000)

*Six year remaining useful life, with little or no current resale value.
Due to its poor showing, management is thinking about dropping the mens formal wear department. If the
department is dropped, a make-work position will be found for one long-time employee who is due to retire in
several years. That employees salary is $30,000. The fixtures in the department would have no resale value and
would be hauled to the county dump.
Prepare an analysis, using the following form, to determine whether the department should be dropped.
Contribution margin lost if the department is dropped .................

$ _____________

Less avoidable fixed costs:

______________________________..................................... $ _____________
______________________________.....................................

_____________

______________________________.....................................

_____________

______________

Increase (decrease) in operating income........................................

Based on this analysis, should the mens formal wear department be dropped?
Redo the analysis, using the alternate format shown below:
Keep
Department

Drop
Department

Difference:
Income
Increase or
(Decrease)

Sales ....................................................................

$500,000

$_________

$_________

Less variable expenses .........................................

200,000

_________

_________

Contribution margin .............................................

300,000

_________

_________

Salaries and wages ...............................................

150,000

_________

_________

Insurance on inventories ......................................

10,000

_________

_________

Depreciation of equipment ...................................

65,000

_________

_________

Advertising ...........................................................

100,000

_________

_________

Total fixed expenses .........................................

325,000

_________

_________

Less fixed expenses:

Net operating income (loss) .................................

$ (25,000)

Chapter 11
11-2. Watson Company produces two products from a common input. Data relating to the two products are
given below:
Product A
Product B
Sales value at the split-off point ....................... $60,000
$120,000
Allocated joint product costs ............................
45,000
90,000
Sales value after further processing ..................
90,000
200,000
Cost of further processing ................................
20,000
85,000
Determine which of the products should be sold at the split-off point, and which should be processed further
before sale. Use the form that appears below.
Sales value after further processing ....................................

Product A
$__________

Product B
$__________

Sales value at the split-off point .........................................

__________

__________

Incremental revenue from further processing .....................

__________

__________

Less cost of further processing ...........................................

__________

__________

Profit (loss) from further processing ..................................

11-3. Petre Company is now making a small part that is used in one of its products. The companys accounting
department reports the following costs of producing the part internally:
Direct materials .................................................................................
Direct labor .......................................................................................
Variable manufacturing overhead .....................................................
Fixed manufacturing overhead, traceable .........................................
Fixed manufacturing overhead, allocated common ..........................
Unit product cost .............................................................................

Per Part
$15
10
2
4
5
$36

A total of 75% of the traceable fixed manufacturing overhead cost consists of depreciation of special equipment,
and 25% consists of supervisory salaries. The special equipment has no resale value. The supervisory salaries
could be avoided if production of the part were discontinued.
An outside supplier has offered to sell the parts to Petre Company for $30 each, based on an order of 5,000
parts per year. Should Petre Company accept this offer, or continue to make the parts internally? Assume that
direct labor is a variable cost. Use the following form in your answer:
Per Unit
Differential Cost
Make
Buy
Outside purchase price .....................................

5,000 Parts
Make
Buy

$______

$________

Cost of making internally:

_________________________..................

$______

$__________

_________________________..................

______

__________

_________________________..................

______

__________

_________________________..................

______

__________

_________________________..................

______

__________

Total cost ...........................................................

Chapter 11
11-4.
Kuski Corporation makes two models of its hair dryer at a facility in Lexington. The copper-winding
machine has been the constraint in the factory in the past. The capacity of this machine is 9,600 minutes per month.
Data concerning these two products appear below:
Unit selling price ..............................................
Variable cost per unit ........................................
Copper-winding machine time per unit ............
Monthly demand per month .............................

Standard
$14.00
5.00
0.5 minute
12,000 units

Premium
$20.00
8.00
0.6 minute
8,000 units

a. Determine if the copper-winding machine is currently a constraint. In other words, does demand exceed
capacity? Use the form below to answer this question
Standard

Premium

Total

........
........
Copper-winding time required
to satisfy demand ...........................................
b. Compute the contribution margin per copper-winding minute for the two products using the following
form:
Standard

Premium

Unit selling price ..............................................

Variable cost per unit ........................................
Contribution margin per unit ............................
Copper-winding machine time per unit ............
Contribution margin per minute .......................
c. Assuming that the copper-winding machine is the companys constraint, how many units of each product
should be made in order to maximize net operating income?

Answers to Questions and Exercises

True or False
1. T

Costs that differ between alternatives are

relevant. Costs that do not differ between
alternatives are not relevant.

2. F

Fixed costs can be relevant and variable

costs can be irrelevant. What is relevant and
what is irrelevant depends on the situation.

3. F

Sunk costs are never relevant since they

have already been incurred and thus cant be
avoided by choosing one alternative over
another.

4. T

Depreciation on equipment that has not yet

been purchased is avoidable and therefore
relevant.

5. F

Future costs are relevant only if they differ

between alternatives; future costs that do not
differ between alternatives are irrelevant.

6. T

For example, a product line managers

salary would be relevant in a decision to
drop the product line, but would not be
relevant in a decision about how much to
spend on advertising.

7. T

If the avoidable fixed costs exceed the lost

contribution margin, profits would increase
if the product line were dropped.

8. F

9. F

Allocation of common fixed costs to

product lines and to other segments of a
company can easily result in misleading
data and can make a product line appear to
be unprofitable when in fact it may be one
of a companys best products.
Even if a product line has a negative
segment margin, the products costs must
still be analyzed to determine if the product
should be dropped. For example,
depreciation on special equipment with no
resale value would be traceable to the
product line, but would not be relevant in a
decision to drop the product line.

10. T

Opportunity cost can be a key factor in any

decision involving a constrained resource.

11. F

The product with the highest contribution

margin per unit of the constrained resource

should be emphasized. A product might

have a high contribution margin per unit but
require a disproportionately large amount of
the constrained resource.
Multiple Choice
1. e

These costs are all relevant because they all

differ between the alternatives.

2. c

The computations are:

Contribution margin lost ..................$(50,000)
Less avoidable fixed costs ................ 20,000*
Decrease in operating income ..........$(30,000)
*$60,000 $40,000 = $20,000

3. a

The computations are:

Differential Cost
Make
Buy
Variable manuf. costs ......... $ 7.50
__
Avoidable fixed
manufacturing cost ........
4.00
__
Outside purchase price ......

$10.00
Total relevant cost .............. $11.50 $10.00
2,000 units $1.50 = $3,000

4. b

The computations are:

A
Contribution margin
per unit (a) .................
Machine-hours to
produce (b) ................
CM per machine-hour
(a) (b) .....................

5. c

$8.00

$12.00

4.00

5.00

$2.00

$ 2.40

The computations are:

Incremental revenue
($9.95 1,000) .................
Incremental costs:
Variable production
($5.25 1,000) .................
Variable selling
($0.15 1,000) .................
Increase in operating income...........

$9,950
5,250
150
$4,550

Exercises
11-1.
Contribution margin lost if the department is dropped .................
Less avoidable fixed costs:
Salaries and wages ($150,000 - $30,000) ................................
Insurance on inventories ..........................................................
Advertising ...............................................................................
Decrease in overall company net operating income ......................

$(300,000)
$120,000
10,000
100,000

230,000
$ (70,000)

Based on the analysis above, the department should not be dropped. The solution using the alternate format
appears below:
Difference:
Income
Keep
Drop
Increase or
Department
Department
(Decrease)
Sales ................................................................... $500,000
$ -0$(500,000)
Less variable expenses .......................................
200,000
-0200,000
Contribution margin ...........................................
300,000
-0$(300,000)
Less fixed expenses:
Salaries and wages ........................................
150,000
30,000
120,000
Insurance on inventories ...............................
10,000
-010,000
Depreciation of fixtures ................................
65,000
65,000*
-0Advertising ....................................................
100,000
-0100,000
Total fixed expenses ...........................................
325,000
95,000
230,000
Net operating income (loss) ............................... $(25,000)
$(95,000)
$ (70,000)
* If the department were dropped, the remaining book value of the fixtures would be written off
immediately. If the department were not dropped, the remaining book value would be written off over a
number of years in the form of depreciation charges. In either case, the entire remaining book value will
eventually flow through the income statement as charges in one form or another.
11-2.
Sales value after further processing ...........................................
Sales value at the split-off point ................................................
Incremental revenue from further processing ............................
Less cost of further processing ..................................................
Profit (loss) from further processing ..........................................
11-3.
Make
Outside purchase price ...........................................................
Cost of making internally:
Direct materials ......................................................................
Direct labor ............................................................................
Variable manufacturing overhead ..........................................
Fixed manufacturing overhead, traceable ..............................
Fixed manufacturing overhead, allocated common ...............
Total ....................................................................................
Difference in favor of making .................................

Product A
$ 90,000
60,000
30,000
20,000
$ 10,000

Per Unit
Differential Costs
Buy
Make
$30
$15
10
2
1*
$28

$30
$2

Product B
$200,000
120,000
80,000
85,000
$ (5,000)

5,000 Parts ___

Buy
$150,000
$ 75,000
50,000
10,000
5,000
$140,000

$150,000

$10,000

*$4 25% = $1. The depreciation on the equipment and the common fixed overhead would not be
avoidable costs.

11-4.
a.

Demand exceeds capacity for the copper-winding machine, as shown below:

Monthly demand per month (a) ........................
Copper-winding machine
time per unit (b) ...........................................
Copper-winding time required
to satisfy demand (a) (b) ............................

Standard
12,000 units

Premium
8,000 units

0.5 min./unit

0.6 min./unit

6,000 min.

4,800 min.

Standard
$14.00
5.00
$ 9.00

Premium
$20.00
8.00
$12.00

0.5 min.
$ 18/min.

0.6 min.
$ 20/min.

Total

10,800 min.

b.
Unit selling price ..............................................
Variable cost per unit ........................................
Contribution margin per unit (a) .......................
Copper-winding machine
time per unit (b) ............................................
Contribution margin per minute (a) (b)..........
c.

Since the contribution margin per copper-winding minute is higher for the premium model than for the
standard model, the premium model should be emphasized. The optimal plan is to produce all 8,000 units
of the premium model and use the remaining capacity to make 9,600 units of the standard model.
Total copper-winding time available .............................................................
Time required to produce 8,000 units of the premium model .......................
Time remaining with which to make the standard model (a) ........................
Time required to make one unit of the standard model (b) ...........................
Number of units of the standard model produced (a) (b) ...........................

9,600 minutes
4,800 minutes
4,800 minutes
0.5 minute/unit
9,600 units

Chapter 12
Capital Budgeting Decisions

Chapter Study Suggestions

You must have a solid understanding of the concept of present value to

understand the material in this chapter. If you have not worked with
present value before, carefully study Appendix 12A, The Concept of
Present Value.
Once you understand present value, you will be ready to tackle the
capital budgeting methods in the chapter. The first of these methods is
called the net present value method. Follow through each number in
Exhibits 12-1 and 12-2 and trace the factors back to the tables given at
the end of the chapter.
Two other methods of making capital budgeting decisions are
presented in detail in the chapter. These are the payback method and the
simple rate of return method. Formulas are provided for both methods.
Pay particular attention to the formula for the simple rate of returnit
can be tricky to apply.

Chapter 12

CHAPTER HIGHLIGHTS
A. The term capital budgeting is used to describe
planning major outlays on projects that commit the
company for some time into the future such as
purchasing new equipment, building a new facility, or
introducing a new product.
1. Capital budgeting usually involves investment;
i.e., committing funds now so as to obtain cash
inflows in the future.

result (which is net of the initial investment) is called

the net present value of the project.
5. In a screening decision, if the net present value
is positive, the investment is acceptable. If the net
present value is negative, the investment should be
rejected.

2. Capital budgeting decisions fall into two broad

categories:

C. Discounted cash flow analysis is based entirely on

cash flowsnot on accounting net income.
Accounting net income is ignored in cash flow
analysis.

a. Screening decisions: Potential projects are

categorized as acceptable or unacceptable.

1. Typical
investment are:

b. Preference decisions: Projects must be

ranked because funds are insufficient to support all of
the acceptable projects.

a. Outflows: initial investment (including

installation costs); increased working capital needs;
repairs and maintenance; and incremental operating
costs.

3. The time value of money should be

considered. A dollar in the future is worth less than a
dollar today for the simple reason that a dollar today
can be invested to yield more than a dollar in the
future.
a. Discounted cash flow methods give full
recognition to the time value of money.
b. There are two methods that use
discounted cash flowsthe net present value method
and the internal rate of return method.
B. The net present value method is illustrated in
Example A (Exhibit 12-1) and in Example B (Exhibit
12-2). The basic steps in this method are:
1. Determine the required investment.
2. Determine the future cash inflows and
outflows that result from the investment.
3. Use the present value tables to find the
appropriate present value factors.
a. The values (or factors) in the present
value tables depend on the discount rate and the
number of periods (usually years).
b. The discount rate in present value
analysis is the companys required rate of return,
which is often the companys cost of capital. The cost
of capital is the average rate of return the company
must pay its long-term creditors and shareholders for
the use of their funds. The details of the cost of capital
are covered in finance courses.
4. Multiply each cash flow by the appropriate
present value factor and then sum the results. The end

cash

flows associated

with an

b. Inflows: include incremental revenues;

reductions in costs; salvage value; and release of
working capital at the end of the project.
2. Depreciation is not a cash flow and therefore
is not part of the analysis. (However, depreciation can
affect taxes, which is a cash flow. This aspect of
depreciation is covered in more advanced texts.)
3. Quite often, a project requires an infusion of
cash (i.e., working capital) to finance inventories,
receivables, and other working capital items.
Typically, at the end of the project these working
capital items can be liquidated (i.e., the inventory can
be sold) and the cash that had been invested in these
items can be recovered. Thus, working capital is
counted as a cash outflow at the beginning of a project
and as a cash inflow at the end of the project.
4. We usually assume that all cash flows, other
than the initial investment, occur at the end of a
period.
D. The internal rate of return method is another
discounted cash flow method used in capital budgeting
decisions. The internal rate of return is the rate of
return promised by an investment project over its
useful life; it is the discount rate for which the net
present value of a project is zero. The details of the
internal rate of return method are covered in more
advanced texts.
E. The total-cost approach or the incremental-cost
approach can be used to compare projects.
1. The total-cost approach is the most flexible
and the most widely used method. Exhibit 12-3 shows
this approach. Note in Exhibit 12-3 that all cash

inflows and all cash outflows are included in the

solution under each alternative.
2. The incremental-cost approach is a simpler
and more direct route to a decision since it ignores all
cash flows that are the same under both alternatives.
The incremental-cost approach focuses on differential
costs. Exhibit 12-4 shows this approach.
3. The
total-cost
and
incremental-cost
approaches should lead to the same decision.
F. Sometimes no revenue or cash inflow is directly
involved in a decision. In this situation, the alternative
with the least cost should be selected. The least cost
alternative can be determined using either the totalcost approach or the incremental approach. Exhibits
12-5 and 12-6 illustrate least-cost decisions.
H. Preference decisions involve ranking investment
projects. Such a ranking is necessary whenever there
are limited funds available for investment.
1. Preference decisions are sometimes called
ranking decisions or rationing decisions because they
ration limited investment funds among competing
investment opportunities.
2. When using the internal rate of return to rank
competing investment projects, the preference rule is:
The higher the internal rate of return, the more
desirable the project.
3. If the net present value method is used to rank
competing investment projects, the net present value
of one project should not be compared directly to the
net present value of another project, unless the
investments in the projects are of equal size.
a. To make a valid comparison between
projects that require different investment amounts, a
profitability index is computed. The formula for the
profitability index is:

1. The payback method focuses on how long it

takes for a project to recover its initial cost out of the
cash receipts it generates. The payback period is
expressed in years.
a. When the cash inflows from the project
are the same every year, the following formula can be
used to compute the payback period:

Payback period

b. If new equipment is replacing old

equipment, the investment required should be
reduced by any salvage value obtained from the
disposal of old equipment. And in this case, in
computing the net annual cash inflows, only the
incremental cash inflow provided by the new
equipment over the old equipment should be used.
2. The payback period is not a measure of
profitability. Rather it is a measure of how long it
takes for a project to recover its investment cost.
3. Major defects in the payback method are that
it ignores the time value of money, and that it ignores
all cash flows that occur once the initial cost has been
recovered. Therefore, this method is very crude and
should be used only with a great deal of caution.
Nevertheless, the payback method can be useful in
industries where project lives are very short and
uncertain.
I. The simple rate of return method is another
capital budgeting method that does not involve
discounted cash flows.
1. The simple rate of return method focuses on
accounting net income, rather than on cash flows. The
formula for its computation is:

Simple rate
Present value of cash inflows of retun
Profitability index
Investment required

This is basically an application of the idea from

Chapter 11 of utilization of a scarce resource. In this
case, the scarce resource is the investment funds. The
profitability index is similar to the contribution margin
per unit of the scarce resource.
b. The preference rule when using the
profitability index is: The higher the profitability
index, the more desirable the project.
H. Two other capital budgeting methods are
considered in the chapter. These methods do not
involve discounting cash flows One of these is the
payback method.

Investment required
Net annual cash inflows

Incremental Incremental
revenue
expenses
Initial investment

If new equipment is replacing old equipment, then the

initial investment in the new equipment is the cost
of the new equipment reduced by any salvage value
obtained from the old equipment.
2. Like the payback method, the simple rate of
return method does not consider the time value of
money. Therefore, the rate of return computed by this
method will not be an accurate guide to the
profitability of an investment project.

Chapter 12
Appendix 12A: The Concept of Present Value
A. Since most business investments extend over long
periods, it is important to recognize the time value of
money in capital budgeting analysis. Essentially, a
dollar received today is more valuable than a dollar
received in the future for the simple reason that a
dollar received today can be investedyielding more
than a dollar in the future.
B. Present value analysis recognizes the time value
of money in capital budgeting decisions.
1. Present value analysis involves expressing a
future cash flow in terms of present dollars. When a
future cash flow is expressed in terms of its present
value, the process is called discounting.

2. Use Table 12B-3 in Appendix 12B to

determine the present value of a single sum to be
received in the future. This table contains factors for
various rates of interest for various periods, which
when multiplied by a future sum, will give the sums
present value.
3. Use Table 12B-4 in Appendix 12B to
determine the present value of an annuity, or stream,
of cash flows. This table contains factors that, when
multiplied by the stream of cash flows, will give the
streams present value. Be careful to note that this
annuity table is for a very specific type of annuity in
which the first payment occurs at the end of the first
year.

REVIEW AND SELF TEST

Questions and Exercises
True or False

Multiple Choice

Enter a T or an F in the blank to indicate whether the

statement is true or false.

Choose the best answer or response by placing the

identifying letter in the space provided.

___ 1. Under the net present value method, the

present value of all cash inflows associated with an
investment project is compared to the present value of
all cash outflows, with the difference, or net present
value, determining whether or not the project is
acceptable.

The following data relate to questions 1 and 2.

___ 2. Cash outlays for noncurrent assets such as

machines would be considered in a capital budgeting
analysis, but not cash outlays for current assets such as
inventory.
___ 3. The internal rate of return is the discount
rate for which a projects net present value is zero.
___ 4. In present value analysis, the higher the
discount rate, the higher is the present value of a given
future cash inflow.
___ 5. When
comparing
two
investment
alternatives, the total-cost approach provides the same
ultimate answer as the incremental-cost approach.
___ 6. In ranking investment projects, a project
with a high net present value should be ranked above a
project with a lower net present value.
___ 7. The simple rate of return method explicitly
takes depreciation into account.
___ 8. The payback method does not consider the
time value of money.
___ 9. The present value of a cash inflow to be
received in 5 years is greater than the present value of
the same sum to be received in 10 years.

Peters Company is considering the purchase of a

machine to further automate its production line. The
machine would cost $30,000, and have a ten-year life
with no salvage value. It would save $8,000 per year
in labor costs, but would increase power costs by
$1,000 annually. The companys discount rate is 12%.
___ 1. The present value of the net annual cost
savings would be: a) $39,550; b) $45,200; c) $5,650;
d) $70,000.
___ 2. The net present value of the proposed
machine would be: a) $(15,200); b) $5,650; c) $9,550;
d) $30,000.
___ 3. White Companys required rate of return
and discount rate is 12%. The company is considering
an investment opportunity that would yield a return of
$10,000 in five years. What is the most that the
company should be willing to invest in this project? a)
$36,050; b) $5,670; c) $17,637; d) $2,774.
___ 4. Dover Company is considering an
investment project in which a working capital
investment of $30,000 would be required. The
investment would provide cash inflows of $10,000 per
year for six years. If the companys discount rate is
18%, and if the working capital is released at the end
of the project, then the projects net present value is: a)
$4,980; b) $(4,980); c) $16,080; d) $(12,360).
___ 5. Frumer Company has purchased a machine
that cost $30,000, that will save $6,000 per year in
cash operating costs, and that has an expected life of
15 years with zero salvage value. The payback period
on the machine will be: a) 2 years; b) 7.5 years; c) 5
years; d) 0.2 years.
___ 6. Refer to the data in question (5) above. The
simple rate of return on the machine is approximately:
a) 20%; b) 13.3%; c) 18%; d) 10%.

Exercises
12-1. You have recently won $100,000 in a contest. You have been given the option of receiving $100,000 today
or receiving $12,000 at the end of each year for the next 20 years.
a.

If you can earn 8% on investments, which of these two options would you select? (Note: The net present
value method assumes that any cash flows are reinvested at a rate of return equal to the discount rate.
Therefore, to answer this question you can compare the net present values of the cash flows under the two
alternatives using 8% as the discount rate.)
Year(s)

Amount of
Cash Flows

8%
Factor

Receive the annuity .................

_____

__________

________

$________

Receive the lump sum .............

_____

__________

________

________

Item

Present Value
of Cash Flows

Net present value in favor

of ____________________...
b.

If you can earn 12% on investments, which of these two options would you select?
Year(s)

Amount of
Cash Flows

12%
Factor

Receive the annuity .................

_____

$ __________

________

$________

Receive the lump sum .............

_____

__________

________

________

Item

Present Value
of Cash Flows

Net present value in favor

of ____________________...

12-2. Lynde Company has been offered a contract to provide a key replacement part for the Armys main attack
helicopter. The contract would expire in eight years. The projected cash flows that result from the contract are
given below:
Cost of new equipment ................................................... $300,000
Working capital needed ................................................... 100,000
Net annual cash inflows ..................................................
85,000
Salvage value of equipment in eight years .....................
50,000
The companys required rate of return and discount rate is 16%. The working capital would be released for use
elsewhere at the end of the project.
Complete the analysis below to determine whether the contract should be accepted.
Year(s)

Amount of
Cash Flows

16%
Factor

Present Value
of Cash Flows

Cost of new equipment

_____

$__________

________

$____________

Working capital needed

_____

__________

________

____________

Net annual cash inflows

_____

__________

________

____________

Salvage value of equipment

_____

__________

________

____________

Working capital released

_____

__________

________

____________

Salvage value of equipment

_____

__________

________

____________

Item

Net present value

Should the contract be accepted? Explain.

12-3. Harlan Company would like to purchase a new machine that makes wonderfully smooth fruit sorbet that
the company can sell in the premium frozen dessert sections of supermarkets. The machine costs $450,000 and
has a useful life of ten years with a salvage value of $50,000. Annual revenues and expenses resulting from the
new machine follow:
Sales revenue ....................................
Less operating expenses:
Advertising ...................................
Salaries of operators .....................
Maintenance .................................
Depreciation .................................
Net income .......................................

$300,000
$100,000
70,000
30,000
40,000

240,000
$ 60,000

a. Harlan Company will not invest in new equipment unless it promises a payback period of 4 years or
less. Compute the payback period on the sorbet machine.
Computation of the net annual cash inflow:
Net income ..........................................................................

$_____________

Add: Noncash deduction for depreciation ..........................

_____________

Net annual cash inflow .......................................................

Computation of the payback period:

Payback period
______________________
______________________
b.

Investment required
Net annual cash inflows

=______ years

Compute the simple rate of return on the investment in the new machine.

Simple rate

of retun
______________________
______________________

Incremental Incremental
revenue
expenses
Initial investment

=______ %

Answers to Questions and Exercises

True or False
1. T

Exhibit 12-2 illustrates this point.

2. F

All cash flows should be included in a

capital budgeting analysis.

3. T

This statement is true by definition.

4. F

The opposite is truethe higher the

discount rate, the lower is the present value
of a given future cash inflow.

5. T

The total-cost approach and the incrementalcost approach are just different ways of
obtaining the same result.

6. F

7. T

3. b

Net present value shouldnt be used to rank

projects when investment funds are limited,
since one project may have a higher net
present value than another simply because it
is larger. The profitability index should be
used to compare projects.
This point is illustrated in formulas (3) and
(4) in the text.

8. T

A major defect of the payback method is

that dollars are given the same weight
regardless of when they are received.

9. T

When discounting the shorter the time

period, the greater the present value.

Return in 5 years........................ $10,000

Factor for 12% for 5 years
(Table 12B-3).......................... 0.567
Present value ............................. $ 5,670
This is the maximum amount the company
is willing to invest. If it were to invest more
than $5,670, the net present value of the
investment would be negative.
4. c

Working capital
investment
Now $(30,000) 1.000 $(30,000)
Cash inflow
1-6
10,000 3.498 34,980
Working capital
released
6
30,000 0.370 11,100
Net present value
$ 16,080
5. c

Savings in labor costs...................

Less increased power costs..........
Net cost savings...........................
Present value factor for 12% for
10 years (Table 12B-4).............
Present value of cost savings.......
2. c

$ 8,000
1,000
$ 7,000
5.650
$39,550

The computations are:

Investment in the machine.......... $(30,000)
Present value of cost savings ......
39,550
Net present value.......................... $ 9,550

The computation is:

Payback
Investment required
=
period
Net annual
cash inflows
=

6. b

The computations are:

The computations are:

18% Present
Year(s) Amount Factor Value

Multiple Choice
1. a

The computations are:

$30,000
= 5 years
$6,000

The computation is:

Incremental Incremental
revenues
expenses
Simple rate
=
of return
Initial investment
=

$6,000* $2,000**
= 13.3%
$30,000

* The incremental revenue is the cost

savings of $6,000 per year.
** The incremental expense is the annual
depreciation charge of $2,000 = $30,000
15 years.

Exercises
12-1.

a.

The annuity is preferable if the discount rate is 8%:

Item
Year(s)
Receive the annuity ....................... 1-20
Receive the lump sum ................... Now
Net present value in
favor of the annuity ....................

b.

Amount of
Cash Flows
$ 12,000
100,000

8%
Factor
9.818
1.000

Present Value
of Cash Flows
$117,816
100,000
$ 17,816

The lump sum is preferable if the discount rate is 12%:

Item
Year(s)
Receive the annuity ....................... 1-20
Receive the lump sum ................... Now
Net present value in favor
of the lump sum .........................

12-2.
Item
Year(s)
Cost of new equipment ................. Now
Working capital needed ................ Now
Net annual cash receipts ...............
1-8
Salvage value of equipment ..........
8
Working capital released ...............
8
Net present value .......................

Amount of
Cash Flows
$ 12,000
100,000

12%
Factor
7.469
1.000

Present Value
of Cash Flows
$ 89,628
100,000
$ 10,372

Amount of
Cash Flows
($300,000)
( 100,000)
85,000
50,000
100,000

16%
Factor
1.000
1.000
4.344
0.305
0.305

Present Value
of Cash Flows
($300,000)
( 100,000)
369,240
15,250
30,500
$ 14,990

Yes, the contract should be accepted. The net present value is positive, which means that the contract
will provide more than the companys 16% required rate of return.

12-3.

a.

The net annual cash inflow would be:

Net income .................................................................... $ 60,000
Add: Noncash deduction for depreciation ....................
40,000
Net annual cash inflow .................................................. $100,000
The payback period would be:
Payback
Investment required
$450,000
=
=
= 4.5 years
period
Net annual cash inflows $100,000
The machine would not be purchased since it will not provide the 4-year payback period required by
the company.

b.

The simple rate of return would be:

Incremental Incremental
revenues
expenses
Simple rate
$300,000 $240,000
=
=
= 13.3%
of return
Initial investment
$450,000

Chapter 13
How Well Am I Doing?
Statement of Cash Flows

Chapter Study Suggestions

This chapter explains how to prepare a statement of cash flows. The

statement of cash flows is constructed by examining changes in balance
sheet accounts. The chapter contains three key exhibits. The first, Exhibit
13-2, classifies changes in balance sheet accounts as sources and uses of
cash. The second key exhibit is Exhibit 13-7, which provides guidelines
for classifying transactions as operating, investing, and financing
activities. Once transactions have been classified as sources or uses and
as operating, investing, or financing activities, it is fairly straightforward
to put together a statement of cash flows. However, you must keep track
of many details. Therefore, we recommend a systematic approach based
on a worksheet such as the one in Exhibit 13-10 or the T-account
approach in Appendix 3B.

Chapter 13

CHAPTER HIGHLIGHTS
A. The purpose of the statement of cash flows is to
highlight the major activities that have provided and
used cash during the period.
B. The term cash on the statement of cash flows is
broadly defined to include both cash and cash
equivalents. Cash equivalents consist of short-term,
highly liquid investments such as treasury bills,
commercial paper, and money market funds that are
made solely for the purpose of generating a return on
cash that is temporarily idle.
C. A periods net cash flow is equal to the change in
the cash account during the period. Exhibit 13-1 shows
that the change in cash during a period can be
expressed in terms of the changes in all of the noncash
balance sheet accounts. The statement of cash flows is
based on this fact. The statement is basically a listing
of changes in the noncash balance sheet accounts.
D. Changes in noncash account balances can be
classified as sources and uses. On the statement of
cash flows, sources positively affect cash flow and
uses negatively affect cash flow.
1. The following are classified as sources:
a. Net income.
b. Decreases in noncash assets.
c. Increases in liabilities.
d. Increases in capital stock accounts.
2. The following are classified as uses:
a. Increases in noncash assets.
b. Decreases in liabilities.
c. Decreases in capital stock accounts.
d. Dividends paid to shareholders.
3. The sources and uses usually make intuitive
sense. For example, an increase in inventory (a
noncash asset) implicitly requires cash and is
considered to be a use.
E. The FASB requires that the statement of cash
flows be divided into three sections. These sections
relate to operating activities, investing activities, and
financing activities.
1. As a general rule, operating activities enter
directly or indirectly into the determination of net
income. These activities include:
a.

Net income (or net loss).

b.

Changes in current assets.

c. Changes in noncurrent assets that affect

net income, such as depreciation and amortization.

d. Changes in current liabilities (except for

debts to lenders and dividends).
e. Changes in noncurrent liabilities that
affect net income, such as interest on debt.
2. Investing activities consist of changes in
noncurrent assets that are not included in net income.
3. Financing activities consist of transactions
involving borrowing from creditors (other than the
payment of interest), and transactions involving the
owners of a company. Specific financing activities
include:
a. Changes in current liabilities that are
debts to lenders rather than obligations to suppliers,
employees, or government.
b. Changes in noncurrent liabilities that are
not included in net income.
c.

Changes in capital stock accounts.

d. Dividends
shareholders.

paid

to

the

companys

F. Companies sometimes acquire assets or dispose of

liabilities through direct exchange transactions.
1. Examples include issuing capital stock in
exchange for property and equipment and converting
long-term debt into common stock.
2. Direct exchanges that affect only non-current
balance sheet accounts are not reported on the
statement of cash flows itself. Instead, they are
disclosed in a separate schedule accompanying the
statement of cash flows.
G. In some cases, the net change in an account is
shown on the statement of cash flows. In other cases,
the increases and decreases are disclosed separately.
The treatment depends on whether the change appears
in the operating activities section or in the investing
and financing activities sections.
1. For both financing and investing activities,
items on the statement of cash flows must be presented
in gross amounts rather than in net amounts. For
example, if a company buys $100,000 of new
equipment and sells $30,000 of used equipment, both
amounts must be disclosed rather than the net effect of
a $70,000 increase in the equipment account.
2. For operating activities, only the net change in
an account is shown on the statement of cash flows.
H. The net result of the cash inflows and outflows
arising from operating activities is referred to as the

Chapter 13
net cash provided by operating activities. This figure
can be computed using the direct method or the
indirect method.
1. Under the direct method, the income statement
is reconstructed on a cash basis from top to bottom.
This method is discussed in Appendix 17A.

2. To adjust cost of goods sold to a cash basis:

Add (subtract) any increase (decrease) in
inventory.
Subtract (add) any increase (decrease) in
accounts payable.

2. Under the indirect method, the net cash

provided by operations is computed by starting with
net income and adjusting it to a cash basis. The steps
to follow in this adjustment process are shown in
Exhibit 13-8.

3. To adjust operating expenses to a cash basis:

Add (subtract) any increase (decrease) in
prepaid expenses.
Subtract (add) any increase (decrease) in
accrued liabilities.
Subtract the periods depreciation and
amortization charges.

3. The direct and indirect methods yield exactly

the same figure for the net cash provided by operating
activities.

4. To adjust income tax expense to a cash basis:

Subtract (add) any increase (decrease) in
taxes payable.

I. Carefully study Exhibit 13-10, which illustrates

the mechanics of putting together a worksheet. Make
sure you understand each of the entries on this
worksheet. Once this worksheet has been completed,
the statement of cash flows can be easily constructed.
J. Carefully study Exhibit 13-12, which illustrates
the format of the statement of cash flows. Trace each
of the entries from the worksheet in Exhibit 13-10 to
the statement of cash flows in Exhibit 13-12.

Appendix 13A: The Direct Method

A. The direct method differs from the indirect
method only in the operating activities section of the
statement of cash flows. The investing and financing
activities sections of the statement are identical for the
direct and indirect methods.
B. In the indirect method, the income statement is
reconstructed from the top down by converting it to a
cash basis.
1. To adjust revenue to a cash basis:
Subtract (add) any increase (decrease) in
accounts receivable.

Subtract (add) any increase (decrease) in

deferred taxes.

Appendix 13B: The T-account Approach

A. A worksheet is used in the text to prepare the
statement of cash flows using the indirect method.
Instead of the worksheet, T-accounts can be used.
B. To use the T-account approach, create a blank Taccount for cash and T-accounts for each noncash
balance sheet account. Enter the beginning and ending
balances in the noncash T-accounts. Then analyze each
of the noncash T-accounts, making entries much like
journal entries to reconcile the beginning and ending
balances. Decreases in assets, increases in liabilities,
and increases in stockholders equity accounts are
offset by debits to the cash T-account. Increases in
assets, decreases in liabilities, and decreases in
stockholders equity accounts are offset by credits to
the cash T-account.
C. When the beginning and ending balances in all of
the noncash balance sheet accounts have been
reconciled, all of the data for constructing the
statement of cash flows will be in the cash T-account.

Chapter 13

REVIEW AND SELF TEST

Questions and Exercises
True or False

Multiple Choice

Enter a T or an F in the blank to indicate whether the

statement is true or false.

Choose the best answer or response by placing the

identifying letter in the space provided.

___ 1. Dividends received on stock held as an

investment are included in the operating activities
section of the statement of cash flows.

___ 1. For purposes of constructing a statement of

cash flows, an increase in inventory would be
classified as: a) a source and an operating activity; b) a
use and an operating activity; c) a source and an
investing activity; d) a use and an investing activity.

___ 2. Interest paid on amounts borrowed is

included in the financing activities section of the
statement of cash flows.
___ 3. Lending money to another entity (such as
to a subsidiary) is classified as a financing activity.
___ 4. Paying cash dividends to the companys
stockholders is classified as a financing activity.
___ 5. Transactions involving all forms of debt,
including accounts payable, short-term borrowing, and
long-term borrowing, are classified as financing
activities on the statement of cash flows.
___ 6. For both financing and investing activities,
items on the statement of cash flows should be
presented gross rather than net.
___ 7. The direct and indirect methods can yield
different figures for the net cash provided by operating
activities.
___ 8. Only changes in noncurrent accounts are
analyzed for a statement of cash flows.
___ 9. If a company is profitable, the net cash
flow must be positive.
___ 10. (Appendix 17A) The income statement is
reconstructed on a cash basis from top to bottom under
the direct method of computing the net cash provided
by operating activities.
___ 11. (Appendix 17A) In computing the net cash
provided by operating activities, depreciation is added
to net income under the indirect method, but it is
deducted from operating expenses under the direct
method.

___ 2. An increase in accounts payable would be

classified as: a) a source and an operating activity; b) a
use and an operating activity; c) a source and a
financing activity; d) a use and a financing activity.
___ 3. An increase in bonds payable would be
classified as: a) a source and an investing activity; b) a
use and an investing activity; c) a source and a
financing activity; d) a use and a financing activity.
___ 4. An increase in long-term investments
would be classified as: a) a source and an investing
activity; b) a use and an investing activity; c) a source
and a financing activity; d) a use and a financing
activity.
___ 5. Cash dividends paid to the companys
stockholders would be classified as: a) a source and an
operating activity; b) a use and an operating activity;
c) a source and a financing activity; d) a use and a
financing activity.
___ 6. An increase in the companys common
stock account would be classified as: a) a source and
an investing activity; b) a use and an investing
activity; c) a source and a financing activity; d) a use
and a financing activity.

Chapter 13
Exercises
13-1.

Ingall Companys comparative balance sheet and income statement for the most recent year follow:
INGALL COMPANY
Comparative Balance Sheet
(dollars in millions)
Ending
Balance

Beginning
Balance

Assets
Cash .................................................................................
Accounts receivable ........................................................
Inventory .........................................................................
Prepaid expenses .............................................................
Plant and equipment ........................................................
Less accumulated depreciation .......................................
Long-term investments ...................................................
Total assets .................................................................

$ 14
21
50
2
190
(65)
70
$282

$ 10
15
43
6
140
(54)
90
$250

Liabilities and Stockholders Equity

Accounts payable ............................................................
Accrued liabilities ...........................................................
Taxes payable ..................................................................
Bonds payable .................................................................
Deferred income taxes ....................................................
Common stock ................................................................
Retained earnings ............................................................
Total liabilities and stockholders equity ...................

$ 26
10
13
50
36
80
67
$282

$ 25
12
18
40
31
70
54
$250

INGALL COMPANY
Income Statement
(dollars in millions)
Sales .....................................................................
Less cost of goods sold ........................................
Gross margin ........................................................
Less operating expenses .......................................
Net operating income ...........................................
Gain on sale of long-term investments ................
Income before taxes .............................................
Less income taxes ................................................
Net income ...........................................................

$230
120
110
70
40
5
45
14
$ 31

Notes: Dividends of $18 million were declared and paid during the year. The gain on sale of long-term
investments was from the sale of investments for $25 million in cash. These investments had an original
cost of $20 million. There were no retirements or disposals of plant or equipment during the year.
Using the blank form on the following page, prepare a worksheet like Exhibit 13-10 for Ingall Company.

Chapter 13

INGALL COMPANY
Statement of Cash Flows Worksheet
Source
or use?

Cash
Flow
Effect

Accounts receivable ......................... ______

________

Inventory .......................................... ______

Prepaid expenses .............................. ______

Adjusted
Effect

Classification

______

______

_________

________

______

______

_________

________

______

______

_________

Plant and equipment ......................... ______

________

______

______

_________

Long-term investments ..................... ______

________

______

______

_________

Change

Adjustments

Assets (except cash and cash equivalents)

Current assets:

Noncurrent assets:
_______

Liabilities, Contra-Assets, and Stockholders Equity

Contra-assets:
Accumulated depreciation ................ ______

________

______

______

_________

Accounts payable ............................. ______

________

______

______

_________

Accrued liabilities ............................ ______

________

______

______

_________

Taxes payable ................................... ______

________

______

______

_________

Bonds payable .................................. ______

________

______

______

_________

Deferred income taxes ...................... ______

________

______

______

_________

________

______

______

_________

Net income ..................................... ______

________

______

______

_________

Dividends ....................................... ______

________

______

______

_________

______

______

_________

______

______

_________

Current liabilities:

Noncurrent liabilities:

Stockholders equity:
Common stock .................................. ______
Retained earnings

Additional Entries
Proceeds from sale of
long-term investments .......................
Gain on sale of long-term
investments .......................................
Total (net cash flow) ..............................

Chapter 13
13-2. Determine Ingall Companys net cash provided by operating activities using the indirect method.
Net income ........................................................................................

$_________

Adjustments to convert net income to a cash basis:

Depreciation charges ..................................................................

_________

____________ in accounts receivable .......................................

_________

____________ in inventory .......................................................

_________

____________ in prepaid expenses ...........................................

_________

____________ in accounts payable ...........................................

_________

____________ in accrued liabilities ..........................................

_________

____________ in taxes payable .................................................

_________

____________ in deferred taxes ................................................

_________

Gain on sale of long-term investments ......................................

_________

Net cash flow provided by (used in) operations ...............................

13-3. (Appendix 17A) Using the direct method, determine Ingall Companys net cash provided by operating
activities.
Sales ...............................................................................................................

230

Adjustments to convert sales to a cash basis:

____________ in accounts receivable ...................................................
Cost of goods sold .........................................................................................

$
$

120

70

14

Adjustments to convert cost of goods sold to a cash basis:

____________ in inventory ...................................................................
____________ in accounts payable .......................................................
Operating expenses ........................................................................................
Adjustments to convert operating expenses to a cash basis:
____________ in prepaid expenses .......................................................
____________ in accrued liabilities ......................................................
Depreciation charges ..............................................................................
Income taxes ..................................................................................................
Adjustments to convert income taxes to a cash basis:
____________ in taxes payable .............................................................
____________ in deferred taxes ............................................................
Net cash provided by (used in) operating activities ......................................

Chapter 13
13-4.

Prepare a statement of cash flows for Ingall Company using the form below.
INGALL COMPANY
Statement of Cash Flows
Operating activities
Net cash provided by (used in) operating activities .....................................

$_______

Investing activities
_____________________________________________.....................

$_______

_____________________________________________.....................

_______

Net cash provided by (used in) investing activities......................................

_______

Financing activities
_____________________________________________.....................

$_______

_____________________________________________.....................

_______

_____________________________________________.....................

_______

Net cash provided by (used in) financing activities .....................................

_______

Net increase (decrease) in cash ....................................................................

_______

Cash balance, beginning ..............................................................................

_______

Cash balance, ending ...................................................................................

Answers to Questions and Exercises

True or False

Multiple Choice

1. T

Dividends received enter into the determination of net income and therefore are
included in operating rather than investing
activities.

1. b

Inventory is a current asset. Increases in

current assets are classified as uses. Changes
in current assets are considered to be the
result of operating activities.

2. F

Interest paid on amounts borrowed is

included in operating activities since interest
enters into net income.

2. a

3. F

Lending money to another entity is classified as an investing activity.

Accounts payable is a current liability.

Increases in current liabilities are classified
as sources. Changes in current liabilities are
considered to be the result of operating
activities.

4. T

Dividends do not affect net income and

therefore are not considered to be an
operating activity.

3. c

5. F

Transactions involving accounts payable are

included among operating activitiesnot
financing activities.

Bonds payable is a noncurrent liability. An

increase in a noncurrent liability is
considered to be a source. A change in a
noncurrent liability is considered to be a
financing activity unless it enters into net
income.

4. b

Long-term investments is a noncurrent asset

account. An increase in a noncurrent asset is
considered to be a use. A change in a
noncurrent asset is considered to be an
investing activity unless it directly enters
into the determination of net income.

5. d

Dividends are considered to be a use. They

are classified as a financing activity since
they do not enter into the determination of
net income.

6. c

An increase in the common stock account is

considered to be a source and a financing
activity.

6. T

Only transactions involving operating

activities are presented in net amounts.

7. F

The direct and indirect methods will always

yield exactly the same figure for the net
cash provided by operating activities.

8. F

Changes in all noncash accounts, current as

well as noncurrent, are analyzed when
preparing a statement of cash flows.

9. F

The net cash flow may be negative even if a

company is profitable. For example, a
profitable company may make a major
investment using cash reserves it has
accumulated in the past.

10. T

See Exhibit 17A-1 for an example.

11. T

Subtracting depreciation from an expense is

equivalent to adding it to net income.

Exercises
13-1.

The completed worksheet for Ingall Company appears below:

Change
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable ....................
+6
Inventory .....................................
+7
Prepaid expenses .........................
-4
Noncurrent assets:
Plant and equipment ....................
+50
Long-term investments ...............
-20
Liabilities, Contra-Assets, and Stockholders Equity
Contra-assets:
Accumulated depreciation ..........
+11
Current liabilities:
Accounts payable ........................
+1
Accrued liabilities .......................
-2
Taxes payable ..............................
-5
Noncurrent liabilities:
Bonds payable .............................
+10
Deferred income taxes ................
+5
Stockholders equity:
Common stock ............................
+10
Retained earnings
Net income ................................
+31
Dividends ..................................
-18

Source
or use?

Cash
Flow
Effect

Use
Use
Source

-6
-7
+4

Use
Source

-50
+20

Source

Classification*

-6
-7
+4

Operating
Operating
Operating

-50
0

Investing
Investing

+11

+11

Operating

Source
Use
Use

+1
-2
-5

+1
-2
-5

Operating
Operating
Operating

Source
Source

+10
+5

+10
+5

Financing
Operating

Source

+10

+10

Financing

Source
Use

+31
-18

+31
-18

Operating
Financing

+25

+25

Investing

-5

-5

Operating

+4

Additional Entries
Proceeds from sale of
long-term investments .................
Gain on sale of long-term
investments .................................
Total (net cash flow) .........................

Adjust- Adjusted
ments
Effect

+4

-20

Note: The most difficult part of this worksheet is the adjustment for the sale of the long-term invest ments.
Basically, the adjustment moves the gain on the sale from the operating activities section to the investing section.
It would be wise to pay particular attention to this entry and how it affects the statement of cash flows.

13-2. The operating activities section of the statement of cash flows constructed using the indirect method
appears below:
Net income ........................................................................................
Adjustments to convert net income to a cash basis:
Depreciation charges ..................................................................
Increase in accounts receivable .................................................
Increase in inventory ..................................................................
Decrease in prepaid expenses ....................................................
Increase in accounts payable .....................................................
Decrease in accrued liabilities ...................................................
Decrease in taxes payable ..........................................................
Increase in deferred taxes ..........................................................
Gain on sale of long-term investments ......................................
Net cash flow provided by operations ..............................................

$31
11
( 6)
( 7)
4
1
( 2)
( 5)
5
( 5)
$27

Note that the gain on sale of long-term investments is deducted from net income. This removes the gain from the
operating activities section of the statement of cash flows. The gain will show up implicitly in the investing
activities section of the statement of cash flows. See the solution to 13-4 below.

13-3.

The direct method can be used to arrive at the same answer as in 13-2 above.
Sales ................................................................................................................
Adjustments to convert sales to a cash basis:
Increase in accounts receivable ................................................................

$230

Cost of goods sold ...........................................................................................

Adjustments to convert cost of goods sold to a cash basis:
Increase in inventory ................................................................................
Increase in accounts payable ....................................................................

120

Operating expenses .........................................................................................

Adjustments to convert operating expenses to a cash basis:
Decrease in prepaid expenses ..................................................................
Decrease in accrued liabilities ..................................................................
Depreciation charges ................................................................................

70

Income taxes ....................................................................................................

Adjustments to convert income taxes to a cash basis:
Decrease in taxes payable ........................................................................
Increase in deferred taxes .........................................................................
Net cash provided by operating activities .......................................................

(6)

7
(1)

(4)
2
(11)

$224

126

57

14
5
(5)

14
$ 27

13-4.

INGALL COMPANY
Statement of Cash Flows
Operating activities
Net cash provided by operating activities ................................................

$ 27

Investing activities
Proceeds from sale of long-term investments ...................................
Increase in plant and equipment .......................................................
Net cash used for investing activities .......................................................

$25
(50)

Financing activities
Increase in bonds payable .................................................................
Increase in common stock .................................................................
Dividends ..........................................................................................
Net cash provided by financing activities ................................................

10
10
(18)

Net increase in cash ..................................................................................

Cash balance, beginning ..........................................................................
Cash balance, ending ................................................................................

(25)

2
4
10
$14

Chapter 14
How Well Am I Doing?
Financial Statement Analysis

Chapter Study Suggestions

The chapter is divided into two parts. The first part discusses the
preparation and use of statements in comparative and common-size form.
This part of the chapter is easy and involves nothing more complicated
than computing percentages. Your study in this part should be focused on
Exhibits 14-1, 14-2, and 14-4 in the text. These exhibits show how
statements in comparative and common-size form are prepared.
The second part of the chapter deals with ratio analysis. Altogether,
seventeen ratios are presented in this part of the chapter. You should
memorize the formula for each ratio since it is likely that you will be
expected to know these formulas on exams. This may at first seem like an
overwhelming task, but most of the ratios are intuitive and easy to
compute. You should also learn how to interpret each ratio. Exhibit 14-7
in the text provides a compact summary of the ratios.

Chapter 14

CHAPTER HIGHLIGHTS
A. Financial statement analysis is concerned with
assessing the financial condition of the firm.
1. To be most useful, financial statement analysis
should involve comparisons. Comparisons can be
made from one year to another, as well as to other
firms within the same industry.
2. The analyst must be careful not to rely just on
financial statement analysis in making a judgment
about a firm.
a. The ratios should be viewed as a starting
point for analysis rather than as an end in themselves.
They indicate what should be pursued in greater depth.
b. One problem is that companies may use
different accounting methods such as LIFO or FIFO
and these differences in accounting methods may
make comparisons difficult.
c. Another problem is that the ratios are
based on accounting data that show what has
happened in the past. This may not be a reliable guide
to what is going to happen in the future.
B. Three common analytical techniques for financial
statement analysis are: 1) dollar and percentage
changes on statements (horizontal analysis); 2) common-size statements (vertical analysis); and 3) ratios.
1. Horizontal analysis involves placing two or
more yearly statements side-by-side and analyzing
changes between years. These comparisons are made
both in terms of dollars and in terms of percentage
changes from year to year.
a. Showing changes in dollar form helps
identify the most significant changes.
b. Showing changes in percentage form
helps to identify the most unusual changes.
c. Trend percentages are often computed.
Each item, such as sales or net income, is stated as a
percentage of the same item in a base year.
2. A common-size statement shows items in percentages rather than in dollars. Balance Sheet items
are stated as a percentage of Total Assets and Income
Statement items are stated as a percentage of sales.
Preparation of common-size statements is known as
vertical analysis. Showing the balance sheet and the
income statement in common-size form helps the
analyst see the relative importance of the various
items.

3. The gross margin percentage is a particularly

important item on the common-size income statement.
It is defined as follows:
Gross margin percentage =

Gross margin
Sales

The gross margin percentage is used as a rough measure of the overall profitability of a companys products. However, caution is advised. In manufacturing
firms, the gross margin percentage should increase as
sales increase since fixed production costs are spread
across more units.
4. In addition to horizontal and vertical analysis,
stockholders, short-term creditors, and long-term
creditors use a variety of ratios to help them evaluate
companies. Ratios that are designed to meet the needs
of these three different groups are discussed in sections C, D, and E below.
C. Several ratios provide measures of how well the
company is doing from the shareholders perspective.
1. Earnings per share is an important measure of
the annual earnings available for common shareholders. The formula is:

Earnings Net income - Preferred dividends

=
per share
Average number of common
shares outstanding
Preferred dividends are subtracted from net income
since they are not an expense on the income statement
but reduce the earnings that can be distributed to
common shareholders.
2. The price-earnings ratio shows the relation
between the market price of a share of stock and the
stocks current earnings per share. The price-earnings
ratio is computed as follows:
Price - earnings ratio =

Market price per share

Earnings per share

Price-earnings ratios differ from one company to

another although they tend to be similar for companies
in the same industry. One of the biggest factors
affecting the price-earnings ratio is future earnings
growth. If investors believe high future earnings
growth is likely for a company, they will bid up the
price of its stock and hence it will have a high priceearnings ratio.
3. The dividend payout ratio gauges the proportion of current earnings being paid out as dividends.
The formula is:

Chapter 14
Dividend payout ratio =

Dividends per share

Earnings per share

A company with a high dividend payout ratio is paying

out most of its earnings to shareholders as dividends
rather than reinvesting the earnings in the company.
4. The dividend yield ratio measures the cash
yield on the common stockholders investment. The
ratio is computed as follows:
Dividend yield ratio=

Dividends per share

Market price per share

Investors hope to profit from both dividends and

increases in the market value of the stock they own.
The dividend yield measures only the contribution of
the dividends. Note that the current market price per
share is used in this ratio and not the price the investor
originally paid for the shares.
5. The return on total assets is a measure of how
effectively a company has used its assets. The formula
is:

Interest expense
Net income +

(1 - Tax rate)
Return on
=
total assets
Average total assets
a. Note that interest expense is placed on an
after-tax basis by multiplying it by one minus the tax
rate before being added back to net income.
b. Interest expense is added back to net
income to show earnings before any distributions have
been made to either creditors or shareholders. This
adjustment results in a total return on assets that
measures operating performance independently of how
the assets were financed.

return than the fixed rate of return required by the

suppliers of the funds, then financial leverage is
positive. Financial leverage is negative if the assets
earn a return that is less than the fixed rate of return
required by creditors.
b. Sources of leverage include long-term
debt, preferred stock, and current liabilities.
c. Long-term debt is usually a more effective
source of financial leverage than preferred stock since
interest on long-term debt is tax-deductible, whereas
dividends on preferred stock are not.
d. If a company has positive financial
leverage, its common stockholders are likely to benefit
if the company takes on debt.
7. The book value per share measures the common stockholders equity on a per share basis. The
formula is:

Book value Common stockholders' equity

per share =
Number of common
shares outstanding
a. Note that the denominator in this ratio is
the number of common shares outstanding at the end
of the yearnot the average number of shares
outstanding over the year as in the earnings per share
calculation.
b. The book value per share is usually less
than the market value per share. Market value reflects
investors expectations concerning future earnings and
dividends. By contrast, book value measures financial
effects of already completed transactions and hence
looks to the past. Because of this, book value is of
limited usefulness.

6. The return on common stockholders equity

measures a companys ability to generate income. The
formula is:

D. Short-term creditors are concerned with being

paid on time and are far more concerned with a
companys financial assets and cash flows than with
its accounting net income.

Returnoncommon Netincome Preferreddividends

stockholders' equity =
Averagecommon
stockholders' equity

1. Working capital measures the excess of current

assets over current liabilities.

As with earnings per share, preferred dividends are

subtracted from net income since preferred dividends
reduce the earnings available to common shareholders.
The return on common stockholders equity is often
higher than the return on total assets because of
financial leverage.

Negative working capital signals that current assets are

insufficient to cover current liabilities.

a. Financial leverage involves purchasing

assets with funds obtained from creditors or from
preferred stockholders at a fixed rate of return. If the
assets in which the funds are invested earn a greater

Current Current
Working capital = assets - liabilities

2. The current ratio is also a widely used

measure of short-term debt-paying ability. The
formula is:
Current ratio =

Current assets
Current liabilities

Chapter 14
The current ratio, as well as working capital, should be
interpreted with care. The composition of the assets
and liabilities is very important. A high current ratio
does not necessarily mean that the company is easily
able to pay its current liabilities. For example, most of
the current assets may be inventory that is difficult to
sell quickly.
3. The acid-test or quick ratio is designed to
measure how well a company can meet its short-term
obligations using only its most liquid current assets.
The formula is:
Acid - test
=
ratio

Cash + Marketable securities

+ Current receivables
Current liabilities

Current receivables includes accounts receivable and

short-term notes receivable. The current assets in this
ratio do not include inventories or prepaid assets since
they may be difficult to convert into cash.
4. The accounts receivable turnover ratio measures the relation between sales on account and
accounts receivable. The formula is:
Sales on account
Accounts receivable
= Average accounts
turnover
receivable balance

Inventory
Cost of goods sold
turnover = Average inventory balance
The higher this ratio, the quicker inventory is sold.
This is easier to see if the inventory turnover is
divided into 365 days. The resulting figure is called
the average sale period and measures how many days
on average it takes to sell inventory. The formula is:
Average
365 days
sale period = Inventory turnover
The average sale period can differ dramatically from
one industry to another. For example, the average sale
period is much shorter in a florist shop than in a
jewelry shop. Florists have to sell their inventory
quickly or it will perish.
E. Long-term creditors are concerned with both the
near-term and the long-term ability of a firm to repay
its debts.
1. The times interest earned ratio gauges the
ability of a firm to pay interest. The formula is:
Earnings before interest expense
and income taxes
Times interest
=
earned
Interest expense

The higher this ratio, the quicker accounts receivable

are collected. This is easier to see if the accounts
receivable turnover is divided into 365 days. This
gives the average collection period which is computed
as follows:

Generally, the higher the times interest earned, the

greater the ability of the company to make interest
payments.

Average collection
365 days
=
period
Accounts receivable turnover

Debt - to - equity
Total liabilities
=
ratio
Stockholders' equity

As its name implies, the average collection period

indicates the average number of days required to
collect credit sales. Ordinarily a short average collection period is desirable.
5. The inventory turnover ratio relates cost of
goods sold to the average inventory balance using the
following formula:

2. The debt-to-equity ratio relates debt to equity

using the following formula:

The lower this ratio, the greater the excess of assets

over liabilities. Therefore creditors generally prefer a
low debt-to-equity ratio since this provides a large
cushion of protection.

Chapter 14

REVIEW AND SELF TEST

Questions and Exercises
True or False
Enter a T or an F in the blank to indicate whether the
statement is true or false.
___ 1. Horizontal analysis uses dollar and
percentage changes from year to year to highlight
trends.
___ 2. Common-size statements focus on companies of similar size and operations.
___ 3. The current ratio is current assets less
current liabilities.
___ 4. Trend percentages in financial statements
would be an example of vertical analysis.
___ 5. A common-size statement shows items in
percentage form, with each item stated as a percentage
of a total of which that item is a part.
___ 6. The earnings per share figure is computed
after deducting preferred dividends from the net
income of a company.
___ 7. If earnings remain unchanged and the
price-earnings ratio goes up, then the market price of
the stock must have gone down.
___ 8. Dividing the market price of a share of
stock by the dividends per share gives the priceearnings ratio.
___ 9. Book value per share is not a good predictor of future earnings potential.
___ 10. The acid test ratio excludes inventories
from current assets.
___ 11. When computing the return on total assets,
after-tax interest expense is subtracted from net
income.
___ 12. Inventory turnover is computed by dividing
sales by average inventory.
___ 13. If a companys return on total assets is
substantially higher than its cost of borrowing, then
the common stockholders would normally want the
company to have a high debt-to-equity ratio.
Multiple Choice
Choose the best answer or response by placing the
identifying letter in the space provided.

___ 1. Artway Companys net income last year

was $200,000. It paid dividends of $50,000 to the
owners of the companys preferred stock. There were
10,000 shares of common stock outstanding
throughout the year. What was the companys earnings
per share for the year? a) $20; b) $5; c) $15; d) $25.
___ 2. Carston Companys earnings per share is
$3.50 and its market price per share is $28. There are 1
million shares of common stock outstanding. What is
the companys price-earnings ratio? a) 43.75; b) 4.375;
c) 80.0; d) 8.0.
___ 3. Refer to the data for Carston Company in
question 2 above. Assume in addition that the
company pays an annual dividend of $2.17 per share.
What is the companys dividend payout ratio? a) 62%;
b) 7.75%; c) 217%; d) 8.9%.
___ 4. Refer again to the data for Carston
Company in questions 2 and 3 above. What is the
companys dividend yield ratio? a) 62%; b) 7.75%; c)
217%; d) 8.9%.
___ 5. Darsden Companys net income last year
was $800,000; its average assets were $4,000,000; its
interest expense was $200,000; and its tax rate was
30%. What was the companys return on total assets?
a) 23.5%; b) 25%; c) 16.5%; d) 30%.
___ 6. Kristal Companys net income last year
was $600,000. The company paid preferred dividends
of $200,000 to the owners of its preferred stock. The
average common stockholders equity was $5,000,000.
What was the companys return on common
stockholders equity? a) 12%; b) 4%; c) 10%; d) 8%.
___ 7. Harrison Companys common stockholders equity is $24 million. There are 6 million
shares of common stock and 2 million shares of
preferred stock outstanding. What is the companys
book value per share? a) $3.00; b) $4.00; c) $6.00; d)
$2.40.
___ 8. J.J. Companys current assets are $6
million and its current liabilities are $2 million. What
is the companys working capital? a) $6 million; b) $2
million; c) $4 million; d) $8 million.
___ 9. Refer to the data for J.J. Company in
question 8 above. What is the companys current ratio?
a) 3.0 to 1; b) 2.0 to 1; c) 0.33 to 1; d) 0.50 to 1.
___ 10. Refer to the data for J.J. Company in
question 8 above. Assume in addition that the
company has $1 million in cash and marketable

Chapter 14
securities and $1.2 million in current receivables.
What is the companys acid-test ratio? a) 0.8 to 1; b)
1.0 to 1; c) 1.2 to 1; d) 1.1 to 1.
___ 11. Proctor Company had $25 million of credit
sales last year and its average accounts receivable
balance was $5 million. What was the companys
average collection period? a) 73 days; b) 5 days; c) 20
days; d) 84 days.
___ 12. Larimart Companys cost of goods sold last
year was $750,000 and its average inventory balance
was $300,000. What was the companys average days
to sell inventory? a) 2.5 days; b) 5 days; c) 146 days;
d) 912.5 days.

___ 13. Bresser Companys earnings before taxes

last year was $42,000 and its interest expense was
$6,000. What was the companys times interest
earned? a) 12.5 times; b) 1.25 times; c) 80 times; d)
8.0 times.
___ 14. Nupper Companys total liabilities are
$320,000 and its stockholders equity is $400,000.
What is the companys debt-to-equity ratio? a) 0.2 to
1; b) 1.25 to 1; c) 0.8 to 1; d) 5 to 1.
___ 15. The acid-test ratio: a) can be expected to be
less than the current ratio; b) can be expected to be
greater than the current ratio; c) could be either greater
or less than the current ratio; d) none of these.

Chapter 14
Exercises
14-1. The financial statements of Amfac, Inc., are given below for the just completed year (This Year) and for
the previous year (Last Year):
AMFAC, INC.
Balance Sheet
December 31
Assets
Cash ..................................................................
Accounts receivable, net ...................................
Inventory ...........................................................
Prepaid expenses ..............................................
Plant and equipment, net ..................................
Total Assets ...................................................

This Year
$ 8,000
36,000
40,000
2,000
214,000
$300,000

Last Year
$ 10,000
34,000
32,000
1,000
173,000
$250,000

$ 40,000
60,000
50,000
30,000
120,000
$300,000

$ 30,000
40,000
50,000
30,000
100,000
$250,000

Liabilities & Equities

Current liabilities ..............................................
Long-term liabilities .........................................
Preferred stock ..................................................
Common stock ..................................................
Retained earnings .............................................
Total liabilities and equity ............................

AMFAC, INC.
Income Statement
For the Year Ended December 31
Sales (all on account) ........................................
Cost of goods sold ............................................
Gross margin .....................................................
Operating expenses ...........................................
Net operating income .......................................
Interest expense ................................................
Net income before taxes ...................................
Income taxes (30%) ..........................................
Net Income ...................................................
Preferred dividends were $4,000 this year.
Compute the following ratios for this year:
a.

Current ratio.

This Year
$450 000
270,000
180,000
129,000
51,000
6,000
45,000
13,500
$ 31,500

Chapter 14
b.

Acid-test ratio.

c.

Debt-to-equity ratio.

d.

Average collection period.

e.

Inventory turnover.

f.

Times interest earned.

g.

Return on total assets.

h.

Return on common stockholders equity.

i.

Is financial leverage positive or negative? Explain.

Chapter 14
14-2. Cartwright Company has reported the following data relating to sales and accounts receivable in its most
recent annual report
Sales
Accounts receivable

Year 5
$700,000
$ 72,000

Year 4
$675,000
$ 60,000

Year 3
$650,000
$ 52,000

Year 2
$575,000
$ 46,000

Year 1
$500,000
$ 40,000

Express the data above in trend percentages. Use Year 1 as the base year.
Year 5

Year 4

Year 3

Year 2

Year 1

Sales

_______

_______

_______

_______

_______

Accounts receivable

_______

_______

_______

_______

_______

Comment on the significant information revealed by your trend percentages:

Chapter 14
14-3. Consider the following comparative income statements of Eldredge Company, a jewelry design and
manufacturing company:
ELDREDGE COMPANY
Income Statements
For the Years Ended December 31
Sales .........................................................
Cost of goods sold ...................................
Gross margin ........................................
Operating expenses:
Selling expenses .....................................
Administrative expenses ........................
Total operating expenses ......................
Net operating income ...............................
Interest expense .......................................
Net income before taxes ..........................
Income taxes ............................................
Net Income ...............................................
a.

This Year
$600,000
420,000
180,000

Last Year
$500,000
331,000
169,000

87,000
46,800
133,800
46,200
1,200
45,000
13,500
$ 31,500

72,500
51,000
123,500
45,500
1,500
44,000
13,200
$ 30,800

Express the income statements for both years in common-size percentages. Round percentages to one
decimal point.
This Year

Last Year

Sales .........................................................

________

________

Cost of goods sold ...................................

________

________

Gross margin ........................................

________

________

Selling expenses .....................................

________

________

Administrative expenses ........................

________

________

Total operating expenses ......................

________

________

Net operating income ...............................

________

________

Interest expense .......................................

________

________

Net income before taxes ..........................

________

________

Income taxes ............................................

________

________

Net Income ...............................................

________

________

Operating expenses:

b.

Comment briefly on the changes between the two years.

Answers to Questions and Exercises

$200, 000 - $50, 000
= $15
10, 000

True or False
1. T

This is true by definition.

2. F

A common-size statement shows items in

percentage form. Each item is stated as a
percentage of some total of which that item
is a part.

2. d

The computations are:

Price - earnings ratio =

Market price per share

Earnings per share

$28.00
= 8.0
$3.50

3. F

The current ratio is current assets divided by

current liabilities.

4. F

Trend percentages would be an example of

horizontal analysis.

3. a

5. T

This point is discussed in connection with

question 2 above.

Dividend payout ratio =

6. T

The net income available to the common

shareholders is the amount that remains
after paying preferred dividends.

7. F

The opposite is true. If the price-earnings

ratio goes up, then the stock is selling for a
higher market price per dollar of earnings.

8. F

Dividing the market price of a share of stock

by the earnings per share gives the priceearnings ratio.

9. T

Book value per share is the balance sheet

carrying value of completed transactionsit
tells little about the future.

10. T

Inventories are excluded because they may

be difficult to quickly convert to cash.

11. F

When computing the total return on assets,

the after-tax interest expense is added back
to net income to remove its effect.

12. F

Inventory turnover is computed by dividing

cost of goods sold by average inventory.

13. T

If a companys return on total assets is

higher than its cost of borrowing, then
financial leverage is positive. Common
stockholders would want the company to
use this positive financial leverage to their
advantage by having a high amount of debt
in the company.

The computations are:

Earnings Net income - Preferred dividends

=
per share
Average number of common
shares outstanding

Dividends per share

Earnings per share

$2.17
= 62.0%
$3.50
4. b

The computations are:

Dividend yield ratio=

Dividends per share

Market price per share

$2.17
= 7.75%
$28.00
5. a

The computations are:

Interest expense
Net income +

(1 - Tax rate)
Return on
=
total assets
Average total assets

$200, 000
$800, 000 +
(1 - 0.30) = 23.5%
$4,000, 000
6. d

The computations are:

Net income
Preferred dividends
Return on common
stockholers' equity =
Average common
stockholders' equity

$600, 000 $200, 000

= 8%
$5,000, 000

Multiple Choice
1. c

The computations are:

7. b

The computations are:

Book value Common stockholders' equity

per share =
Number of common
shares outstanding

$24, 000, 000

= $4.00 per share
6, 000, 000
8. c

The computations are:

12. c

Inventory
Cost of goods sold
turnover = Average inventory balance

$750, 000
= 2.5 to 1
$300, 000

Current Current
Working capital = assets - liabilities
$6,000 - $2,000 = $4,000,000
9. a

Current assets
Current liabilities

$6, 000, 000

= 3.0 to 1
$2, 000, 000
10. d

The computations are:

Acid - test
=
ratio

Cash + Marketable securities

+ Current receivables
Current liabilities

$1, 000, 000 + $1, 200, 000

= 1.1 to 1
$2, 000, 000
11. a

Average
365 days
sale period = Inventory turnover

The computations are:

Current ratio =

The computations are:

Sales on account
Accounts receivable
= Average accounts
turnover
receivable balance

$25, 000, 000

= 5.0 to 1
$5, 000,000

Average collection
365 days
=
period
Accounts receivable turnover

365 days
= 73 days
5.0

The computations are:

365 days
= 146 days
2.5
13. d

The computations are:

Earnings before interest expense

and income taxes
Times interest
=
earned
Interest expense

$42, 000 + $6, 000

= 8.0 times
$6, 000
14. c

The computations are:

Debt - to - equity
Total liabilities
=
ratio
Stockholders' equity

$320, 000
= 0.8 to 1
$400, 000
15. a

The acid-test ratio will always be less than

the current ratio because it contains fewer
assets in the numerator but the same amount
of liabilities in the denominator.

Chapter14
Exercises
14-1.

$8, 000 + $36, 000 + $40, 000 + $2, 000

Current assets
=
= 2.15 to 1
$40,000
Current liabilities

a.

Current ratio =

b.

Acid - test
=
ratio

c.

Debt - to - equity
Total liabilities
$40, 000 + $60, 000
=
=
= 0.50 to 1
ratio
Stockholders' equity $50, 000 + $30, 000 + $120, 000

d.

Sales on account
Accounts receivable
$450, 000
= Average accounts
turnover
=
= 12.9 times (rounded)
receivable balance $36,000 + $34, 000/2

Cash + Marketable securities $8, 000 + $36, 000

+ Current receivables
=
= 1.10 to 1
$40, 000
Current liabilities

Average collection
365 days
365 days
=
=
= 28 days (rounded)
period
Accounts receivable turnover
12.9
e.

$270,000
Inventory
Cost of goods sold
turnover = Average inventory balance = $40,000 + $32, 000/2 = 7.5 times

f.

Times interest
=
earned

g.

Earnings before interest expense

$51, 000
and income taxes
=
= 8.5 times
$6, 000
Interest expense

Interest expense
$6, 000
Net income +
$31,
500
+
(1 - Tax rate) =
( 1 - 0.30) = 13.0%
Return on
total assets =
Average total assets
$300,000 + $250, 000/2

(rounded)
h.
Total stockholders equity ...........................
Less preferred stock ....................................
Common stockholders equity .....................

End of
Year
$200,000
50,000
$150,000

Beginning
of Year
$180,000
50,000
$130,000

Net income
$31, 500 - $4, 000
Preferred dividends
Return on common
stockholers' equity =
Average common = $150,000 + $130, 000/2 = 19.6% (rounded)
stockholders' equity
i.

Financial leverage is positive, since the return on the common stockholders equity is greater than the
return on total assets.

Chapter 14
14-2.
Sales
Accounts receivable

Year 5
140%
180%

Year 4
135%
150%

Year 3
130%
130%

Year 2
115%
115%

Year 1
100%
100%

Sales grew by about 15% per year through Year 3, and then dropped off to about a 5% growth rate for the
next two years. The accounts receivable grew at about a 15% rate through Year 3, but then rather than
dropping off to about a 5% rate, the accounts receivable grew at an even faster rate through Year 5. This
suggests that the company may be granting credit too liberally and is having difficulty collecting.

14-3.
a.
ELDREDGE COMPANY
Common-Size Comparative Income Statements
For the Years Ended December 31
Sales ....................................................................
Cost of goods sold ..............................................
Gross margin ..................................................
Operating expenses:
Selling expenses ...............................................
Administrative expenses ...................................
Total operating expenses ...............................
Net operating income .........................................
Interest expense ..................................................
Net income before taxes .....................................
Income taxes .......................................................
Net Income .........................................................

This Year
100.0
70.0
30.0

Last Year
100.0
66.2
33.8

14.5
7.8
22.3
7.7
0.2
7.5
2.2
5.3

14.5
10.2
24.7
9.1
0.3
8.8
2.6
6.2

b.
Cost of goods sold and administrative expenses were the two primary areas affecting the percentage
decrease in net income. Cost of goods sold increased from 66.2% of sales in to 70.0% of salesan increase of
3.8% points. On the other hand, administrative expenses dropped from 10.2% of sales to only 7.8% of salesa
decrease of 2.4 percentage points. The net effect was a decrease in net income as a percentage of sales, which fell
from 6.2% of sales to only 5.3% of sales. The increase in the cost of goods sold as a percentage of sales is puzzling
since sales increased. Ordinarily, cost of goods sold as a percentage of sales should decrease as sales increase
because fixed production costs are spread across more units.
Incremental Incremental
revenues
expenses
Simple rate
$300,000 $240,000
=
=
= 13.3%
of return
Initial investment
$450,000