CHAPTER 12 INTRODUCTION TO PRODUCT COSTING 12-1 FedEx's Handling Costs This question gets at two principal concepts: (1) the difference between unit cost and total cost and (2) the effects on unit cost of volume changes In this example, volume rises, but it could just as easily have fallen, with a commensurate rise in unit costs FedEx's total domestic handling costs increased The 12% increase in volume overwhelmed the 1.5% decrease in unit cost Using their numbers, 1993 Daily packages* Average cost, assumed for 1993 Total cost 1,633,333 $10 $16,333,330 1994 1,829,333 $9.85 $18,018,930 * Daily packages in 1994 were 12% and 196,000 higher than in 1993 So 1993 packages were about 1,633,333 (196,000/12%) The 1993 per-package cost is arbitrary Any number will show the same result The decline in unit cost is probably due to the increase in volume, rather than to savings in variable costs As FedEx increases its volume, its per-unit cost will fall, and therefore its profit margin will rise (assuming level selling prices) Total costs will rise less rapidly than volume and revenue and total fixed costs will be spread over more units 12-2 Overhead Absorption The statement means that Trane used 85% of capacity to set its overhead rates If Trane works at 85% of capacity it will not have a fixed overhead volume variance (It could still, of course, have a budget variance.) If it works more or less than 85%, it absorbs more or less overhead into inventory, but the economic situation (actual overhead) remains the same, ignoring tax effects (as we did in the chapter) Selecting a level of activity for a cost driver used as an overhead base is similar to selecting any other kind of estimate bad debts, useful lives of fixed assets, estimated provision for inventory losses, and so on The use of an overhead rate based on some specified level of activity speeds up or defers the recognition of overhead as an expense but does not, in itself, change the total expense that will be recognized over a period of years 12-3 Overhead Application The stated relationship of overhead application to variations in fixed cost per unit is true but whether the situations are good or bad is not so clear Overapplication of overhead arises from production in excess of budget, and from the earliest of chapters it was pointed out that fixed cost per unit declines as volume increases The reverse is true for underapplication Underapplication or overapplication are not necessarily good or bad First, under- or overapplied overhead say nothing good or bad about the 3/18/02 12- control of overhead costs The relationship of actual overhead to budgeted overhead is the important point for control If the lower cost per unit (of overapplication) is caused by higher production because of higher sales than budgeted, the situation is good (though under-budgeting sales is not desirable because of the resource requirements generated by sales budgets) If the lower cost is the result of higher production only, the situation is not good unless anticipated sales are higher If the higher cost per unit is caused by lower production because of lower sales, the situation is bad If sales are keeping pace with the budget and production is reduced, the higher cost per unit does not indicate a bad situation Regardless, the variations in fixed cost per unit and the under- or overapplied overhead are not the important factors 12-4 Costing Methods and Inventories This question is deceptively simple There will be no difference in incomes because all costs expire, either as cost of goods sold or as a combination of cost of goods sold and overapplied or underapplied overhead The question brings home the point that different costing methods affect income because they give different inventory valuations In fact, as Chapter 14 shows, but which could be discussed now, the sole difference between incomes using any inventory valuation methods lies in the differences in inventories Students should know this from financial accounting, where FIFO, LIFO, and other inventory valuations are treated, usually for merchandising firms However, students tend to compartmentalize and ignore the lessons of previous coursework, and this simple question should help to get them thinking about the reasons that incomes differ under different methods It is worthwhile to point out that, if the company has inventories during the year, its interim results will differ using actual costing vis a vis normal costing 12-5 "What's Normal About It?" Overall Note to the Instructor: The purpose of this question is obvious: to allow you to bring out the entire set of arguments favoring normal costing The text provides what we believe is a good rationale, but seldom is a text more convincing than an explanation from the instructor If the usual arguments (confusing results, potential difficulties in pricing and analyzing profitability on work done in different months) don't seem to convince the class, you might want to refer to some points that students learned in financial accounting There is a strong similarity between normal costing and accrual/deferral practices used in financial accounting Perhaps the closest parallel is the units-of-production method of depreciation, but the same principle applies to accruing vacation pay and major maintenance over an entire year Note also that taxes, bonuses, and profit-sharing obligations are accrued as the company earns income, even though these items not become liabilities until the final results are in for the year In fact, virtually any allocation of costs to different periods parallels normal costing Though depreciation is the obvious example, perhaps more striking is the case where a firm pays a year's rent in January and cannot sublease the property We have found no student who advocated expensing the 3/18/02 12- whole year's rent in January even though the expenditure occurs then and cannot be recouped (Indeed, even those financial analysts who argue to "let the chips fall where they may" and equate "reality" with cash flows show no support for such an expensing practice.) In essence, normal costing treats the year as the relevant accounting period, not the month or quarter That estimates prove incorrect should not deter one from using them, just as basing depreciation on estimates (of useful life and salvage value) does not deter one from computing annual depreciation expense Thus, such conditions as high heating costs in the winter should not bind a firm to actual costing for each month 12-6 Are Cost Accountants the Villains? Mr Fox probably means that the company uses absorption costing and decreases unit costs by producing more units A supervisor could also reduce unfavorable labor efficiency variances by producing more units than were required The company is probably applying factory overhead on the basis of machine hours Managers of individual departments are therefore encouraged to produce as much as they possibly can during each hour of machine use (The labor cost for an hour of machine time is probably fixed and material costs charged to departments are probably independent of machine time.) To reduce overhead charges by producing as much as possible per hour of machine use, department managers could be bunching their jobs, and so affecting the flow of jobs through the factory ("each hour is running") The overall issue is whether cost accounting systems are used, more or less exclusively, to evaluate performance The same news story quoted Fox as saying that "Cost accountants never said this is a tool to measure the performance of people." Chapter 13 treats dysfunctional consequences of absorption costing 12-7 Basic Actual Job-Order Costing $11 per hour (10-15 minutes) $220,000/(11,000 + 9,000) $121,000 to King Louis, $99,000 to Ranchero King Louis Direct labor hours 11,000 Times $11 rate equals overhead applied $121,000 $366,000 for King Louis, $234,000 for Ranchero King Louis $150,000 95,000 121,000 $366,000 Material cost Direct labor cost Overhead cost (part 2) Total costs 12-8 Ranchero 9,000 $99,000 Basic Normal Job-Order Costing Ranchero $ 60,000 75,000 99,000 $234,000 (15-20 minutes) $110,000 to King Louis, $90,000 to Ranchero King Louis Direct labor hours 11,000 Times $10 rate equals overhead applied $110,000 $355,000 for King Louis, $225,000 for Ranchero King Louis Material cost $150,000 Ranchero 9,000 $90,000 3/18/02 12- Ranchero $ 60,000 Direct labor cost Overhead cost (requirement 1) Total costs 95,000 110,000 $355,000 75,000 90,000 $225,000 $20,000 Underapplied Actual overhead Applied overhead ($110,000 + $90,000) Underapplied overhead $220,000 200,000 $ 20,000 Applied overhead also equals 20,000 direct labor hours at the $10 rate You might wish to verify the overhead rate calculation for the class Rate = ($150,000 + [$4 x 25,000])/25,000 = $250,000/25,000 = $10 You might want to point out that the rate has a $6 fixed component and a $4 variable component $10,000 F and $30,000 U Actual overhead Budgeted overhead ($150,000 + [$4 x 20,000]) Favorable budget variance $220,000 230,000 $ 10,000 Budgeted overhead Applied overhead Unfavorable volume variance $230,000 200,000 $ 30,000 The volume variance is also 5,000 hours (25,000 - 20,000) x $6 12-9 Job-Order Costing Income Statements Sales Cost of goods sold Gross profit Selling and administrative expenses Income (15-20 minutes) $650,000 366,000 284,000 260,000 $ 24,000 Showing the details of the cost of sales section, we have the following Sales Cost of goods sold: Material cost ($150,000 + $60,000) Direct labor cost ($95,000 + $75,000) Overhead cost Total costs Less ending inventory (Ranchero) Cost of goods sold Gross profit Selling and administrative expenses Income Sales Normal cost of goods sold $355,000 Plus underapplied overhead 20,000 Cost of goods sold Gross profit Selling and administrative expenses Income 3/18/02 12- $650,000 $210,000 170,000 220,000 600,000 234,000 366,000 284,000 260,000 $ 24,000 $650,000 375,000 275,000 260,000 $ 15,000 Again, showing the details of cost of sales, we have the following Sales Cost of goods sold: Material cost ($150,000 + $60,000) Direct labor cost ($95,000 + $75,000) Overhead applied Total costs Less ending inventory (Ranchero) Normal cost of goods sold Plus underapplied overhead Cost of goods sold Gross profit Selling and administrative expenses Income $650,000 $210,000 170,000 200,000 580,000 225,000 355,000 20,000 375,000 275,000 260,000 $ 15,000 The company should average more each month because August was a low month, only 20,000 hours, 5,000 below the monthly average We ask this question to get students thinking about how the company makes its money, which presumably is labor 12-10 Job Order Costing Income Statement, Service Company (15-20 minutes) $5, $2 variable plus $3 fixed ($600,000/200,000 hours), or ($600,000 + [$2 x 200,000])/200,000 Sales Normal cost of sales* Less overapplied overhead** Cost of sales Gross profit Selling and administrative expenses Profit * $5,200,000 $3,100,000 60,000 3,040,000 2,160,000 1,900,000 $ 260,000 Normal cost of sales: Materials Direct labor Overhead ($5 x 160,000) Total $ 600,000 1,700,000 800,000 $3,100 000 ** Actual overhead Applied overhead ($5 x 180,000) Overapplied overhead $ $ 840,000 900,000 60,000 An alternative calculation of cost of sales using the totals follows Direct expenses Professional salary cost Applied overhead Total costs Less ending inventory* Normal cost of sales Less overapplied overhead Cost of sales $ 700,000 1,900,000 900,000 3,500,000 400,000 $3,100,000 60,000 $3,040,000 3/18/02 12- * Direct expenses Professional salary cost Applied overhead ($5 x 20,000) Total cost $100,000 200,000 100,000 $400,000 Note to the Instructor: You might want to comment on the similarities of service and manufacturing companies here Service providers not use direct materials in the same sense in which manufacturers do, but they incur costs that are direct to specific jobs Professionals not like being called "direct labor," but the analogy is apt They are the people who, like direct laborers, work specifically and directly on jobs 12-11 Predetermined Overhead Rates (15-20 minutes) (b) (e) $100,000 $ 90,000 $5 x 20,000 $5 x 18,000 (a) (e) $8 $256,000 $240,000/30,000 $8 x 32,000 (a) (c) $7 10,000 $63,000/9,000 $70,000/$7 (c) (d) 40,000 43,000 $160,000/$4 $172,000/$4 12-12 Ethics and Overhead Application (10 minutes) The controller's proposal is unethical and violates the IMA Standards If machine time is the principal overhead cost driver, to change the application base to labor time violates even the competence standard Of course, to change the base simply to increase government billings is illegal as well as unethical Such an act violates the integrity standard of "engaging in or supporting any activity that would discredit the profession." 12-13 Overhead Relationships Variances (15-20 minutes) (b) (e) $596,000 $ 15,000 U $600,000 - $4,000 favorable budget variance $600,000 - $585,000 (d) (e) $3,000 F $2,000 F $400,000 - $397,000 $400,000 - $402,000 (b) (c) $394,000 $390,000 $400,000 - $6,000 favorable budget variance $400,000 - $10,000 favorable volume variance (a) (c) $304,000 $322,000 $310,000 - $6,000 unfavorable budget variance $304,000 + $18,000 favorable volume variance 12-14 Job-Order Costing Assigning Overhead (15 minutes) $1.40 $0.80 variable plus $0.60 fixed ($600,000/$1,000,000), or [$600,000 + ($0.80 x $1,000,000)]/$1,000,000 $2,478,000 (see below) $320,000 (see below) 3/18/02 12- $276,000 (see below) Jobs Sold Applied overhead: $820,000 x $1.40 $100,000 x $1.40 $ 90,000 x $1.40 Materials Direct labor Totals Ending Work-in-Process Ending Finished Goods $1,148,000 $140,000 510,000 820,000 $2,478,000 $126,000 60,000 90,000 $276,000 80,000 100,000 $320,000 $7,000 overapplied Applied overhead ($1,148,000 + $140,000 + $126,000) Actual overhead Overapplied overhead $1,414,000 1,407,000 $ 7,000 Alternatively, applied overhead is actual direct labor cost of $1,010,000 times $1.40 $6,000 F $1,000 F 12-15 $600,000 budgeted - $606,000 applied ($1,010,000 x $0.60) $1,407,000 - ($1,010,000 x $0.80) + $600,000 Predetermined Overhead Rates Job-Order Costing $6 per hour (15-20 minutes) $240,000/40,000 Machine hours Overhead applied at $6 12 18,000 $108,000 13 14,000 $84,000 14 7,000 $42,000 Totals 39,000 $234,000 $2,000 unfavorable budget variance and $6,000 unfavorable volume variance Actual Overhead $242,000 Budgeted Overhead $240,000 $2,000 U Budget variance Applied Overhead $234,000 $6,000 U Volume variance $8,000 U Total underapplied overhead Note to the Instructor: Because this simple exercise contains only fixed overhead, it can be used effectively to show why the volume variance is economically irrelevant Students can see that the $6,000 unfavorable variance comes about because Midus worked 1,000 fewer hours (40,000 - 39,000) than the number used to set the predetermined overhead rate You could point out that in order to make the volume variance zero, Midus could either (1) work 40,000 hours or (2) have used 39,000 hours as the denominator in calculating the rate Obviously, working additional hours is senseless unless there is profitable work to be done 3/18/02 12- You might wish to point out that the volume variance does show that Midus was less busy than it had originally forecast (The managers not need the volume variance to tell them that they were not as busy as they had originally forecast.) But the profit lost because of inability to generate work requiring 40,000 hours (if that was the case) is not the $6,000 volume variance but rather the contribution margin that Midus could have earned had it gotten more work (It is also possible that Midus did about as much business as originally forecast but did it in fewer hours.) 12-16 Activity-Based Overhead Rates (20-25 minutes) $0.24 per part and $7.00 per machine hour Budgeted overhead Measure of activity Rates Part-related Machine-related $240,000 $700,000 1,000,000 parts 100,000 hours $0.24 $7.00 Cost of Sales Overhead applied: Part-related at $0.24* $ 235,200 249,600 Machine-related at $7.00** 539,000 686,000 Materials, given 1,321,000 1,582,000 Direct labor, given 788,000 869,000 Totals $2,883,200 $3,386,600 WIP $ 6,000 Finished Goods $ 8,400 49,000 98,000 82,000 179,000 33,000 48,000 $170,000 $333,400 Total $ * 980,000 x $0.24 = $235,200; 25,000 x $0.24 = $6,000; 35,000 x $0.24 = $8,400 ** $7.00 x 77,000 = $539,000; $7.00 x 7,000 = $49,000; $7.00 x 14,000 = $98,000 Sales Normal cost of sales Overapplied overhead (below) Cost of sales Gross margin Administrative expenses Income $3,890,000 $2,883,200 4,600 2,878,600 1,011,400 356,000 $ 655,400 Actual overhead Applied overhead (total column, part 2) Underapplied (overapplied) 12-17 Basic Job Order Costing Part-related $234,000 249,600 ($ 15,600) Machine-related $697,000 686,000 $ 11,000 (15 minutes) Machine hours Overhead applied at $4.20/hour QB-002 2,180 $9,156 WB-011 1,130 $4,746 LB-012 2,810 $11,802 Cost of sales, Job QB-002 ($23,400 + $24,570 + $9,156) Ending inventories: 3/18/02 12- Total 6,120 $25,704 $ 57,126 Job WB-011 ($14,200 + $9,220 + $4,746) Job LB-012 ($36,320 + $26,245 + $11,802) Total ending inventory $ 28,166 74,367 $102,533 Overhead incurred Applied overhead (requirement 1) Overapplied overhead $ 25,210 25,704 $ 494 12-18 Comparison of Actual and Normal Costing $2.80 (25-30 minutes) $196,000/($24,000 + $18,000 + $28,000) Material cost Direct labor cost Overhead applied at $2.80 Total cost A-1 $ 22,000 24,000 67,200 $113,200 A-2 $ 51,000 18,000 50,400 $119,400 Sales Cost of sales (Job A-1) Gross profit Selling and administrative expenses Profit A-3 $ 38,000 28,000 78,400 $144,400 Total $111,000 70,000 196,000 $377,000 $160,000 113,200 46,800 28,000 $ 18,800 The predetermined overhead rate is $3 ($2,100,000/$700,000) Material cost Direct labor cost Overhead applied at $3 Total cost A-1 $ 22,000 24,000 72,000 $118,000 Sales Normal cost of sales (Job A-1) Normal gross margin Plus overapplied overhead Gross margin Selling and administrative expenses Profit * Overhead applied Actual overhead Overapplied overhead A-2 $ 51,000 18,000 54,000 $123,000 A-3 $ 38,000 28,000 84,000 $150,000 Total $111,000 70,000 210,000 $391,000 $160,000 118,000 42,000 14,000 56,000 28,000 $ 28,000 $210,000 196,000 $ 14,000 Note to the Instructor: We include the total column for two reasons First, total material and direct labor costs are the same under both methods, a point that students sometimes miss Second, the total column emphasizes that overhead applied to jobs under actual costing is actual overhead, while under normal costing it is the predetermined rate multiplied by the actual volume of the input factor (direct labor cost here) Students can therefore determine applied overhead either by adding total overhead applied to individual jobs or by multiplying total direct labor cost by the overhead rate They can then subtract actual overhead to find overapplied overhead We cannot determine budget and volume variances because the fixed and variable components of overhead are not given 3/18/02 12- 12-19 Graphical Analysis of Overhead (20 minutes) Note to the Instructor: This assignment allows you to discuss several points: the relationship of applied overhead to budgeted overhead, the visual interpretation of the volume variance, and the effects of differing levels of activity on the volume variance The basic purpose of requirement is to show that the volume variance depends only on fixed costs Because the predetermined overhead rate covers both variable and fixed costs, the amount absorbed at any volume level should cover the variable costs at that level, leaving only unabsorbed fixed costs to constitute the volume variance You might best start the coverage by directing the students' attention to the budget line That line indicates that manufacturing overhead has a fixed component of $200,000 (the y-axis intersect) The variable component is $2.50 per direct hour (At 120,000 hours, total overhead is $500,000 Subtracting the $200,000 fixed costs from $500,000 leaves $300,000 of variable costs; dividing $300,000 by 120,000 hours yields the variable component of $2.50 per hour.) We believe it is important to deal first, and independently, with the budget equation for this cost, so as to distinguish clearly between the behavior of the cost and "behavior" of overhead application The original graph emphasizes the behavior of the cost completely apart from any manipulation of that cost by means of an overhead application rate Students should have no difficulty drawing the first absorption line, for an absorption rate of $5 per hour (requirement la) For the second line, requirement lb, students need only to connect the origin with the budget line at that level of volume used to set the overhead rate (100,000) Graphically, the volume variance (requirement 2) is the vertical distance between the budget line at 90,000 hours and the absorption line at 90,000 hours The volume variance for the first overhead rate is $25,000 favorable, computed as follows: Budgeted overhead at 90,000 hours $200,000 + ($2.50 x 90,000) Overhead applied at 90,000 hours ($5 x 90,000) Volume variance, favorable $425,000 450,000 $ 25,000 The volume variance for the second overhead rate is $20,000 unfavorable, computed as follows: Budgeted overhead at 100,000 hours used to set the overhead rate $200,000 + ($2.50 x 100,000) Overhead rate ($450,000/100,000) Budgeted overhead at 90,000 hours, as above Overhead applied at 90,000 hours ($4.50 x 90,000) Volume variance, unfavorable $450,000 $4.50 $425,000 405,000 $ 20,000 At this point, we have fulfilled the two requirements of the assignment However, we think it is useful to continue the problem to emphasize the point, made in the text, that the volume variance depends only on fixed costs The text introduces the volume variance in the context of a separate overhead rate for fixed overhead and shows its calculation as either: Volume = variance Budgeted fixed overhead - Applied fixed overhead 3/18/02 12-10 does, because our customers cannot make price comparisons as simply as can those of a mass-production company Customers seeing a company charging less for a standard model of refrigerator are in a position to complain and to go elsewhere But price comparisons are not so readily available for custommade equipment such as ours and alternative sources are not as numerous In our case, dissatisfaction among regular customers depends on their knowing about the $75,000 price and their being able to compare that particular custom-made press with others they have purchased Note to the Instructor: This problem gives you the opportunity to discuss pricing methods The company uses a technique not uncommon in industry, with factory cost as the basis for setting prices and allowances added for selling and administrative expenses and for profit Because "allowances" such as the ones used by Walton are not discussed in the text, students may ask about the bases for their establishment You might even want to raise that question yourself so as to show that the approach need not be arbitrary or unsupported A pricing policy such as the one in the problem can come about as a result of analyzing the company's budgeted activity To show how this might happen, we'll assume some additional information about the budgeted activity for Walton for the year Materials $1,000,000 Labor, at $9 per hour on anticipated activity of 300,000 hours 2,700,000 Overhead, budgeted at $1,440,000 + $7.20 per DLH 3,600,000 Budgeted total factory cost $7,300,000 Budgeted total selling and administrative expenses 730,000 Target profit as established by management at 15% of total cost [($7,300,000 + $730,000) x 15%] $1,204,500 At the budgeted level of activity (300,000 hours) the overhead rate is the stated rate of $12 per hour ($3,600,000/300,000), and the portion of the rate representing fixed costs is the stated 40% ($1,440,000/ $3,600,000) or $4.80 The 10% standard allowance for nonfactory costs would derive from the fact that budgeted amounts for such costs bear that relationship to budgeted total factory costs If the company is able to get the budgeted business, expressed in terms of manufacturing costs, and charges prices for that business in line with the policy, it will earn the budgeted $1,204,500 profit Thus, the pricing practice followed by Walton need not be arbitrary and might be supported by the company's budget A variety of pricing practices are found in business, many of which, like Walton's, utilize some type of allowance for various cost factors One statement in the problem is particularly worth discussing because of its similarity to another commonly used but often misleading statement It is not uncommon to hear businesspeople say that "variable overhead is X% of total overhead." The problem, on the other hand, states the variable and fixed portions of the overhead rate For the former statement to be true, the speaker must know total overhead, because the proportion of total variable (or fixed) overhead to total overhead depends on the level of activity Because the overhead rate is what managers generally use for their analyses, we think it likely that our statement expresses the meaning that managers intend to convey when they use the former statement 12-37 Pricing Policy and Profits (25-30 minutes) $7,200,000 Fixed costs ($1,200,000 + $800,000) Variable manufacturing costs (240,000 x $15) 3/18/02 12-22 $2,000,000 3,600,000 Profit Total Divided by 0.90, - variable S & A rate Total revenue required $30 $760,000 880,000 6,480,000 90 $7,200,000 ($7,200,000/240,000) Revenue (230,000 x $30) Variable manufacturing costs (230,000 x $15) Variable S & A ($6,900,000 x 10) Contribution margin Fixed costs Profit $6,900,000 $3,450,000 690,000 4,140,000 2,760,000 2,000,000 $ 760,000 It is worth noting that each hour contributes $12 to profit ($30 - $3 S & A - $15 manufacturing) so that a 10,000 hour difference gives a $120,000 profit difference, $880,000 to $760,000 The same reasoning for requirement gives $1,000,000 profit at 250,000 hours $1,000,000 Revenue (250,000 x $30) Variable manufacturing costs (250,000 x $15) Variable S & A ($7,500,000 x 10) Contribution margin Fixed costs Profit $7,500,000 $3,750,000 750,000 4,500,000 3,000,000 2,000,000 $1,000,000 Note to the Instructor: One purpose of this problem is to allow you to pursue price-volume relationships Setting a price based on an estimated volume does not mean that the volume is achievable, nor that the price will provide a satisfactory profit Domestic automobile manufacturers, among others, learned to their sorrow in the late 1970s and early 1980s that raising prices in the face of falling volume was not a sensible strategy 12-38 Overhead Rates, ABC, and Pricing Driver for Cost Pool Direct labor Machine setups Number of parts/components Recordkeeping transactions (20-25 minutes) Total Cost in pool $4,800,000 1,200,000 900,000 400,000 Annual Activity of Driver 300,000 5,000 450,000 400,000 Rate $ 16 $240 $ $ Amounts of Cost Driver Model 807 600 DLH setup 400 parts 200 transactions Model 5052 150 DLH 12 setups 800 parts 500 transactions Model 807 Chair Number in typical job order Average cost per unit: Materials Direct labor at $10/hour Overhead: 3/18/02 12-23 Model 5052 Table 200 30 $24,000 6,000 $20,400 1,500 Labor-related at $16 $9,600 Machine setups at $240 240 Parts-related at $2 800 Transaction-related at $1 200 Total unit cost Price at 120% of manufacturing cost Price per unit 10,840 $40,840 $49,008 $ 245.04 $2,400 2,880 1,600 500 7,380 $29,280 $35,136 $ 1,171.20 Memorandum To: From: Subj: Date: Jarod Kane Student Activity-based costs Today My analysis (requirement 1) shows that if we recognize that our overhead costs are driven by activities other than direct labor, we are miscosting much of our work We now apply overhead by direct labor, which means that high-volume, labor-intensive lines will bear most of the cost The analysis shows that smaller lines generate significant costs for recordkeeping and setups Lines with large numbers of parts also generate overhead costs As we now apply overhead, we not recognize these drivers and so introduce a systematic bias High-volume, labor-intensive lines are overcosted because they require proportionately fewer setups and transactions Low-volume lines are systematically undercosted Low-volume lines generate considerable costs simply because they require setups, parts, and transactions in greater proportion to their volumes than the higher-volume lines A significant amount of cost is related to the complexity of our operations−how many products we have, as opposed to the total unit volume of each product Covered in requirement One point of this question is partly to help students with requirement 12-39 Changing Overhead Rates (15-20 minutes) $8.8 million before, $8.7 million after, a difference of $100,000 Overhead per unit Times 50,000 units equals total overhead Before $176 $8,800,000 After $174 $8,700,000 Overhead cost did not drop as rapidly as the managers had expected because it was, as the following analysis shows, mostly fixed with respect to direct labor Accordingly, the company was concentrating on the wrong factor Variable component = = = $8,800,000 - $8,700,000 (50,000 x $44) - (50,000 x $29) $100,000 $750,000 $0.133 per labor dollar The explanation is partly that overhead varies little with direct labor, so reducing labor time and cost does not reduce overhead cost significantly The labor saving is eight times the overhead saving The managers should search for other factors with which total overhead might vary They can also separate overhead into pools based on what factor 3/18/02 12-24 might drive particular types of cost They might better identify cost drivers, which should lead to more effective cost-reduction efforts 12-40 Normal Costing (25 minutes) Boardman Company Income Statement 20X5 (000s) Sales Cost of sales: Beginning inventories Materials Direct labor Applied overhead (1) Cost of goods available for sale Ending inventories (2) Cost of goods sold, normal Gross margin normal Variances: (3) Budget variance Volume variance Actual gross margin Selling and administrative expense Income $7,960 $ 360 2,240 1,780 2,492 6,872 1,070 5,802 2,158 $ 12 U 16 U 28 2,130 880 $1,250 (1) Overhead applied = $1,780 x $1.40 (2) Ending inventories Materials Direct labor Overhead at $1.40 per DL Totals (3) Variances Actual Overhead $2,520 In-Process $120 100 140 $360 Finished $230 200 280 $710 Budgeted Overhead Total 350 300 420 $1,070 $ Applied Overhead $1,440 + ($0.60 x $1,780) $2,508 $2,492 $12 U $16 U Budget variance Volume variance $28 Total underapplied overhead (above) Alternatively, the volume variance is $0.80 (fixed rate) times $20 (difference between budgeted and actual direct labor cost) 12-41 Overhead Rate Behavior (15 minutes) About $0.26, which is negligible Lotus 1-2-3 output appears below is not high and the standard error of the coefficient is high, t =1.58, $0.2606/0.1647, indicating a poor fit Regression Output: Constant 3413.464 Std Err of Y Est 0.931066 R Squared 0.455017 No of Observations Degrees of Freedom X Coefficient(s) 0.260603 3/18/02 12-25 R2 Std Err of Coef 0.164662 There are two plausible reasons First, overhead might be largely fixed Second, a considerable amount of overhead might vary with some factor other than DLH If the latter, Clinton should focus cost-cutting efforts on finding ways to reduce the activities that cause the cost The results that Clinton has seen can mislead managers by making them believe that considerable savings exist in reducing labor because the overhead rate per DLH is so high This is one of the problems of absorption costing Note, however, that the failure of the overhead rate to decline with labor savings drew the attention of the manager to the possibility of benefits from a study of cost drivers 12-42 Job-Order Costing and Decisions (25-30 minutes) Total costs charged to job Original Specifications Randle's Specifications Cost to complete: Materials $ 4,000 $ 6,000 Direct labor at $11/hour 8,800 19,800 Overhead at $10/hour 8,000 18,000 Totals 20,800 43,800 Accumulated to date 178,500 178,500 Total costs $199,300 $222,300 The Randle offer is more profitable, but not by a decisive amount Z-Store Randle Price $182,000 $202,000 Incremental costs to complete: Materials 4,000 6,000 Direct labor 8,800 19,800 Variable overhead at $4/DLH 3,200 7,200 Total incremental costs 16,000 33,000 Incremental profit $166,000 $169,000 The accumulated costs, both fixed and variable, are sunk this point will the following Specifications Selling price $182,000 Total costs charged to job, from part 199,300 Book losses ($17,300) Students who miss Specifications $202,000 222,300 ($20,300) When the fixed overhead amounts are removed, the job shows positive contribution margins under either alternative Total costs charged to job Less fixed costs: 7,800 hours at $6 8,800 hours at $6 Total variable costs Selling price Contribution margin Difference in favor of Randle offer 12-43 $199,300 46,800 $152,500 182,000 $ 29,500 $ 3,000 Job-Order Costing−Service Business $15, $222,300 calculated as follows 3/18/02 12-26 52,800 $169,500 202,000 $ 32,500 (20-25 minutes) Total manufacturing overhead ($120,000 + $240,000) Divided by direct labor hours Predetermined overhead rate per direct labor hour $360,000 24,000 $15 $15,950 Direct labor Overhead applied (450 x $15) Total cost $ 9,200 6,750 $15,950 $6,800 underapplied Actual overhead ($360,000/12) Idle time Total overhead Applied overhead (l,800 x $15) Underapplied overhead $30,000 3,800 33,800 27,000 $ 6,800 Sales Cost of sales: Salaries Overhead (1,350 x $15) Cost of sales, normal Underapplied overhead Cost of sales Gross profit Selling & administrative Income $170,000 $27,000 20,250 47,250 6,800 54,050 115,950 15,000 $100,950 Note to the Instructor: This problem shows an application of product costing to a service business, with the complication of idle labor time being treated as overhead, a point not explicitly covered in the text However, the problem is clear on the treatment of the idle time You might also show that normal costing and the treatment of idle time not produce a different result from those using the formula: expense = beginning inventory + current period costs - ending inventory An alternative income statement follows Sales Cost of sales: Total salaries Total overhead Total costs Less ending inventory Cost of sales Gross profit Selling and administrative Income 12-44 $170,000 $40,000 30,000 70,000 15,950 54,050 115,950 15,000 $100,950 Comparing Actual and Normal Costing−Seasonal Business $2.00 $3,200,000 + ($1.20 x $4,000,000) $4,000,000 Materials Direct labor = (15-20 minutes) $0.80 + $1.20 = $2.00 Job J-12 $10,410 16,900 3/18/02 12-27 A-16 $10,310 16,400 Overhead applied at $2 Total costs 33,800 $61,110 32,800 $59,510 We treat the advantages in the text, but in the specific situation we see that overhead costs are nearly level Managers should find normal costing less confusing than actual costing, once they understand the idea of overhead application They will still be using costs that contain fixed elements, but at least they will be the same per-unit fixed elements because the unit cost (here, per labor dollar) is the same throughout the year 12-45 Activity-Based Overhead Rates Activity Labor hours Machine set-ups Recordkeeping entries (20-25 minutes) Overhead Costs in Pool / $1,600,000 $ 600,000 $ 150,000 Budgeted Amount of Activity 400,000 hours 2,000 set-ups 150,000 entries = Rate $ 4.00 $300.00 $ 1.00 Cost of Sales Overhead applied: * Labor-related at $4.00 Set-up-related at $300 Recordkeeping at $1.00 Total applied overhead * Inventories $1,484,000 561,000 136,000 $2,181,000 $156,000 24,000 16,000 $196,000 Totals $1,640,000 585,000 152,000 $2,377,000 $4.00 x 371,000 = $1,484,000; $4.00 x 39,000 = $156,000; $300 x 1,870 = $561,000; $300 x 80 = $24,000 $1.00 x 136,000 = $136,000; $1.00 x 16,000 = $16,000 Material cost Direct labor cost Total applied overhead Total costs Cost of Sales $2,321,000 3,788,000 2,181,000 $8,290,000 Inventories $261,000 381,000 196,000 $838,000 Totals $2,582,000 4,169,000 2,377,000 $9,128,000 Activity Labor hours Machine set-ups under Recordkeeping entries Totals 12-46 Applied Overhead - Actual Overhead Misapplied $1,640,000 585,000 $1,620,000 592,000 $20,000 over 7,000 152,000 $2,377,000 148,000 $2,360,000 4,000 over $17,000 over Effects of Separate Overhead Rates (15-20 minutes) Materials costs Labor cost Overhead applied: * Labor-driven Set-up driven Entry-driven Total costs Price at 150% of total cost Product XT-12 $260 280 80 3,600 400 $4,620 $6,930 3/18/02 12-28 Product JY-09 $ 780 2,880 800 300 80 $4,840 $7,260 * Direct labor hours Machine set-ups Recordkeeping entries 20 12 400 x $4.00 = $ 80 x $300 = 3,600 x $1.00 = 400 200 x $4.00 = $800 x $300 = 300 80 x $1.00 = 80 Materials costs Labor cost Overhead applied at $5.875 Total costs Price at 150% of cost Rate = $5.875 Product XT-12 $ 260 280 118 $ 658 $ 987 Product JY-09 $ 780 2,880 1,175 $4,835 $7,253 ($1,600,000 + $600,000 + $150,000)/400,000 The labor-intensive product, JY-09 shows virtually the same costs using the labor-based rate, while the more resource-intensive product, XT-12, shows much lower costs using the labor-based rate This does not mean that using the labor-based rate saves the company money on XT-12 The rates are accounting artifacts The cost of XT-12 drops because it requires relatively high amounts of non-labor-driven activities, while JY-09's cost holds about the same because it is labor-intensive and does not use significant amounts of other resources If the controller is satisfied that the separation of costs into pools is reasonable, then it is probably worthwhile to use the separate rates to evaluate profitability and set prices, particularly if there are significant numbers of products with the characteristics of XT-12 The indicated price of XT-12 using activity-based rates is roughly six times the price using the direct labor-based rate That suggests a serious miscosting The company should probably raise the price of XT-12 and see if there are any objections from customers 12-47 Analyzing Overhead (25 minutes) Note to the Instructor: This problem is more open-ended than the others that deal with the interpretation of misapplied overhead First, you could verify the $6 predetermined overhead rate predetermined rate = = = total budgeted overhead total budgeted activity $480,000 + ($2 x 120,000) 120,000 $6 per machine hour We can start by determining what amounts of overapplied or underapplied overhead are budget variances and volume variances Actual Overhead Budget Variances Budgeted Overhead Volume Variances Applied Overhead March $71,000 $3,000U $40,000 + ($2 x 14,000) $68,000 $16,000F $13,000 overapplied $6 x 14,000 $84,000 April $40,000 + ($2 x 8,000) 3/18/02 12-29 $6 x 8,000 $52,000 $56,000 $4,000F $48,000 $8,000U $4,000 underapplied May $40,000 + ($2 x 5,000) $50,000 $51,000 $1,000U $21,000 $6 x 5,000 $30,000 $20,000U underapplied Overhead was overapplied in March because of heavy volume (average volume is 10,000 hours per month, 120,000/12) The budget variance was unfavorable, indicating that costs might not have been under control April and May both saw unfavorable volume variances, as volume was less than the 10,000 monthly average This analysis, which isolates the budget variance, gives the president a starting point for determining whether costs were under control As Chapter 11 showed, variances are only the first step in evaluating the control of costs But as pointed out in Chapter 12, the volume variance has no economic significance; it may show whether or not the plant was as busy as the monthly average, but not whether it was as busy as expected for that month We don't know how much activity the company should have in each of the three months, so we cannot say anything about whether operations are on schedule for the year or whether activity will or will not reach the 120,000 budgeted hours It is desirable to develop monthly budgets for labor (or whatever activity is used to develop the predetermined overhead rate) so that the president can see whether the company is about as busy as expected That information, in conjunction with the budget variances, would not tell him everything about overhead, but would be a reasonable start for his review 12-48 Departmental versus Plant-Wide Overhead Rates (30 minutes) Bids of $14,220 and $10,770 for Jobs 391 and 547, respectively Job 391 Job 547 Total direct labor hours 360 260 Overhead applied, at $8 per hr $2,880 $2,080 Materials 3,000 2,500 Labor 3,600 2,600 Total costs $9,480 $7,180 Bid price (total costs x 150%) $14,220 $10,770 The significantly higher per-hour variable overhead in assembly ($6 vs $2) could make the use of the plant-wide rate for pricing even more misleading The variable-cost rate alone in assembly is only $2 less than the plant-wide rate for total overhead ($6 vs $8) If, as might quite likely be the case, the company accepts business at less-than-normal prices during slack period, it might well price very close to variable cost For example, if it accepts work at "cost" based on the plant-wide rate, it will have a margin of only $2 per hour over the variable cost in the assembly department The more work it accepts in the assembly department, the lower its profits will be compared to what they might be if the company used departmental variable overhead rates in setting prices during slack periods Or if the company reduces prices below full cost, making some estimate of what the variable portion of total factory overhead is, it could well price below variable cost For example, suppose that a manager determines variable costs in total overhead at the budgeted volume to be $700,000 [($2 x 200,000 for grinding) + ($6 x 50,000 for assembly)] and concludes that variable overhead is, therefore, about 35% of total overhead ($700,000/[$1,200,000 + $800,000]) 3/18/02 12-30 The manager might erroneously apply that rate to the plant-wide overhead rate of $8 and conclude that variable overhead was about $2.80 ($8 x 35%) Obviously, below-full-cost pricing based on an estimated variable cost per hour of $2.80 could lead to losses since that amount is considerably below the variable overhead rate in the assembly department Of course, because the company does budget overhead by department, its managers presumably must know something about the cost relationships Thus, for ad hoc decisions they probably would not be as naive as we have just pictured them Nevertheless, the plant-wide rate is incorporated in the company's records, which are one of the principal sources of information to managers $6 per hour in grinding, $16 per hour in assembly Grinding Assembly $800,000 + ($2 x 200,000) 200,000 $500,000 + ($6 x 50,000) 50,000 $1,200,000 200,000 $800,000 = 50,000 = = $6 = $16 Bids of $13,590 and $12,690 for Jobs 391 and 547, respectively Job 391 Grinding overhead: 330 x $6 80 x $6 Assembly overhead: 30 x $16 180 x $16 Total overhead applied Materials and labor Total costs Bid price (total costs x 150%) Job 547 $ 1,980 $ 480 480 2,460 6,600 $ 9,060 $13,590 Overhead under departmental rates Overhead using plant-wide rate Differences in total costs Effects if differences on bids at 150% 2,880 3,360 5,100 $8,460 $12,690 Job 391 $2,460 2,880 ($ 420) ($630) Job 547 $3,360 2,080 $1,280 $1,920 It is reasonable to say that the plant-wide rate understates costs in assembly and overstates them in grinding As a result, the company might be overpricing work in grinding and underpricing work in assembly If the market is highly competitive, the company will win jobs that require much assembly work and lose jobs that require much grinding Over time, capacity in assembly will be strained, while grinding will have excess capacity 12-49 CVP Analysis in a Job-Order Company (20-25 minutes) $42.50 per hour Total costs: Direct labor (20,000 DLH x $15) Variable overhead ($300,000 x 80%) Fixed overhead Selling and administrative expenses Materials Total budgeted costs Desired profit Required revenue 3/18/02 12-31 $ 300,000 240,000 250,000 80,000 400,000 1,270,000 180,000 1,450,000 Revenue from materials ($400,000 x 1.50) Revenue required from labor charges Divided by 20,000 hours = price per hour $ 600,000 850,000 $42.50 $169,000 Revenue [($440,000 x 1.50) + (18,000 x $42.50)] Materials Direct labor (18,000 x $15) Variable overhead ($270,000 x 80%) Fixed overhead Selling and administrative expenses Profit $1,425,000 $440,000 270,000 216,000 250,000 80,000 1,256,000 $ 169,000 Note to the Instructor: You might wish to pursue a couple of points First, the company has two "products," materials and direct labor, with different contribution margins and percentages The company is therefore a multiproduct operation and the mix of its products affects its profits, as does its total revenue Materials Direct Labor Price per dollar $1.50 Price per hour $42.50 Variable costs, $1, $15 x 1.8 1.00 27.00 Contribution margin $0.50 $15.50 Contribution margin percentage 33% 36.5% Direct labor provides a higher margin than materials, so shifts from labor to materials, total costs remaining constant, will reduce revenue and profits Second, you might wish to ask the class to analyze the difference between budgeted and actual profit using Chapter techniques Some students will see quickly that the analysis could proceed about as follows Variance from materials [($440,000 - $400,000) x 0.50] Variance from labor [(18,000 - 20,000) x $15.50] Total variance ($180,000 - $169,000) 12-50 Overhead Application and Cost Control $20,000 F 31,000 U $11,000 U (25 minutes) $6, $2 variable plus $4 fixed ($240,000/60,000) 3,000 in April, 4,500 in May, 6,000 in June April Applied overhead costs $18,000 Divided by $6 rate = direct labor hours 3,000 May $27,000 4,500 June $36,000 6,000 Actual overhead costs Budgeted overhead costs: $20,000 + (3,000 x $2) $20,000 + (4,500 x $2) $20,000 + (6,000 x $2) Budget variance (favorable) April $25,000 May $28,000 June $34,000 29,000 _ ($ 1,000) 32,000 $ 2,000 26,000 _ ($ 1,000) Guinn needs to understand the difference between the volume variance and the budget variance components of misapplied overhead Cost control was actually good in April and May, because actual costs were less than budgeted costs (This assumes that costs were not below budget because of some unwise 3/18/02 12-32 actions taken by Guinn's employees, perhaps to reduce underapplied overhead because Guinn seems to pay so much attention to it.) Cost control was not good in June, where actual costs exceeded budgeted costs The volume variances are calculated below, showing that the bulk of misapplied overhead in each month resulted from working fewer (April and May) or more (June) hours than the average monthly amount of 5,000 (60,000/12) Budgeted overhead costs (above) Applied overhead costs Volume variance (favorable) 12-51 Cost Justification $26,000 18,000 $ 8,000 $29,000 27,000 $ 2,000 $32,000 36,000 ($ 4,000) (15-20 minutes) As President Reagan's consultant, you would mention the following points (a) The 30 minutes spent with the PFC people is only part of the portal- to-portal time, not the time spent on business of both political and nonpolitical kinds Even assuming that the speech given to the Chamber of Commerce was not political (which could be disputed), a better allocation would be based on the relative productive times If time on the plane was spent conducting business, which seems reasonable to assume, that part devoted to preparation for the PFC address should be used in making the allocation (b) The other seven people on the flight presumably had something to with the PFC speech The Secret Service agents surely protected Simon while he was giving the speech Others may have worked on the speech with him on the plane If Simon had taken 19 other people he would have been charged only 5% of the base cost of $2,310, then 5% of that amount (c) What was the primary purpose of the trip? Was the speech to the Chamber set up before or after the PFC reception? If the trip would have been made even if the Chamber speech were not given, the entire cost should be charged to the PFC, including the cost of the other seven travelers That is, the whole cost would have been incremental with regard to the political speech (Of course, it would be easy to get around this problem simply by making sure that a nonpolitical engagement was scheduled before the political one.) (d) Is the $2,310 charge reasonable? Does it correspond to charges for commercial service? If the charge is lower than commercial charges, the incumbent has an advantage over challengers (It would probably not be wise to bring up the method of determining the $2,310, which may include some allocations by the Air Force The PFC could argue that only the incremental cost of the flight should be charged, as we discuss in requirement 2.) Even if the PFC could contend that the Committee was paying at least the total cost of the flight, the Reagan forces could argue that access to low cost transportation is closed to other candidates and is therefore discriminatory The PFC spokesperson could make the following contentions (a) The plane was going to North Carolina on nonpolitical business (the speech to the Chamber of Commerce) and therefore the PFC is being generous in paying for any part of the flight No incremental cost is involved in Mr Simon's appearance before the PFC (There is some question whether the plane and crew had to put in more than 30 minutes because of the PFC speech It is probable that the trip would have been more than 30 minutes shorter if the speech had not been made and Mr Simon had gone back right after the Chamber 3/18/02 12-33 speech.) This is the major point and most others would be derivatives of it The point is to justify the Chamber speech as the primary reason for the trip (b) The other travelers may have had little or nothing to with the PFC speech, being primarily concerned with other work being done by Mr Simon on the trip If so, then the allocation of one-eighth of the cost to Mr Simon is, again, generous In sum, the PFC would base its claim on the lack of incremental cost involved in the PFC speech, while the Reagan forces would concentrate on the inequity of the situation and the (to them) transparent motive for the trip in the first place 12-52 text Easy that more ones $360 What Is Cost?−Consumer Action (15-20 minutes) This case can be used to illustrate the point made very early in this that there are different meanings for "cost" in different contexts Ed's explanation of "cost" will not stand up at any volume other than experienced last year It can be shown that Ed's income will increase than $100 per car for every car he sells If his agency operates as the described in Consumer Scoop, he does indeed earn additional profit of for each additional car sold Ed is arguing, in effect, that "$100 over cost" means $50,000 per year profit based on 500 cars sold Using this interpretation, he could charge $14,740 per car and earn $100 per car if volume were 250 cars per year Income Statements 500 Cars Revenue $14,190 per car $14,740 per car Variable costs $13,540 per car Contribution margin Fixed costs* Income 250 Cars $7,095,000 $3,685,000 6,770,000 325,000 275,000 $ 50,000/500 = $100 3,385,000 300,000 275,000 $ 25,000/250 = $100 *Based on allocated fixed costs at 500 cars Make-ready services contain fixed costs of $120 per car ($160 - $40), which, when added to the $430 general overhead, gives $550 per car $550 x 500 = $275,000 As an expert witness, one could point out that Ed's profit increases by $360 every time he sells a car at $14,190 The fact that he could charge different prices at different volumes and still be selling at $100 over "cost" is another point that the court might find appealing Finally, it might be shown that if Ed sells more than 500 cars this year, his profit per car will be more than $100 and that the selection of the 500-car volume on which to base the $14,090 cost is arbitrary and self-serving An income statement for 600 cars sold would show a profit of over $100 per car Sales ($14,190 per car) Variable costs ($13,540 per car) Contribution margin Fixed costs Income $8,514,000 8,124,000 390,000 275,000 $ 115,000/600 = $191.67 One might then ask the judge whether Ed should have to refund $91.67 to 3/18/02 12-34 each customer if he did sell 600 cars in one year A student of one of the authors said in class that a similar question had arisen in his hometown Some automobile dealers were advertising prices that they alleged to be some amount over cost and were including allocated overhead costs in the computation The student was working for a consumer protection agency that took the case up with the dealers, with the argument proceeding along the lines suggested in this solution The dealers subsequently agreed that only direct costs should be included when using such advertising claims 12-53 Determining Product Costs (25-35 minutes) (This case could also be assigned with Chapter 5.) The company should buy the unsorted tomatoes and can both whole tomatoes and tomato paste You can reach this conclusion using any of the standard costs suggested We believe that the following analysis, which treats the cost of tomatoes as a lump sum, is as good as any other method Do not buy unsorted tomatoes Production of paste cases 5,000,000/25 lbs per case Contribution margin per case, tomatoes at $0.08 per lb Monthly contribution margin 200,000 $.20 $ 40,000 Buy unsorted tomatoes Production of tomato paste cases (5,000,000 x 60%)/25 lbs Contribution margin, without cost of tomatoes ($5.80 - $3.60 "other variable costs" from controller's schedule) Total margin per month Production of whole tomatoes cases (5,000,000 x 40%)/20 lbs Contribution margin without tomato cost ($6.00 - $3.22) Total margin per month Total monthly margin Less cost of tomatoes (5,000,000 x $0.10) Contribution margin per month 120,000 $2.20 $264,000 100,000 $2.78 278,000 542,000 500,000 $ 42,000 Contribution margin per month will be $2,000 greater if the tomatoes are bought unsorted, and both products produced The same result can be obtained by using any of the solutions suggested by the participants, but these will not always give the correct impression of profitability The problem here is that the tomatoes, A and B grades, are joint products There really is no such thing as "the" cost of either grade The sorting cost is joint with respect to the two grades, as is the purchase price The question then becomes whether the joint cost can be allocated in ways that will assist, or at least not hinder, planning and control functions, including decision making The controller's first method, the one shown in the schedule, clearly does not help It shows a large loss on paste, which fails to recognize that paste is profitable if the B grade tomatoes are purchased separately The second method proposed by the controller would show a loss for whole tomatoes, with paste still being profitable As given, the contribution margins for the products follows 3/18/02 12-35 Whole Tomatoes $6.00 Selling price Variable costs: Tomatoes ($0.141 and $0.07267) Other variable costs Total variable costs Contribution margin Tomato Paste $5.80 2.82 3.22 6.04 ($0.04) 1.817 3.600 5.417 $0.383 The method proposed by the president could be done either way The cost of A grade tomatoes purchased separately could be used to set the cost for whole tomatoes, then the rest allocated to B grade tomatoes The solution achieved would sometimes show whole tomatoes earning a positive contribution margin even though the firm would be better off buying B grade tomatoes and making only tomato paste With the data given, the method does work, in the sense that both products would show a positive contribution margin The following contribution margins result from the president's method Selling price Variable costs: Tomatoes ($0.13 and $0.08) Other variable costs Total variable costs Contribution margin Whole Tomatoes $6.00 2.60 3.22 5.82 $0.18 Tomato Paste $5.80 2.00 3.60 5.60 $0.20 Any of the proposed allocations will give the correct production decision if applied correctly Using the $0.04 for whole tomatoes and $0.383 for paste as computed by the relative value method suggested by the controller, we find the following Whole Tomatoes Tomato Paste Contribution margin per case Cases Contribution margin ($.04) 100,000 ($ 4,000) $0.383 120,000 $ 45,960 The sum of the contribution margins is $41,960, which is different from the $42,000 previously computed because of rounding the unit cost of tomatoes Using the schedule given in the problem, with tomatoes at 10 cents for both products, we would get the same approximate result Whole Tomatoes Tomato Paste Contribution margin per case Cases Contribution margin $.78 100,000 $ 78,000 ($.30) 120.000 ($ 36,000) Again, the sum is $42,000, as computed at the beginning of the solution None of the suggested methods will always give results that can be used for planning and control, and especially for deciding whether to produce both products or only one Any material use variances calculated using the suggested costs would be defective in the sense that they would not measure the cost of shortfalls in production or overuse of tomatoes if production were scheduled below capacity Perhaps the best recommendation is to omit the material cost from the determination of standard costs of the separate products and instead plan and control tomato cost using total budgeted amounts This is especially appealing if the company can always operate at full capacity 3/18/02 12-36 ... Job-Order Company (25-30 minutes) $72,000 Material cost Direct labor cost Factory overhead Total factory costs Revenue at 120% of factory cost Factory cost Selling and administrative expenses Profit... the cost of sales section, we have the following Sales Cost of goods sold: Material cost ($150,000 + $60,000) Direct labor cost ($95,000 + $75,000) Overhead cost Total costs Less ending inventory... calculation of cost of sales using the totals follows Direct expenses Professional salary cost Applied overhead Total costs Less ending inventory* Normal cost of sales Less overapplied overhead Cost of