CHAPTER12

INTRODUCTIONTOPRODUCTCOSTING

121FedEx'sHandlingCosts
Thisquestiongetsattwoprincipalconcepts:(1)thedifference
betweenunitcostandtotalcostand(2)theeffectsonunitcostofvolume
changes.Inthisexample,volumerises,butitcouldjustaseasilyhave
fallen,withacommensurateriseinunitcosts.
1.FedEx'stotaldomestichandlingcostsincreased.The12%increasein
volumeoverwhelmedthe1.5%decreaseinunitcost.Usingtheirnumbers,
19931994
Dailypackages*1,633,3331,829,333
Averagecost,assumedfor1993$10$9.85
Totalcost$16,333,330$18,018,930
*Dailypackagesin1994were12%and196,000higherthanin1993.So1993
packageswereabout1,633,333(196,000/12%).The1993perpackagecostis
arbitrary.Anynumberwillshowthesameresult.Thedeclineinunitcost
isprobablyduetotheincreaseinvolume,ratherthantosavingsinvariable
costs.
2.AsFedExincreasesitsvolume,itsperunitcostwillfall,andtherefore
itsprofitmarginwillrise(assuminglevelsellingprices).Totalcosts
willriselessrapidlythanvolumeandrevenueandtotalfixedcostswillbe
spreadovermoreunits.
122OverheadAbsorption
ThestatementmeansthatTraneused85%ofcapacitytosetitsoverhead
rates.IfTraneworksat85%ofcapacityitwillnothaveafixedoverhead
volumevariance.(Itcouldstill,ofcourse,haveabudgetvariance.)Ifit
worksmoreorlessthan85%,itabsorbsmoreorlessoverheadintoinventory,
buttheeconomicsituation(actualoverhead)remainsthesame,ignoringtax
effects(aswedidinthechapter).Selectingalevelofactivityforacost
driverusedasanoverheadbaseissimilartoselectinganyotherkindof
estimatebaddebts,usefullivesoffixedassets,estimatedprovisionfor
inventorylosses,andsoon.Theuseofanoverheadratebasedonsome
specifiedlevelofactivityspeedsupordeferstherecognitionofoverhead
asanexpensebutdoesnot,initself,changethetotalexpensethatwillbe
recognizedoveraperiodofyears.
123OverheadApplication
Thestatedrelationshipofoverheadapplicationtovariationsinfixed
costperunitistruebutwhetherthesituationsaregoodorbadisnotso
clear.Overapplicationofoverheadarisesfromproductioninexcessof
budget,andfromtheearliestofchaptersitwaspointedoutthatfixedcost
perunitdeclinesasvolumeincreases.Thereverseistruefor
underapplication.
Underapplicationoroverapplicationarenotnecessarilygoodorbad.
First,underoroverappliedoverheadsaynothinggoodorbadaboutthe

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controlofoverheadcosts.Therelationshipofactualoverheadtobudgeted
overheadistheimportantpointforcontrol.
Ifthelowercostperunit(ofoverapplication)iscausedbyhigher
productionbecauseofhighersalesthanbudgeted,thesituationisgood
(thoughunderbudgetingsalesisnotdesirablebecauseoftheresource
requirementsgeneratedbysalesbudgets).Ifthelowercostistheresultof
higherproductiononly,thesituationisnotgoodunlessanticipatedsales
arehigher.Ifthehighercostperunitiscausedbylowerproduction
becauseoflowersales,thesituationisbad.Ifsalesarekeepingpacewith
thebudgetandproductionisreduced,thehighercostperunitdoesnot
indicateabadsituation.

Regardless,thevariationsinfixedcostperunitandtheunderor
overappliedoverheadarenottheimportantfactors.
124CostingMethodsandInventories
Thisquestionisdeceptivelysimple.Therewillbenodifferencein
incomesbecauseallcostsexpire,eitherascostofgoodssoldorasa
combinationofcostofgoodssoldandoverappliedorunderappliedoverhead.
Thequestionbringshomethepointthatdifferentcostingmethodsaffect
incomebecausetheygivedifferentinventoryvaluations.Infact,asChapter
14shows,butwhichcouldbediscussednow,thesoledifferencebetween
incomesusinganyinventoryvaluationmethodsliesinthedifferencesin
inventories.
Studentsshouldknowthisfromfinancialaccounting,whereFIFO,LIFO,
andotherinventoryvaluationsaretreated,usuallyformerchandisingfirms.
However,studentsdotendtocompartmentalizeandignorethelessonsof
previouscoursework,andthissimplequestionshouldhelptogetthem
thinkingaboutthereasonsthatincomesdifferunderdifferentmethods.
Itisworthwhiletopointoutthat,ifthecompanyhasinventoriesduring
theyear,itsinterimresultswilldifferusingactualcostingvisavis
normalcosting.
125"What'sNormalAboutIt?"
OverallNotetotheInstructor:Thepurposeofthisquestionis
obvious:toallowyoutobringouttheentiresetofargumentsfavoring
normalcosting.Thetextprovideswhatwebelieveisagoodrationale,but
seldomisatextmoreconvincingthananexplanationfromtheinstructor.If
theusualarguments(confusingresults,potentialdifficultiesinpricingand
analyzingprofitabilityonworkdoneindifferentmonths)don'tseemto
convincetheclass,youmightwanttorefertosomepointsthatstudents
learnedinfinancialaccounting.
Thereisastrongsimilaritybetweennormalcostingandaccrual/deferral
practicesusedinfinancialaccounting.Perhapstheclosestparallelisthe
unitsofproductionmethodofdepreciation,butthesameprincipleappliesto
accruingvacationpayandmajormaintenanceoveranentireyear.Notealso
thattaxes,bonuses,andprofitsharingobligationsareaccruedasthe
companyearnsincome,eventhoughtheseitemsdonotbecomeliabilitiesuntil
thefinalresultsareinfortheyear.
Infact,virtuallyanyallocationofcoststodifferentperiodsparallels
normalcosting.Thoughdepreciationistheobviousexample,perhapsmore
strikingisthecasewhereafirmpaysayear'srentinJanuaryandcannot
subleasetheproperty.Wehavefoundnostudentwhoadvocatedexpensingthe

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wholeyear'srentinJanuaryeventhoughtheexpenditureoccursthenand
cannotberecouped.(Indeed,eventhosefinancialanalystswhoargueto"let
thechipsfallwheretheymay"andequate"reality"withcashflowsshowno
supportforsuchanexpensingpractice.)Inessence,normalcostingtreats
theyearastherelevantaccountingperiod,notthemonthorquarter.That
estimatesproveincorrectshouldnotdeteronefromusingthem,justas
basingdepreciationonestimates(ofusefullifeandsalvagevalue)doesnot
deteronefromcomputingannualdepreciationexpense.Thus,suchconditions
ashighheatingcostsinthewintershouldnotbindafirmtoactualcosting
foreachmonth.
126AreCostAccountantstheVillains?
Mr.Foxprobablymeansthatthecompanyusesabsorptioncostingand
decreasesunitcostsbyproducingmoreunits.Asupervisorcouldalsoreduce
unfavorablelaborefficiencyvariancesbyproducingmoreunitsthanwere
required.
Thecompanyisprobablyapplyingfactoryoverheadonthebasisofmachine
hours.Managersofindividualdepartmentsarethereforeencouragedto
produceasmuchastheypossiblycanduringeachhourofmachineuse.(The
laborcostforanhourofmachinetimeisprobablyfixedandmaterialcosts
chargedtodepartmentsareprobablyindependentofmachinetime.)Toreduce
overheadchargesbyproducingasmuchaspossibleperhourofmachineuse,
departmentmanagerscouldbebunchingtheirjobs,andsoaffectingtheflow
ofjobsthroughthefactory("eachhour...isrunning").Theoverall
issueiswhethercostaccountingsystemsareused,moreorlessexclusively,
toevaluateperformance.ThesamenewsstoryquotedFoxassayingthat"Cost
accountantsneversaidthisisatooltomeasuretheperformanceofpeople."
Chapter13treatsdysfunctionalconsequencesofabsorptioncosting.
127BasicActualJobOrderCosting(1015minutes)
1.$11perhour$220,000/(11,000+9,000)
2.$121,000toKingLouis,$99,000toRanchero.
KingLouisRanchero
Directlaborhours11,0009,000
Times$11rateequalsoverheadapplied$121,000$99,000
3.$366,000forKingLouis,$234,000forRanchero.
KingLouisRanchero
Materialcost$150,000$60,000
Directlaborcost95,00075,000
Overheadcost(part2)121,00099,000
Totalcosts$366,000$234,000
128BasicNormalJobOrderCosting(1520minutes)
1.$110,000toKingLouis,$90,000toRanchero.
KingLouisRanchero
Directlaborhours11,0009,000
Times$10rateequalsoverheadapplied$110,000$90,000
2.$355,000forKingLouis,$225,000forRanchero.
KingLouisRanchero
Materialcost$150,000$60,000

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Directlaborcost95,00075,000
Overheadcost(requirement1)110,00090,000
Totalcosts$355,000$225,000
3.$20,000Underapplied
Actualoverhead$220,000
Appliedoverhead($110,000+$90,000)200,000
Underappliedoverhead$20,000
Appliedoverheadalsoequals20,000directlaborhoursatthe$10rate.
4.Youmightwishtoverifytheoverheadratecalculationfortheclass.
Rate=($150,000+[$4x25,000])/25,000=$250,000/25,000=$10
Youmightwanttopointoutthattheratehasa$6fixedcomponentanda$4
variablecomponent.
$10,000Fand$30,000U
Actualoverhead$220,000
Budgetedoverhead($150,000+[$4x20,000])230,000
Favorablebudgetvariance$10,000
Budgetedoverhead$230,000
Appliedoverhead200,000
Unfavorablevolumevariance$30,000
Thevolumevarianceisalso5,000hours(25,00020,000)x$6
129JobOrderCostingIncomeStatements(1520minutes)
1.
Sales$650,000
Costofgoodssold366,000
Grossprofit284,000
Sellingandadministrativeexpenses260,000
Income$24,000
Showingthedetailsofthecostofsalessection,wehavethefollowing.
Sales$650,000
Costofgoodssold:
Materialcost($150,000+$60,000)$210,000
Directlaborcost($95,000+$75,000)170,000
Overheadcost220,000
Totalcosts600,000
Lessendinginventory(Ranchero)234,000
Costofgoodssold366,000
Grossprofit284,000
Sellingandadministrativeexpenses260,000
Income$24,000
2.
Sales$650,000
Normalcostofgoodssold$355,000
Plusunderappliedoverhead20,000
Costofgoodssold375,000
Grossprofit275,000
Sellingandadministrativeexpenses260,000
Income$15,000

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Again,showingthedetailsofcostofsales,wehavethefollowing.

Sales$650,000
Costofgoodssold:
Materialcost($150,000+$60,000)$210,000
Directlaborcost($95,000+$75,000)170,000
Overheadapplied200,000
Totalcosts580,000
Lessendinginventory(Ranchero)225,000
Normalcostofgoodssold355,000
Plusunderappliedoverhead20,000
Costofgoodssold375,000
Grossprofit275,000
Sellingandadministrativeexpenses260,000
Income$15,000
3.ThecompanyshouldaveragemoreeachmonthbecauseAugustwasalow
month,only20,000hours,5,000belowthemonthlyaverage.Weaskthis
questiontogetstudentsthinkingabouthowthecompanymakesitsmoney,
whichpresumablyislabor.
1210JobOrderCostingIncomeStatement,ServiceCompany(1520minutes)
1.$5,$2variableplus$3fixed($600,000/200,000hours),or
($600,000+[$2x200,000])/200,000
2.
Sales$5,200,000
Normalcostofsales*$3,100,000
Lessoverappliedoverhead**60,000
Costofsales3,040,000
Grossprofit2,160,000
Sellingandadministrativeexpenses1,900,000
Profit$260,000
*Normalcostofsales:
Materials$600,000
Directlabor1,700,000
Overhead($5x160,000)800,000
Total$3,100000
**Actualoverhead$840,000
Appliedoverhead($5x180,000)900,000
Overappliedoverhead$60,000
Analternativecalculationofcostofsalesusingthetotalsfollows.
Directexpenses$700,000
Professionalsalarycost1,900,000
Appliedoverhead900,000
Totalcosts3,500,000
Lessendinginventory*400,000
Normalcostofsales$3,100,000
Lessoverappliedoverhead60,000
Costofsales$3,040,000

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*Directexpenses$100,000
Professionalsalarycost200,000
Appliedoverhead($5x20,000)100,000
Totalcost$400,000
NotetotheInstructor:Youmightwanttocommentonthesimilarities
ofserviceandmanufacturingcompanieshere.Serviceprovidersdonotuse
directmaterialsinthesamesenseinwhichmanufacturersdo,buttheyincur
coststhataredirecttospecificjobs.Professionalsdonotlikebeing
called"directlabor,"buttheanalogyisapt.Theyarethepeoplewho,like
directlaborers,workspecificallyanddirectlyonjobs.
1211PredeterminedOverheadRates(1520minutes)
1.(b)$100,000$5x20,000
(e)$90,000$5x18,000
2.(a)$8$240,000/30,000
(e)$256,000$8x32,000
3.(a)$7$63,000/9,000
(c)10,000$70,000/$7
4.(c)40,000$160,000/$4
(d)43,000$172,000/$4
1212EthicsandOverheadApplication(10minutes)
Thecontroller'sproposalisunethicalandviolatestheIMAStandards.
Ifmachinetimeistheprincipaloverheadcostdriver,tochangethe
applicationbasetolabortimeviolateseventhecompetencestandard.Of
course,tochangethebasesimplytoincreasegovernmentbillingsisillegal
aswellasunethical.Suchanactviolatestheintegritystandardof
"engaginginorsupportinganyactivitythatwoulddiscredittheprofession."
1213OverheadRelationshipsVariances(1520minutes)
1.(b)$596,000$600,000$4,000favorablebudgetvariance
(e)$15,000U$600,000$585,000
2.(d)$3,000F$400,000$397,000
(e)$2,000F$400,000$402,000
3.(b)$394,000$400,000$6,000favorablebudgetvariance
(c)$390,000$400,000$10,000favorablevolumevariance
4.(a)$304,000$310,000$6,000unfavorablebudgetvariance
(c)$322,000$304,000+$18,000favorablevolumevariance
1214JobOrderCostingAssigningOverhead(15minutes)
1.$1.40$0.80variableplus$0.60fixed($600,000/$1,000,000),or
[$600,000+($0.80x$1,000,000)]/$1,000,000
2.$2,478,000(seebelow)
3.$320,000(seebelow)

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4.$276,000(seebelow)

EndingEnding

JobsSoldWorkinProcessFinishedGoods
Appliedoverhead:
$820,000x$1.40$1,148,000
$100,000x$1.40$140,000
$90,000x$1.40$126,000
Materials510,00080,00060,000
Directlabor820,000100,00090,000
Totals$2,478,000$320,000$276,000
5.$7,000overapplied
Appliedoverhead($1,148,000+$140,000+$126,000)$1,414,000
Actualoverhead1,407,000
Overappliedoverhead$7,000
Alternatively,appliedoverheadisactualdirectlaborcostof$1,010,000
times$1.40.
6.$6,000F$600,000budgeted$606,000applied($1,010,000x$0.60)
7.$1,000F$1,407,000($1,010,000x$0.80)+$600,000
1215PredeterminedOverheadRatesJobOrderCosting(1520minutes)
1.$6perhour$240,000/40,000
2.

121314Totals
Machinehours18,00014,0007,00039,000
Overheadappliedat$6$108,000$84,000$42,000$234,000
3.$2,000unfavorablebudgetvarianceand$6,000unfavorablevolume
variance.
ActualOverheadBudgetedOverheadAppliedOverhead
$242,000$240,000$234,000
$2,000U$6,000U
BudgetvarianceVolumevariance
$8,000U
Totalunderappliedoverhead
NotetotheInstructor:Becausethissimpleexercisecontainsonlyfixed
overhead,itcanbeusedeffectivelytoshowwhythevolumevarianceis
economicallyirrelevant.Studentscanseethatthe$6,000unfavorable
variancecomesaboutbecauseMidusworked1,000fewerhours(40,00039,000)
thanthenumberusedtosetthepredeterminedoverheadrate.Youcouldpoint
outthatinordertomakethevolumevariancezero,Miduscouldeither(1)
work40,000hoursor(2)haveused39,000hoursasthedenominatorin
calculatingtherate.Obviously,workingadditionalhoursissenseless
unlessthereisprofitableworktobedone.

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YoumightwishtopointoutthatthevolumevariancedoesshowthatMidus
waslessbusythanithadoriginallyforecast.(Themanagersdonotneedthe
volumevariancetotellthemthattheywerenotasbusyastheyhad
originallyforecast.)Buttheprofitlostbecauseofinabilitytogenerate
workrequiring40,000hours(ifthatwasthecase)isnotthe$6,000volume
variancebutratherthecontributionmarginthatMiduscouldhaveearnedhad
itgottenmorework.(ItisalsopossiblethatMidusdidaboutasmuch
businessasoriginallyforecastbutdiditinfewerhours.)
1216ActivityBasedOverheadRates(2025minutes)
1.$0.24perpartand$7.00permachinehour
PartrelatedMachinerelated
Budgetedoverhead$240,000$700,000
Measureofactivity1,000,000parts100,000hours
Rates$0.24$7.00
2.
CostofSalesWIPFinishedGoodsTotal
Overheadapplied:
Partrelatedat$0.24*$235,200$6,000$8,400$
249,600
Machinerelatedat$7.00**539,00049,00098,000
686,000
Materials,given1,321,00082,000179,000
1,582,000
Directlabor,given788,00033,00048,000
869,000
Totals$2,883,200$170,000$333,400
$3,386,600
*980,000x$0.24=$235,200;25,000x$0.24=$6,000;35,000x$0.24=
$8,400
**$7.00x77,000=$539,000;$7.00x7,000=$49,000;$7.00x14,000=
$98,000
3.Sales$3,890,000
Normalcostofsales$2,883,200
Overappliedoverhead(below)4,600
Costofsales2,878,600
Grossmargin1,011,400
Administrativeexpenses356,000
Income$655,400

PartrelatedMachinerelated
Actualoverhead
$234,000$697,000
Appliedoverhead(totalcolumn,part2)
249,600686,000
Underapplied(overapplied)
($15,600)$11,000

1217BasicJobOrderCosting(15minutes)
1.

QB002WB011LB012Total
Machinehours2,1801,1302,8106,120
Overheadappliedat$4.20/hour$9,156$4,746$11,802$25,704
2.Costofsales,JobQB002($23,400+$24,570+$9,156)$57,126
Endinginventories:

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JobWB011($14,200+$9,220+$4,746)$28,166
JobLB012($36,320+$26,245+$11,802)74,367
Totalendinginventory$102,533
3.Overheadincurred$25,210
Appliedoverhead(requirement1)25,704
Overappliedoverhead$494
1218ComparisonofActualandNormalCosting(2530minutes)
1.$2.80$196,000/($24,000+$18,000+$28,000)
2.

A1A2A3Total
Materialcost$22,000$51,000$38,000$111,000
Directlaborcost24,00018,00028,00070,000
Overheadappliedat$2.8067,20050,40078,400196,000
Totalcost$113,200$119,400$144,400$377,000
3.
Sales$160,000
Costofsales(JobA1)113,200
Grossprofit46,800
Sellingandadministrativeexpenses28,000
Profit$18,800
4.Thepredeterminedoverheadrateis$3($2,100,000/$700,000).

A1A2A3Total
Materialcost$22,000$51,000$38,000$111,000
Directlaborcost24,00018,00028,00070,000
Overheadappliedat$372,00054,00084,000210,000
Totalcost$118,000$123,000$150,000$391,000
Sales$160,000
Normalcostofsales(JobA1)118,000
Normalgrossmargin42,000
Plusoverappliedoverhead14,000
Grossmargin56,000
Sellingandadministrativeexpenses28,000
Profit$28,000
*Overheadapplied$210,000
Actualoverhead196,000
Overappliedoverhead$14,000
NotetotheInstructor:Weincludethetotalcolumnfortworeasons.
First,totalmaterialanddirectlaborcostsarethesameunderbothmethods,
apointthatstudentssometimesmiss.Second,thetotalcolumnemphasizes
thatoverheadappliedtojobsunderactualcostingisactualoverhead,while
undernormalcostingitisthepredeterminedratemultipliedbytheactual
volumeoftheinputfactor(directlaborcosthere).Studentscantherefore
determineappliedoverheadeitherbyaddingtotaloverheadappliedto
individualjobsorbymultiplyingtotaldirectlaborcostbytheoverhead
rate.Theycanthensubtractactualoverheadtofindoverappliedoverhead.
Wecannotdeterminebudgetandvolumevariancesbecausethefixedand
variablecomponentsofoverheadarenotgiven.

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1219GraphicalAnalysisofOverhead(20minutes)
NotetotheInstructor:Thisassignmentallowsyoutodiscussseveral
points:therelationshipofappliedoverheadtobudgetedoverhead,thevisual
interpretationofthevolumevariance,andtheeffectsofdifferinglevelsof
activityonthevolumevariance.Thebasicpurposeofrequirement2isto
showthatthevolumevariancedependsonlyonfixedcosts.Becausethe
predeterminedoverheadratecoversbothvariableandfixedcosts,theamount
absorbedatanyvolumelevelshouldcoverthevariablecostsatthatlevel,
leavingonlyunabsorbedfixedcoststoconstitutethevolumevariance.
Youmightbeststartthecoveragebydirectingthestudents'attentionto
thebudgetline.Thatlineindicatesthatmanufacturingoverheadhasafixed
componentof$200,000(theyaxisintersect).Thevariablecomponentis$2.50
perdirecthour.(At120,000hours,totaloverheadis$500,000.Subtracting
the$200,000fixedcostsfrom$500,000leaves$300,000ofvariablecosts;
dividing$300,000by120,000hoursyieldsthevariablecomponentof$2.50per
hour.)Webelieveitisimportanttodealfirst,andindependently,withthe
budgetequationforthiscost,soastodistinguishclearlybetweenthe
behaviorofthecostand"behavior"ofoverheadapplication.Theoriginal
graphemphasizesthebehaviorofthecostcompletelyapartfromany
manipulationofthatcostbymeansofanoverheadapplicationrate.
Studentsshouldhavenodifficultydrawingthefirstabsorptionline,for
anabsorptionrateof$5perhour(requirementla).Forthesecondline,
requirementlb,studentsneedonlytoconnecttheoriginwiththebudgetline
atthatlevelofvolumeusedtosettheoverheadrate(100,000).
Graphically,thevolumevariance(requirement2)istheverticaldistance
betweenthebudgetlineat90,000hoursandtheabsorptionlineat90,000
hours.
Thevolumevarianceforthefirstoverheadrateis$25,000favorable,
computedasfollows:

Budgetedoverheadat90,000hours
$200,000+($2.50x90,000)$425,000
Overheadappliedat90,000hours($5x90,000)450,000
Volumevariance,favorable$25,000

Thevolumevarianceforthesecondoverheadrateis$20,000unfavorable,
computedasfollows:
Budgetedoverheadat100,000hoursusedtoset
theoverheadrate
$200,000+($2.50x100,000)$450,000
Overheadrate($450,000/100,000)$4.50
Budgetedoverheadat90,000hours,asabove$425,000
Overheadappliedat90,000hours($4.50x90,000)405,000
Volumevariance,unfavorable$20,000
Atthispoint,wehavefulfilledthetworequirementsoftheassignment.
However,wethinkitisusefultocontinuetheproblemtoemphasizethe
point,madeinthetext,thatthevolumevariancedependsonlyonfixed
costs.Thetextintroducesthevolumevarianceinthecontextofaseparate
overheadrateforfixedoverheadandshowsitscalculationaseither:
VolumeBudgetedApplied
=fixedfixed
varianceoverheadoverhead

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or
Volumepredetermined
=(budgetedhoursactualhours)xfixedoverhead
variancerate

Knowingthevariablecomponentofthebudgetequationtobe$2.50per
hour,andknowingthe$5perhouroverheadrateinpartla,wecaninferthat
$2.50($5$2.50)oftherateisforfixedoverhead.Atthelevelof
activityatwhichtheabsorptionratewasset,allfixedcosts(aswellas
allvariablecosts,ofcourse)areabsorbed,sowecancomputethatlevelof
activityas80,000hours($200,000fixedcosts/$2.50perhour).The
previouslycomputedvolumevarianceof$25,000favorableisconsistentwith
thisapproach.Actualvolumeof90,000hoursis10,000hoursgreaterthan
thevolumelevelusedtocomputetheoverheadrate(80,000).Thevolume
varianceequals$25,000or10,000hourstimesthe$2.50perhourratefor
fixedoverhead.
Knowingthevariablecomponentofthebudgetequation($2.50)andthe
$4.50perhouroverheadrateinpart1b(computedabove),wecaninferthe
$2.00perhourcomponentforfixedcosts.(Notethat$2isconsistentwith
fixedcostsof$200,000andvolumeof100,000hours.)The$20,000
unfavorablevolumecanbeseennowas10,000hourslessthanbudgetedvolume
timesthe$2.00perhourrateforfixedoverhead.

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$(000s)

500=
_______

$25F
_____$20U
400

200

|
100
volume(thousands)
1220JobOrderCostingforaServiceBusiness(20minutes)
1.$32,$3,200,000/100,000
2.
GrandBayGoldBigButteCopperFlakeRiver
Engineers'cost$5,000$8,300$3,600
Otherexpenses2,0002,5001,200
Overheadat$32perhour6,40011,2004,800
Totalcosts$13,400$22,000$9,600
NotetotheInstructor:Youmightwishtopointoutthatanengineering
firm,oranyotherserviceorganizationthatchargesfortime,doesnothave
inventorybutdoeshaveworkinprocess.Grimm'sWIPisitsjobs,whichit
couldcallunbilledrevenueorsomeotherdescriptivetitle.
1221BasicJobOrderCosting(1015minutes)
1.311312313Totals
Machinehours1,4801,2308603,570
Overheadappliedat$3.70$5,476$4,551$3,182$13,209
Materialcost15,26021,3408,89045,490
Directlaborcost18,25014,55011,10043,900

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Totalcost$38,986$40,441$23,172$102,599
2.$229overapplied,$13,209applied$12,980actual
NotetotheInstructor:Wecannotisolatethebudgetvarianceandvolume
variancebecausewedonothavethebudgetformula.
1222OverheadApplication(15minutes)
1.$2.66($186,200/70,000)
2.(a)$178,220(67,000x$2.66)
(b)$87,100(67,000x$1.30)Thisistheanswertobothparts,
incurredandapplied.
(c)$1,500unfavorablebudgetvariance,$7,980unfavorablevolume
variance.
Actualoverhead$274,800
Budgetedoverhead($186,200+$87,100[partb])273,300
Unfavorablebudgetvariance$1,500
Budgetedoverhead$273,300
Appliedoverhead($178,220[parta]+$87,100)265,320
Unfavorablevolumevariance$7,980
NotetotheInstructor:Thisexercisehastwoaspectsthatyoumight
wishtodevelopinclass.First,itlistsoverheaditemsinsteadofsimply
givingtotals.Studentsoccasionallyneedremindingthatoverheadconsists
ofanumberofseparateelements.Second,youcouldreinforcethepointthat
thevolumevariancerelatesonlytofixedoverhead.Bothbudgetedand
appliedvariableoverheadaregiveninrequirement2b,sothatthevolume
varianceiseasilyseenasthedifferencebetweenbudgetedandappliedfixed
overhead.
Budgetedfixedoverhead$186,200
Appliedfixedoverhead(part2a)178,220
Unfavorablevolumevariance,3,000x$2.38$7,980
1223OverheadApplication(1520minutes)
1.$5.00[$600,000+($3x300,000)]/300,000,ordoingthefixedand
variableratesseparately,$3variable+$2fixed($600,000/300,000)
2.
Appliedoverheadincostofsales(275,000x$5)$1,375,000
Appliedoverheadininventories(40,000x$5)200,000
Totalappliedoverhead1,575,000
Incurredoverhead1,585,000
Totalunderappliedoverhead$10,000
ActualoverheadBudgetedoverheadAppliedoverhead
$600,000+($3x315,000)
$1,585,000$1,545,000$1,575,000
$40,000U$30,000F
BudgetvarianceVolumevariance
$10,000
Totalunderappliedoverhead
NotetotheInstructor:Youmayalsoshowthatthevolumevariance

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1213

relatesonlytofixedoverhead.
Budgetedfixedoverhead$600,000
Appliedfixedoverhead($2x315,000)630,000
Favorablevolumevariance$30,000
1224JobOrderCostingActivityBasedOverheadRates(20minutes)
1.$0.40permaterialdollarand$5.50permachinehour
MaterialrelatedMachinerelated
Budgetedoverhead$640,000$1,100,000
Measureofactivity$1,600,000200,000
Rates$0.40$5.50
2.
JobXT56JobXR23JobXY67Total
Overheadapplied:
Materialrelatedat$0.40*$8,400$32,800$15,600$
56,800
Machinerelatedat$5.50**46,75024,75015,950
87,450Totalappliedoverhead$55,150$57,550$31,550
$144,250Materials,given21,00082,00039,000
142,000Directlabor,given16,00013,00018,000
47,000Totalcostsofjobs$92,150$152,550$88,550
$333,250
*$0.40x$21,000=$8,400;$0.40x$82,000=$32,800;$0.40x$39,000=
$15,600
**$5.50x8,500=$46,750;$5.50x4,500=$24,750;$5.50x2,900=
$15,950
Weincludethetotalcolumnonlyforcheckinganddeterminingtotal
appliedoverhead.Itisnotpartoftherequirements.

3.
MaterialrelatedMachinerelated
Actualoverhead$59,200$92,800
Appliedoverhead*56,80087,450
Underapplied$2,400$5,350
*Fromrequirement2,totalcolumnAlternatively,$0.40x($21,000+
$82,000+$39,000)=$56,800and$5.50x(8,500+4,500+2,900)=$87,450

1225JobOrderCosting

TwoDepartments(2025minutes)
1.$6permachinehourand$2perdirectlaborhour
MachiningAssembly
Budgetedoverhead$720,000$120,000
Measureofactivity120,00060,000
Rates$6$2
2.Job#1029Job#1030Totals
Overheadapplied:
Machiningat$6(4,000and5,000)$24,000$30,000$54,000
Assemblyat$2(2,000and3,200)*4,0006,40010,400
Materialsandlabor,given45,00070,400115,400
Totalcosts$73,000$106,800$179,800
*Laborhoursaredeterminedbydividinglaborcostby$12.

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3.MachiningAssembly
Actualoverhead$55,500$10,200
Appliedoverhead(totalsabove)54,00010,400
Underapplied(overapplied)$1,500($200)
NotetotheInstructor:Youmightwishtoasktheclasswhetherthe
underappliedoverheadindicatespoorcontrolovercostsduringMarch.(Good
controlfortheoverappliedoverhead.)Thequestioncannotbeanswered
definitivelybecausewedonotknowwhetherthefixedcomponentsarebudgeted
inequalmonthlyamounts.(Forexample,insomeareas,Marchisacold
month,givinghigherthanaverageutilitybills.)Wecansaythatactivity
inMarchwasbelowtheaveragemonthlyamountinmachining,andaboveitin
assembly,asshownbelow.
MachiningAssembly
Actualactivity(4,000+5,000),(2,000+3,200)9,000MH5,200
DLHAverageactivity(120,000/12),(60,000/12)10,000
5,000Over(under)averageactivity(1,000)
200

1226BasicJobOrderCosting(20minutes)
1.M101R12Z610
Machinehours8,8008,2007,200
Overheadappliedat$11.40/hour$100,320$93,480$82,080
2.Costofsales,JobM101($35,800+$123,200+$100,320)$259,320
Endinginventory:
JobR12($73,200+$120,200+$93,480)286,880
JobZ610($40,600+$78,300+$82,080)200,980
Totalendinginventory$487,860
3.
Appliedoverhead($100,320+$93,480+$82,080)$275,880
Overheadincurred271,300
Overappliedoverhead$4,580

NotetotheInstructor:Youcanusethisproblemtomaketwopoints
beyonditsgivenscope.First,wecannotdeterminewhethercostswereunder
controlbecausewedonotknowbudgetedoverhead.Wehaveonlyasingle
predeterminedrateandnoinformationaboutitsfixedandvariable
components.Thisisclearlyadrawbackasfarasanalysisisconcerned.
Second,wedoknowthatthemonthwasrelativelybusybecausemachinehours,
totaling24,200,werewellaboveapaceof280,000hoursfortheyear(24,200
x12=290,400).Therefore,partofoverappliedoverheadresultsfroma
favorablevolumevariance,theamountofwhichdependsonthefixedcomponent
ofthepredeterminedoverheadrate.
1227JobCostinginaServiceFirm(1520minutes)
1.$260,000
Revenue:
Professionalstaff,$700,000x.80x2.5$1,400,000
Supportstaff,$78,000x.40x2.578,000
BarnesandDiLello,1,200x2x$100240,000
Totalrevenue1,718,000
Expenses1,458,000
Income$260,000

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2.$1,092
Hourlyrates($30,000/1,800)x2.5$42
($35,000/1,800)x2.5)49
Total91
Hoursworked12
Charge$1,092
1228OverheadCostsandPricingPolicy(10minutes)
1.Busymonthswillappearmoreprofitable,partlybecausetheyaremore
profitable,butalsobecauseoverheadassignedtojobsinbusymonthswillbe
spreadmorethinly.
2.Thepricingpolicyisreasonablebecauseitisbasedonexpectedresults
(andhistoricalresults)forafairlylongperiod.Horton'sproblemisthat
thedifferentprofitabilitiesofsimilarjobsconfusesher.Hortonshould
usenormalcostingtoavoidthemonthlyfluctuationsinoverheadrates.
NotetotheInstructor:Thisshortproblemisnotdifficult,butitis
interestingbecauseitshowsasituationoppositetothatmentionedinthe
chapter.Thechapterspeaksofthedangersofusingactualcostingdatafor
pricingpurposes.Thisprobleminvolvesamanagerwhowiselyusesanormal
costingapproachtopricingandalsowiselyquestionsthevalueofthe
actualcostingdatashereceives.
1229JobOrderCosting(2025minutes)
1.$678,600inworkinprocess,$1,806,510incostofsales

WorkinProcessCostofSales
Directlaborusedthismonth$452,400$892,880
Overheadat$1.50$678,600$1,339,320
Overheadinbeginninginventory467,190
Totaloverhead$1,806,510
2.$1,999,490
Appliedoverhead($678,600+$1,339,320)$2,017,920
Lessoverappliedoverhead18,430
Actualoverhead$1,999,490
3.
Sales$4,680,000
Normalcostofsales*$4,140,740
Lessoverappliedoverhead18,430
Costofsales4,122,310
Grossmargin557,690
Sellingandadministrativeexpenses453,650
Profit$104,040
*Normalcostofsales:
Materials($237,670BI+$881,480)$1,119,150
Directlabor($322,200BI+$892,880)1,215,080
Overheadapplied(part1)1,806,510
Normalcostofsales$4,140,740
Analternativeistousetheformat:
Beginninginventory($237,670+$322,200+$467,190)$1,027,060
Currentperiodcosts:

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Materials($228,310+$881,480)1,109,790
Directlabor($452,400+$892,880)1,345,280
Overheadapplied($1,345,280x$1.50)2,017,920
Total5,500,050
Lessendinginventory($228,310+$452,400+$678,600)1,359,310
Normalcostofsales$4,140,740

1230JobOrderCostingComparisonofOverheadRates(20minutes)
1.$8.90,$1,780,000/200,000Notethatalloverheadmustbeincluded
here.Studentsfrequentlyuseonlythecostapplicabletothesingledriver.
2.
JobXT56JobXR23JobXY67Totals
Overheadappliedat$8.90$75,650$40,050$25,810$141,510
Materials,given21,00082,00039,000142,000
Directlabor,given16,00013,00018,00047,000
Totalcostsofjobs$112,650$135,050$82,810$330,510
3.$0.30permaterialdollarand$6.50permachinehour
MaterialrelatedMachinerelated
Budgetedoverhead$480,000$1,300,000
Measureofactivity$1,600,000200,000
Rates$0.30$6.50

JobXT56JobXR23JobXY67Totals
Overheadapplied:
Materialrelatedat$0.30*$6,300$24,600$11,700$
42,600
Machinerelatedat$6.50**55,25029,25018,850
103,350Totalappliedoverhead$61,550$53,850$30,550
$145,950Materials,given21,00082,00039,000
142,000Directlabor,given16,00013,00018,000
47,000Totalcostsofjobs$98,550$148,850$87,550
$334,950
*$0.30x$21,000=$6,300;$0.30x$82,000=$24,600;$0.30x$39,000=
$11,700
**$6.50x8,500=$55,250;$6.50x4,500=$29,250;$6.50x2,900=$18,850
Weincludethetotalcolumnonlyforcheckingandfordeterminingtotal
appliedoverhead.Itisnotpartoftherequirements.
JobXT56showsalowercostbecauseithashighmachinetimeand
relativelylittlematerialcost.The$2.40decreaseinthematerialrate
(from$8.90to$6.50)affectedthecostofXT56considerablymorethanthe
addingof$0.30permaterialdollar.ThecostofJobXR23increasedbecause
ithassomuchmaterialthattheaddedoverheadappliedexceededthe
reductionofmachinerelatedoverheadapplied.ThecostofXY67alsorose.
ThatjobissimilartoXR23exceptthatitissmallerintotal.
Allthreejobsshowedsignificantchanges.Thequestioniswhetherthe
refinementwillenablemanagerstomakebetterdecisions,sufficientlybetter
torepaytheincreasedbookkeepingcost.

1231JobOrderCostingforaServiceBusiness(20minutes)
NotetotheInstructor:Westlakecombinesanoverheadandprofitrate,
whichmightconfusestudents.ItmightbehelpfultopointoutthatWestlake

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isnotapubliccompanyandsodoesnothavetoabidebyGAAP.
Weused"allotherjobs"becauseataxfirmwillhaveamultitudeof
clientsanditisobviouslyimpracticable,andundesirable,forstudentsto
repeatcalculationsoverandover.Wegavethejobsnamesthatyoumight
wishtousetoexplainthesortsofthingsthattaxspecialistsdo.
1.$30forseniors,$60,000/2,000,$15forjuniors,$30,000/2,000
2.$44perhour,($8,200,000+$600,000)/200,000

3.
WaltonEstateGHK,IncAll

PlanningFederalReturnOtherJobs
Senioraccountantcost*$1,200$600$90,000
Junioraccountantcost**9001,500180,000
Overhead/profitat$44/hour***4,4005,280660,000
Totalprice$6,500$7,380$930,000
*$30x40,20,and3,000
**$15x60,100,and12,000
***$44x(40+60),(20+100),(3,000+12,000)
4.Westlake'ssystemdiffersonlyinthatitcombinesprofitwithoverhead.
Amanufacturercoulddothesameforinternalpurposes,thoughnotfortax
andGAAPpurposes.Westlake'smethodmakessenseinthatitallowsthe
companytodeterminewhatitschargesmustbetoachieveitsprofit
objective.
1232JobOrderCostingBeginningInventory(25minutes)

1.Overheadapplication

422423
424425Total
Directlaborhours(cost/$8)2,0004,0006,5001,500
14,000
Overheadappliedat$15xDLH$30,000$60,000$97,500$22,500
$210,000

2.$2,000underapplied($212,000incurred$210,000applied)
3.Costofgoodssold=$609,500,endinginventory=$43,500(costof425)

TotalcostsofjobsforMarch

422423424425Total
Materials$11,000$46,000$60,000$9,000
$126,000
Directlabor16,00032,00052,00012,000
112,000
Overheadapplied30,00060,00097,50022,500
210,000
TotalcostsforMarch57,000138,000209,50043,500
448,000
Beginninginventorycosts172,00033,00000
205,000Totalcosts$229,000$171,000$209,500$43,500

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$653,000
Normalcostofsales=costsofjobs422,423,and424=$229,000+
$171,000+$209,500=$609,500
4.Incomestatement

Sales$860,000
Normalcostofsales$609,500
Underappliedoverhead2,000
Costofsales611,500
Grossmargin248,500
S&Aexpenses180,000
Profit$68,500
1233CVPAnalysisforaJobOrderCompany(2530minutes)
1.$72,000

Materialcost$200,000
Directlaborcost360,000
Factoryoverhead400,000
Totalfactorycosts$960,000
Revenueat120%offactorycost$1,152,000
Factorycost$960,000
Sellingandadministrativeexpenses120,0001,080,000
Profit$72,000
2.$18,000,calculatedasfollows.
Materials($200,000x87.5%)$175,000
Directlabor($9x35,000)315,000
Appliedoverhead($10x35,000)350,000
Totalmanufacturingcostforpricingpurposes$840,000
Revenueat$840,000x120%$1,008,000
Costs:
Materials$175,000
Directlabor315,000
Variableoverhead($160,000x87.5%)140,000
Fixedoverhead240,000
Sellingandadministrativeexpenses120,000990,000
Profit$18,000
Sales$1,008,000
Normalcostofsales(above)$840,000
Underappliedoverhead($140,000+
$240,000$350,000applied)30,000
Costofsales870,000
Grossprofit138,000
Sellingandadministrativeexpenses120,000
Profit$18,000
3.About22.9%overfactorycost,calculatedasfollows.

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Totalmanufacturingcost$960,000
Sellingandadministrativeexpenses120,000
Desiredprofit100,000
Requiredrevenue$1,180,000
Dividedbymanufacturingcostequals122.9%

1234CostingandPricinginaHospital(20minutes)
1.$0.979,totalcostof$960,000dividedby981,000minutes
ClassofTimeRequiredNumberPerformedTotalTime

Test(minutes)xinAverageYear=forClass
I1238,000456,000
II1517,000255,000
III309,000270,000
Totalminutes981,000
2.Prices
ClassofTimeRequired

Test(minutes)x$0.979=PriceperTest
I12$11.75
II1514.69
III3029.37
3.Profitof$13,180,revenueof$978,180$965,000
Classof

TestNumberPerformedxPrice=Revenue
I37,000$11.75$434,750
II17,00014.69249,730
III10,00029.37293,700
Totalrevenue$978,180
NotetotheInstructor:Besidesshowingtheapplicationofnormal
costingtechniquestoahospital,thisproblemallowsyoutoshowtheeffects
ofmissedestimationsofcostandactivity.Inrequirement3,thelaboratory
did18,000minutesmorevolumethanplanned(1,000moreClassIIItestsadded
30,000minutes,while1,000fewerClassItestssaved12,000minutes).At
$0.979perminute,theadditionalvolumebrought$17,600+additional
revenue.(Fortheoriginalmixoftests,expectedrevenueisabout$960,500.)
1235OverheadApplicationandPricingDecisions(1520minutes)
1.Allelseequal,Westminstershouldaccepttheorderbecauseitwillhave
revenueof$43,000andincrementalcostsof$37,500.Fromthetwoyears'
budgetdatathevariableandfixedcomponentsofoverheadcanbecomputedas
follows:
Budgetat60,000hours$300,000
Budgetat50,000hours275,000
Difference$25,000
Changeinbudgetfor1hourchange,$25,000/10,000$2.50
Totalbudgetat60,000hours$300,000
Lessvariableportion,60,000x$2.50150,000
Fixedcomponent$150,000

Theincrementalcostofproducingtheorderis
Materials$12,000

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Labor18,000
Variableportionofoverhead($2.50x3,000hrs.)7,500
Total$37,500

2.Thesalesmanagershouldbemostlikelytoknowwhetherthespecial
ordermightreduceregularsales.Shesaysthattherewillbenoeffect.
Thoughtheremightbenoeffectonthesalesofthecurrentyear,salesof
futureyearsmightwellbeaffected.Highqualityfurnitureisexpensive,
andpurchasesaremajoritemsinaconsumer'sbudget.Thelowerpriceat
whichthewholesaleriswillingtobuycanbeexpectedtoresultinlower
retailpricesinsomestores.Theselowerpricesmighttemptsomeconsumers
topurchaseearlierthanplanned,sofuturesalesbyWestminstermightbe
hurt.
Thereisnoindicationintheproblemthatthemerchandiseforthe
specialorderwillnotbearthecompany'sname.Ifthecompany'snameis
used,thesalesmanager'sestimateofnoeffectonregularsalesismore
questionable.Evenifregularsalesarenotaffectedthisyear,itisquite
possiblethatthecompany'sdealerswillbeunhappyifnewcompetitorsappear
aftertheregulardealershavebuiltareputationforcarryingtheline.
Westminstermightalsofinditselfacceptingmoreandmorebusinessat
pricesthatdonotcovertotalcosts,sothatitmightfillupitscapacity
withsuchbusinesstothedetrimentofprofitability.

1236OverheadRatesandCostAnalysis(1015minutes)
Memorandum
To:Mr.Williams
From:Student
Subj:Bidprice
Date:Today
Consideringonlytheimmediateeconomiceffects,weshouldacceptthe
order.Thecostsrelevanttothedecisionaretheincremental(inthiscase,
allvariable)costs.Myanalysisfollows.

Sellingpriceforthespecialpress$75,000
Variablecosts:
Materialsandlabor,$29,600+$19,800$49,400
Overhead,$7.20x2,200*15,84065,240
Additionalcontributionmarginfromorder$9,760
*$12perhr.x60%=$7.20perhr.
$19,800/$9perhr.=2,200hrs.
The$9,760increaseinmarginmightwellbetheminimumincreasetobe
expected,becauseitisquitepossiblethatsomeportionoflaborcostis
fixed.Thisisthecaseifwedecide,becauseoftheriskoflosingworkers
tootherfirmsorforotherreasons,tokeepworkersonevenifweare
operatingbelowcapacity.
Animportantquestioninmostspecialordersituationsiswhether
acceptinganorderatapricebelowthatnormallychargedwillcreateill
willamongregularcustomers.Asajobordercompany,weprobablydonot
confrontthatproblemtotheextentthatamanufacturerofstandardproducts

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does,becauseourcustomerscannotmakepricecomparisonsassimplyascan
thoseofamassproductioncompany.Customersseeingacompanychargingless
forastandardmodelofrefrigeratorareinapositiontocomplainandtogo
elsewhere.Butpricecomparisonsarenotsoreadilyavailableforcustom
madeequipmentsuchasoursandalternativesourcesarenotasnumerous.In
ourcase,dissatisfactionamongregularcustomersdependsontheirknowing
aboutthe$75,000priceandtheirbeingabletocomparethatparticular
custommadepresswithotherstheyhavepurchased.
NotetotheInstructor:Thisproblemgivesyoutheopportunityto
discusspricingmethods.Thecompanyusesatechniquenotuncommonin
industry,withfactorycostasthebasisforsettingpricesandallowances
addedforsellingandadministrativeexpensesandforprofit.Because
"allowances"suchastheonesusedbyWaltonarenotdiscussedinthetext,
studentsmayaskaboutthebasesfortheirestablishment.Youmighteven
wanttoraisethatquestionyourselfsoastoshowthattheapproachneednot
bearbitraryorunsupported.
Apricingpolicysuchastheoneintheproblemcancomeaboutasa
resultofanalyzingthecompany'sbudgetedactivity.Toshowhowthismight
happen,we'llassumesomeadditionalinformationaboutthebudgetedactivity
forWaltonfortheyear.
Materials$1,000,000
Labor,at$9perhouronanticipatedactivityof300,000hours2,700,000
Overhead,budgetedat$1,440,000+$7.20perDLH3,600,000
Budgetedtotalfactorycost$7,300,000
Budgetedtotalsellingandadministrativeexpenses730,000
Targetprofitasestablishedbymanagementat15%
oftotalcost[($7,300,000+$730,000)x15%]$1,204,500
Atthebudgetedlevelofactivity(300,000hours)theoverheadrateis
thestatedrateof$12perhour($3,600,000/300,000),andtheportionofthe
raterepresentingfixedcostsisthestated40%($1,440,000/$3,600,000)or
$4.80.The10%standardallowancefornonfactorycostswouldderivefromthe
factthatbudgetedamountsforsuchcostsbearthatrelationshiptobudgeted
totalfactorycosts.Ifthecompanyisabletogetthebudgetedbusiness,
expressedintermsofmanufacturingcosts,andchargespricesforthat
businessinlinewiththepolicy,itwillearnthebudgeted$1,204,500
profit.Thus,thepricingpracticefollowedbyWaltonneednotbearbitrary
andmightbesupportedbythecompany'sbudget.Avarietyofpricing
practicesarefoundinbusiness,manyofwhich,likeWalton's,utilizesome
typeofallowanceforvariouscostfactors.
Onestatementintheproblemisparticularlyworthdiscussingbecauseof
itssimilaritytoanothercommonlyusedbutoftenmisleadingstatement.Itis
notuncommontohearbusinesspeoplesaythat"variableoverheadisX%of
totaloverhead."Theproblem,ontheotherhand,statesthevariableand
fixedportionsoftheoverheadrate.Fortheformerstatementtobetrue,
thespeakermustknowtotaloverhead,becausetheproportionoftotal
variable(orfixed)overheadtototaloverheaddependsonthelevelof
activity.Becausetheoverheadrateiswhatmanagersgenerallyusefortheir
analyses,wethinkitlikelythatourstatementexpressesthemeaningthat
managersintendtoconveywhentheyusetheformerstatement.
1237PricingPolicyandProfits(2530minutes)
1.$7,200,000
Fixedcosts($1,200,000+$800,000)$2,000,000
Variablemanufacturingcosts(240,000x$15)3,600,000

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1222

Profit880,000
Total6,480,000
Dividedby0.90,1variableS&Arate.90
Totalrevenuerequired$7,200,000
2.$30($7,200,000/240,000)
3.$760,000
Revenue(230,000x$30)$6,900,000
Variablemanufacturingcosts(230,000x$15)$3,450,000
VariableS&A($6,900,000x.10)690,0004,140,000
Contributionmargin2,760,000
Fixedcosts2,000,000
Profit$760,000

Itisworthnotingthateachhourcontributes$12toprofit($30$3S
&A$15manufacturing)sothata10,000hourdifferencegivesa$120,000
profitdifference,$880,000to$760,000.Thesamereasoningforrequirement
4gives$1,000,000profitat250,000hours.
4.$1,000,000
Revenue(250,000x$30)$7,500,000
Variablemanufacturingcosts(250,000x$15)$3,750,000
VariableS&A($7,500,000x.10)750,0004,500,000
Contributionmargin3,000,000
Fixedcosts2,000,000
Profit$1,000,000
NotetotheInstructor:Onepurposeofthisproblemistoallowyouto
pursuepricevolumerelationships.Settingapricebasedonanestimated
volumedoesnotmeanthatthevolumeisachievable,northatthepricewill
provideasatisfactoryprofit.Domesticautomobilemanufacturers,among
others,learnedtotheirsorrowinthelate1970sandearly1980sthat
raisingpricesinthefaceoffallingvolumewasnotasensiblestrategy.
1238OverheadRates,ABC,andPricing(2025minutes)

1.TotalCostAnnualActivity

DriverforCostPoolinpoolofDriverRate
Directlabor$4,800,000300,000$16
Machinesetups1,200,0005,000$240
Numberofparts/components900,000450,000$2
Recordkeepingtransactions400,000400,000$1
AmountsofCostDriver
Model807Model5052
600DLH150DLH
1setup12setups
400parts800parts
200transactions500transactions
Model807ChairModel5052Table
Numberintypicaljoborder20030
Averagecostperunit:
Materials$24,000$20,400
Directlaborat$10/hour6,0001,500
Overhead:

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1223

Laborrelatedat$16$9,600$2,400
Machinesetupsat$2402402,880
Partsrelatedat$28001,600
Transactionrelatedat$120010,8405007,380
Totalunitcost$40,840$29,280
Priceat120%ofmanufacturingcost$49,008$35,136
Priceperunit$245.04$1,171.20
2.
Memorandum
To:JarodKane
From:Student
Subj:Activitybasedcosts
Date:Today
Myanalysis(requirement1)showsthatifwerecognizethatouroverhead
costsaredrivenbyactivitiesotherthandirectlabor,wearemiscosting
muchofourwork.Wenowapplyoverheadbydirectlabor,whichmeansthat
highvolume,laborintensivelineswillbearmostofthecost.Theanalysis
showsthatsmallerlinesgeneratesignificantcostsforrecordkeepingand
setups.Lineswithlargenumbersofpartsalsogenerateoverheadcosts.As
wenowapplyoverhead,wedonotrecognizethesedriversandsointroducea
systematicbias.Highvolume,laborintensivelinesareovercostedbecause
theyrequireproportionatelyfewersetupsandtransactions.Lowvolumelines
aresystematicallyundercosted.
Lowvolumelinesgenerateconsiderablecostssimplybecausetheyrequire
setups,parts,andtransactionsingreaterproportiontotheirvolumesthan
dothehighervolumelines.Asignificantamountofcostisrelatedtothe
complexityofouroperationshowmanyproductswehave,asopposedtothe
totalunitvolumeofeachproduct.
3.Coveredinrequirement2.Onepointofthisquestionispartlytohelp
studentswithrequirement2.
1239ChangingOverheadRates(1520minutes)
1.$8.8millionbefore,$8.7millionafter,adifferenceof$100,000.

BeforeAfter
Overheadperunit$176$174
Times50,000unitsequalstotaloverhead$8,800,000$8,700,000
2.Overheadcostdidnotdropasrapidlyasthemanagershadexpected
becauseitwas,asthefollowinganalysisshows,mostlyfixedwithrespectto
directlabor.Accordingly,thecompanywasconcentratingonthewrong
factor.

Variablecomponent=$8,800,000$8,700,000
(50,000x$44)(50,000x$29)
=$100,000
$750,000
=$0.133perlabordollar
Theexplanationispartlythatoverheadvarieslittlewithdirectlabor,
soreducinglabortimeandcostdoesnotreduceoverheadcostsignificantly.
Thelaborsavingiseighttimestheoverheadsaving.
3.Themanagersshouldsearchforotherfactorswithwhichtotaloverhead
mightvary.Theycanalsoseparateoverheadintopoolsbasedonwhatfactor

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mightdriveparticulartypesofcost.Theymightbetteridentifycost
drivers,whichshouldleadtomoreeffectivecostreductionefforts.
1240NormalCosting(25minutes)

BoardmanCompany
IncomeStatement
20X5(000s)
Sales$7,960
Costofsales:
Beginninginventories$360
Materials2,240
Directlabor1,780
Appliedoverhead(1)2,492
Costofgoodsavailableforsale6,872
Endinginventories(2)1,070
Costofgoodssold,normal5,802
Grossmarginnormal2,158
Variances:(3)
Budgetvariance$12U
Volumevariance16U28
Actualgrossmargin2,130
Sellingandadministrativeexpense880
Income$1,250
(1)Overheadapplied=$1,780x$1.40
(2)Endinginventories
InProcessFinishedTotal
Materials$120$230$350
Directlabor100200300
Overheadat$1.40perDL140280420
Totals$360$710$1,070
(3)Variances
ActualOverhead
BudgetedOverheadAppliedOverhead
$1,440+($0.60x$1,780)
$2,520$2,508$2,492(above)
$12U$16U
BudgetvarianceVolumevariance
$28
Totalunderappliedoverhead
Alternatively,thevolumevarianceis$0.80(fixedrate)times$20
(differencebetweenbudgetedandactualdirectlaborcost)
1241OverheadRateBehavior(15minutes)
1.About$0.26,whichisnegligible.Lotus123outputappearsbelow.R 2
isnothighandthestandarderrorofthecoefficientishigh,t=1.58,
$0.2606/0.1647,indicatingapoorfit.
RegressionOutput:
Constant3413.464
StdErrofYEst0.931066
RSquared0.455017
No.ofObservations5
DegreesofFreedom3
XCoefficient(s)0.260603

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StdErrofCoef.0.164662
2.Therearetwoplausiblereasons.First,overheadmightbelargelyfixed.
Second,aconsiderableamountofoverheadmightvarywithsomefactorother
thanDLH.Ifthelatter,Clintonshouldfocuscostcuttingeffortsonfinding
waystoreducetheactivitiesthatcausethecost.TheresultsthatClinton
hasseencanmisleadmanagersbymakingthembelievethatconsiderable
savingsexistinreducinglaborbecausetheoverheadrateperDLHissohigh.
Thisisoneoftheproblemsofabsorptioncosting.Note,however,thatthe
failureoftheoverheadratetodeclinewithlaborsavingsdrewtheattention
ofthemanagertothepossibilityofbenefitsfromastudyofcostdrivers.
1242JobOrderCostingandDecisions(2530minutes)
1.Totalcostschargedtojob
OriginalRandle's
SpecificationsSpecifications
Costtocomplete:
Materials$4,000$6,000
Directlaborat$11/hour8,80019,800
Overheadat$10/hour8,00018,000
Totals20,80043,800
Accumulatedtodate178,500178,500
Totalcosts$199,300$222,300
2.TheRandleofferismoreprofitable,butnotbyadecisiveamount.

ZStoreRandle
Price$182,000$202,000
Incrementalcoststocomplete:
Materials4,0006,000
Directlabor8,80019,800
Variableoverheadat$4/DLH3,2007,200
Totalincrementalcosts16,00033,000
Incrementalprofit$166,000$169,000
Theaccumulatedcosts,bothfixedandvariable,aresunk.Studentswhomiss
thispointwilldothefollowing.
SpecificationsSpecifications
Sellingprice$182,000$202,000
Totalcostschargedtojob,frompart1199,300222,300
Booklosses($17,300)($20,300)

Whenthefixedoverheadamountsareremoved,thejobshowspositive
contributionmarginsundereitheralternative.

Totalcostschargedtojob$199,300$222,300
Lessfixedcosts:
7,800hoursat$646,800
8,800hoursat$652,800
Totalvariablecosts$152,500$169,500
Sellingprice182,000202,000
Contributionmargin$29,500$32,500
DifferenceinfavorofRandleoffer$3,000

1243JobOrderCosting

ServiceBusiness(2025minutes)
1.$15,calculatedasfollows.

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Totalmanufacturingoverhead($120,000+$240,000)$360,000
Dividedbydirectlaborhours24,000
Predeterminedoverheadrateperdirectlaborhour$15
2.$15,950
Directlabor$9,200
Overheadapplied(450x$15)6,750
Totalcost$15,950
3.$6,800underapplied
Actualoverhead($360,000/12)$30,000
Idletime3,800
Totaloverhead33,800
Appliedoverhead(l,800x$15)27,000
Underappliedoverhead$6,800
4.
Sales$170,000
Costofsales:
Salaries$27,000
Overhead(1,350x$15)20,250
Costofsales,normal47,250
Underappliedoverhead6,800
Costofsales54,050
Grossprofit115,950
Selling&administrative15,000
Income$100,950
NotetotheInstructor:Thisproblemshowsanapplicationofproduct
costingtoaservicebusiness,withthecomplicationofidlelabortimebeing
treatedasoverhead,apointnotexplicitlycoveredinthetext.However,
theproblemisclearonthetreatmentoftheidletime.Youmightalsoshow
thatnormalcostingandthetreatmentofidletimedonotproduceadifferent
resultfromthoseusingtheformula:expense=beginninginventory+current
periodcostsendinginventory.Analternativeincomestatementfollows.
Sales$170,000
Costofsales:
Totalsalaries$40,000
Totaloverhead30,000
Totalcosts70,000
Lessendinginventory15,950
Costofsales54,050
Grossprofit115,950
Sellingandadministrative15,000
Income$100,950

1244ComparingActualandNormalCosting

SeasonalBusiness(1520minutes)

1.$2.00$3,200,000+($1.20x$4,000,000)=$0.80+$1.20=$2.00
$4,000,000
2.Job

J12A16
Materials$10,410$10,310
Directlabor16,90016,400

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Overheadappliedat$233,80032,800
Totalcosts$61,110$59,510
3.Wetreattheadvantagesinthetext,butinthespecificsituationwesee
thatoverheadcostsarenearlylevel.Managersshouldfindnormalcosting
lessconfusingthanactualcosting,oncetheyunderstandtheideaofoverhead
application.Theywillstillbeusingcoststhatcontainfixedelements,but
atleasttheywillbethesameperunitfixedelementsbecausetheunitcost
(here,perlabordollar)isthesamethroughouttheyear.

1245ActivityBasedOverheadRates(2025minutes)
1.OverheadCostsBudgetedAmount

ActivityinPool/ofActivity=Rate
Laborhours$1,600,000400,000hours$4.00
Machinesetups$600,0002,000setups$300.00
Recordkeepingentries$150,000150,000entries$1.00

2.
CostofSalesInventoriesTotals
Overheadapplied:*
Laborrelatedat$4.00$1,484,000$156,000$1,640,000
Setuprelatedat$300561,00024,000585,000
Recordkeepingat$1.00136,00016,000152,000
Totalappliedoverhead$2,181,000$196,000$2,377,000
*$4.00x371,000=$1,484,000;$4.00x39,000=$156,000;
$300x1,870=$561,000;$300x80=$24,000
$1.00x136,000=$136,000;$1.00x16,000=$16,000
3.
CostofSalesInventoriesTotals
Materialcost$2,321,000$261,000$2,582,000
Directlaborcost3,788,000381,0004,169,000
Totalappliedoverhead2,181,000196,0002,377,000
Totalcosts$8,290,000$838,000$9,128,000

4.

ActivityAppliedOverheadActualOverheadMisapplied
Laborhours$1,640,000$1,620,000$20,000over
Machinesetups585,000592,0007,000
under
Recordkeepingentries152,000148,0004,000over
Totals$2,377,000$2,360,000$17,000over
1246EffectsofSeparateOverheadRates(1520minutes)
1.
ProductXT12ProductJY09
Materialscosts$260$780
Laborcost2802,880
Overheadapplied:*
Labordriven80800
Setupdriven3,600300
Entrydriven40080
Totalcosts$4,620$4,840
Priceat150%oftotalcost$6,930$7,260

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*Directlaborhours20x$4.00=$80200x$4.00=$800
Machinesetups12x$300=3,6001x$300=300
Recordkeepingentries400x$1.00=40080x$1.00=80
2.
ProductXT12ProductJY09
Materialscosts$260$780
Laborcost2802,880
Overheadappliedat$5.8751181,175
Totalcosts$658$4,835
Priceat150%ofcost$987$7,253
Rate=$5.875($1,600,000+$600,000+$150,000)/400,000
3.Thelaborintensiveproduct,JY09showsvirtuallythesamecostsusing
thelaborbasedrate,whilethemoreresourceintensiveproduct,XT12,shows
muchlowercostsusingthelaborbasedrate.Thisdoesnotmeanthatusing
thelaborbasedratesavesthecompanymoneyonXT12.Theratesare
accountingartifacts.ThecostofXT12dropsbecauseitrequiresrelatively
highamountsofnonlabordrivenactivities,whileJY09'scostholdsabout
thesamebecauseitislaborintensiveanddoesnotusesignificantamounts
ofotherresources.
Ifthecontrollerissatisfiedthattheseparationofcostsintopoolsis
reasonable,thenitisprobablyworthwhiletousetheseparateratesto
evaluateprofitabilityandsetprices,particularlyiftherearesignificant
numbersofproductswiththecharacteristicsofXT12.Theindicatedprice
ofXT12usingactivitybasedratesisroughlysixtimesthepriceusingthe
directlaborbasedrate.Thatsuggestsaseriousmiscosting.Thecompany
shouldprobablyraisethepriceofXT12andseeifthereareanyobjections
fromcustomers.

1247AnalyzingOverhead(25minutes)
NotetotheInstructor:Thisproblemismoreopenendedthanthe
othersthatdealwiththeinterpretationofmisappliedoverhead.First,you
couldverifythe$6predeterminedoverheadrate.
predeterminedrate=totalbudgetedoverhead
totalbudgetedactivity
=$480,000+($2x120,000)
120,000
=$6permachinehour

Wecanstartbydeterminingwhatamountsofoverappliedorunderapplied
overheadarebudgetvariancesandvolumevariances.
ActualBudgetBudgetedVolumeApplied
OverheadVariancesOverheadVariancesOverhead
March
$40,000+($2x14,000)$6x14,000
$71,000$68,000$84,000
$3,000U$16,000F
$13,000overapplied
April
$40,000+($2x8,000)$6x8,000

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$52,000$56,000$48,000
$4,000F$8,000U
$4,000underapplied
May
$40,000+($2x5,000)$6x5,000
$51,000$50,000$30,000
$1,000U$20,000U
$21,000underapplied
OverheadwasoverappliedinMarchbecauseofheavyvolume(average
volumeis10,000hourspermonth,120,000/12).Thebudgetvariancewas
unfavorable,indicatingthatcostsmightnothavebeenundercontrol.April
andMaybothsawunfavorablevolumevariances,asvolumewaslessthanthe
10,000monthlyaverage.Thisanalysis,whichisolatesthebudgetvariance,
givesthepresidentastartingpointfordeterminingwhethercostswereunder
control.AsChapter11showed,variancesareonlythefirststepin
evaluatingthecontrolofcosts.ButaspointedoutinChapter12,the
volumevariancehasnoeconomicsignificance;itmayshowwhetherornotthe
plantwasasbusyasthemonthlyaverage,butnotwhetheritwasasbusyas
expectedforthatmonth.Wedon'tknowhowmuchactivitythecompanyshould
haveineachofthethreemonths,sowecannotsayanythingaboutwhether
operationsareonschedulefortheyearorwhetheractivitywillorwillnot
reachthe120,000budgetedhours.
Itisdesirabletodevelopmonthlybudgetsforlabor(orwhatever
activityisusedtodevelopthepredeterminedoverheadrate)sothatthe
presidentcanseewhetherthecompanyisaboutasbusyasexpected.That
information,inconjunctionwiththebudgetvariances,wouldnottellhim
everythingaboutoverhead,butwouldbeareasonablestartforhisreview.
1248DepartmentalversusPlantWideOverheadRates(30minutes)
1.Bidsof$14,220and$10,770forJobs391and547,respectively.
Job391Job547
Totaldirectlaborhours360260
Overheadapplied,at$8perhr.$2,880$2,080
Materials3,0002,500
Labor3,6002,600
Totalcosts$9,480$7,180
Bidprice(totalcostsx150%)$14,220$10,770
Thesignificantlyhigherperhourvariableoverheadinassembly($6vs.
$2)couldmaketheuseoftheplantwiderateforpricingevenmore
misleading.Thevariablecostratealoneinassemblyisonly$2lessthanthe
plantwideratefortotaloverhead($6vs.$8).If,asmightquitelikelybe
thecase,thecompanyacceptsbusinessatlessthannormalpricesduring
slackperiod,itmightwellpriceveryclosetovariablecost.Forexample,
ifitacceptsworkat"cost"basedontheplantwiderate,itwillhavea
marginofonly$2perhouroverthevariablecostintheassemblydepartment.
Themoreworkitacceptsintheassemblydepartment,theloweritsprofits
willbecomparedtowhattheymightbeifthecompanyuseddepartmental
variableoverheadratesinsettingpricesduringslackperiods.Orifthe
companyreducespricesbelowfullcost,makingsomeestimateofwhatthe
variableportionoftotalfactoryoverheadis,itcouldwellpricebelow
variablecost.
Forexample,supposethatamanagerdeterminesvariablecostsintotal
overheadatthebudgetedvolumetobe$700,000[($2x200,000forgrinding)+
($6x50,000forassembly)]andconcludesthatvariableoverheadis,
therefore,about35%oftotaloverhead($700,000/[$1,200,000+$800,000]).

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Themanagermighterroneouslyapplythatratetotheplantwideoverheadrate
of$8andconcludethatvariableoverheadwasabout$2.80($8x35%).
Obviously,belowfullcostpricingbasedonanestimatedvariablecostper
hourof$2.80couldleadtolossessincethatamountisconsiderablybelow
thevariableoverheadrateintheassemblydepartment.
Ofcourse,becausethecompanydoesbudgetoverheadbydepartment,its
managerspresumablymustknowsomethingaboutthecostrelationships.Thus,
foradhocdecisionstheyprobablywouldnotbeasnaiveaswehavejust
picturedthem.Nevertheless,theplantwiderateisincorporatedinthe
company'srecords,whichareoneoftheprincipalsourcesofinformationto
managers.
2.$6perhouringrinding,$16perhourinassembly.
Grinding$800,000+($2x200,000)$1,200,000
200,000=200,000=$6
Assembly$500,000+($6x50,000)$800,000
50,000=50,000=$16
3.Bidsof$13,590and$12,690forJobs391and547,respectively.

Job391Job547
Grindingoverhead:
330x$6$1,980
80x$6$480
Assemblyoverhead:
30x$16480
180x$162,880
Totaloverheadapplied2,4603,360
Materialsandlabor6,6005,100
Totalcosts$9,060$8,460
Bidprice(totalcostsx150%)$13,590$12,690
4.Job391Job547
Overheadunderdepartmentalrates$2,460$3,360
Overheadusingplantwiderate2,8802,080
Differencesintotalcosts($420)$1,280
Effectsifdifferencesonbidsat150%($630)$1,920
Itisreasonabletosaythattheplantwiderateunderstatescostsin
assemblyandoverstatesthemingrinding.Asaresult,thecompanymightbe
overpricingworkingrindingandunderpricingworkinassembly.Ifthe
marketishighlycompetitive,thecompanywillwinjobsthatrequiremuch
assemblyworkandlosejobsthatrequiremuchgrinding.Overtime,capacity
inassemblywillbestrained,whilegrindingwillhaveexcesscapacity.

1249CVPAnalysisinaJobOrderCompany(2025minutes)
1.$42.50perhour
Totalcosts:
Directlabor(20,000DLHx$15)$300,000
Variableoverhead($300,000x80%)240,000
Fixedoverhead250,000
Sellingandadministrativeexpenses80,000
Materials400,000
Totalbudgetedcosts1,270,000
Desiredprofit180,000
Requiredrevenue1,450,000

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Revenuefrommaterials($400,000x1.50)600,000
Revenuerequiredfromlaborcharges$850,000
Dividedby20,000hours=priceperhour$42.50
2.$169,000

Revenue[($440,000x1.50)+(18,000x$42.50)]$1,425,000
Materials$440,000
Directlabor(18,000x$15)270,000
Variableoverhead($270,000x80%)216,000
Fixedoverhead250,000
Sellingandadministrativeexpenses80,0001,256,000
Profit$169,000

NotetotheInstructor:Youmightwishtopursueacoupleofpoints.
First,thecompanyhastwo"products,"materialsanddirectlabor,with
differentcontributionmarginsandpercentages.Thecompanyisthereforea
multiproductoperationandthemixofitsproductsaffectsitsprofits,as
doesitstotalrevenue.
MaterialsDirectLabor
Priceperdollar$1.50
Priceperhour$42.50
Variablecosts,$1,$15x1.81.0027.00
Contributionmargin$0.50$15.50
Contributionmarginpercentage33%36.5%
Directlaborprovidesahighermarginthanmaterials,soshiftsfrom
labortomaterials,totalcostsremainingconstant,willreducerevenueand
profits.
Second,youmightwishtoasktheclasstoanalyzethedifference
betweenbudgetedandactualprofitusingChapter4techniques.Somestudents
willseequicklythattheanalysiscouldproceedaboutasfollows.
Variancefrommaterials[($440,000$400,000)x0.50]$20,000F
Variancefromlabor[(18,00020,000)x$15.50]31,000U
Totalvariance($180,000$169,000)$11,000U

1250OverheadApplicationandCostControl(25minutes)
1.$6,$2variableplus$4fixed($240,000/60,000)

2.3,000inApril,4,500inMay,6,000inJune

AprilMayJune
Appliedoverheadcosts$18,000$27,000$36,000
Dividedby$6rate=directlaborhours3,0004,5006,000
3.

AprilMayJune
Actualoverheadcosts$25,000$28,000$34,000
Budgetedoverheadcosts:
$20,000+(3,000x$2)26,000
$20,000+(4,500x$2)29,000
$20,000+(6,000x$2)______________32,000
Budgetvariance(favorable)($1,000)($1,000)$2,000
4.Guinnneedstounderstandthedifferencebetweenthevolumevarianceand
thebudgetvariancecomponentsofmisappliedoverhead.Costcontrolwas
actuallygoodinAprilandMay,becauseactualcostswerelessthanbudgeted
costs.(Thisassumesthatcostswerenotbelowbudgetbecauseofsomeunwise

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actionstakenbyGuinn'semployees,perhapstoreduceunderappliedoverhead
becauseGuinnseemstopaysomuchattentiontoit.)Costcontrolwasnot
goodinJune,whereactualcostsexceededbudgetedcosts.Thevolume
variancesarecalculatedbelow,showingthatthebulkofmisappliedoverhead
ineachmonthresultedfromworkingfewer(AprilandMay)ormore(June)
hoursthantheaveragemonthlyamountof5,000(60,000/12).
Budgetedoverheadcosts(above)$26,000$29,000$32,000
Appliedoverheadcosts18,00027,00036,000
Volumevariance(favorable)$8,000$2,000($4,000)

1251CostJustification(1520minutes)
AsPresidentReagan'sconsultant,youwouldmentionthefollowingpoints.
(a)The30minutesspentwiththePFCpeopleisonlypartofthe
portaltoportaltime,notthetimespentonbusinessofbothpoliticaland
nonpoliticalkinds.EvenassumingthatthespeechgiventotheChamberof
Commercewasnotpolitical(whichcouldbedisputed),abetterallocation
wouldbebasedontherelativeproductivetimes.Iftimeontheplanewas
spentconductingbusiness,whichseemsreasonabletoassume,thatpart
devotedtopreparationforthePFCaddressshouldbeusedinmakingthe
allocation.
(b)Theothersevenpeopleontheflightpresumablyhadsomethingtodo
withthePFCspeech.TheSecretServiceagentssurelyprotectedSimonwhile
hewasgivingthespeech.Othersmayhaveworkedonthespeechwithhimon
theplane.IfSimonhadtaken19otherpeoplehewouldhavebeencharged
only5%ofthebasecostof$2,310,then5%ofthatamount.
(c)Whatwastheprimarypurposeofthetrip?Wasthespeechtothe
ChambersetupbeforeorafterthePFCreception?Ifthetripwouldhave
beenmadeeveniftheChamberspeechwerenotgiven,theentirecostshould
bechargedtothePFC,includingthecostoftheotherseventravelers.That
is,thewholecostwouldhavebeenincrementalwithregardtothepolitical
speech.(Ofcourse,itwouldbeeasytogetaroundthisproblemsimplyby
makingsurethatanonpoliticalengagementwasscheduledbeforethepolitical
one.)
(d)Isthe$2,310chargereasonable?Doesitcorrespondtochargesfor
commercialservice?Ifthechargeislowerthancommercialcharges,the
incumbenthasanadvantageoverchallengers.(Itwouldprobablynotbewise
tobringupthemethodofdeterminingthe$2,310,whichmayincludesome
allocationsbytheAirForce.ThePFCcouldarguethatonlytheincremental
costoftheflightshouldbecharged,aswediscussinrequirement2.)
EvenifthePFCcouldcontendthattheCommitteewaspayingatleastthe
totalcostoftheflight,theReaganforcescouldarguethataccesstolow
costtransportationisclosedtoothercandidatesandistherefore
discriminatory.
2.ThePFCspokespersoncouldmakethefollowingcontentions.
(a)TheplanewasgoingtoNorthCarolinaonnonpoliticalbusiness(the
speechtotheChamberofCommerce)andthereforethePFCisbeinggenerousin
payingforanypartoftheflight.NoincrementalcostisinvolvedinMr.
Simon'sappearancebeforethePFC.(Thereissomequestionwhethertheplane
andcrewhadtoputinmorethan30minutesbecauseofthePFCspeech.Itis
probablethatthetripwouldhavebeenmorethan30minutesshorterifthe
speechhadnotbeenmadeandMr.SimonhadgonebackrightaftertheChamber

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speech.)Thisisthemajorpointandmostotherswouldbederivativesofit.
ThepointistojustifytheChamberspeechastheprimaryreasonforthe
trip.
(b)Theothertravelersmayhavehadlittleornothingtodowiththe
PFCspeech,beingprimarilyconcernedwithotherworkbeingdonebyMr.Simon
onthetrip.Ifso,thentheallocationofoneeighthofthecosttoMr.
Simonis,again,generous.
Insum,thePFCwouldbaseitsclaimonthelackofincrementalcost
involvedinthePFCspeech,whiletheReaganforceswouldconcentrateonthe
inequityofthesituationandthe(tothem)transparentmotiveforthetrip
inthefirstplace.

1252WhatIsCost?

ConsumerAction(1520minutes)
Thiscasecanbeusedtoillustratethepointmadeveryearlyinthis
textthattherearedifferentmeaningsfor"cost"indifferentcontexts.
EasyEd'sexplanationof"cost"willnotstandupatanyvolumeotherthan
thatexperiencedlastyear.ItcanbeshownthatEd'sincomewillincrease
morethan$100percarforeverycarhesells.Ifhisagencyoperatesasthe
onesdescribedinConsumerScoop,hedoesindeedearnadditionalprofitof
$360foreachadditionalcarsold.
Edisarguing,ineffect,that"$100overcost"means$50,000peryear
profitbasedon500carssold.Usingthisinterpretation,hecouldcharge
$14,740percarandearn$100percarifvolumewere250carsperyear.
IncomeStatements

500Cars250Cars
Revenue
$14,190percar$7,095,000
$14,740percar$3,685,000
Variablecosts
$13,540percar6,770,0003,385,000
Contributionmargin325,000300,000
Fixedcosts*275,000275,000
Income$50,000/500=$100$25,000/250=$100
*Basedonallocatedfixedcostsat500cars.Makereadyservicescontain
fixedcostsof$120percar($160$40),which,whenaddedtothe$430
generaloverhead,gives$550percar.$550x500=$275,000.

Asanexpertwitness,onecouldpointoutthatEd'sprofitincreasesby$360
everytimehesellsacarat$14,190.Thefactthathecouldcharge
differentpricesatdifferentvolumesandstillbesellingat$100over
"cost"isanotherpointthatthecourtmightfindappealing.Finally,it
mightbeshownthatifEdsellsmorethan500carsthisyear,hisprofitper
carwillbemorethan$100andthattheselectionofthe500carvolumeon
whichtobasethe$14,090costisarbitraryandselfserving.Anincome
statementfor600carssoldwouldshowaprofitofover$100percar.
Sales($14,190percar)$8,514,000
Variablecosts($13,540percar)8,124,000
Contributionmargin390,000
Fixedcosts275,000
Income$115,000/600=$191.67
OnemightthenaskthejudgewhetherEdshouldhavetorefund$91.67to

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1234

eachcustomerifhedidsell600carsinoneyear.
Astudentofoneoftheauthorssaidinclassthatasimilarquestion
hadariseninhishometown.Someautomobiledealerswereadvertisingprices
thattheyallegedtobesomeamountovercostandwereincludingallocated
overheadcostsinthecomputation.Thestudentwasworkingforaconsumer
protectionagencythattookthecaseupwiththedealers,withtheargument
proceedingalongthelinessuggestedinthissolution.Thedealers
subsequentlyagreedthatonlydirectcostsshouldbeincludedwhenusingsuch
advertisingclaims.
1253DeterminingProductCosts(2535minutes)
1.(ThiscasecouldalsobeassignedwithChapter5.)Thecompanyshould
buytheunsortedtomatoesandcanbothwholetomatoesandtomatopaste.You
canreachthisconclusionusinganyofthestandardcostssuggested.We
believethatthefollowinganalysis,whichtreatsthecostoftomatoesasa
lumpsum,isasgoodasanyothermethod.
Donotbuyunsortedtomatoes
Productionofpastecases
5,000,000/25lbs.percase200,000
Contributionmarginpercase,
tomatoesat$0.08perlb.$.20
Monthlycontributionmargin$40,000
Buyunsortedtomatoes
Productionoftomatopastecases
(5,000,000x60%)/25lbs.120,000
Contributionmargin,withoutcostoftomatoes
($5.80$3.60"othervariablecosts"from
controller'sschedule)$2.20
Totalmarginpermonth$264,000
Productionofwholetomatoescases
(5,000,000x40%)/20lbs.100,000
Contributionmarginwithouttomatocost
($6.00$3.22)$2.78
Totalmarginpermonth278,000
Totalmonthlymargin542,000
Lesscostoftomatoes(5,000,000x$0.10)500,000
Contributionmarginpermonth$42,000

Contributionmarginpermonthwillbe$2,000greaterifthetomatoesare
boughtunsorted,andbothproductsproduced.Thesameresultcanbeobtained
byusinganyofthesolutionssuggestedbytheparticipants,butthesewill
notalwaysgivethecorrectimpressionofprofitability.
2.Theproblemhereisthatthetomatoes,AandBgrades,arejoint
products.Therereallyisnosuchthingas"the"costofeithergrade.The
sortingcostisjointwithrespecttothetwogrades,asisthepurchase
price.Thequestionthenbecomeswhetherthejointcostcanbeallocatedin
waysthatwillassist,oratleastnothinder,planningandcontrol
functions,includingdecisionmaking.Thecontroller'sfirstmethod,theone
shownintheschedule,clearlydoesnothelp.Itshowsalargelosson
paste,whichfailstorecognizethatpasteisprofitableiftheBgrade
tomatoesarepurchasedseparately.

Thesecondmethodproposedbythecontrollerwouldshowalossforwhole
tomatoes,withpastestillbeingprofitable.Asgiven,thecontribution
marginsfortheproductsfollows.

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WholeTomatoesTomatoPaste
Sellingprice$6.00$5.80
Variablecosts:
Tomatoes($0.141and$0.07267)2.821.817
Othervariablecosts3.223.600
Totalvariablecosts6.045.417
Contributionmargin($0.04)$0.383
Themethodproposedbythepresidentcouldbedoneeitherway.Thecost
ofAgradetomatoespurchasedseparatelycouldbeusedtosetthecostfor
wholetomatoes,thentherestallocatedtoBgradetomatoes.Thesolution
achievedwouldsometimesshowwholetomatoesearningapositivecontribution
margineventhoughthefirmwouldbebetteroffbuyingBgradetomatoesand
makingonlytomatopaste.Withthedatagiven,themethoddoeswork,inthe
sensethatbothproductswouldshowapositivecontributionmargin.The
followingcontributionmarginsresultfromthepresident'smethod.
WholeTomatoesTomatoPaste
Sellingprice$6.00$5.80
Variablecosts:
Tomatoes($0.13and$0.08)2.602.00
Othervariablecosts3.223.60
Totalvariablecosts5.825.60
Contributionmargin$0.18$0.20
Anyoftheproposedallocationswillgivethecorrectproductiondecision
ifappliedcorrectly.Usingthe$0.04forwholetomatoesand$0.383for
pasteascomputedbytherelativevaluemethodsuggestedbythecontroller,
wefindthefollowing.
WholeTomatoesTomatoPaste
Contributionmarginpercase($.04)$0.383
Cases100,000120,000
Contributionmargin($4,000)$45,960
Thesumofthecontributionmarginsis$41,960,whichisdifferentfromthe
$42,000previouslycomputedbecauseofroundingtheunitcostoftomatoes.
Usingtheschedulegivenintheproblem,withtomatoesat10centsforboth
products,wewouldgetthesameapproximateresult.

WholeTomatoesTomatoPaste
Contributionmarginpercase$.78($.30)
Cases100,000120.000
Contributionmargin$78,000($36,000)

Again,thesumis$42,000,ascomputedatthebeginningofthesolution.

Noneofthesuggestedmethodswillalwaysgiveresultsthatcanbeused
forplanningandcontrol,andespeciallyfordecidingwhethertoproduceboth
productsoronlyone.Anymaterialusevariancescalculatedusingthe
suggestedcostswouldbedefectiveinthesensethattheywouldnotmeasure
thecostofshortfallsinproductionoroveruseoftomatoesifproduction
werescheduledbelowcapacity.

Perhapsthebestrecommendationistoomitthematerialcostfromthe
determinationofstandardcostsoftheseparateproductsandinsteadplanand
controltomatocostusingtotalbudgetedamounts.Thisisespecially
appealingifthecompanycanalwaysoperateatfullcapacity.

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