Book Part II

7
• •
Additional °PIC In
Product Costing
LEARNING OBJECTIVES
L01 Differentiate between product and

service department costs and
direct and indirect department
costs. (p. 220)
L02 Describe the allocation of service The challenge of product costing, which we have explored in the previ-
department costs under the ous two chapters, is how to trace and assign the costs of production to
direct, step, and linear algebra a company's various products. Determining how much it costs to make a
methods. (p. 220) product can be very simple and straightforward for a company that makes
only one product; however, as product lines become more extensive and
L03 Understand lean production processes more complex, the costing system becomes more complex.
and just-in-time inventory The product cost system is essentially a reflection of a company's product
management. (p. 229) strategy and production processes.
The development of highly complex product lines, processes, and
L04 Explain how lean production cost systems is illustrated by the automobile industry in the post World
and just-in-time affect War II era. What began as a simple business plan with Ford Motor Com-
performance evaluation and pany producing a single model automobile in one color in the 1920s and
recordkeeping. (p. 232) 1930s evolved into an explosion of diversity and choice in automobile
brands. General Motors had five major divisions, each offering multiple
L05 Discuss performance models with an almost unlimited combination of options; Ford and Chrys-
reporting in a lean production ler were forced to follow a similar strategy just to keep from losing ground
environment. (p. 234) to GM. In the last half of the 20th century, the number of different automo-
bile brands expanded exponentially, and product cost systems at the "Big
Three" U.S. auto manufacturers evolved in complexity to keep up with this
rapidly expanding product diversity.
At the same time the automobile industry was developing in the U.S.,
a small struggling Japanese automobile company, founded by Kiichiro
218
Toyoda in the 1930s, and later renamed Toyota Motor Corporation, was establishing itself as a leading
Japanese auto manufacturer. Toyoda's colleague and chief production manager, Taiichi Ohno, soon began
developing a production philosophy, which came to be known as the Toyota Production System. Ironically,
Ohno's inspiration for his system originated with a tour of a Ford Motor plant in the U.S. and the belief that
the methods that U.S. grocery supermarkets used to manage their inventories could be applied to an auto-
mobile plant. Over the past two decades, the Toyota system arguably has had more influence on production
methods worldwide than any other single influence or person. Business Week magazine described Toyota's
influence in the following manner: " ... Toyota didn't just revolutionize car making - but pretty much global
manufacturing as wei!.'
In the early 1980s Toyota's Chairman came to the U.S. to study the U.S. automobile industry and con-
cluded that to be successful in the international markets, especially the U.S., it could not simply copy the U.S.
industry, but had to produce superior automobiles, and do it with creativity, resourcefulness, wisdom, and
hard work. Twenty-five years later, in the first quarter of 2007, Toyota became the World's largest automobile
manufacturer by selling 2.35 million cars worldwide, compared with GIV1's 2.26 million for the same period. 2
This chapter discusses two major topics in cost management: (1) service department cost allocations,
which are likely to be found in an organization like GM with its many divisions and departments, and (2) the
lean production/just-in-time approach to managing production and product costs, first introduced by the'
Toyota Company.
1 Brian Bremner, "Toyota: A Carmaker Wired to Win," Business Week, April 24, 2007, as presented at http://www.businessweek.com/
globalbiz/content/apr2007/gb20070424_480904.htm)
2Ronal M. Becker, "Lean Manufacturing and the Toyota Production System," Society of Automotive Engineers International (SAE), as
presented at hltp://www.sae.orgltopics/leanjunOJ.htm
219
220 Chapter 7 I Additional Topics in Product Costing
CHAPTER
ORGANIZATION B,;mm·'iE~~
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I I I I
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~~ ~'liO ,- ~'1'm:r"M!Mi'f'\,j. tD?
-'-
Direct and Indirect 1I Direct Method
• Reducing Incoming .::I Performance Evaluation
Department Costs
.
~
Step Method
Linear Algebra Method
Materials Inventory
Reducing Work-in- .. Measures
Simplified
Process Inventory Recordkeeping
• Dual Rates
u Reducing Finished • Performance Reporting
Goods Inventory with Lean Production
PRODUCTION AND SERVICE DEPARTMENT

COSTS
L 0 1 Differentiate In Chapter 5, we discussed two basic methods Uob order costing and process costing) for accumulating,
between product measuring and recording the costs of producing goods. In Chapter 6, we discussed both traditional and
and service activity-based methods for assigning indirect costs to products. We now look in more detail at another
department aspect of assigning indirect costs.
costs and direct In addition to production departments that actually perfonn work on a product, many companies have
and indirect production support departments, such as payroll, human resources, security, and facilities, that provide
department costs. support services for all of the production departments, and sometimes even for each other. These de-
partments are typically called service departments. The cost of producing products, therefore, includes
the costs inculTed within production departments, as well as the cost of services received from service
departments.
A direct department cost is a cost assigned directly to a department (production or service) when it
is incurred. For a production department, direct department costs include both direct product costs (direct
materials and direct labor) as well as indirect product costs (such as indirect labor and indirect materials)
incurred directly in the department. An indirect department cost is a cost assigned to a department as a
result of an indirect allocation, or reassignment, from another department, such as a service department.
The product costing system must include a policy for assigning to products the cost of services re-
ceived from service departments. For companies that use a plantwide overhead rate, the costs of all service
departments are added to the indirect product costs incurred within all of the producing departments to get
total plantwide manufacturing overhead, which is then assigned to products using a single overhead rate
based on a common factor such as direct labor hours. For companies that use departmental overhead rates,
service department costs are allocated to the production departments that utilize their services, and the
allocated service department costs are added to the indirect costs incUlTed within the department to arrive
at total depaltmental overhead and allocation rates. Also, as illustrated in Chapter 6, service department
costs may also be assigned to products using activity-based costing.
L02 Describe
ERVICE DEPARTMENT COST ALLOCATION
the allocation As discussed above, service departments (maintenance, administration, security, etc.) provide a wide
of service range of support functions, primarily for one or more production departments. These departments, which
department costs are considered essential elements in the overall manufacturing process, do not work directly on the "prod-
under the direct, uct" but provide auxiliary support to the producing departments. In addition to providing support for the
step, and linear various producing departments, some service departments also provide services to other service depart-
algebra methods. ments. For example, the payroll and personnel departments may provide services to all dep3ltments, and
Chapter 7 I Additional Topics in Product Costing 221
maintenance may provide services to the producing departments as well as to the medical center and food
services. Services provided by one service department to other service departments are called interde-
partment services.
To illustrate service department cost allocations, consider the Manufacturing Division of Krown
Drink Company, which has two producing departments, three service departments, and two products. The
service departments and their respective service functions and cost allocation bases are as follows:
Department Service Functions Allocation Base
Support Services Receiving and inventory Total amount of department

control capital investment
Engineering Resources Production setup and Number of employees
engineering and testing
Building and Grounds Machinery maintenance and Amount of square footage
depreciation occupied
Difficulty in choosing an allocation base for service department costs is not uncommon. For example,
Krown Drink may have readily determined the appropriate allocation bases for the Engineering Resources
and the Building and Grounds Departments but may have found the choice for Support Services to be less
clear. Perhaps after conducting correlation studies, the most equitable base for allocating Support Ser-
vices costs to other departments was determined to be total capital investment in the departments because
they included expensive computer-tracking equipment, both manual and automated forklifts, and other
material-moving equipment. The following Business Insight box discusses how computer software helps
companies to track and allocate telephone service costs in a large organization.
Direct department costs and allocation base information used to illustrate Krown Drink's July service
department cost allocations are summarized as follows:
Amount Total Amount of

Direct Number of Square Department
Department of Footage Capital
Costs Employees Occupied Investment
Service departments
Support Services .......... $ 27,000 15 15% 4,000 8%
Engineering Resources ...... 20,000 2,000 4 $ 45,000 8%
Building and Grounds ....... 10,000 5 5 50,000 9
Producing departments
Mixing ................... 40,000· 24 24 11,000 22 180,000 33
Bottling .................. 90,000· 56 56 33,000 66 270,000 50
- ---
$187,000 100 100% 50,000 100% $545,000 100%
'Direct department overhead
The preceding information omitted the,amount of capital investment in the Support Services De-
partment, the number of employees in the Engineering Resources Department, and the amount of square
footage used by the Building and Grounds Department. These data were omitted because a department
normally does not allocate costs to itself; it allocates costs only to the departments it serves. The three
methods commonly used for service department cost allocations-direct, step, and linear algebra-are
discussed next.
0" t th
The direct method allocates all service department costs based only on the amount of services provided
to the producing departments. Exhibit 7.1 shows the flow of costs using the direct method. All arrows
depicting the cost flows extend directly from service departments to producing departments; there are no
cost allocations between the service departments.
BUSINESS INSIGHT Computer Software Aids Telephone service Cost Allocation
In a large organization, a service as basic as telephone usage can represent a substantial cost and,
hence, a significant cost allocation challenge. All departments, both production and service, are users
of telephone services, including installing and repairing new lines and providing ongoing monthly ser-
vice. Many companies have thousands of telephones in service for which costs have to be allocated
to the various departments.
A Canadian software company, Digital Fairway, is a leading developer of software that helps or-
ganizations centralize and automate the management of their telecommunications infrastructure. Most
companies still manage the allocations of these costs manually using spreadsheets. "Keeping track of
cost center assignments and cost allocations for communication services in a spreadsheet are time
consuming and error prone tasks," says Digital Fairway CEO Joe Warnement. Digital's Provergent soft-
ware product enables enterprises to associate a communications service and its cost to a general led-
ger code within the telecommunications electronics system, allowing the service costs to be accurately
allocated to the cost center consuming that service. The ability to associate a unique service or circuit
identifier to both the cost and a general ledger code enables enterprises to gain a more accurate view
into the telecoms services being consumed by different parts of the organization.
Source: "Digital Fairway's Provergent Enables Enterprises to Accurately Allocate Corporate Telecom Costs," Market Wire, Sep-
tember 4, 2007.
EXHIBIT 7.1 low of Costs-Direct Method
Service Support Engineering Building

Departments Services Resources and Grounds
Producing
Departments
Product Product Product
Exhibit 7.2 shows the service department cost allocations for the direct method. Notice the allocation
base used to allocate Engineering Resources costs; only the employees in the producing departments are
considered in computing the allocation percentages-24 in Mixing and 56 in Bottling, for a total of 80 em-
ployees in the allocation base. Thirty percent (24 -7- 80) of the producing department employees work in
Mixing; therefore, 30 percent of Engineering Resources costs are allocated to Mixing. Applying the same
reasoning, 70 percent of Engineering Resources costs are allocated to Bottling. Similar logic is followed
in computing the cost allocations for Building and Grounds and Support Services.
The cost allocation summary at the bottom of Exhibit 7.2 shows that all service department costs have
been allocated, decreasing the service department costs to zero and increasing the producing department
overhead balances by the amounts of the respective allocations. Also, total costs are not affected by the
allocations; the total of $187,000 was merely redistributed so that all costs are reassigned to the produc-
ing departments. Total department overhead costs of the producing departments after allocation of service.
costs are $59,300 for Mixing and $127,700 for Bottling.
The advantage of the direct method of allocating service department costs is that it is easy and conve-
nient to use (see the Business Insight that follows). Its primary disadvantage is that it does not recognize
the costs for interdepartment services provided by one service department to another. Instead, any costs
incurred to provide services to other service departments are passed directly to the producing departments.
service Department Cost Allocations-Direct Method
Total Mixing Bottling
Support Services Department

Allocation base (capital investment) . $450,000 $180,000 $270,000
Percent of total base . 100% 40% 60%
Cost allocations . $ 27,000 $ 10,800 $ 16,200
Engineering Resources Department
Allocation base (number of employees) . 80 24 56
Building and Grounds Department
Allocation base (square footage occupied) .. 44,000 11,000 33,000
Cost Allocation Summary
Support Engineering Building and

Services Resources Grounds Mixing Bottling Total
Department cost before allocations . $27,000 $20,000 $10,000 $40,000 $ 90,000 $187,000
Cost allocations
Support Services . (27,000) 10,800 16,200
Engineering Resources . (20,000) 6,000 14,000
Building and Grounds . (10,000) 2,500 7,500
Department costs after allocations . $ 0 $ 0 $ 0 $59,300 $127,700 $187,000
The step method improves on the allocation procedure by redirecting some of the costs to other service
departments before they are finally allocated to the production departments.
BUSINESS INSIGHT Cost Allocations for College Services
Service department cost allocation using the direct method is applied at many colleges. The produc-
ing departments of a college are its academic departments and professional schools; its support
service departments are those such as student services (which includes housing, dining, and student
life activities), facilities management (which is responsible for the physical campus), academic sup-
port (such as libraries and computer centers), and administration (such as the president's office, fund-
raising activities, and the legal department). Commonly used bases for allocating these service
department costs are the number of students for student services and academic support, square
footage of space occupied for facilities management, and total revenues for administration.
The allocation of these support service costs are often major bUdget line items in the operating
budgets for deans and department heads. These costs greatly affect the amount of money left for
direct operating needs such as faculty salaries, research support, and professional development. It
is important that the cost allocation method be perceived as fair and appropriate by those whose
budgets are charged with these allocated costs. Using the direct allocation method is appropriate in
allocating some college service costs, such as student services; it would probably not be appropriate
in allocating others, such as computer services, which are used by both academic departments and
other service departments.
Step Method
The step method gives partial recognition of interdepartmental services by using a methodology that
allocates the service department costs sequentially both to the remaining service departments and the
producing departments. Any indirect costs allocated to a service department in this process are added to
that department's direct costs to determine the total costs for allocation to the remaining departments. All
service department costs will be assigned to the production departments and ultimately to the products.
To illustrate the problem that can result from using the direct method, assume that Ramso Company
has two service departments, 5 I and 52, and two producing departments, P I and P2, that provide services
as follows:
Receiver of Services
Provider of Services .•.... S1 S2 P1 P2
S1 . 0% 0% 70% 30%
S2 . 50% 0% 25% 25%
If the direct method is used to allocate service department costs to the producing departments, 52
total costs will be allocated equally to the producing departments because they use the same amount of
52 services (25 percent each). Is this an equitable allocation of 52 costs? 52 actually provides half of its
services to the other service department (51), which, in turn, provides the majority of its services to PI.
Assume that 52 has total direct department costs of $100,000. If the direct method is used to allocate ser-
vice department costs, the entire $100,000 will be divided equally among the two producing departments,
each being allocated $50,000, with no allocation to 51.
S1 S2 P1 P2
Direct allocation of S2 to P1 and P2 .... $0 $(100,000) $50,000 $50,000
Consider the following alternative allocation of the $100,000 of 52 costs that takes into account inter-
department services. First, 25 percent, or $25,000, is allocated to each of the producing departments, and
50 percent, or $50,000, is allocated to 51. Next, the $50,000 allocated to 51 from 52 is reallocated to the
producing departments in proportion to the amount of services provided to them by 51: 70 percent and 30
percent, respectively. In this scenario, the $100,000 of 52 costs is ultimately allocated $60,000 to PI and
$40,000 to P2 as follows:
S1 S2 P1 P2
Step 1:
Allocate S2 costs to S1, P1, and P2 .... $50,000 $(100,000) $25,000 $25,000
Step 2:
Reallocate S1 costs to P1 and P2 ..... (50,000) 0 35,000 15,000
Total allocation of S2
costs via step method .............. $ 0 $ 0 $60,000 $40,000
This calculation shows only the ultimate allocation of 52 costs. Of course, any 51 direct department costs
would also have to be allocated to PI and P2 on a 70:30 basis. If interdepartmental services are ignored, PI
is allocated only $50,000 of 52 costs; by considering interdepartmental services, PI is allocated $60,000.
Certainly, a more accurate measure of both the direct and indirect services received by PI from 52 is
$60,000, not $50,000.
As long as all producing departments use approximately the same percentage of services of each
service department, the direct method provides a reasonably accurate cost assignment. In this example,
the percentages of services used by the producing departments were quite different: 70 percent and 30
percent for 51, and 50 percent and 50 percent for 52. In such situations, the direct method can result in
significantly different allocations.
The step method is illustrated graphi-

EXHIBIT 7.3 Flow of Costs-Step Method
cally in Exhibit 7.3 for the Krown Drink
Company. Notice the sequence of the al-
locations: Engineering Resources, Sup- Service Engineering
port Services, and Building and Grounds. Departments Resources
When using the step method, the se- Support
Services
quence of allocation is typically based on
Building
the relative percentage of services provided and Grounds
to other service departments, with the larg-
est provider of interdepartmental services
allocated first and the smallest provider of
interdepartmental services allocated last.
For Krown Drink, Engineering Resources
is allocated first because, of the three ser-
vice departments, it provides the largest
percentage (20 percent) of its services to Producing
other service departments: 15 percent to Departments
Support Services and 5 percent to Building
and Grounds (see previous cost allocation
data). Building and Grounds is allocated
last because it provides the least amount
(12 percent) of its services to other service
departments: 8 percent to Support Services
and 4 percent to Engineering Resources.
The service department cost allocations
for Krown Drink using the step method are
shown in Exhibit 7.4.
EXHIBIT 7.4 Service Department Cost A1locations-Step Method
Support Building and

Total Services Grounds Mixing B.ottling
Engineering Resources Department

Allocation base (number of employees) .... 100 15 5 24 56
Percent of total base................... 100% 15% 5% 24% 56%
Cost allocations ...................... $20,000 $3,000 $1,000 $4,800 $11,200
Support Services Department
Allocation base (capital investment) ....... $500,000 $50,000 $180,000 $270,000
Percent of total base................... 100% 10% 36% 54%
Cost allocations ...................... $30,000 $3,000 $10,800 $16,200
Building and Grounds Department
Allocation base (square footage occupied) . 44,000 11,000 33,000
Percent of total base................... 100% 25% 75%
Cost allocations ...................... $14,000 $3,500 $10,500
Engineering Support Building and

Resources Services Grounds Mixing Bottling Total
Department costs before allocations ........ $ 20,000 $ 27,000 $ 10,000 $40,000 $ 90,000 $187,000
Cost allocations
Engineering Resources ............... (20,000) 3,000 1,000 4,800 11,200
Support Services.................... (30,000)'" 3,000 10,800 16,200
Building and Grounds ................ l+- (14,000) 3,500 10,500
---
Department costs after allocations........ $ 0 $ 0 $ 0 $59,100 $127,900 $187,000
Linear Algebra eciprocal) Metho

The disadvantage of the step method is that it provides only partial recognition of interdepartmental ser-
vices. For Krown Drink, the step method recognizes Engineering Resources services provided to the
other two service departments; however, no services received by Engineeling Resources from the other
two departments are recognized. Similarly, services from Support Services to Building and Grounds are
recognized, but not the reverse. To achieve the most mathematically accurate service department cost
allocation, there should be full recognition of services between service departments as well as between
service and producing departments. This requires using the linear algebra method, sometimes called the
reciprocal method. The linear algebra (reciprocal) method uses a series of linear algebraic equations,
which are solved simultaneously, to allocate service department costs both interdepartmentally and to the
producing departments. This method is illustrated graphically in Exhibit 7.5 for a company that has two
service departments and two producing departments. The cost allocation arrows run from each service
department to the other service department as well as to the producing departments. Further discussion
of this method can be found in Cost Accounting texts. Whether a company should use the direct method,
step method, or linear algebra method depends on the extensiveness of interdepartmental services and how
evenly services are used by the producing departments.
EXHIBIT 7.5 Flow of Costs-Unear Algebra Method
Service
Departments
Producing
Departments
-1'-,lLI.
• You are the Controller
As the person responsible for the product costing system, you are trying to decide which method is
best to use in allocating service department costs to the producing departments and to the products.
Some of the service departments provide services only to producing departments; whereas, others
provide services to both producing and service departments. You would like to use the method that
provides reliable cost measurements, but without creating more costs than the benefits derived.
Which method do you recommend? [Answer, p. 236]
ua' Rates
When pooling costs for subsequent reassignment or allocation, it can be useful to provide separate pools
for fixed costs and variable costs. This will result in cost allocations that more accurately reflect the fac-
tors that drive costs. The capacity provided most often dlives fixed costs, whereas some type of actual
activity usually drives variable costs. Dual rates involve establishing separate bases for allocating fixed
and variable costs. Dual rates may be used for one or all service departments, depending on the size and
nature of the costs in each service department. They may also be used in conjunction with the direct, step,
or linear algebra methods.
It is important to remember the relationship between capacity and cost when selecting the allocation
method. Total variable costs change as activity changes. Fixed costs, however, are the same whether the
activity is at or below capacity. Fixed costs should usually be allocated based on the relative capacity pro-
vided the benefiting department, while variable costs should be allocated on the basis of actual usage. The
allocation methods and bases also may be different for variable and fixed costs.
Fixed costs based on capacity provided eliminates the possibility that the amount of the cost allo-
cation to one department is affected by the level of services utilized by other departments. When fixed
service department costs are allocated based on the capacity provided to the user department, managers of
the user departments are charged for that capacity whether they use it or not, and their use of services has
no effect on the amount of costs allocated to other departments. A benefit of this allocation system is that
it reduces the temptation for managers to avoid or delay services to minimize fixed cost allocations to their
departments. Dual rates are examined in more detail in most cost accounting texts.
MID-CHAPTER REVIEW
The Apparel Store, LTD is organized into four departments: Women's Apparel, Men's Apparel, Administrative
Services, and Facilities Services. The first two departments are the primary producing depattments; the last
two departments provide services to the producing departments as well as to each other. Top management has
decided that, for internal reporting purposes, the cost of service department operations should be allocated to
the producing departments. Administrative Services costs are allocated on the basis of the number of employees,
and Facilities Services costs are allocated based on the amount of square footage of !loor space occupied. Data
pertaining to the cost allocations for February 2009 are as follows:
Square
Direct Number of Footage
Department Department Cost Employees Occupied
Women's Apparel . $ 60,000 15 15,000

Men's Apparel. . 50,000 9 7,500
Administrative Services . 18,000 3 2,500
Facilities . 12,000 2 1,000
Total . $140,000 29 26,000
Required
a. . Determine the amount of service department costs to be allocated to the producing departments under both
the direct method and the step method of service department cost allocation.
b. Discuss the linear algebra method of service department cost allocation, explaining circumstances when it
should be considered over the direct and step methods.
c. Should The Apparel Store consider using the linear algebra method?
Solution
Service Department Cost Allocation
a. Direct Method
Total Women's Men's
Administrative Services Department

Allocation base (number of employees) . 24 15 9
Percent of total base . 100% 62.5% 37.5%
Cost allocation . $18,000 $11,250 $6,750
Facilities Services Department
Allocation base (square footage) . 22,500 15,000 7,500
Percent of total base . 100% 66.7% 33.3%
Cost allocation .. - - - . $12,000 $ 8,000 $4,000
Administrative Facilities Women's Men's Total
Departmental costs
before allocation. . . . . .. $18,000 $12,000 $60,000 $50,000 $140,000
Cost allocations
Administrative. . . . . . . . . (18,000) 11,250 6,750 o
Facilities . (12,000) 8,000 4,000 o
Departmental costs
after allocation $ o $ o $79,250 $60,750 $140,000
Step Method
Allocation Sequence
Administrative Facilities
Allocation base . Number of Amount of

employees square footage
Total base for other service and
producing departments (a) . . . . . . 26 25,000
Total base for other service departments (b) . 2 2,500
Percent of total services provided to other
service departments (b -;- a) . 7.7% 10.0%
Order of allocation . Second First
Step Allocations
Total Administrative Women's Men's
Facilities Services Department

Allocation base (square footage) ........ 25,000 2,500 15,000 7,500
Percent of total base.................. 100% 10% 60% 30%
Cost allocation ...................... $12,000 $1,200 $ 7,200 $3,600
Administrative Services Department
Allocation base (number of
employees) ....................... 24 - 15 9
Percent of total base.................. 100% 62.5% 37.5%
Cost allocation ($18,000 + $1,200) ...... $19,200 - $12,000 $7,200
Facilities Administrative Women's Men's Total
Departmental costs
before allocation ........ $12,000 $18,000 $60,000 $50,000 $140,000
Cost allocations
Facilities ..... ...... (12,000) 1,200 7,200 3,600 0
Administrative. ...... - (19,200) 12,000 7,200 0
---
Departmental costs
after allocations ........ $ 0 $ 0 $79,200 $60,800 $140,000
b. Another service department cost allocation method is the linear alxehra method. This method simul-
taneously allocates service department costs both to other service departments and to the producing
departments. It has an advantage over the step method in that it fully recognizes interdepartmental
services.
c. If The Apparel Store wants the most precise allocation of service department costs to the producing
departments, considering both direct services and indirect services, it must use the linear algebra meth-
od of service department allocation. As indicated in the Allocation sequence section of the step method
in (a), Facilities provides 10 percent of its services to Administrative, and Administrative provides
7.7 percent of its services to Facilities. The step method recognized the Facilities services provided to
Administrative, but it did not recognize the Administrative services provided to Facilities.
In this case, the producing departments are using approximately the same proportion of services from
each of the service departments (60.0 percent to 62.5 percent for the Women's Department and 30.0
percent to 37.5 percent for the Men's Department). Hence, using a more precise measure of cost allo-
cation is not likely to produce significantly different results, especially since the interdepartmental
services are so close (7.7 percent versus 10.0 percent). Just as the step method allocation results were
quite close to the direct method results, the linear method results would likely be quite close to both
the direct and step method results. Use of the linear algebra method is not recommended in this case.
On the basis of simplicity and convenience, the direct method is probably the best method for The
Apparel Store to use.
LEAN PRODUCTION AND JUST-IN-TIME

INV NTO V MANAG MENT
Previously, our discussions about inventories have centered around how to meaSUTe the cost of products. L03 Understand
A related issue is how to manage the production process and physical inventory levels. Cost accounting lean production
textbooks, as well as operations management textbooks, usually discuss models that have been used for and just-in-
decades to determine the economic order quantities for products given the pal1icular level of inventory time inventory
a company wants to maintain. Although these models are still relevant in many situations, managing the management.
production process and inventory levels has changed dramatically for companies that have adopted a value
chain approach to management. No longer do most managers consider only their company's strategies,
goals, and objectives in deciding the characteristics and quantities of inventory that should be acquired or
produced and maintained.
A value chain approach to inventory management requires that managers consider their suppliers'
and customers' strategies, goals, and objectives as well if they hope to compete successfully in a global
marketplace. Computer technology has affected the way inventories are manufactured and handled (using
robotics, fully computerized manufacturing and product handling systems, bar code identification sys-
tems, etc.), and it is changing the way companies relate to other parties in the value chain. It has spawned
worldwide use of alternative inventory production and management techniques and processes including
just-in-time (JIT) inventory management and lean production methods.
Just-in-time (JIT) inventory management is a comprehensive inventory management philosophy
that emerged in the 1970s that stresses policies, procedures, and attitudes by managers and other workers
that result in the efficient production of high-quality goods while maintaining the minimum level of in-
ventories. JIT is often described simply as an inventory model that maintains only the level of inventories
required to meet current production and sales requirements, but it is, in reality, much more than that. The
key elements of the JIT philosophy, which has come to be known as the "lean production" philosophy,
include increased coordination throughout the value chain, reduced inventory, reduced production times,
increased product quality, and increased employee involvement and empowerment.
In sum, JIT/lean production is a system aimed at reducing or eliminating waste, increasing cost ef-
ficiency, and securing a competitive advantage. Accordingly, it emphasizes a nimble production process
with small lot sizes, short setup and changeover times, effective and efficient quality controls, a minimum
number of bottlenecks and backups, and maximum efficiency of people. See the following Business In-
sight for background on the development of lean production.
BUSINESS INSIGHT The History of Lean Production
Although the lean concept was developed by Toyota based primarily on mass production processes
first developed by Henry Ford, the term "lean production" was coined by MIT research scientists in their
book, The Machine that Changed the World, published in 1990. In this landmark study of the automobile
industry, Jim Womack, Dan Jones, and Daniel Roos explain lean production to the world for the first
time, and discuss its profound implications for society. The book is self-described as a report of "the
largest and most thorough study ever undertaken in any industry: the MIT five-million-dollar, five-year,
fourteen-country International Motor Vehicle Program's study of the worldwide auto industry."
Since the publication of The Machine that Changed the World, Womack and Jones have gone on
to study, promote, and document the development of lean production around the world. To gain addi-
tional insights into lean issues, see the websites of two organizations founded and headed by Womack
and Jones, the Lean Enterprise Institute and the Lean Enterprise Academy. Their websites are, respec-
tively, www.lean.org and www.leanuk.org. For an informative overview of the State of Lean in 2007
see http://www.lean.org/Community/Registered/ArticleDocuments/Lean%20Yearbook%202007.pdf
Source: www.lean.org
Survey research has documented the cost cutting and other benefits of lean production, as shown in the
following Research Insight.
RESEARCH INSIGHT Survey Documents Benefits of Lean Production Strategy
Although cutting costs was rated the top benefit in a recent lean production survey conducted by the
Lean Enterprise Institute (LEI) and completed by nearly 2,500 businesspeople, James Womack, PhD.,
the founder of LEI, warned that companies are missing the full growth potential of lean management.
A whopping 46.1 percent of the managers and executives rated "reduced cost" as the biggest
benefit of implementing lean management concepts, more than all other benefits combined, accord-
ing to the opinion survey conducted by LEI. Respondents rated the other top three benefits as in-
creased customer satisfaction (16.3 percent), reduced inventory (7.5 percent), and increased product
quality (6.4 percent).
"When I look back over the past 10 years, I'm gratified that most products cost less and work
better," said Womack, Ph.D., who launched LEI in 1997. "And I'm equally gratified that lean manage-
ment works in every company, industry, and country where it is seriously tried."
"But the biggest benefit of lean is that it frees resources by using less human effort, less space,
less capital, and less time to make a given amount of products and services and to make them
with fewer defects to precise customer desires, compared with traditional management," Womack
continued. "By freeing resources, lean management turns waste into available capacity. The biggest
benefits come when management uses this capacity to grow the business, whether it is a service or
manufacturing enterprise."
Source: Business Wire, Aug 15, 2007
e e
The JIT/lean approach to reducing incoming materials includes these elements:
1. Developing long-teon relationships with a limited number of vendors.

2. Selecting vendors on the basis of service and material quality, as well as price.
3. Establishing procedures for key employees to order materials for current needs directly from ap-
proved vendors.
4. Accepting vendor deliveries directly to the shop floor, and only as needed.
When fully implemented, these steps minimize or eliminate many materials inventories. Sufficient
materials would be on hand to meet only immediate needs, and the materials inventories in the manufac-
turing setting are located on the shop floor.
To achieve this reduction, it is apparent that vendors and buyers must work as a team and that key employ-
ees must be involved in decision making. The goal of the nT approach to purchasing is not to shift materials
carrying costs to vendors. A close, long-term working relationship between purchasers and vendors should be
beneficial to both. Purchasers' scheduling information is provided to vendors so that vendors also can reduce
inventories and minimize costs. Vendors are therefore able to manufacture small batches frequently, rather
than manufactUling large batches infrequently. Further, vendors are more confident of future sales.
Re u 9 rk-in- Procpss ·...,·..''''''''n T ' ... I'''1.'

Reducing the total time required to complete a process, or the cycle time, is the key to reducing work-in-
process inventories and is central to a lean production approach. In a manufacturing organization, cycle
time is composed of the time needed for setup, processing, movement, waiting, and inspection. Setup
time is the time required to prepare equipment to produce a specific product, or to change from producing
one product to another product. Processing time is the time spent working on units. Movement time is
the time units spend moving between work or inspection stations. Waiting time is the time units spend in
temporary storage waiting to be processed, moved, or inspected. Inspection time is the amount of time
it takes units to be inspected. Of the five elements of cycle time, only processing time adds value to the
product. Efforts to reduce cycle time are appropriate for both continuous and batch production.
Devising means of reducing setup times will directly reduce the cycle time for batch production and
thus reduce setup costs. Setup times can also be reduced by shifting from batch to continuous production
whenever practical. Rearranging the shop floor to eliminate unnecessary movements of materials can help
reduce movement time for both continuous and batch production.
Many companies have created quality circles, which are groups of employees involved in produc-
tion who have the authority, within certain parameters, to address and resolve quality problems as they
occur, without seeking management approval. Giving employees more authority and responsibility for
quality, including the right to stop production whenever quality problems are noted, can reduce the need
for separate inspection time.
Waiting time can be reduced by moving from a materials push to a materials pull approach to produc-
tion. Under a traditional materials push system, employees work to reduce the pile of inventory build-
ing up at their workstations. Workers at each station remove materials from an in-process storage area,
complete their operation, and place the output in another in-process storage area. Hence, they push the
work to the next workstation. The emphasis is on production efficiency at each station. In a push system,
one of the functions of work-in-process inventory is to help make workstations independent of each other.
Inventories are large enough to allow for variations in processing speeds, for discarding defective units
without interrupting production, and for machine downtime.
Under a materials pull system (often called a Kanban system), employees at each station work to
provide inventory for the next workstation only as needed. (Kanban, the Japanese word for card, is a system
created in Japan that originally used cards to indicate that a department needed additional components.) The
building of excess inventories is strictly prohibited. When the number of units in inventory reaches a speci-
fied limit, work at the station stops until workers at a subsequent station pull a unit from the in-process stor-
age area. Hence, the pull of inventory by a subsequent station authorizes production to continue.
A pull, or Kanban, system's low inventory levels require a team effort. To avoid idle time, process-
ing speeds must be balanced and equipment must be kept in good repair. Quality problems are identified
immediately, and the low inventory levels require immediate correction of quality problems. To make a
pull system work, management must accept the notion that it is better to have employees idle than to have
them building excess inventory. A pull system also requires careful planning by management and active
participation in decision making by employees. A lean production process inVOlves minimizing cycle
time, eliminating waste, producing inventory only as needed, and ensuring the highest level of quality
and efficiency. To achieve these results on a continuing basis, there is a strong emphasis on continuous
improvement programs (See Chapter 8). The following Business Insight discusses the use of a type of JIT,
calJed Just-in-Sequence, used by Mercedes in making its Smart Car.
educ' Fin' hed Good Invent

Finished goods inventory can be reduced by reducing cycle time and by better predicting customer demand
for finished units. Lowering cycle times reduces the need for speculative inventories. If finished goods
Mercedes Benz Produces Smart Car Using Just-in-Sequence

BUSINESS INSIGHT
Production
In early 2008, Mercedes Benz delivered the first units of its newly redesigned "Smart Car" automobile
in the United States after ten years of success with this tiny vehicle in Europe and around the world.
This two-person vehicle that sells for under $12,000 is designed to occupy less space in crowded cit-
ies and operate at a higher level of fuel efficiency than virtually any other car, and it is produced with
an emphasis on environmental sustainability and the latest in production technology.
The plant where the Smart ForTwo is produced is called "Smartville" and is touted in the Smart
Car product brochure as "... one of the most modern factories on the planet .... where the environ-
mental aspects have been thoroughly thought out." The production system is described as one where
"many components are produced on the premises of system partners. This reduces transport costs,
packaging material and enables just-in-sequence production: all parts are delivered in the exact order
in which they are required."
Source: "The 2008 Smart For Two" marketing brochure, Smart USA Distributor LLC, Bloomfield Hills, MI.
can be replenished quickly, the need diminishes for large inventory levels to satisfy customer needs and to
provide for unanticipated fluctuations in customer orders. Anticipating customers' demand for goods can
be improved by adopting a value chain approach to inventory management by which the manufacturer or
supplier is working as a partner with its customers to meet their inventory needs. This frequently involves
having online computer access to customers' inventory levels on a real-time basis and being able to syn-
Chronize changes in production with changes in customers' inventory levels as they occur.
Sharing this type of information obviously requires an enormous amount of mutual trust between
a manufacturer or supplier and its customers, but it is becoming increasingly common among world-
class organizations. An example of this type of vendor-customer relationship is the relationship between
Procter & G<lmble, one of the world's largest consumer products companies, and its largest customer,
''''ai-Mart. By having access to Wal-Mart's computer inventory system, Procter & Gamble is better able
to determine and fill Wal-Mart's specific needs for products, such as disposable diapers.
PERFORMANCE EVALUATION AND

RECORDKEEPING WITH LEAN PRODUCTIO
AND ..JIT
L04 Explain Movement toward a JIT/lean production philosophy requires changes in performance evaluation proce-
how lean dures and offers opportunities for significant reductions in recordkeeping costs. These changes are dis-
production and cussed in this section.
just-in-time affect
performance
e"""'n.... n'1~n,...~ r="~h .~*i_"'"
evaluation and
recordkeeping. JIT regards inventory as something to be eliminated. Hence, in a manufacturing organization, inventories
are kept as small as possible. Under the JIT ideal, inventories do not exist because vendors deliver raw
materials in small batches directly to the shop floor. JIT also strives to minimize, or eliminate, work-in-
process inventory by minimizing the non-processing elements of cycle time and by having processing
times as short as possible. Ideally, setup, waiting, movement, and inspection times do not exist.
Dysfunctional Effects of Traditional Performance Measures

A potential conflict exists between the goals of JIT and lean production and those of traditional per-
formance measures applied at the level of the department or cost center. Although lean production em-
phasizes overall efficiency, many traditional performance measures emphasize local (departmental) cost
savings and local (departmental) efficiency. Consider the following traditional performance measures for
a purchasing agent and a departmental production supervisor:
To achieve quantity discounts and favorable prices, a purchasing agent might order excess
inventory, thereby increasing subsequent storage, obsolescence, and handling costs.
To obtain a low price, a purchasing agent might order from a supplier whose goods have not been
certified as meeting quality specifications, thereby causing subsequent inspection, rework, and
spoilage costs, and perhaps, dissatisfied customers further down the value chain.
To avoid having idle employees and equipment, a supervisor might refuse to halt production to
determine the cause of a quality problem, thereby increasing inspection, rework, and spoilage costs.
To obtain low fixed costs per unit under absorption costing, a supervisor might produce in excess of
CUlTent needs (preferably in long production runs), thereby causing subsequent increases in storage,
obsolescence, and handling costs.
Performance Measures Under Lean Production and JIT

In accordance with the goal of eliminating inventory and reducing cycle time to processing time, JIT sup-
portive performance measures emphasize inventory turnover, cycle time, and cycle efficiency (the ratio of
value-added to non-value-added manufacturing activities).
When applied to a specific item of raw materials or finished goods, inventory turnover is computed
as the annual demand in units divided by the average inventory in units:
Inventory turnover = Annual ,demand i~ unit~

Average Illventory III umts
Progress toward the goal of reducing inventory is measured by comparing successive inventory turnover
ratios. Generally, the higher the inventory turnover, the better.
When stated in dollars, inventory turnover can be used as a measure of the organization's overall suc-
cess in reducing inventory, or in increasing sales in relation to inventories. This financial measure can be
derived directly from a firm's financial statements.
Cost of goods sold

Inventory turnover = Average , ,
Illventory (Ill dollars)
Another ratio often used to monitor the effectiveness of inventory levels is gross margin return on
inventory investment (GMROI), calculated as follows:
GMROI = Gross ~argin

Average Illventory
Cycle time is a measure of the total time required to produce one unit of a product:
Cycle Setup + Processing + Movement + Waiting + Inspection

time time time time time time
Under ideal circumstances, cycle time would consist of only processing time, and processing time
would be as low as possible. Only processing time adds value to the product; hence, the time required for
all other activities should be driven toward zero. The use of flexible manufacturing systems, properly se-
quencing jobs, and properly placing tools will minimize setup time. If the shop floor is optimally alTanged,
workers pass products directly from one workstation to the next. If production is optimally scheduled,
inventory will not wait in temporary storage between workstations. If raw materials are of high quality
and products are manufactured so that they always conform to specifications, separate inspection activi-
ties are not needed.
Cycle efficiency is computed as the ratio of processing time to total cycle time:
" - Processing time

C yc Ie e fflClency - C I '
yc e tIme
The highest cycle efficiency possible is always sought. If all non-value-added activities are eliminated,
this ratio equals one.
ir"1p~ifie e in
Lean Production and JIT enable significant reductions in the number of accounting transactions required
for purchasing and production activities. This results in cost savings for bookkeeping activities and in
shifting accounting resources from detailed bookkeeping to the development of more useful activity coSl
data.
Purchasing
In a traditional accounting system, every purchase results in the generation of several documents. Addi-
tional documents are prepared for the issuance of raw materials to the factory. JIT, on the other hand, at-
tempts to minimize inventory levels and stresses long-term relationships with a limited number of vendors
who have demonstrated their ability to provide quality raw materials on a timely basis, as well as at a com-
petitive price. Under a JIT inventory system, a company often has standing purchase orders for specified
materials from specified vendors at specified prices. Production personnel are authorized to requisition
materials directly from authorized vendors, who deliver limited quantities of materials as needed directly
to the shop floor. Production personnel verify receipt of the raw materials. Periodically, each vendor sends
an invoice for several shipments, which the company acknowledges and pays.
Product Costing
Another advantage of a lean production system is that it reduces the amount of detailed bookkeeping re-
quired for financial accounting purposes. If ending inventories are nonexistent, or so small that the costs
assigned to them are insignificant in comparison with the costs assigned to Cost of Goods Sold, it makes
little sense to track product costs through several inventory accounts. Instead of using a traditional product
cost accounting system (as illustrated in Chapter 5), firms that have implemented JIT often use what is
sometimes referred to as a backflush approach to accounting for product costs.
Under backtlush costing, all costs of direct materials, direct labor, and manufacturing overhead are
assigned as incurred to Cost of Goods Sold. If there are no inventories on hand at the end of the period, no
additional steps are required. However, if there are inventories on hand at year-end, costs are backed out
of Cost of Goods Sold and assigned to the appropriate inventory accounts. For a complete discussion of
backflush costing, refer to a cost accounting text.
Also under a JIT inventory approach, many of the distinctions and arguments regarding absorption
versus variable costing are moot. If the quantity of inventory is insignificant, it matters little whether in-
ventory cost includes only variable manufacturing costs or both variable and fixed manufacturing costs.
Whether absorption or variable costing is used, the total cost assigned to inventory on the balance sheet
will be small, and the income reported on the income statement is likely to be about the same amount.
a
L05 Discuss As we discussed in previous chapters, traditional product costing systems go to great lengths to calcu-
performance late the materials, labor, and manufacturing overhead cost per unit for each unit produced. Overhead is
reporting in a typically assigned to inventory using a predetermined overhead rate based on an assumed volume-based
lean production driver such as direct labor hours or machine hours. If actual production is less than budgeted production,
environment. there will be underapplied overhead, which is usually written off as an expense of the period. To avoid
this expense, managers are often motivated to overproduce product in order to ensure that all overhead is
allocated to product. Also, by budgeting a large amount of produced units, fixed overhead cost is spread
over more units, resulting in a lower cost per unit. Such overproduction is equivalent to a cardinal sin in
a lean production company.
As we will see in Chapter 10, many companies also adopt standard cost systems where they account
for product cost components on both an actual and budgeted cost basis, with variances between actual cost
and standard (or allowed) costs reported on the internal performance reports as increased expenses if they
are unfavorable and as a reduction of expenses if they are favorable. In such cases, managers are moti-
vated to maximize favorable variances and minimize or eliminate unfavorable variances. Such systems of
reporting often lead managers to actions that are contrary to the lean production philosophy.
Consider the example of a company using traditional costing and performance reporting that had the
income statement shown in Exhibit 7.6 for one of its groups of products.
EXHIBIT 7.6 TraditionaJ Perfonnance Report with Standard Costs
Current Period Prior Period
Net sales.......................................... $1,400 100% $1,000 100%

Less cost of goods sold (based on standard costs) ........ -770 55% -540 54%
--
Gross margin (based on standard costs) ................. 630 45% 460 46%
Materials variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (80) (5.7%) (30) (3%)
Labor variance ..................................... (54) (3.9%) (40) (4%)
Overhead variance .................................. (50) (3.6%) (35) (3.5%)
Gross margin (actual) ................................ $ 446 31.9% $ 355 35.5%
This performance report provides limited insight into what happened during the period that caused the
gross margin percentage to drop by seven percentage points from 35.5% to 31.9%, even though net sales
increased by 40%. About all we can determine is that the standard cost of goods sold increased by 1%
of sales from 54% to 55%, and the unfavorable materials variance increased from 3% to 5.7% of sales.
Now, see how the same performance might appear under a lean production reporting approach, as shown
in Exhibit 7.7.
EXHIBIT 7.7 Lean Production Performance Report
Current Prior Percent

Year Year Change
Net Sales . $1,400 $1,000 40%

Less cost of goods sold:
Materials cost . 600 350 71.4%
Wages . 140 120 16.7%

Employee benefits ..................•........................ 120 60 100%
Services & Supplies . 25 26 (3.8%)
Equipment depreciation . 20 18 11.1 %
Scrap . 26 40 (35%)
Total processing costs . 331 264 25.4%
---
Building depreciation . 3 3
Building services . 20 28 (28.6%)
Total occupancy costs . 23 31 (25.8%)
Total cost of goods sold . 954 645 47.9%
---
Gross margin . $ 446 $355 25.6%
This performance report provides a much clearer picture of why the company's gross margin increased by
only 25.6%, even though there was a 40% increase in sales. Immediately, we can see that the percentage
increases in materials cost and employee benefits were each substantially higher than the rate of increase
in sales. All other cost categories had percentage decreases, or increases proportionately less than the in-
crease in sales. This report clearly shows areas of improvement during the year as well as areas for needed
improvement in the future. In a lean environment, managers are not seeking to perform well against an
artificial standard; instead, the goal is constant improvement in cost efficiency and quality.
These reports assume a pure JIT system where there were no significant amounts in inventories at the
end of the period. If that were not the case, it would be necessary to make an adjustment to total cost of
goods sold for the increase or decrease in inventory during the period in the lean production report.
In a lean production environment, costs are typically collected for each value stream. A value stream
consists of the production processes for similar products. For example, a company like Hewlett Packard
that produces multiple types and models of computers and printers may have two value streams, one for
computers and another for printers. By identifying value streams as the primary cost objectives, more
costs are directly traceable to the cost objectives, resulting in fewer cost allocations. You might recall that
we said in ao earlier chapter that a company that produces only one product does not have to make any
cost allocations for product costing purposes, because the cost per unit is equal to total cost for the period
divided by units produced in the period. Each value stream in a lean company not only has lean processes;
it also has a lean accounting system because most costs should be directly traceable to one of the value
streams. For indirect costs that cannot be traced directly to the value streams, cost assignments would need
to be made using either a volume-based or activity-based method, as illustrated in Chapter 6.
CHAPTER-END REVIEW
The Champion Golf Company is trying to decide which automated production line to use to produce its new Pro
XII golf balls. The two best systems under consideration have the following estimated performance characteris-
tics, based on minutes per 1,000 balls produced:
System A System B
Setup time 25 10
Movement time from start to finish 10 14
Waiting time 3 16
Inspection time 5 7
Processing time 40 30
Total time in minutes 83 77
Required
a. Determine the cycle time per batch for each system.
h. Determine the cycle efficiency for each system.
c. Which system do you recommend and why?
d. Assuming Champion is a "lean" manufacturer, what improvements in the selected system is it likely to
pursue.
Solution
a. Cycle time is the total time required to produce one batch, including both value-added and non-value-added
activities: System A = 83 System B = 77
h. The cycle efficiency is the percent of total time used in value-added activities. In this case, only the processing
time is adding value to the product. Cycle efficiency: System A = 40/83 = 0.48 System B = 30/77 = 0.39
c. In selecting between A and B, the system with the highest efficiency would not likely be chosen because it
has the longest total cycle time. Assuming both systems produce products of equal quality and characteris-
tics, B is appealing because it requires one-foUl1h less processing time than A and offers greater opportunity
for continuous improvement.
d. In a lean environment management and all employees involved will be seeking ways to reduce the cycle
time while maintaining a high-quality product. For B, the most likely opportunity for significant reduction
is to reduce the large amount of movement and waiting time. If these components of total cycle time can
be reduced, B becomes even more attractive.
GUIDANCE ANSWER
.]'r.1LJ.
• You are the Controller
Designing any information processing system is a matter of weighing benefits with the costs of designing and
operating the system. The same is true for a cost allocation system. Also, you have to decide how the cost infor-
mation will be used. If it is used only for external financial reporting purposes, a high degree of precision may not
be necessary. However, if it is used to determine the most profitable product mix, it may be crucial to have the
most precise cost information. For the service departments that provide only services to producing departments
and that receive no services from other service departments, a direct allocation method might be adequate. For
departments that provide and/or receive interdepartmental services, you should consider using either a step or
linear algebra approach to assigning costs. Whether you use a direct, step or linear algebra approach, you will
have to decide whether to assign the costs using a single volume-based cost driver (such as square footage or
number of employees) or using multiple cost drivers that reflect the actual activities performed. In most cases,
the ABC approach will give a higher level of precision, but at considerably greater cost.
DISCUSSION QUESTIONS
Q7.I. Distinguish between the following sets of terms:
a. Direct product costs and indirect product costs.
b. Direct department costs and indirect department costs.
Q7.2. Define the terms direct cost and indirect cost.
Q7.3. Differentiate between cost assignment and cost allocation.
Q7.4. Explain how a cost item can be both a direct cost and an indirect cost.
Q7-5. What is the primary advantage of separately allocating fixed and variable indirect costs?
Q7-6 Define interdepartmental services.
Q7.7. To what extent are interdepartmental services recognized under the direct, step, and linear algebra
methods of service department cost allocation?
Q7-8. Is it feasible to assign interdepartmental services to production departments using ABC?
Q7-9. Explain the concept of just-in-time inventory management.
Q7-10. What are the major elements of lean production?
Q7.1I. What is the relationship between JIT and the lean production concept?
Q7.12. What role did Toyota have in the development of the lean production concept?
Q7.13. What elements of the lIT approach contribute to reducing materials inventories?
Q7-14. Define and identify the elements of cycle time. Which of these elements adds value to the product?
Q7-15. Explain briefly how JIT/lean production benefits organizations that take a value-chain approach to
management.
Q7-16. Explain how traditional performance evaluation systems using standard costs conflict with the lean
production concept.
MINI EXERCISES
M7-17. Allocating Service Department Costs: Allocation Basis Alternatives (L02)
Koming Glassworks has two producing departments, P I and P2, and one service department, S I. Estimated
direct overhead costs per month are as follows:
P1 . $100,000
P2 200,000
S1 . 66,000
Other data follow:
P1 P2
Number of employees . 75 25
Production capacity (units) . 50,000 30,000
Space occupied (square feet) .. 2,500 7,500
Five-year average percent of
S1 's service output used . 65% 35%
Required
a. For each of the following allocation bases, determine the total estimated overhead cost for PI and P2
after allocating S I cost to the producing departments.
I. Number of employees
2. Production capacity in units
3. Space occupied
4. Five-year average percentage of S 1 services used
S. Estimated direct overhead costs. (Round your answer to the nearest dollar.)
b. For each of the five allocation bases, explain the circumstances (including examples) under which each
allocation base might be most appropriately used to allocate service depal1ment cost in a manufactur-
238 Chapter 7 I AddH:ional Topics in Product Costing
ing plant such as Korning Glassworks. Also, discuss the advantages and disadvantages that might
result from using each of the allocation bases.
M7-18. Indirect Cost Allocation: Direct Method lL021

Sprint Manufacturing Company has two production departments, Melting and Molding. Direct general
plant management and plant security costs benefit both production departments. Sprint allocates general
plant management costs on the basis of the number of production employees and plant security costs on the
basis of space occupied by the production departments. In November, the following overhead costs were
recorded:
Melting Department direct overhead . $150,000

Molding Department direct overhead . 300,000
General plant management . 100,000
Plant security . 35,000
Other pertinent data follow:
Melting Molding
Number of employees . . . . 25 45
Space occupied (square feet). 10,000 40,000
Machine hours . 10,000 2,000
Direct labor hours . 4,000 20,000
Required
a. Prepare a schedule allocating general plant management costs and plant security costs to the Melting
and Molding Departments.
h. Determine the total departmental overhead costs for the Melting and Molding Departments.
c. Assuming the Melting Department uses machine hours and the Molding Department uses direct labor
hours to apply overhead to production, calculate the overhead rate for each production department.
M7-19. Interdepartment Services: Direct Method (L021
Tucson Manufacturing Company has five operating departments, two of which are producing departments
(PI and P2) and three of which are service departments (S l, S2, and S3). All costs of the service depart-
ments are allocated to the producing departments. The following table shows the distribution of services
from the service departments.
Services Services Provided to

provided
from 51 52 53 P1 P2
S1 ....... - ,,5% 25% 50% 20"10

S2 ....... 10% - 5 '.45 ,.40'\
S3 ....•.. (5 5 - :20 60
The direct operating costs of the service departments are as follows:
S1 .. $42,000
S2 . 85,000
S3 . 19,000
Required
Using the direct method, prepare a schedule allocating the service department costs to the producing
departments.
M7-20. Inventory Ratio Calculations (L03,41
Delroi, Inc. provided the following data for 2008 and 2009:
Inventory
December 31,2007 . $200,200
December 31,2008 . 190,400
December 31,2009 . 182,500
Cost of goods sold
2008 . $654,000
2009 . 724,000
Gross margin
2008 . $340,000
2009 . 410,000
Required
(round all calculations to two decimal places)
a. Calculate the inventory turnover ratio for 2008 and 2009.
b. Calculate the gross margin return on inventOIy investment for 2008 and 2009.
c. Comment on Delroi's progress toward becoming a more lean company.
M7-21. Inventory Ratio Calculations (L03,4)

McMahan, LTD. provided the following data for 2008 and 2009:
Inventory
December 31, 2007 . $176,000
December 31,2008 . 185,000
December 31,2009 . 194,000
Cost of goods sold
2008 . $546,000
2009 . 589,000
Gross margin
2008 . $256,000
2009 . 287,000
Required
(round all calculations to two decimal places)
a. Calculate the inventory turnover ratio for 2008 and 2009.
b. Calculate the gross margin return on inventory investment for 2008 and 2009.
c. Comment on McMahan's progress toward becoming a more lean company.
M7-22. Evaluating Production Options CL04)

Jonas Manufacturing operates a small facility with several different flexible production cells that are used
in making a variety of extruded material products. A potential customer has requested a quote for making
10,000 plastic components. Jonas is committed to lean production and is considering using one of two pro-
duction cells for the job. Data (in hours) for the two cells is provided below.
Cell1 Cell 2
Setup time . 8.5 6.2

Total movement time . .6 .8
Waiting time . 1.3 .8
Inspection time . .5 .5
Processing time . 12.5 16.6
Total time . 23.4 24.9
Required
a. Which of the above items are included in the calculation of total cycle time?
b. Which of the above items would be considered to be non-value added?
c. Calculate the cycle efficiency of the two options.
d. Which cell do you recommend for this job?
e. If Jonas is truly committed to a lean production, what additional actions might it take to make the job
more profitable?
EXERCISES
E7-23. Interdepartment Services: Step Method (L02)
Refer to the data in Mini-Exercise M7-l9. Using the step method, prepare a schedule for Tucson Manufac-
turing Company allocating the service department costs to the producing departments. (Round calculations
to the nearest doHar.)
E7·24. Interdepartment Services: Step Method (L021

O'Brian's Department Stores allocates the costs of the Personnel and Payroll departments to three retail
sales departments, Housewares, Clothing, and Furniture. In addition to providing services to the operating
departments, Personnel and Payroll provide services to each other. O'Brian's allocates Personnel Depart·
ment costs on the basis of the number of employees and Payroll Department costs on the basis of gross
payroll. Cost and allocation information for June is as follows:
Personnel Payroll Housewares Clothing Furniture
Direct department cost. ....... $6,900 $3,200 $12,200 $20,000 $15,750

Number of employees ........ 5 3 8 15 4
Gross payroll ............... $6,000 $3,300 $11,200 $17,400 $8,100
Required
a. Determine the percentage of total Personnel Department services that was provided to the Payroll
Department.
h. Determine the percentage of total Payroll Department services that was provided to the Personnel
Department.
c. Prepare a schedule showing Personnel Department and Payroll Department cost allocations to the
operating departments, assuming O'Brian's uses the step method. (Round calculations to the nearest
dollar.)
E7-2S. Product Costing ill a JIT/Lean Environment (L03,41

Doll Computer manufactures laptop computers under its own brand, but acquires all the components from
outside vendors. No computers are assembled until the order is received online from customers, so there
is no finished goods inventory. When an order is received, the bill of materials required to fill the order is
prepared automatically and sent electronically to the various vendors. All components are received from
vendors within three days and the completed order is shipped to the customer immediately when completed,
usually on the same day the components are received from vendors. The number of units in process at the
end of any day is negligible.
The following data are provided for the most recent month of operations:
Actual components costs incurred . $905,000

Actual conversion costs incurred . $192,000
Units in process, beginning of month . -0-
Units started in process during the month . 5,000
Units in process, end of month . -0-
Required
a. Assuming Doll uses traditional cost accounting procedures:
I. How much cost was charged to Work-in-Process during the month?
2. How much cost was charged to cost of goods sold during the month?
b. Assuming Doll is a lean production company and uses backflush costing method:
1. How much cost was charged to Work-in-Process during the month?
2. How much cost was charged to cost of goods sold during the month?
E7-26. Performance Reporting With Lean Production (L03, 4, 51
Hi-Standard Company prepared the following performance report for the month of March 2009:
2009
Net sales . $350,000
Less cost of goods sold (based on standard costs) . (178,000)
Gross margin (based on standard costs) . 172,000
Materials variance . (5,000)
Labor variance . 3,000
Manufacturing overhead variance . 2,000
Gross margin (actual) ................•...........•...... $172,000
Hi-Standard's general ledger included the following:
Materials purchases . $51,000

Wages expense . 61,000
Services & supplies .........•.......................... 14,000
Equipment depreciation . 20,000
Building depreciation . 18,000
Building services . 11,000
Scrap . 3,000
Inventories at the end of the month were negligible.

Required
a. Prepare a revised performance report that would be more appropriate if Hi-Standard were following a
lean production strategy.
b. What additional information would be useful for evaluating Hi-Standard's performance for March.
c. What are some of the potential pitfalls associated with reporting variances such as those presented in
Hi-Standard's original performance report for March.
E7·27. Inventory Management Metrics (L04)

Large retailers like The Home Depot and Wal-Mart typically use gross margin ratio (gross margin -;- sales),
inventory turnover (sometimes referred to as inventory turns), and gross margin return on investment (GM-
ROI) to evaluate how well inventory has been managed. The goal is to maximize profits while minimizing
the investment in inventory. Below are data for four scenarios, a base scenario (# I) followed by three
modifications (#s 2, 3, & 4) to the base scenario.
Scenario 1 Scenario 2 Scenario 3 Scenario 4
Sales ....................... $10,000 $20,000 $12,000 $10,000

Cost of goods sold ............ 6,000 12,000 6,000 6,000
--- --- --- ---
Gross profit.................. $ 4,000 $ 8,000 $ 6,000 $ 4,000
Average inventory............. $ 6,000 $ 6,000 $ 6,000 $ 5,000
Required
a. For each scenario calculate the gross margin percent, the inventory turnover, and GMROI.
b. For Scenarios 2 though 4, explain what change occurred relative to Scenario 1 to cause GMROI to
change. For example, was the change in GMROI caused by a change in inventory turns, a change in
gross margin percent, or by reducing inventory levels.
c. What general conclusions can be made from the above calculations and observations regarding the
factors that influence GMROI.
PROBLEMS
P7·28. Selecting Cost Allocation Bases and Direct Method Allocations IL021
Ohio Company has three producing departments (P 1, P2, and P3) for which direct department costs are ac-
cumulated. In January, the following indirect costs of operation were incurred.
Plant manager's salary and office expense . $ 9,600

Plant security . 2,400
Plant nurse's salary and office expense . 3.000
Plant depreciation . 4,000
Machine maintenance . 4,800
Plant cafeteria cost subsidy . 2,400
$26,200
The following additional data have been collected for the three producing departments:
P1 P2 P3
Number of employees ........... 10 15 5

Space occupied (square feet) ...... 2,000 5,000 3,000
Direct labor hours ............... 1,600 4,000 750
Machine hours ................. 4,800 8,000 3,200
Number of nurse office visits ...... 20 45 10
Required
a. Group the indirect cost items into cost pools based on the nature of the costs and their common basis
for allocation. Identify the most appropriate allocation basis for each cost pool and determine the total
January costs in the pool. (Hin!: A cost pool may consist of one or more cost items.)
b. Allocate the cost pools directly to the three producing depaItments using the allocation bases selected
in requirement (a).
c. How much indirect cost would be allocated to each producing department if Ohio Company were using
a plantwide rate based on direct labor hours? Based on machine hours?
d. Comment on the benefits of allocating costs in pools compared with using a plantwide rate.
P7-29. Evaluating Allocation Bases and Direct Method Allocations (L021

Cheyenne Company has two service departments, Maintenance and Cafeteria, that serve two producing
departments, Mixing and Packaging. The following data have been collected for these departments for the
current year:
Cafeteria Maintenance Mixing Packaging

---
Direct department costs $176,000 $112,000 $465,000 $295,000
Number of employees . 50 30
Number of meals served 9,000 7,000
Number of maintenance
hours used . 800 600
Number of maintenance
orders . 180 170
Required
a. Using the direct method, allocate the service department costs under the following independent
assumptions:
1. Cafeteria costs are allocated based on the number of employees, and Maintenance costs are al-
located based on the number of maintenance hours used.
2. Cafeteria costs are allocated based on the number of meals served, and Maintenance costs are al-
located based on the number of maintenance orders.
b. Comment on the reasonableness of the bases used in the calculations in requirement (a). What consid-
erations should determine which bases to use for allocating Cafeteria and Maintenance costs?
P7-30. Cost Reimbursement and Step Allocation Method (L02)

Community Clinic is a not-for-profit outpatient facility that provides medical services to both fee-paying
patients and low-income government-supported patients. Reimbursement from the government is based on
total actual costs of services provided, including both direct costs of patient services and indirect operating
costs. Patient services are provided through two producing departments, Medical Services and Ancillary
Services (includes X-ray, therapy, etc.). In addition to the direct costs of these departments, the clinic incurs
indirect costs in two service departments, Administration and Facilities. Administration costs are allocated
based on the number of full-time employees, and Facilities costs are allocated based on space occupied.
Costs and related data for the current month are as follows:
Medical Ancillary
Administration Facilities Services Services
Direct costs . $18,000 $6,000 $121,400 $37,200

Number of employees . 5 4 12 8
Amount of space occupied (square feet) . 1,500 8,000 2,000
Number of patient visits . 4,000 1,500
Required
a. Using the step method, prepare a schedule allocating the common service department costs to the pro-
ducing departments.
b. Determine the amount to be reimbursed from the government for each Jow-income patient visit.
P7-31. Budgeted Service Department Cost Allocation: Pricing a New Product tL02)
Trimco Products Company is adding a new diet food concentrate called Body Trim to its line of bodybuilding
and exercise products. A plant is being built for manufacturing the new product. Management has decided to
price the new product based on a 100 percent markup on total manufacturing costs. A direct cost budget for
the new plant projects that direct department costs of $2, 100,000 will be incurred in producing an expected
normal output of 700,000 pounds of finished product. In addition, indirect costs for Administration and Tech-
nical Support will be shared by Body Trim with the two exercise products divisions, Commercial Products
and Retail Products. Budgeted annual data to be used in making the allocations are summarized here.
Technical Commercial Retail Body

Administration Support Products Products Trim
Number of employees ...... 5 5 50 30 20

Amount of technical
support time (hours) ...... 500 1,500 1,250 750
Direct costs are budgeted at $135,000 for the Administration Department and $240,000 for the Technical
Support Department.
Required
a. Using the step method, determine the total direct and indirect costs of Body Trim.
b. Detennine the selling price per pound of Body Trim. (Round calculations to the nearest cent.)
P7-32. Allocation and Responsibility Accounting (L02)
Assume that Timberland Company uses a responsibility accounting system for evaluating its managers, TImberland Company
and that abbreviated performance reports for the company's three divisions for the month of March are as (TBl)
presented on the following page (amounts in thousands).
Total East Central West
Income ............ $165,000 $60,000 $75,000 $30,000

Less allocated costs:
Computer Services ....... (66,000) (22,000) (22,000) (22,000)
Personnel .............. (72,000) (28,000) (32,000) (12,000)
---
Division income ........... $ 27,000 $10,000 $21,000 $ (4,000)
The West Division manager is very disturbed over his performance report and recent rumors that his divi-
sion may be closed because of its failure to report a profit in recent periods. He believes that the reported
profit figures do not fairly present operating results because his division is being unfairly burdened with
service department costs. He is particularly concerned over the amount of Computer Services costs charged
to his division. He believes that it is inequitable for his division to be charged with one-third of the total
cost when it is using only 20 percent of the services. He believes that the Personnel Department's use of
the Computer Services Department should also be considered in the cost allocations. Cost allocations were
based on the following distributions of service provided:
Services Receiver
Computer
Services Provider Personnel Services East Central West
Computer Services ....... 40% - 20% 20% 20%

Personnel .............. - 10% 35 40 15
Required
a. What method is the company using to allocate Personnel and Computer Services costs?
b. Recompute the cost allocations using the step method. (Round calculations to the nearest dollar.)
c. Revise the performance reports to reflect the cost allocations computed in requirement (b).
d. Comment on the complaint of the West Division's manager.
P7-33. Allocating Service Department Costs: Direct and Step Methods; Department and Plantwide Over·
head Rates IL02)
Pennington Group Assume that Pennin~ton Group, a manufacturer of fine casual outdoor furniture, allocates Human Re-
sources Department costs to the producing departments (Cutting and Welding) based on number of em-
ployees; Facilities Department costs are allocated based on the amount of square footage occupied. Direct
department costs, labor hours, and square footage data for the four departments for October are as follows:
Human
Resources Facilities Cutting Welding
Direct department
overhead costs ............... $60,000 $120,000 $800,000 $350,000
Number of employees ........... 5 5 35 60
Number of direct labor hours ...... 8,000 10,000
Amount of square footage ........ 10,000 3,000 100,000 50,000
Assume that two jobs, A I and A2, were completed during October and that each job had direct materials
costs of $1 ,200. Job A 1 used 80 direct labor hours in the Cutting Department and 20 direct labor hours in
the Welding Department. Job A2 used 20 direct labor hours in the Cutting Department and 80 direct labor
hours in the Welding Department. The direct labor rate is $50 in both departments.
Required
a. Find the cost of each job using a plantwide rate based on direct labor hours.
b. Find the cost of each job using department rates with direct service department cost allocation.
c. Find the cost of each job using department rates with step service department cost allocation.
d. Explain the differences in the costs computed in requirements (a)-(c) for each job. Which cosling
method is better for product pricing and profitability analysis?
P7-34. JIT/Lean Production and Product Costing (L04)

Presented is information pertaining to the standard or budgeted unit cost of a product manufactured in a
JIT/Lean Production environment at Simko Systems Inc.:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15

Conversion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Total. . . . . . . ... . . . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . .. ... . $25
All materials are added at the stali of the production process. All raw materials purchases and conversion
costs are directly assigned to Cost of Goods Sold. At the end of the period, costs are backed out and as-
signed to Raw Materials in Process (only for materials still in the plant) and Finished Goods Inventory
(for materials and conversion costs). Costs assigned to inventories are based on the standard or budgeted
cost multiplied by the number of units in inventory. Conversion costs are assigned to inventories only for
fully converted units. Since inventory levels tend to be small in this JIT environment, partially completed
units are assigned no conversion costs. Simko had no beginning inventories on August 1,2009. During the
month, it incurred the following manufacturing-related costs:
Purchase of raw materials on account. . $300,000

Factory wages . 125,000
Factory supervision salaries . 30,000
Utilities bill for month . 17,000
Factory supplies purchased . 15,000
Depreciation . 9,500
The end-of-month inventory included raw materials in process of 600 units and finished goods of 400 units.
One hundred units of raw materials were zero percent converted; the other 500 units averaged 60 percent
converted.
Required
a. Calculate the total cost charged to Cost of Goods Sold during August.
b. Calculate the balances in Raw Materials in Process, Finished Goods Inventory, and Cost of Goods Sold
at the end of August.
c. Assuming that August is a typical month, is it likely that using the company's shortcut backflush
accounting procedures will produce misleading financial statements? Explain.
P7-3S. Benefits of Implementing a Just-in-Time Inventory System (L04)

Car Parts Inc. distributes replacement parts for various automobile models, competing primarily with the
dealers for the major automobile manufacturers. The key to Car Parts' success is having parts in stock when
independent mechanics come to one of its retail stores. The firm's controller has become concerned about
the escalating costs of maintaining large inventories at each store location. At the beginning of 2009, she
decided to test a modified just-in-time inventory system in the Canton, Ohio, store that significantly reduced
the number of parts for each inventory item stocked. After one year of experience with the JlT system, the
controller assessed the benefits of using JlT and gathered the following data for the Canton store:
Average inventory declined from $800,000 to $200,000.
Annual insurance costs declined from $60,000 to $15,000.
As a result of reduced inventory levels, a 5,000-square-foot warehouse that had been leased for $ J 0,000
per year to store parts was not used at all during the year. Car Parts was able to sublet the space for the
year for $2.50 per square foot.
The employee who staffed the parts warehouse was reassigned to help coordinate the JlT inventory
system. His $30,000 salary was charged to the fixed portion of indirect manufacturing costs.
With the reduction in inventory levels, increases in overnight shipping costs were required to meet
customer demands on a timely basis. The estimated overnight shipping premium paid was $5 per part
on a total of 5,000 parts. It was also estimated that sales of 3,000 parts were lost due to stockouts.
In the past, Car Parts store in Canton has had an annual expense of about $30,000 for obsolete inven-
tories. With the implementation of lIT, the current year's expense was only $5,000.
Car Parts has a cost of capital rate of 15 percent for investments in inventory.
Before deciding to implement the JIT inventory system, the budgeted income statement for the Canton,
Ohio, store for 2009 had been projected as follows:
Sales (300,000 parts) . $6,600,000

Cost of goods sold
Variable manufacturing costs .... $2,850,000
Fixed manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000 (4,050,000)
Gross profit . 2,550,000
Selling and administrative expenses
Variable , . 750,000
Fixed . 550,000 (1,300,000)
Operating income . 1,250,000
Interest expense . (160,000)
Income before taxes . $1,090,000
Required
a. Calculate the sav ings (loss) before taxes for Car Parts' Canton, Ohio, store related to implementing the
JlT inventory system.
b. What factors other than financial considerations should Car Parts consider before deciding whether to
implement the JIT inventory system throughout its entire retail organization?
P7-36. Just-in-Time Performance Evaluation (L051

To control operations, lVC Company makes extensive and exclusive use of financial performance reports
for each department. Although all departments have been reporting favorable cost variances in most peri-
ods, management is perplexed by the firm's low overall return on investment. You have been asked to look
into the matter. Believing the purchasing department is typical of the company's operations, you obtained
the following information concerning the purchases of parts for a product it started producing in 2004:
Purchase Quantity Average

Price Used Inventory
Year Variance (units) (units)
2004 ................................•. $ 1,000 F 20,000 5,000

2005 . 10,000 F 30,000 7,500
2006 . 12,000 F 30,000 10,000
2007 ...............................•........ 20,000 U 25,000 6,250
2008 ...............................•........ 8,000 F 36,000 9,000
2009 . 9,500 F 29,000 7,250
Required
a. Compute the inventory turnover for each year. What conclusions can be drawn from a yearly compari-
son of the purchase price variance and the inventory turnover?
b. Identify problems likely to be caused by evaluating purchasing only on the basis of the purchase price
variance.
c. Offer whatever recommendations you believe appropriate.
P7-37. Dual Allocation of Shared Services (L02)

Greenwood Corporation is part owner in three major hotels in the Boston area. To create cost efficiencies
Greenwood runs a centralized reservation system (CRS) for the three hotels. The reservation center has the
following monthly cost structure: $120,000 in fixed costs and $3 in variable cost per room sold. The follow-
ing information is available for the three hotels:
Property # Rooms Rooms Sold
1 . 400 9,600
2 . 800 16,800
3 . 1200 21,600
Required:
a. Allocate the reservation center costs to the hotels assuming that all costs are allocated based on number
of rooms sold.
b. Allocate the reservation center costs to the hotels assuming that fixed costs are allocated based on
capacity provided and variable costs are allocated based on rooms sold.
c. Comment on the advantages and disadvantages of the two methods in parts a. and b.
P7-38. Dual Allocation Approach and Charging for Services (L02)

The Maintenance Department of Management Suites Hotel has fixed costs of $400,000 a year. It also incurs
$20 in out-of-pocket expenses for every hour of work. During the year the Rooms Department used 20,000
maintenance hours. The Food and Beverage (F&B) Department used 5,000 maintenance hours. When the
Maintenance Department was established the Rooms and F&B departments estimated they would need 20,000
and 12,000 maintenance hours, respectively. It turns out F&B cut back on maintenance hours used to insure it
would meet its budget.
Required:
a. Calculate the amount of Maintenance Department costs to allocate to Rooms and F&B based entirely on
actual usage.
b. Calculate the amount of Maintenance DepaJ1ment costs to allocate to Rooms and F&B using a dual al-
location approach where fixed cost is allocated based on estimated capacity needed and variable cost is
allocated based on actual usage.
c. Which of the two methods applied in parts a. and b. is most fair to the two departments?
d. Assume that the maintenance depaltment allocates costs to the producing departments using a user charge.
What amount would you suggest for the user charge? Is it a good idea to use a user charge for allocat·
ing costs?
CASES
C7-39. Cost Allocation and Performance Evaluation IL01}
The Village Branch of First Bank is managed by Ron Short, who has full responsibility for the bank's
operations. The Village Branch is treated as a profit center within the company's responsibility accounting
system; according to rumors throughout the company, if The VilJage Branch does not become more profit-
able, it is likely to be closed. Ron is upset with the corporate accounting department because of the number
of different indirect costs that are allocated to his branch each period. He believes that many of these costs
provide no direct benefits to his branch and that they are not relevant to an evaluation of his pelfOlmance or
that of The Village Branch. An income statement for The Village Branch for February follows:
Branch revenues . $450,000

Direct branch costs (345,000)
Branch margin . 105,000
Allocated costs
Computer operations . $14,500
Personnel . 15,000
Payroll , . 23,800
Maintenance . 6,000
Accounting . 5,200
Legal and audit . 4,200
Transportation . 9,000
Administrative overhead . 22,000 (99,700)
Branch net income . $ 5,300
An investigation of Mr. Short's complaint by the controller's office provided the following additional
information:
Computer operations costs are billed based on actual CPU and computer connection time used by the
branch.
Personnel and payroll costs, primarily fixed, are allocated to the various operating departments based
on the number of employees in each division.
Maintenance costs are charged to the operating departments based on the standard hours actually
worked in each department plus the actual cost of materials and supplies used.
Accounting costs are allocated based on the number of transactions processed by the computer for each
branch.
Legal and audit costs are allocated based on the total revenues of the operating departments. The Vil-
lage Branch has been involved in only one lawsuit, which was about five years ago. Mr. Short receives
a copy of the company audit report each year but seldom reads it.
Transportation costs consist primarily of the costs of operating the company helicopter and the com-
pany airplane. The helicopter is used to deliver checks to the local clearing center and for local ex-
ecutive transportation; the airplane is used primarily for executive travel out of town. Transportation
costs are allocated to the operating departments based on revenues. Mr. Short has never flown in the
corporate airplane.
Administrative overhead consists of all other administrative costs including home office salaries and
office expenses. These costs are allocated to the operating departments based on revenues. Mr. Short
seldom sees anyone from the home office.
Required
a. Evaluate each cost allocation to determine whether it seems appropriate to allocate it to the operating
divisions. Also evaluate the basis on which each cost is allocated to the operating departments.
h. Prepare a revised income statement for The Village Branch based on your evaluations in requirement
(a).
c. Do you agree with Mr. Short's complaint? How do the cost allocations affect the decision to continue
or discontinue The Village Branch?
C7-40. Materials Push and Materials Pull Systems (L03,41

Media Storage Inc. produces three models of hard disk drives for personal computers. Each model is pro-
duced on a separate assembly line. Production consists of several operations in separate work centers.
Because of a high demand for Media's products, management is most interested in high-production volume
and operating efficiency. Each work center is evaluated on the basis of its operating efficiency. To avoid idle
time caused by defective units, variations in machine times, and machine breakdowns, significant invento-
ries are maintained between each workstation.
At a recent administrative committee meeting, the director of research announced that the firm's engi-
neers have made a dramatic breakthrough in designing a low-cost, read/write optical storage device. Media
Storage's president is very enthusiastic, and the vice president of marketing wishes to add an assembly line
for optical storage devices as soon as possible. The equipment necessary to manufacture the new product
can be purchased and installed in less than 60 days. Unfortunately, all available plant space is currently
devoted to the production of hard disk drives, and expansion is not possible at the current plant location. It
appears that adding the new product will require dropping a current product, relocating the entire operation,
or manufacturing the optical storage devices at a separate location.
The vice president of marketing is opposed to dropping a current product. The vice president of finance
is opposed to relocating the entire operation because of financing requirements and the associated financial
risks. The vice president of production is opposed to splitting up production activities because of the loss of
control and the added costs for various types of overhead.
Required
Explain how switching to a materials pull (Kanban) system can help solve Media Storage's space problems
while improving quality and cycle time. Describe how a materials pull system works and the changes re-
quired in management attitude toward inventory and efficiency to make it work.
C7-41. Product Costing Using Activity-Based Costing and Just-in-Time: A Value Chain Approach jL03,4}
Wearwell Carpet Company is a small residential carpet manufacturer started by Don Stegall, a longtime
engineer and manager in the carpet industry. Stegall began Wearwell in the early 1990s after learning about
ABC, JIT, total quality management, and several other manufacturing concepts being used successfully in
Japan and other paIts of the world. Although it was a small company, he believed that with his many years
of experience and by applying these advanced techniques, Wearwell could very quickly become a world-
class competitor.
Stegall buys dyed carpet yarns for Wearwell from three different major yarn manufacturers with which
he has done business for many years. He chose these companies because of their reputation for producing
high-quality products and their state-of-the art research and development departments. He has arranged for
two carpet manufacturing companies to produce (tuft) all of his carpets on a contractual basis. Both com-
panies have their own brands, but they also do contract work for other companies. For each manufacturer,
Stegall had to agree to use the full output of one manufacturing production line at least one day per month.
Each production line was dedicated to producing only one style of carpet, but each manufacturer had pro-
duction lines capable of running each type of carpet that Wearwell sold.
Stegall signed a contract with a large transport company (CTC), which specializes in carpet-related
shipping, to pick up and deliver yarn from the yarn plants to the tufting mills. This company will then de-
liver the finished product from the tufting mills to Wearwell's ten customers, which are carpet retailers in the
ten largest residential building markets in the country. These retailers pay the shipping charges to have the
carpets delivered to them. Wearwell maintains a small sales staff (which also doubles as a customer service
staff) to deal with the retailers and occasionally with the end customers on quality problems that arise.
Wearwell started selling only one line of carpet, a medium-grade plush, but as new carpet styles were
developed, it added two additional lines, a medium-grade berber carpet and a medium-grade textured car-
pet. Three colors are offered in each carpet style. By selling only medium grades with limited color choices,
Stegall felt that he would reach a very large segment of the carpet market without having to deal with a large
number of different products. As textured (trackless) carpets have become more popular, sales of plush have
diminished substantially.
Required
a. Describe the value chain for Wearwell Carpet Company, and identify the parties who compose this
value chain.
b. Identify and discuss the cost categories that would be included in the cost of the product for financial
reporting purposes.
c. Identify and discuss the cost categories that would be included in the cost of the product for pricing and
other management purposes.
d. Discuss some of the challenges that Stegall will have trying to apply JIT to regulate the levels of con-
trol at Wearwell. Suggest changes that might be necessary to make JIT work.
e. Does Wearwell seem to be an appropriate setting for implementing ABC? If so, what are likely to be
the most important activities and related cost drivers?
C7-42. JITlLean Production Performance Evaluation (L03, 4, 5)

The vice president of manufacturing is perplexed. When the new southside plant began operations, it ap-
peared to live up to the expectations of top management. The plant was modern, well lighted, and spacious.
Cost variances were favorable, customers were highly satisfied with quality and service, and the plant re-
ported large segment contributions to common costs and profits despite high stalt-up costs and early period
depreciation.
Just three years later, the southside plant seems to be declining into crisis management. Although most
cost variances, especially those dealing with cost center efficiency, remain favorable, the plant's segment
contribution is declining, and customers are complaining about poor quality and slow delivery. Several cus-
tomers have suggested that if the firm cannot cOlTect its quality and delivery problems, they will take their
business elsewhere. The shop floor is a mess with work-in-process inventory piled everywhere. Production
employees complain of difficulty in locating jobs to be worked on, and scheduling personnel have recently
requested a larger computer to help track work in process. The vice president said she does not know where
to begin to determine how to solve the plant's problems. She commented, "What is really weird is that we
all work so hard. Our facilities are the best in the business, and I know our employees are dedicated, well
trained, and hardworking. They do exactly what we ask, and we have never had any labor problems. It just
seems like the harder we work, the worse our problems become."
Required
Suggest the nature of the southside plant's problems and recommend how the vice president might begin to
determine how to solve the plant's problems.
8
Pricing and Other Product

Management Decisions
LEARNING OB'-'ECTIVES
LO 1 Explain the importance of the value

chain in managing products and
identify the key components of an
organization's internal and external
value chain. (p. 252)
Strong competition exists among Japanese, U.S., and European auto-
L02 Distinguish between economic and makers to develop the next generation of cars-the "green cars" that
cost-based approaches to pricing. cut pollution and boost fuel economy. Rising international tensions and
(p.256) spiraling oil prices (topping $100 per barrel for the first time in early 2008)
have added intensity to the race for new technologies to power automo-
L 0 3 Explain target costing and its biles. The technological, production, and marketing challenges, however,
acceptance in highly competitive are substantial. Competing technologies include hydrogen fuel cells and
industries. (p. 261) hybrid-powered formats.
Honda and Toyota favor hybrid car technology that combines gaso-
L04 Describe the relation between target line and electric power. Ford, General Motors, and Daimler favor hydro-
costing and continuous improvement gen fuel cells that combine hydrogen and oxygen to make electricity and
costing. (p. 266) water. Despite competing technological approaches, all of these firms
share an important strategic management goal-convincing customers to
LOS Explain how benchmarking enhances buy a green car. To achieve this goal, firms must price these cars competi-
quality management, continuous tively and create reasonable alternatives for potential customers who are
improvement, and process satisfied with a regular car.
reengineering. (p. 267) To succeed in this emerging market, automakers rely on important
management accounting tools, such as target costing and continuous
improvement (Kaizen) costing, to achieve a competitive price that is also
profitable. Two hybrid cars, the Honda Insight and Toyota Prius, both had
initial price tags of around $20,000 and initial yearly target sales between
4,000 and 12,000 units. During development, Toyota relied on continuous
improvement to achieve the cost savings necessary to make the Prius
profitable. The firm established this price to be competitive with its popular
250
Corolla model. Toyota has now added the hybrid to its luxury Lexus brand, and the Detroit auto manufacturers
have followed suit.
For manufacturers using hydrogen fuel cell technology, the goal is a $20,000 hydrogen fuel cell vehicle
before 2010. Managers on these projects count on increased fuel cell performance, reductions in size, and
changes in materials to lower the cost of this power source.
Ford and Daimler transferred their hydrogen fuel cell research and development to Ballard Power
Systems of Canada-a world leader in hydrogen fuel cell technology. In return, both Ford and Daimler hold
substantial ownership stakes in Ballard. Ballard's mandate from the automakers is clear: Develop a fuel cell
automobile propulsion system that has the right size, weight, range, and cost attributes to be commercially
successful. Mercedes buses in Australia, and UPS package delivery vehicles in the U.S., are now being tested
with hydrogen fuel cells.
Within this emerging market for green cars as well as other emerging and existing markets, strategic cost
management tools are increasingly important for managers involved in the development, manufacture, and
marketing of products and services. Companies that are successful in introducing new products, as well as
managing existing products, invariably have a focus on the value chain for all of their products.'
I Jeffrey Ball, "Ballard Power Expands Fuel-Cell Drive as Ford, DaimlerChrysler Boost Stakes, The Wall S'reet Journal (Interactive Edi-
tion), October 3, 2001; Terril Ye Jones, "Whose Car Is Greener?" Forbes, October 18, 1999, p. 60; Keith Naughton, "Can You Have Green
Cars Without Red Ink?" Business Week, December 29, 1997, p. 50; Keith Naughton, "Detroit's Impossible Dream," Business Week, March
2,1998, pp. 66 & 68; Emily Thornton, Keith Naughton, and David Woodruff, "Toyota's Green Machine," Business Week, December 15,
1997, pp. 108-110; David Woodruff and William C. Symonds, "The Hottest Thing in 'Green' Wheels," Business Week, April 28, 1997,
p.42.
251
252 Chapter 8 I Pricing and Other Product Management Decisions
CHAPTER
ORGANIZATION ~1~l!Gmillli1fMll.¥lilEJaWil:J
I
I I I I
r-
•
~
Impact of the Value
Chain on Core
Competencies
Value-Added
--
•
•
mmr:m::mm
I!'fMtMtml
Economic
Approaches to
Pricing
Cost-Based
---
•
•
= . .
Target Costing and
Cost Management
Target Costing and
Design
::::I
~
~
Continuous
Improvement
Costing
=0 Benchmarking
I
and Value Chain Approaches to • Target Costing and

Perspectives Pricing Product Life Cycles
Strategic cost management techniques, such as target costing and continuous improvement costing, repre-
sent important concepts for product management professionals involved in the development, manufacture,
and marketing of products and services. Virtually all such techniques are grounded in the notion of manag-
ing the value chain. This chapter examines pricing, the intenelation between price and cost, and the role
of benchmarking in meeting customer needs at the lowest possible price.
We begin with a discussion of the value chain, followed by an overview of the pricing model econo-
mists use to explain price equilibrium. Given the limitations of this long-run equilibrium model for deter-
mining price of a product or service, we consider the widely used cost-plus approach to identifying initial
prices. We then examine how intense competition (such as that for the green car market) has inverted the
cost-plus pricing model into one that starts with an acceptable market price and subtracts a desired profit
to determine a target cost. We also consider life cycle costs from the perspectives of both the seller, who
increasingly plans for all costs before production begins, and the buyer, who regards subsequent operat-
ing, maintenance, repair, and disposal costs as important as price. Finally, we consider how benchmarking
can assist in improving competitiveness and profitability.
UNDERSTANDING THE VALUE CHAIN

The value chain for a product or service is the set of value-producing activities that stretches from basic
LO 1 Explain the
raw materials to the final consumer. Each product or service has a distinct value chain, and all entities
importance of
along the value chain depend on the final customer's perception of the value and cost of a product or
the value chain
service. It is the final customer who ultimately pays all costs and provides all profits to all organizations
in managing
along the entire value chain. Consequently, the goal of every organization is to maximize the value, while
products and
minimizing the cost, of a product or service to final customers.
identify the key
The value chain provides a viewpoint that encompasses all activities peJiormed to deliver products
components of
and services to final customers. Depending on the needs of management, value chains are developed
an organization's
at varying levels of detail. Analyzing a value chain from the perspective of the final consumer requires
internal and
working backward from the end product or service to the basic raw materials entering into the product
external value
or service. Analyzing a value chain from the viewpoint of an organization that is in the middle of a
chain.
value chain requires working forward (downstream) to the final consumer and backward (upstream) to
the source of raw materials. The paper industry provides a convenient context for illustrating the value
chain concept.
Exhibit 8.1 presents the value chain for the paperboard cartons used to package beverages, such as
Coca-Cola, Pepsi, or Evian products. The value chain is presented at three levels, with each successive
level containing additional details. The first level depicts the various business entities in the value chain:
Timber producers grow the pulp wood (usually pine) used as the basic input into paper products.
Some large paper companies, such as Boise Cascade and Georgia Pacific, harvest much of
their pulp wood from timberlands that they manage. Other companies, including Ri"erwood
Chapter 8 I Pricing and Other Product Management Decisions 253
EXHIBIT 8.1 Value Chain for a Beverage-Packaging Product
First level: Business Entities
Timber Pulp Paperboard Paperboard Beverage Grocery Final

Producer Mill Manufacturer Converter Company Store Customer
Second level: Processes
Procurement Storage ,......,.... Display Sell to

--+
customer
Third level: Activities
Preparing Receiving Inspecting Moving Paying

purchase order delivery to storage invoice
order
International, which is a leading producer of paperboard for the beverage industry, do not
manage their own timberlands, but purchase pulp for their mills on the open market through pulp
intermediaries.
Pulp mills produce the kraft (unbleached) paper used to produce the paperboard. Some of the
smaller paperboard manufacturers purchase the kraft paper product from pulp mills; Riverwood
International, however, owns its own paper mills that produce paper for its paperboard production
facilities.
Paperboard manufacturers perform a laminating process of coating paperboard material used to
produce beverage packages. The paperboard consists of two layers of paper product plus three
layers of coating that gives the top sUiface a high gloss finish that is water resistent and suitable
for multicolor printing. Riverwood International is a manufacturer of paperboard for the beverage
industry that is marketed under the name of Aqua-Kote.
The paperboard converter uses manufactured paperboard to print and produce the completed
beverage packaging product, such as the cartons used to package the Diet Coca-Cola 12-pack.
Beverage distributors, such as Coca-Cola Enterprises and Anheuser-Busch, purchase the
completed paperboard packages from Riverwood International to package their many different
brands in various package sizes and shapes.
Grocery and convenience stores, such as Safeway and 7·Eleven, display and sell beverages
packaged in the paperboard containers.
The final customer purchases beverages packaged in paperboard packages and uses the packages to
canoy the beverages and to store them until consumed. The packages not only perform a transport
and storage function but also serve as an advertising medium for the beverage company. The
beverage company's advertising on the paperboard packages is intended to entice customers to
purchase the beverage company's product and to help create a sense of satisfaction for the customer.
To better understand how business entities within the chain add value and incur costs, management
might further refine the value chain into processes, collections of related activities intended to achieve a
common purpose. The second level in Exhibit 8.1 represents major processes concerning the procurement
and sale of Coca-Cola products by a grocery store. To simplify our illustration, we show only the processes
for the grocery store related to the purchase and sale of Coca-Cola products packaged in paperboard pack-
ages. These processes include procuring Coca-Cola products from the bottling company, storing and display-
ing the product, and selling the product to the final consumer.
An activity is a unit of work. In the third level of Exhibit 8.1, the grocery store process to procure
Coca-Cola products is further broken up into the following activities:
Placing a purchase order for Coca-Cola products packaged in paperboard packages.
Receiving delivery of the Coca-Cola products in paperboard packages.
Inspecting the delivery to make sure it corresponds with the purchase order and to verify that the
products are in good condition.
Storing Coca-Cola products in paperboard packages until needed for display.
Paying for Coca-Cola products acquired after the invoice arrives.
Each of the activities involved in procuring product from a vendor is described by a word ending with ing.
This suggests that most work activities involve action. One way to think about the internal value chain for
a particular company is provided in Exhibit 8.2 in terms of the basic components of the value chain that
are found in most organizations. This generic model, first developed by Michael Porter, is a good starting
point in identifying the internal value chain links for a particular organization.
EXHIBIT 8.2 Generic Internal Processes of the Internal Value Chain
Inbound
Logisflcs
i-- Operations
-- Outbound
Logistics
f-- Marketing
and Sales
:-- service
Supporting Processes: Examples are Accounting, Design, Finance,

Human Resources, and Maintenance
Usefulness of a Valu Chai Perspective

The goal of maximizing final customer value while minimizing final customer cost leads organizations to
examine internal and external links in the value chain rather than the departments, processes, or activities
independently. From a value chain perspective, it is total cost across the entire value chain, not the cost of
individual businesses, departments, processes, or activities that is most important.
Value Chain Perspective Fosters Supplier-Buyer Partnerships

In the past, relationships between suppliers and buyers were often adversarial. Contact between suppli-
ers and buyers was solely through the selling and purchasing departments. Suppliers attempted merely
to meet purchasing contract specifications at the lowest possible cost. Buyers encouraged competition
among suppliers with the primary-and often single-goal of obtaining the lowest purchase price.
As discussed in Chapter 7 with JIT and lean production, exploiting cost reduction and value-
enhancing opportunities in the value chain has led many buyers and suppliers to view each other as
partners rather than as adversaries. Buyers have reduced the number of suppliers they deal with, often
developing long-term partnerships with a single supplier. Once they establish mutual trust, both proceed
to share detailed information on internal operations and help each other solve problems. Partners work
closely to examine mutual opportunities by studying their common value chain. Supplier engineers
might determine that a minor relaxation in buyer specifications would significantly reduce supplier
manufacturing costs with only minor increases in subsequent buyer processing costs. Working together,
they determine how best to modify processes to reduce overall costs and share increased profits.
Companies such as Hewlett-Packard and Boeing involve suppliers in design, development, and
manufactUling decisions. Motorola has even developed a survey asking suppliers to assess Motorola
as a buyer. Among other questions, the survey asks sellers to evaluate Motorola's performance in help-
ing suppliers to identify major cost drivers and to increase their profitability. These questions repre-
sent the concems of a partner rather than those of an adversary. The following Business Insight box
describes how Dell has molded partnerships with upstream suppliers and downstream customers into what
company founder Michael Dell identifies as "virtual integration."
BUSINESS INSIGHT Internet Driven Virtual Value Chain at Dell
When Dell Inc. first began using the Internet to expand its business, the company had three basic objec-
tives: to make it easier to do business with Dell, to reduce the cost of doing business with Dell, and to
enhance their customer relationships. By 1999, Dell was selling more than $35 million per day over the
Internet, and by 2006 its annual sales exceeded $57 billion. "But for Dell, online commerce was only the
beginning," writes Michael Dell, the Founder & CEO of Dell Computer Corporation. "Because we
viewed the Internet as a central part of our IT strategy, we started to view the ownership of information
differently, too. Rather than closely guarding our information databases, which took us years to develop,
we used Internet browsers to essentially give that same information to our customers and suppliers-
bringing them literally inside our business. This became the key to what I call a virtually integrated orga-
nization-an organization linked not by physical assets, but by information. By using the Internet to
speed information between companies, essentially eliminating inter-company boundaries, it would be
possible to achieve precision and speed-to-market for products and services in ways not dreamed pos-
sible before. It would be the ultimate business system for a digital economy."2
On a smaller scale, the grocery store in Exhibit 8.1 should examine its extemallinks. It may be will-
ing to pay more for Coca-Cola products if the distributors cooperate to help reduce costs such as the
following:
Making more frequent delivelies in small lots would reduce storage costs.
Being responsible for maintaining and changing the product displays would relieve store workers of
these tasks.
Streamlining ordering and payment procedures would reduce bookkeeping costs.
If partnership alTangements with upstream suppliers enable the grocery store to reduce its total costs,
the store can enhance or maintain its competitive position by reducing prices charged to its consumers. Re-
member that competitors are also striving to reduce costs and enhance their competitive position. Hence,
failing to strive for improvements will likely result in reduced sales and profits.
Value Chain Perspective Fosters Focus on Core Competencies

Using value chain concepts, relationships with suppliers often begin to represent an extended family, al-
lowing companies to focus on core competencies; this capability provides a distinct competitive advantage.
In addition, a new breed of contract manufacturers, such as Solectron Corporation and Sanmina·SCI
have emerged in recent years. These organizations manufacture products for other companies, ranging
from Hewlett-Packard printers to Xerox photocopy machines, with such close partnership arrangements
that they behave like a single company. This allows Hewlett-Packard and Xerox to focus on marketing and
product development while Solectron and SCI Systems focus on efficient, low-cost manufacturing.
Interestingly, because their facilities are available to all innovators with the necessary financing, the
emergence of contract manufacturers may speed innovation. Michael Dell attributes much of Dell's rapid
growth and profitability to virtual integration with suppliers (see Business Insight box above). Virtual
integration is the use of information technology and partnership concepts to allow two or more entities
along a value chain to act as if they were a single economic entity.
Val e- dded and Value Chain Perspectives

The value chain perspective is often contrasted with a value-added perspective. Under a value-added
perspective, decision makers consider only the cost of resources to their organization and the selling price
of products or services to their immediate customers. Using a value-added perspective, the goal is to
maximize the value added (the difference between the selling price and costs) by the organization. To do
2Direct from Dell, Michael Dell with Catherine Fredman, Harper Collins PUblishers, 1999. Also, see http://money.cnn.coml
magazineslfortunelfortune500/2007Ifull Jistfindex.html
this, the value-added perspective focuses primarily on internal activities and costs. Under a value chain
perspective, the goal is to maximize value and minimize cost to final customers, often by developing link-
ages or partnerships with suppliers and customers.
Although initial efforts to enhance competitiveness might start with a value-added perspective, it is
important to expand to a value chain perspective. World-class competitors utilize both a value-added and a
value chain perspective. These firms always keep the final customer in mind and recognize that the profit-
ability of each entity in the value chain depends on the overall value and cost of the products and services
delivered to final customers.
The value-added perspective is the foundation of the make or buy (outsourcing) decision considered
in Chapter 4. The key differences between the partnering decisions considered here and the make or buy
decision in Chapter 4 concern time frame, perspective, and attitude. The make or buy decision is a stand-
alone decision, often in the short run, that does not view vendors and customers as partners. In contrast,
characteristics of the value chain perspective are as follows:
Comprehensive.
Focused on the final customers.
Strategic.
Basis for partnerships between vendors and customers.
Enhancing or maintaining a competitive position requires an understanding of the entire system used
to develop and deliver value to final customers, including interactions among organizations along the
value chain. All organizations in the value chain are in business together and should work together as
partners rather than as adversaries.
THE PRICING DECISIO

Pricing products and services is one of the most important and complex decisions facing management.
L02 Distinguish
Pricing decisions directly affect the salability of individual products or services, as well as the profitability,
between
and even the survival, of the organization. Many economists have spent their entire careers examining the
economic and
foundations of pricing. To respond to the needs of pricing hundreds or thousands of individual items, man-
cost-based
agers have developed pricing guidelines that are typically based on costs. More recently, global competi-
approaches to
tion has turned cost-based approaches upside down. Managers of world-class organizations increasingly
pricing.
start with a price that customers are willing to pay and then determine allowable costs.
Economic Approaches to ricing

In economic models, the firm has a profit-maximizing goal and known cost and revenue functions. Typi-
cally, increases in sales quantity require reductions in selling prices, causing marginal revenue (the vary-
ing increment in total revenue derived from the sale of an additional unit) to decline as sales increase.
Increases in production cause an increase in marginal cost (the varying increment in total cost required to
produce and sell an additional unit of product). In economic models, profits are maximized at the sales vol-
ume at which marginal revenues equal marginal costs. Films continue to produce as long as the marginal
revenue derived from the sale of each additional unit exceeds the marginal cost of producing that unit.
Economic models provide a useful framework for consideling pricing decisions. The ideal price is the
one that will lead customers to purchase all units a firm can provide up to the point at which the last unit
has a marginal cost exactly equal to its marginal revenue.
Despite their conceptual merit, economic models are seldom used for day-to-day pricing deci-
sions. Perfect information and an indefinite time period are required to achieve equilibrium prices at
which marginal revenues equal marginal costs. In the short run, most for-profit organizations attempt
to achieve a target profit rather than a maximum profit. One reason for this is an inability to determine
the single set of actions that will lead to profit maximization. Furthermore, managers are more apt to
strive to satisfy a number of goals (such as profits for investors, job security for themselves and their
employees, and being a "good" corporate citizen) than to strive for the maximization of a single profit
goal. In any case, to maximize profits, a company's management would have to know the cost and rev-
enue functions of every product the firm sells. For most firms, this information cannot be developed at
a reasonable cost.
Cost-Based Approaches Pri Ing

Although cost is not the only consideration in pricing, it has traditionally been the most important for
several reasons.
Cost data are available. When hundreds or thousands of different prices must be set in a short time,
cost could be the only feasible basis for product pricing.
Cost-based prices are defenSible. Managers threatened by legal action or public scrutiny feel secure
using cost-based prices. They can argue that prices are set in a manner that provides a "fair" profit.
Revenues must exceed costs if the firm is to remain in business. In the long run, the selling price
must exceed the full cost of each unit.
Cost-based pricing is illustrated in Exhibit 8.3. The process begins with market research to detennine
customer wants. If the product requires components to be designed and produced by vendors, the process of
obtaining prices can be time consuming. When some costs, such as those fixed costs at the facility level, are
not assigned to specific products, a markup is added to cover these costs. An additional markup is added to
achieve a desired profit. The selling pJice is then set as the sum of the assigned costs, the markup to cover
unassigned costs, and the markup to achieve the desired profit.
The proposed selling price should be
evaluated with regard to competitive infor-
EXHIBIT 8.3 Cost-Based Pricing for a New Product_ _ _....J
mation and what customers are willing to
pay. If the price is acceptable, the product or
service is produced. If the price is too high, Determine
the product might be redesigned, manufac- customer wants
turing procedures might be changed, and dif-
ferent types of materials might be considered
!
until either an acceptable price is achieved
,-- ----------' to meet Design product
customer wants
or it is determined that the product cannot , I
,
be produced at an acceptable price. The fol- I
I
lowing Business Insight box discusses cost- I
I
~
based pricing as a strategy for physician ,, I
Determine Determine
practice groups.
,
I manufacturing or
service procedures
necessary
raw materials
I
Cost-Based Pricing in Single- I
Product Companies ,
I
I
Implementing cost-based pricing in a sin- I
I
.l
I
gle-product company is straightforward if Determine price:
everything is known but the selling price. 1. Predict selected costs.
In this case, all known data are entered into 2. Add markup for other costs.
the profit formula, which is then solved for 3. Add additional markup to
achieve desired profit.
the variable price. Assume that Bright Rug
Cleaners' annual fixed facility-level costs
are $200,000 and the unit cost of cleaning a
J
rug is $10. Management desires to achieve Evaluate the resulting price:
an annual profit of $30,000 at an annual -------- 1. If acceptable, manufacture
and sell.
------
volume of 10,000 rugs. To simplify the ex-
2. If unacceptable, redesign.
ample, assume that management charges the
same price regardless of the type, size, or
shape of the rug. Using the profit formula,
the cost-based price is detennined to be $33:
Profit = Total revenues - Total costs
$30,000 = (Price x 10,000 rugs) - ($200,000 + [$10 x 10,000 rugs])
Solving for the price:
(Price x 10,000) = $300,000 + $30,000
Price = $330,000 -;- 10,000
= $33
BUSINESS INSIGHT Cost-based Pricing Advocated for Medical Groups
Physician practice groups are constantly negotiating with insurers over appropriate pricing of services,
often without regard for the costs incurred in providing the services. One healthcare consultant has ar-
gued that hospitals and healthcare systems should consider pursuing pricing strategies that take into
account the true costs of operating a primary-care-based physician group. Cost-based pricing strate-
gies will allow organizations with underpertorming physician groups to reach break-even positions on
their group practice investments. The cost-based pricing approach is most effective if used as the first
step-preparation-in the contract negotiation process. In the second step-education-the approach
is one of leveraging the information learned and educating payers regarding the true cost of providing
high-quality physician services to a payer's patient population. Initially, payers are likely to resist a
move toward cost-based pricing. However, an employed physician group that has prepared the neces-
sary documentation and information should be able to support its case that it has efficient operations
and appropriate overhead levels. 3
A price of $33 to clean a rug will allow Bright to achieve its desired profit. However, before setting
the price at $33, management should also evaluate the competitive situation and consider what customers
are willing to pay for this service.
Cost-Based Pricing in Multiple-Product Companies

In multiple-product companies, desired profits are determined for the entire company, and standard pro-
cedures are established for determining the initial selling price of each product. These procedures typi-
cally specify the initial selling price as the costs assigned to products or services plus a markup to cover
unassigned costs and provide for the desired profit. Depending on the sophistication of the organization's
accounting system, possible cost bases in a manufacturing organization include markups based on a com-
bination of cost behavior and function. The possible cost bases include:
Direct materials costs.
Variable manufacturing costs.
Total variable costs (manufacturing, selling, and administrative).
Full manufacturing costs.
Regardless of the cost base, the general approach to developing a markup is to recognize that the markup
must be large enough to provide for costs not included in the base plus the desired profit.
in the base + Desired profit
Markup on cost base = Costs not included
. .
Costs mcluded m the base
First we illustrate a pricing decision with variable costs as the cost base; full manufacturing costs is the
cost base in the second illustration.
1. When the markup is based on variable costs, it must be large enough to cover all fixed costs and the
desired profit. Assume that the predicted annual variable and fixed costs for Magnum Enterprises are
as follows:
Variable Fixed
Manufacturing . $600,000 Manufacturing. . . . . . . .. $300,000

Selling and Selling and
administrative . 200,000 administrative . . . . . . . 100,000
Total . $800,000 Total. . . . . . . . . . . . . . . .. $400,000
3Craig D Pederson, "Cost-based Pricing and the Underperforming Physician Group," Hea/rhcare Finaru:ia/ Managemem,
Oct 2005.
Furthermore, assume that Magnum Enterprises has total assets of $1,250,000; management believes that
an annual return of 16 percent on total assets is appropriate in Magnum's industry. A 16 percent return
translates into a desired annual profit of $200,000 ($1,250,000 X 0.16). Assuming all cost predictions
are cOlTect, obtaining a profit of $200,000 requires a 75 percent markup on variable costs:
. + $200 000
Markup on vanable costs = $400'000
$800,000 '
= 0.75
If the predicted variable costs for Product A I are $12 per unit, the initial selling price for Product Al
is $21:
Initial selling price = $12 + ($12 x 0.75)

= $21
2. When the markup is based on full manufacturing costs, it must be large enough to cover selling and
administrative expenses and to provide for the desired profit. Again, it is necessary to determine the
desired profit and predict all costs for the pricing period. The initial prices of individual products
are then determined as their unit manufacturing costs plus the markup. For Magnum, the markup on
manufacturing costs would be 55.6 percent:
. + $200 000
Markup on manufacturmg costs = $300 '000
$900,000 '
= 0.556
If the predicted manufacturing costs for Product B I are $10, the initial selling price for Product B I is
$15.56:
Initial selling price = $10 + ($10 x 0.556)

= $15.56
Cost-Based Pricing for Special Orders

Many organizations use cost-based pricing to bid on unique projects. If the project requires dedicated
assets, the acquisition of new fixed assets, or an investment in employee training, the desired profit on
the special order or project should allow for an adequate return on the dedicated assets or additional
investment.
Critique of Cost-Based Pricing

Cost-based pricing has four major drawbacks:
1. Cost-based pricing requires accurate cost assignments. If costs are not accurately assigned, some
products could be priced too high, losing market share to competitors; other products could be priced
too low, gaining market share but being less profitable than anticipated.
2. The higher the portion of unassigned costs, the greater is the likelihood of over- or under-pricing
individual products.
3. Cost-based pricing assumes that goods or services are relatively scarce and, generally, customers who
want a product or service are willing to pay the price.
4. In a competitive environment, cost-based approaches increase the time and cost of bringing new
products to market.
Cost-based pricing became the dominant approach to pricing during an era when products were relatively
long-lived and there was relatively little competition. Also, these systems tend to focus on organizational
units such as departments, plants, or divisions and not on activities or cost drivers. While easy to imple-
ment, reflecting the need to recover costs and earn a return on investment, and easily justified, cost-based
prices might not be competitive. Competition puts intense downward pressure on prices and removes
slack from pricing formulas. There is little margin for elTor in pricing. In a highly competitive market,
small variations in pricing make significant differences in success.
MID-CHAPTER REVIEW
Presented is the 2009 contribution income statement of Knox Company.
KNOX COMPANY
Contribution Income Statement
For Year Ended December 31, 2009
Sales (100,000 units at $12 per unit) . $1,200,000

Less variable costs
Manufacturing . $300,000
Selling and administrative . 150,000 (450,000)
---
Contribution margin . 750,000
Less fixed costs
Manufacturing . 400,000
---
Net income . $ 150,000
Knox has total assets of $2,000,000, and. management desires an annual return of 10 percent on total assets.
Required
a. Determine the dollar amount by which Knox Company exceeded or fell short of the desired annual rate
of return in 2009.
b. Given the current sales volume and cost structure, determine the unit selling price required to achieve
an annual profit of $250,000.
c. Assume that management wants to state the selling price as a percentage of variable manufacturing
costs. Given your answer to requirement (b) and the current sales volume and cost structure, determine
the selling price as a percentage of variable manufacturing costs.
d. Restate your answer to requirement (c), dividing into two separate markup percentages:
I. The markup on variable manufacturing costs required to cover unassigned costs.
2. The additional markup on variable manufacturing costs required to achieve an annual profit of
$250,000.
Solution
a.
Desired annual profit ($2,000,000 X 0.10) ....•..................... $200,000
Actual profit . (150,000)
Amount actual profit fell short of achieving the desired return . $ 50,000
h.
Predicted costs
Variable . $450,000
Fixed . 600,000 $1,050,000
Desired profit . 250,000
Required revenue . $1,300,000
Unit sales . .;.- 100,000
Required unit selling price . $ 13
c.
Variable manufacturing costs per unit ($300,000/100,000 unit) = $3
Selling price as a percent of variable manufacturing costs = $13/3
= 433'/3%
Markup as a percent of variable manufacturing costs ($10/$3) = 333'13.
d. Detail of markup on variable manufacturing costs:
1. Unassigned costs
Variable selling and administrative . $150,000
Fixed costs . 600,000 $750,000
Variable manufacturing costs . -;-300,000
Markup on variable manufacturing costs to cover
unassigned costs. . . . . . . . . . . . . . . . . 250%
2. Desired profit. . $250,000

Variable manufacturing costs . -;-300,000
Additional markup on variable manufacturing costs

to achieve desired profit ($250,000) .
TARGET COSTING
Economists argue that cost-based prices are not realistic, because in the real world prices are determined
Loa Explain
by the confluence of supply and demand. However, when a new product is introduced into the market
target costing and
for which there is no previously existing supply or demand, there has to be a starting point. As discussed
its acceptance in
above, cost has often been the baseline for determining initial selling prices. All too often, however,
highly competitive
companies introduce new products into the market based on what the designers and engineers "think" the
industries.
market wants (or based on inadequate market research), only to find out later that either the market does
not want the product, or it is not willing to buy the new product at a price sufficient to cover its cost plus
an acceptable profit to the producer. This often leads to costly redesign, or in many cases, complete aban-
donment of the product, typically resulting in substantial financial losses.
Toyota, which has pioneered many of the innovations in manufacturing systems discussed in Chap-
ter 7, turned the notion of cost-based pricing around and came up with the idea of price-based costing,
referred to as target costing. Toyota determined that before a new product is introduced into the market,
it must be able to be produced at a cost that will make it profitable when sold at a price acceptable to
customers. The acceptable selling price to the marketplace determines the acceptable cost of producing
the product.
Target Costing Is Proac ive for Cos Managem t

Target costing starts with determining what customers are willing to pay for a product or service and
then subtracts a desired profit on sales to determine the allowable, or target, cost of the product or
service. This target cost is then communicated to a cross-functional team of employees representing
such diverse areas as marketing, product design, manufacturing, and management accounting. Reflect-
ing value chain concepts and the notion of partnerships up and down the value chain, suppliers of raw
materials and components are often included in the teams. The target costing team is assigned the task
of designing a product that meets customer price, function, and quality requirements while providing
a desired profit. Its job is not completed until the target cost is met, or a determination is made that the
product or service cannot be profitably introduced under the current circumstances. See Exhibit 8.4 for
an overview of target costing.
Although a formula can be used to determine a markup on cost, it is not possible to develop a
formula indicating how to achieve a target cost. Hence, target costing is not a technique. It is more a
philosophy or an approach to pricing and cost management. It takes a proactive approach to cost man-
agement, reflecting the belief that costs are best managed by decisions made during product develop-
ment. This contrasts with the more passive cost-plus belief that costs result from design, procurement,
and manufacture. Like the value chain, target costing helps orient employees toward the final customer
and reinforces the notion that all departments within the organization and all organizations along the
value chain must work together. Target costing also empowers employees who will be assigned the
Target Costing in a Competitive Environment
Determine customer wants

and price sensitivity
1
Set planned selling price
1
Determine target cost:
Selling price - Desired profit
1.
Teams of employees from various
areas and trusted vendors simultaneously
Design
product
Detennine
manufacturing
procedures
I Determine
necessary
raw materials
Costs are considered throughout the process.

Process reqUires trade-offs to meet target cost.
1
After target cost is achieved,
manufacturing begins
1
[ Sell product I
responsibility for carrying out activities necessary to deliver a product or service with the authority to
determine what activities will be selected. Like process mapping, it helps employees to better under-
stand their role in serving the customer. The following Business Insight box explains one company's
approach to implementing target costing.
BUSINESS INSIGHT Target Costing and New Product Development
A personal homecare products company (name withheld by authors) in the Southwest has adopted
target costing as a key element in the introduction of new products. This consumer products com-
pany also uses a proprietary product development control system, called Stage Gate®, which pro-
vides an operational roadmap for driving new product-development projects from idea to launch by
dividing the process into a series of stages (activities) and gates (decision points). A gate precedes
each stage where a decision is made whether or not to proceed to the next stage. At each gate, or
decision point, a senior leader decides to go, kill, hold, or recycle the project. Target costing concepts
are applied at each gate, reqUiring financial analysis to determine whether a business case can be
made to support the new product introduction. This process requires a hard cost target for each new
product that must be achieved in order to move forward with the project. Otherwise, the senior leader
kills the product or places it on hold until the cost target is met. 4
4 Gopalakrishnan, Samuels. and Swenson, "Target Costing at a Consumer Products Company," S/I"alegic Finance, December 2007.
Target Costin Encourages Desig f r Prod cion

In the absence of a target costing approach, design engineers are apt to focus on incorporating leading-edge
technology and the maximum number of features in a product. Target costing keeps the customer's func-
tion, quality, and price requirements in the forefront at all times. If customers do not want leading-edge
technology (which could be expensive and untested) and several product features, they will resist paying
for them. Focusing on achieving a target cost keeps design engineers tuned in to the final customer.
Left on their own, design engineers might believe that their job ends when they design a product that
meets the customer's functional requirements. The tendency is to simply pass on the design to manufactur-
ing and let manufacturing determine how best to produce the product. Further down the line, if the product
needs servicing, it becomes the service department's responsibility to determine how best to service the
product. A target costing approach forces design engineers to explicitly consider the costs of manufactur-
ing and servicing a product while it is being designed. This is known as design for manufacture.
Minor changes in design that do not affect the product's functioning can often produce dramatic sav-
ings in manufacturing and servicing costs. Examples of design for manufacture include the following:
Using molded plastic parts to avoid assembling several small parts.
Designing two parts that must be fit together so that joining them in the correct manner is obvious
to assembly workers.
Placing an access panel in the side of an appliance so service personnel can make repairs quickly.
Using standard-size parts to reduce inventory requirements, to reduce the possibility of assembly
personnel inserting the incorrect part, and to simplify the job of service personnel.
Ensuring that tolerance requirements for parts that must fit together can be met with available
equipment.
Using manufacturing procedures that are common to other products.
The successful implementation of target costing requires employees from all involved disciplines to
be familiar with costing concepts and the notions of value-added and non-value-added activities. When
considering the manufacturing process, team members should minimize non-value-added activities such
as movement, storage, inspection, and setup. They should also select the lowest-cost value-added activi-
ties that do the job properly.
Target Costing Reduces Time to Introduce Produ s

By designing a product to meet a target cost (rather than evaluating the marketability of a product at a cost-
plus price and having to recycle the design through several departments), target costing reduces the time
required to introduce new products. Involving vendors in target costing design teams makes the vendors
aware of the necessity of meeting a target cost. This facilitates the concurrent engineering of components
to be produced outside the organization and reduces the time required to obtain components.
Target Costing Requires Cost Inf rmati n

Implementing target costing requires detailed information on the cost of alternative activities. This infor-
mation allows decision makers to select design and manufacturing alternatives that best meet function and
price requirements. Tables that contain detailed databases of cost information for various manufacturing
variables are occasionally used in designing products and selecting processes to meet target costs.
Target Costing. equires Coordona i

Limitations of target costing are employee and supplier attitudes and the many meetings required to co-
ordinate product design and to select manufacturing processes. All people involved must have a basic
understanding of the overall processes required to bring a product to market and an appreciation of the
cost consequences of alternative actions. They must also respect, cooperate, and communicate with other
team members and be willing to engage in a negotiation process involving trade-offs. Finally, they must
understand that although the total time required to bring a new product to market can be reduced, the
countless coordinating meetings could be quite intrusive on the individuals' otherwise orderly schedule.
See Exhibit 8.5 for an evaluation of target costing.
EXHIBIT 8.5 Pros and Cons of Target Costing
Pros
• Takes proactive approach to cost management.
• Orients organization toward customer.
• Breaks down barriers between departments.
• Enhances employee awareness and empowerment.
• Fosters partnerships with suppliers.
• Minimizes non-value-added activities.
• Encourages selection of lowest-cost value-added activities.
• Reduces time to market.
Cons
• To be effective, requires the development of detailed cost data.
• Requires willingness to cooperate.
• Requires many meetings for coordination.
This aspect of the process is even more difficult when suppliers must be brought in as part of the
coordination process. This concept is frequently referred to as chained target costing because the supply
chain's support is critical for the product to be both competitively priced and delivered to the final cus-
tomer in a timely manner. When multiple suppliers are required, the organization must obtain everyone's
support or the process will probably not be successful due to gaps in the reliability of delivery, quality,
and cost control. Each organization and unit must understand that if the product is not brought to market
within the defined constraints, all will lose. They must make firm commitments for the project undertaken
and to have faith that each participant will carry out whatever part of the supply chain it has promised to
fulfill. An example of this process with suppliers of parts and components to Whirlpool Corporation is
presented in the following Business Insight box. Coordination across the supply chain is vital in the over-
all process of continuous improvement as discussed later in this chapter.
BUSINESS INSIGHT Quality Parts Yield Product Success
Industry leaders in electric motor manufacturing are attempting to provide their customers, equip-
ment manufacturers, with high efficiency and quieter motors at consistently lower costs as part of
the supply chain. An example is Emerson Appliance Solutions, which has teamed with Whirlpool
Corporation to develop a customized capacitor motor for the Sears' Kenmore, Kitchen Aid, and
Whirlpool brand names. Says Emerson's Whirlpool account manager, "An approximate 20 percent
motor energy savings was the result of efforts by engineering teams at both Whirlpool and Emerson
that resulted in a smaller, more efficient motor-pump assembly."
Illustrating Emerson's commitment to Whirlpool, the company had three managers who coordi-
nated components for washers, motors, and controls. These managers worked with Whirlpool to
achieve its new product objective of emphasizing reduced sound and water consumption while deliv-
ering good wash performance. To further enhance the product, Emerson then worked with its sup-
plier, AMP (going up the supply chain), for an improved connection method for the motors' magnet
wires and lead wires. Each member of the supply chain was well aware of Whirlpool's concern about
cost of the new product and made every effort to contain costs from development to production. As
a result, the new product was within the target set by Whirlpool.s
Target Costing is Key for Products with

Short Life Cvcle
From a traditional marketing perspective, products with a relatively long life go through four distinct
stages during their life cycle:
5 Joe Jancsurak, "Value-Added Power," Appliance ManufaCTurer Magazine, February 26, 2001, http://www.ammagazine.com.
I. Start-up. Sales are low when a product is first introduced. Traditionally, initial selling prices are set
high, and customers tend to be relatively affluent trendsetters.
2. Growth. Sales increase as the product gains acceptance. Traditionally, prices have remained high
during this stage because of customer loyalty and the absence of competitive products.
3. Maturity. Sales level off as the product matures. Because of increased competition, pressure on prices
is increasing; some price reductions could be necessary.
4. Decline. Sales decline as the product becomes obsolete. Significant price cuts could be required to
sell remaining inventories.
Target costing is more important for products with a relatively short market life cycle. Products with
a long life cycle present many opportunities to continuously improve design and manufacturing proce-
dures that are not available when a product has a short life cycle. Hence, extra care must go into the initial
planning for short-lived products. This is especial1y true when short product life cycles are combined with
increased worldwide competition. It is important to introduce a product first and at a price that ensures
rapid market penetration.
Target Cos ing Hel s n e ie ts

An awareness of the impact of today's actions on tomorrow's costs underlies the notion of life cycle costs,
which include all costs associated with a product or service ranging from those inculTed with the initial
conception through design, pre-production, production, and after-production support.
The lower line in Exhibit 8.6 illustrates the cumulative expenditure of funds over the life of a
product. For low-technology products with relatively long product lives, decisions committing the or-
ganization to spend money are made at approximately the same time the money is spent. However, for
high-technology products with relatively short product lives, most of the critical decisions affecting
cost, such as product design and the selection of manufacturing procedures, are made before production
begins. The top line in Exhibit 8.6 represents decisions committing the organization to expenditures for
a product. It has been estimated that as much as 70% of the cost of the typical automobile, and 95% of
the cost of high-technology products, is committed during the design stage.
Commitment and Expenditure for High-Technology

EXHIBITS.6
Products with Relatively Short Product Lives
--------_...
Percent of 100%
total costs Conception Design Preproduction Production" Support
Cumulative
commitment
of money
Cumulative
expenditure
of money
o Time
" Production extends over the entire marketing life of a product:

start-up, growth, maturity, and decline.
Reflecting significant changes in vehicle production since the time of Henry Ford and the Model T,
General Motors estimates that 70 percent of the cost of manufacturing truck transmissions is determined
during design. Others estimate that up to 95 percent of the total costs associated with high-technology
products are committed before the first unit is produced.
Life cycle cost concepts have also been usefully applied to low-technology issues, such as repair ver-
sus replace decisions. The New York State Throughway Authority uses life cycle concepts to determine
the point at which it is more expensive to repair than to replace bridges.
-I·.'LI. • You are the Vice President of Product Development
As head of new product development for your electronics company, you are concerned that so many
of the ideas for new products coming from your research and development group are not succeed-
ing in the market. Many recent attempts to take new products to market have failed, not because of
technological deficiencies in the products, but because the market would not support the high prices
for new products that were necessary to produce a satisfactory profit. What should you do to try to
reverse this trend of new product failures? [Answer, p. 274J
CONTINUOUS IMPROVEMENT COSTING

Continuous improvement (Kaizen) costing calls for establishing cost reduction targets for products or
L04 Describe
services that an organization is cUlTently providing to customers. Developed in Japan, this approach to
the relation
cost management is often referred to as Kaizen costing. Kaizen means "continuous improvement" in Japa-
between target
nese. Continuous improvement costing begins where target costing ends. Target costing takes a proactive
costing and
approach to cost management during the conception, design, and preproduction stages of a product's life;
continuous
continuous improvement costing takes a proactive approach to cost management during the production
improvement
stage of a product's life:
costing.
Conception Design
Time
Preproduction Production
.
Target Continuous improvement
costing costing
Continuous improvement costing adds a specific target to be achieved during a time period to the
target costing concept previously discussed. Basically, the mathematics of the concept is quite simple, but
its implementation is difficult. Assume that Home Depot wanted to reduce the cost of materials handling
in each of its stores, and management set a target reduction of 2 percent a year. If a given store had cur-
rent annual materials handling costs of $100,000 and expected an increase the next year due to 10 percent
growth, the budget for the next year would be $107,800 [($100,000 X 1.10) X 0.98]. The budget for next
year based on growth is $110,000 less the continuous improvement factor of 0.02.
Like target costing, Kaizen costing should be viewed as a serious attempt to make processes more
efficient, while maintaining or improving quality, thereby making the company more competitive and
profitable. In Kaizen costing, cost reductions can be achieved both internally and externally through con-
tinuous redesign and improved internal processes, and by working with vendors to improve their designs
and processes. Kaizen is a team effort involving everyone who has an influence on costs. As stated in
Chapter 7, Kaizen is typically found in companies that have adopted a lean production philosophy.
Successful companies use continuous improvement costing to avoid complacency. Competitors are
constantly striving to win market share through better quality or lower prices. Hewlett-Packard studied
Epson to determine its strengths and weaknesses. Isuzu Motors takes competitors' products apart to de-
termine a target cost it must beat. To fend off competition, prices and costs must be continuously reduced.
To maintain its competitive position, Hewlett-Packard has reduced the list price of the basic inkjet printer
from nearly $400 when first introduced to less than $50 today. This could not have been done without
continuousreductionsincos~.
The Daihatsll Motor Compan.v sets Kaizen cost reduction targets for each cost element, including
purchased parts per car, direct materials per car, labor hours per car, and office utilities. Performance
reports developed at the end of each month compare targeted and actual cost reductions. If actual cost re-
ductions are more than the targeted cost reductions, the results are favorable; if the actual cost reductions
are less than the targeted cost reductions, the results are unfavorable.
Because cost reduction targets are set before it is known how they will be achieved, continuous
improvement costing can be stressful to employees. To help reduce this stress at Daihatsu, a period of
about three months following the introduction of a new product is allowed before organizational units are
expected to meet target costs and Kaizen costing targets. A critical element in motivating employee coop-
eration and teamwork in aggressive cost management techniques, such as target and continuous improve-
ment costing, is to avoid using performance reports to place blame for failure. The proper response to an
unfavorable performance report must be an offer of assistance to correct the failure.
BENCHMARKI G
When Isuzu Motors takes a competitor's product apart to determine the competitor's manufacturing costs,
LOS Explain how
or when Hewlett-Packard studies Epson to identify Epson's strengths and weaknesses, each company
benchmarking
is engaging in benchmarking, a practice that has been around for centuries. In recent years, however, as
enhances quality
globalization and increased competitiveness have forced businesses to more aggressively compete on
management,
the bases of cost, quality, and service, benchmarking has become more formalized and open. No longer
continuous
regarded as spying, benchmarking is now a systematic approach to identifying the best practices to help
improvement,
an organization take action to improve performance.
and process
The formalization of benchmarking is largely attributed to a book written in the 1980s by Robert Camp of
reengineering.
Xerox. Since then, many managers have come to believe that benchmarking is a requirement for success. Al-
though benchmarking can focus on anything of interest, it typically deals with target costs for a product, service,
or operation, customer satisfaction, quality, inventory levels, inventory tumover, cycle time, and productivity.
Benchmarking initially focused on studying competitors, but benchmarking efforts have changed dramatically
in recent years to include competitors, as well as companies in very different industries. For example, a com-
puter company like Dell may benchmark its order fulfillment processes against Amazon, or an electronics com-
pany like Sony may benchmark its inventory management processes against an apparel company like Gap.
In considering how to go about benchmarking, an organization must be careful because it must consider
nonfinancial limitations. No single numerical measurement can completely describe the performance of a
complex device such as a microprocessor or a television camera, but benchmarks can be useful tools for
comparing different products, components, and systems. The only totally accurate way to measure the per-
formance of a given product is to test it against other products while performing the exact same activity. The
following Business Insight box describes how Intel Corporation makes benchmarks available with some
infolmation on how to use them.
BUSINESS INSIGHT Intel Benchmarks Performance
Intel Corporation divides its benchmarks into two types, component and system. Component bench-
marks measure the performance of specific parts of a computer system, such as a microprocessor or
hard disk drive. System benchmarks typically measure the performance of the entire computer sys-
tem. The performance obtained will almost certainly vary from benchmark performance for a number
of reasons. First, individual components must usually be tested in a complete computer system, and
it is not always possible to eliminate the considerable effects that differences in system design and
configuration have on benchmark results. For instance, vendors sell systems with a wide variety of
disk capabilities and speeds, system memory, and video and graphics capabilities, all of which influ-
ence how the system components perform in actual use. Differences in software, including operating
systems and compilers, also affect component and system performance. Finally, benchmark tests are
typically written to be exemplary for only a certain type of computer application, which might or might
not be similar to what is being compared.
A benchmark is, at most, only one type of information that an organization might use during the
purchasing or manufacturing process. To get a true picture of the performance of a component or
system being considered, the organization should consult industry sources, publicly available re-
search reports, and even government publications of related information. 6
6 As described on the Intel website at hnp://www.intel.com/performance/resources/benchmark_limitalions.htm

Benchmarking provides measurements that are useful in setting goals. It can lead to dramatic innova-
tions, and it can help overcome resistance to change. When presented with a major cost reduction target,
employees often believe they are being asked to do the impossible. Benchmarking can be a psychological
tool that helps overcome resistance to change by showing how others have already met the target.
Although each organization has its own approach to benchmarking, the following six steps are typical:
1. Decide what to benchmark.
2. Plan the benchmark project.
3. Understand your own performance.
4. Study others.
5. Learn from the data.
6. Take action.
In recent years, professional organizations, such as the Institute of Management Accountants, have
set up clearinghouses for benchmark information or have performed benchmarking studies of interest to
members as have certain corporations such as Intel.
CHAPTER-END REVIEW
MBW, Inc. has been conducting early-stage research on hydrogen powered automobiles and is nearing the point
where product development will soon begin. In order to determine the feasibility of the product, MBW has
conducted marketing research that indicates that the price target for the product must be no more than $35,000
if it is to appeal to a large enough market segment to sell a minimum of 150,000 automobiles in the first year of
production. The CFa has indicated that the new product must meet a 15% minimum profit margin requirement.
Required
a. Calculate the target cost per unit to produce the hydrogen powered automobile.
b. How would MBW go about determining whether the target cost can be achieved.
c. What should MBW do if the estimated cost to produce the product exceeds the target cost?
Solution
a.
Total revenue (150,000 x $35,000) $5,250,000,000
Required profit margin (15%) . - 787,500,000
Total cost. . . . . . . . . $4,462,500,000
Number of units. . . . . . . -;- 150,000
Target cost per unit. . $ 29,750
b. A new product such as an automobile is an extremely complex product with hundreds, if not thousands,
of different components, involving many different vendors. Once MBW has determined what product
features potential customers want, its engineers must determine how best to provide those features,
working with vendors and potential vendors. The idea is to determine how best to provide the final
product that the customers want at a cost that will provide a reasonable profit to MBW and its vendors.
c. Teams of engineers, accountants, designers, etc. from MBW and its vendors should work together to
try to achieve the target cost. If initial cost estimates are too high, they should explore every possibility,
including redesign of the product, using components from existing products, developing new production
systems, etc. to meet the target cost. If it is finally determined that the target cannot be reached, then
management has to decide if it is willing to go forward with the product with a lower than desired
initial profit margin. In some cases, managers will proceed with the idea that additional cost savings
will be found (using Kaizen costing methods) after the product is in production.
APPENDIX SA: Quality Costs

Life cycle costs were previously considered from the seller's perspective within the context of developing target costs.
From the buyer's perspective, life cycle costs include the total costs associated with a product, such as a refrigerator,
furnace, X-ray machine, or tractor, over its entire life. Sophisticated buyers look beyond acquisition cost to life cycle
costs in making decisions. Major home appliances come with stickers estimating their annual operating costs, and new
automobiles have stickers with information on fuel efficiency. The life cycle costs of a furnace include the purchase
price, operating costs such as fuel, maintenance costs such as cleaning the burner, and repair costs such as replacing
an exhaust fan. The preferred furnace is the one that provides the desired heat at the lowest life cycle cost.
Applying the life cycle cost concept, the total cost of materials to a manufacturing company includes much
more than the purchase price. It also includes costs caused by potential and actual quality problems with materials. A
concern that some materials are defective might require purchasing extra materials or inspecting materials. The use of
defective materials could cause a manufacturer to incur costs for production downtime and rework. When life cycle
costs are considered, purchasing decisions are less likely to be made solely on the basis of price. When the effect of
quality on subsequent costs is considered, raw materials quality becomes just as important as price.
Quality, defined as conformance to customer expectations, is an impOltant competitive factor. 7 Successful companies
know that they must meet customers' quality and price expectations. In addition to being ethically questionable, reducing
quality to achieve a target cost will not lead to long-run profits in today's highly competitive markets. Consistent product
quality is a component in the success of companies such as Federal Express, Furd, MI:Dunald's, Toyota, and Intel.
American Airlines found that poor quality (in the form of late arrivals) cost it customer goodwill and millions of
dollars a year in "lost" baggage and employee overtime. R In manufacturing, Intel found that quality leads to lower manu-
facturing costs, lower inventory levels, higher productivity, and increased profits. In repetitive activities, such as process-
ing checks at a bank, an emphasis on "doing it right the first time" reduces the need for inspection and for rework.
Quality is an essential element of the JIT approach to inventory management. Purchasing high-quality materials
reduces the need to inspect incoming materials, reduces the need for extra inventory, and facilitates the delivery of
materials directly to the shop floor. As inventories are reduced, the presence of defective units becomes increasingly
disruptive. Indeed, without buffer stocks, manufacturers might have to stop operations as soon as a defective unit is
detected. While costly in the short run, these disruptions call attention to quality problems and encourage changes that
prevent their recurrence. By eliminating the effort devoted to detecting and reworking or disposing of defective units,
organizations are able to increase their productivity and profitability.
Produdivity is the relationship between outputs and inputs:
Productivity = Outputs 7 Inputs
Measurement of productivity requires a measure of output and of input. Partial measures of productivity are
based on the relationship of units produced to a single input such as the number of employees, direct labor hours, or
machine hours. Total measures of productivity convert all inputs into dollars (a common denominator) and restate
outputs in terms of sales dollars.
Improvements in quality increase productivity by reducing the inputs required to obtain a given level of output.
In turn, these improvements in productivity increase profits by lowering costs for the given level of output. If some
of the cost savings are passed on to customers in the form of lower selling prices, an increase in sales volume could
generate increased profits. Additionally, if an organization achieves a reputation for quality, it might be able to charge
premium prices. The known quality of international brands, such as Coke and Pepsi, allow vendors to sell them at
higher prices than they charge for local brands of soft drinks.
n
A key to improving quality is recognizing that quality is everyone's responsibility. The responsibility for quality starts
with detelmining customer expectations and concludes with the delivery of products and services that conform to these
expectations. The process of delivering a quality product or service can be broken into the following five steps:
Step 1 _ Step 2 _ Step 3 _ Step 4 _ Step 5

Customer Functional Design Manufacturing Actual
expectations specifications specifications specifications results
l. Quality starts with determining customer expectations. An agreement is necessary as to what customers expect
and what the vendor will deliver. If customers at a McDonald's restaurant expect table service, lobster, and
candlelight, they will be disappointed. If they expect fast, courteous service and low prices, they are likely to
be satisfied.
2. The next step in delivering a quality product is to develop functional specifications for the product or service.
These are explicit statements regarding the service or product capabilities, expressed in quantitative terms
whenever possible. Functional specifications for a new automobile engine might include specifications for
horsepower, fuel consumption, and emissions. Functional specifications at a hotel might refer to the types of
services provided for guests, such as prompt room service.
3. The functional specifications then must be turned into design specifications. These are detailed statements
regarding the physical characteristics of the product and engineering drawings illustrating those physical
characteristics. At a Holida)' Inn hotel, the number of towels to be left in each room is a design specification.
7 Much of the material in this section is based on Wayne J. Morse, Harold P. Roth, and Kay M. Poston, Measuring, Ptanning, and
Con/rolling Quality Costs (Montvale, NJ: Nalional Association of Accountants, 1987).

R Wendy Zeller, "Coffee, Tea-And On-Time Arrival," Business Week. January 20, 1997, p. 30.
4. Detailed specifications of how a product will be manufactured to meet design specifications or how a service
will be performed must also be developed. At a Wend)"s fastfood restaurant, manufacturing specifications
include the specified sequence of activities required to prepare a hamburger.
5. Finally, the actual results of a product or service are determined following its delivery in conformance with its
design specifications.
For clarity, we have identified five distinct steps in delivering a quality product or service. In reality, these steps
are often intermingled. As indicated in the discussion of target costing, teams of employees from various functional
areas should work on Steps I through 4 concurrently. Many efforts to deliver quality products succeed or fail during
the design stage. Quality problems and manufacturing costs increase when a complex design makes manufacture dif-
ficult. Warranty costs and buyers' life cycle costs increase when a design does not consider ease of service.
To develop standards for evaluating product quality, it is necessary to distinguish between quality of design and
quality of conformance. Quality of design refers to the degree of conformance between customer expectations for a
product or service and the design specifications of the product or service. Quality of conformance refers to the de-
gree of conformance between a product and its design specifications. Conformance to customer expectations requires
both the quality of design and the quality of conformance.
As shown in Exhibit 8.7, doing the right things wrong (high quality of design but poor quality of conformance)
or the wrong things right (poor quality of design but high quality of conformance) results in failure. The only way to
win customers is by doing the right things right.
Success Requires Quality of Design and Conformance

EXHIBIT 8.7
-----------.......
High
Do right Do right
things things
wrong right
(failure) (winner)
Quality
of
design
Do wrong Do wrong
things things
wrong right
(failure) (failure)
Low
Low High
Quality of conformance
Types of Quality Costs

Many managers find financial information related to quality useful for determining the financial significance of qual-
ity problems, developing an overall strategy for improving quality, evaluating proposals to invest in quality improve-
ment activities, and appraising the performance of quality improvement activities. The concepts of quality costs serve
as the basis for these special-purpose accounting reports for management.
Quality costs are costs incurred because poor quality of conformance does (or could) exist. There are two basic
types of quality costs, and each basic type is classified in two subcategories:
1. Quality costs are incurred because of the possibility of poor conformance between actual products or services
and their design standards:
a. Prevention costs are incurred to prevent nonconforming products from being produced or nonconforming
services from being pertormed.
b. Appraisal costs are incurred to identify nonconforming products or services before they are delivered to
customers.
2. Quality costs are incurred because of poor conformance between actual products or services and their design
standards:
a. Internal failure costs occur when materials, components, products, or services are identified as defective
before delivery to customers.
b. External failure costs occur when nonconforming products or services are delivered to customers. For
example, Stale Farm [nsurance Compan.v sued Ford Motor Company, claiming it paid millions of
doJlars for fires caused by faulty ignition switches on Ford vehicles. Ford had previously recalled 8.7
million vehicles due to the faulty switch. State Farm estimated that 26 million more vehicles had the
potentially faulty switch 9
Quality cost information is periodically summarized in a quality cost report, such as the one in Exhibit 8.8, which also
presents examples of costs in each category. Qual ity cost information cuts across organizational boundaries and quality costs
are related to specific activities. By associating costs with activities, activity based costing facilitates the development of
quality cost information. To provide a benchmark (see later discussion in this chapter) for comparison between periods with
different levels of activity, quality cost infomlation is often restated as a percent of sales or total manufacturing costs.
Exhibit 8.8 reveals that external failure costs are very high in comparison with other quality costs. This indicates
that quality problems are not being identified and corrected before goods are delivered to customers, a situation fre-
quently encountered before the initiation of a quality improvement program. In this case, expenditures on appraisal
and prevention might payoff handsomely with reductions in failure costs.
Quality cost information can be prepared for any time period or cost objective such as a machine, depal1ment,
plant, division, company, product, or product line. Depending on management's information needs, quality cost re-
ports can include fewer than four cost categories. They can even include subjective information such as an estimate
of lost sales resulting from quality problems (an external failure cost). Some organizations have devised unique ways
of turning the umecorded opportunity cost of a lost future sale into a current out-of-pocket cost that is recorded. To
avoid the cost of lost sales due to quality problems, the Ritz-Carlton Hotel Co. authorizes employees to spend up to
$2,000 to correct the problem of a guest's grievance. The underlying philosophy is that guests, remembering the level
of service and the extra effort taken to resolve problems, will return.
EXHIBITS.S Quality Cost Report
BEST WATCH COMPANY

Quality Cost Report
For the Month Ended March 31
Amount Percent of Sales·
Prevention
Design for manufacture ...•................................... ... $ 0
Quality planning . 2,000
Quality training . 3,000
Supplier verification . o
Total prevention . 5,000 0.25%
Appraisal
Accuracy review of sales orders . o
Depreciation of testing equipment. . 1,000
Field inspection and testing. . . . . . . . 8,000
In-process inspection and testing . o
Total appraisal . 9,000 0.46%
Internal failure
Downtime due to quality problems . o
Reinspection . 400
Retest. . o
Rework labor and overhead . 10,000
Scrap . 1,600
Total internal failure . 12,000 0.61%
External failure
Complaint adjustment . 30,000
Product recalls . 60,000
Returns and allowances . 10,000
Warranty repairs . 50,000
Warranty replacement . 80,000
Insurance for product liability . 20,000
Legal fees for product liability . o
Total external failure . 250,000 12.68%
Total quality costs..........•...................................... $276,000 14.00%
'Sales for the month total $1,972,208 (100%).
9 "State Farm Sues Ford over Faulty Ignition Switch," The HWlIsville Times, January 21, 1998.
Qualit ost Tren Anal'-.'sis

A Irend analysis illustrating the effect on quality costs of successfully implementing a quality improvement program
is presented in Exhibit 8:9. The most immediate action management can take to prevent the delivery of poor-quality
products is to implement a rigorous inspection program and identify defective goods before they are delivered. If the
inspection program is successful, there should be a shift in quality costs as a percent of sales, with external failure costs
declining and appraisal and internal failure costs increasing. At this stage in a quality improvement program, total known
quality costs are likely to increase. The ultimate solution to quality problems is to increase efforts to prevent the occur-
rence of defects. In addition to reducing external and internal failure costs, a successful quality improvement program
will make it possible to reduce appraisal costs when management is confident the job is done right the first time.
Quality Cost Trend Analysis of a Successful Quality Improvement

EXHIBIT 8.9
Program
- Total quality costs

20 /
18 J
16/ _.'!...........- ~ Prevention
14--/
12--.//
Percent 10--.//
of sales 8-/'
6'-/ /
4'/
2··/
o
2 3 Period 4 5 6
While the implementation of a quality improvement program could have a significant effect on the total amount
and distribution of quality costs, it is unlikely that quality costs can be reduced to zero. Management must continue to
invest in prevention as new products are introduced and production procedures are changed. Even if the goal of zero
defects is reached, some prevention must be required to maintain this ideal state. Appraisal and internal failure costs
are better than external failure costs, and prevention costs are preferred to appraisal or failure costs. Quality is not free,
but it is less expensive than the alternative.
Exhibit 8.10 shows a hypothesized short-run relationship between the quality of confonnance and quality costs.
Assuming static conditions with a given technology and level of knowledge, the graph shows that total quality costs
are high when quality is low. Total quality costs decline as expenditures for appraisal and prevention produce im-
provements in quality. As quality nears perfection, the incremental returns to additional efforts to improve quality
decline to such an extent that total quality costs begin to rise.
While this hypothesized relationship is a useful way of thinking about quality costs in the short run, remember
that these are static relationships applicable for a given technology and level of knowledge. Advances in technology or
knowledge should have the effect of shifting the prevention and appraisal cost curve down and to the right, increasing
the optimal level of quality. The search for quality improvements is never ending. Once a temporary optimal level of
quality is achieved, management should strive for advances in technology and knowledge that will pennit additional
improvements. Competitors who continue to work toward quality improvements could achieve breakthroughs that
improve quality, productivity, sales volume, and profitability.
ert1;ational n i 7.ati r o;;,;"t"~""'rlar"1izatio (I

The ability to demonstrate a commitment to quality is becoming increasingly important for companies doing busi-
ness in global markets. The opening of countries to external competition has a dramatic impact on how managers and
employees of companies in those countries view customers and the need for quality.
ISO 9000 Certification for Quality Management

The International Organization for Standardization (ISO) has issued a series of standards for quality assurance systems.
These standards, known as ISO 9000 standards, provide organizations with internationally recognized models for the
design and operation of a quality management system. ISO certification means that an organization has documented
EXHIBIT 8.10 hort-Run Analysis of the Economics of Quality*
+----"J---Total quality costs
Total
costs
... -----.-~"'~""...- - - - - - - _ +-Internal and

external failure
0% 100%
Percent conforming to design specifications
'Arrows represent the effect of technological breakthrough in prevention; they cause the prevention and appraisal cost curve to shift
down and to the right. This, in turn, causes the total quality cost curve to shift down and to the right. The net result is an increase in
the percent conforming that minimizes total quality costs.
the procedures used to ensure a quality product and that it follows them consistently. Meeting ISO 9000 standards
beyond the first level requires an independent audit by an outside organization. ISO certification does not ensure that
specific products or services meet customer expectations. Like developing a process map, the most important benefit
of obtaining ISO 9000 certification often comes from forcing everyone involved in a process to carefully consider how
their actions relate to each other and the purpose of the process. Once the current practice is documented, areas for
improvement are easier to detect.
The European Union requires suppliers of certain products to have ISO 9000 certification. The North Atlantic
Treaty Organization, the U.S. Department of Defense, and many U.S. companies, such as IBM and General Electric,
also require suppliers to be ISO 9000 certified. Even when it is not a requirement, achieving ISO 9000 certification
enables companies to differentiate themselves from competitors. Although initially intended for manufacturing opera-
tions, law firms, waste removal companies, and professional associations (such as the American Institute of Certified
Public Accountants) have achieved ISO 9000 certification.
ISO 14000 Certification for Environmental Management

Few companies measure environmental costs, but awareness of the magnitude and decision usefulness of environ-
mental cost information is increasing. Environmental costs have traditionally been pooled with other overhead items,
causing them to be hidden. Placing environmental costs into broad overhead cost pools before assigning them to final
cost objectives results in cross-subsidization, with environmental costs misassigned to products that are less environ-
mentally hazardous.
As is the case for quality costs, the development of ABC makes it easier to evaluate environmental costs. One
approach to organizing environmental cost information is to use a framework similar to that developed for quality
costs:
Prevention---efforts to reduce or prevent environmental hazards from occurring.
Appraisal-inspection to deternline whether an environmental problem exists.
Failure---efforts to correct environmental problems.
The Internal Standards Organization issued a series of environmental management standards. Identified as ISO
14000 standards, they are similar to the ISO 9000 standards in that they focus on systems rather than specific results,
they are flexible to meet an organization's specific situation, and they call for external certification. The standards
are intended to help management communicate environmental information within and outside the company and to
provide management the information to help assess the impact of business decisions on the environment.
Environmental costs, such as those associated with waste treatment, landfill, hazardous waste disposal, and
environmental inspections, are important parts of the life cycle costs of many products. Previously, future costs, such
as those associated with removing oil storage tanks and cleaning up any possible pollution, were seldom considered;
however, financial accounting standards now require the present value of such costs to be included on the balance
sheet, making it also easier to include them in life cycle cost analysis. Including environmental expenditures as part of
a product's life cycle costs could reveal that a product with low acquisition costs but high environmental costs is less
desirable than a product with a higher initial cost.
GUIDANCE ANSWER
.....
• You are the Vice President of Product Development
You should consider adopting target costing methods for new product development. Great product research
ideas are successful only when they translate into products that can be produced and sold for an acceptable
profit. Creating and producing new products before determining what the customer wants and is willing to pay
often leads to failure. Target costing methods reverse this process by applying value chain concepts to bring
customers and suppliers along the value chain together to produce a product only if it has features and a selling
price that are acceptable to potential customers, and if its production costs allow the seller to make an accept-
able profit.
DISCUSSION UESTIONS
Q8-1. What are the relationships among an organization's value chain, processes, and activities?
Q8-2. What should be the goal of every organization along the value chain?
Q8-3. Distinguish between the value-added perspective and the value chain perspective.
Q8-4. Why are economic models seldom used for day-to-day pricing decisions?
Q8-S. Identify three reasons that cost-based approaches to pricing have traditionally been important.
Q8-6. Identify four drawbacks to cost-based pricing.
Q8-7. How does target costing differ from cost-based pricing?
Q8-8. Why is cost-based pricing more a technique, and target costing is more a philosophy? Which approach
takes a more proactive approach to cost management?
Q8-9. Distinguish between the marketing life cycles of products incorporating advanced technology (such as
household electronic equipment) and those using more traditional technology (such as household paper
products). Why would life cycle costing be more important to a manufacturer of household electronic
equipment than to a manufacturer of household paper products?
Q8-10. What is the relationship between target costing and continuous improvement (Kaizen) costing?
Q8-11. Distinguish between the seller's and the buyer's perspective of life cycle costs.
Q8-12. What advantage is derived from benchmarking against firms other than competitors?
MINI EXERCISES
M8-13. Developing a Value Chain from the Perspective of the Final Customer (L01)
Prepare a value chain for bottled orange juice that was purchased for personal consumption at an on-campus
cafeteria.
M8·14. Developing a Value Chain: Upstream and Downstream Entities (L01)
Prepare a value chain for a firm that produces gasoline fuel. Clearly identify upstream and downstream
entities in the value chain.
M8-1S. Classifying Activities Using the Generic Internal Value Chain: Aluminum Cable Manufacturer (L011
Using the generic internal value chain shown in Exhibit 8.2, classify each of the following activities of an
aluminum cable manufacturer as inbound logistics, operations, outbound logistics, marketing and sales,
service, or support.
o. Advertising in a construction magazine
b. Inspecting incoming aluminum ingots
c. Placing bar codes on coils of finished products
d. Borrowing money to finance a buildup of inventory
e. Hiring new employees
.f Heating aluminum ingots
g. Drawing wire from aluminum ingots
h. Coiling wire
i. Visiting a customer to determine the cause of cable breakage
j. Filing tax returns
M8-16. Classifying Activities Using the Generic Internal Value Chain: Cable TV Company IL01)
Using the generic internal value chain shown in Exhibit 8.2, classify each of the following activities of a
cable television company as inbound logistics, operations, outbound logistics, marketing and sales, service,
or support.
a. Installing cable in the apartment of a new customer
b. Repairing cable after a windstoll11
c. Mailing brochures to prospective customers
d. Discussing a rate increase with members of a regulatory agency
e. Selling shares of stock in the company
f Monitoring the quality of reception at the company's satellite downlink
g. Preparing financial statements
h. Visiting a customer to detell11ine the cause of poor-quality television reception
i. Traveling to a conference to learn about technological changes affecting the industry
j. Inspecting television cables for wear
M8-17. Product Pricing: Single Product IL02)
Sue Bee loney is one of the largest processors of its product for the retail market. Assume that it processes Sue Bee Honey
honey at one large facility. Its annual fixed costs total $8,000,000, of which $3,000,000 is for administrative
and selling efforts. Sales are anticipated to be 800,000 cases a year. Variable costs for processing are $4
per case, and variable selling expenses are 24 percent of selling price. There are no variable administrative
expenses.
Required
If the company desires a profit of $4,000,000, what is the selling price per case?
M8-18. Product Pricing: Single Product (L02)

Assume that you plan to open a soft ice cream franchise in a resort community during the summer months.
Fixed operating costs for the three-month period are projected to be $5,250. Variable costs per serving
include the cost of the ice cream and cone, $0.25, and a franchise fee payable to Snowdrift Cooler, $0.10. A
market analysis prepared by Snowdrift Cooler indicates that summer sales in the resort community should
total 24,000 units.
Required
Determine the price you should charge for each ice cream cone to achieve a $7,000 profit for the three-
month period.
M8-19. A Quality Costs: Service Emphasis

Categorize each of the following quality costs as prevention, appraisal, internal failure, or external failure.
a. Inspecting incoming supplies.
b. Following up on complaints by service department.
c. Training new employees.
d. Reconciling of agency contracts with billing statements.
e. Retraining staff members who are not current in area of expertise.
f Maintaining toll-free telephone for client questions.
g. Redesigning reception area so clients have privacy during consultations.
h. Dismissing staff member found guilty of unethical acts regarding company matters.
I. Senior staff reviewing final report before giving it to client.
M8-20. A Quality Costs: Manufacturing Emphasis
Categorize each of the following quality costs as prevention, appraisal, internal failure, or external failure.
a. Disposal of spoiled work-in-process inventory.
b. Downtime due to quality problems.
c. Expediting of work to meet delivery schedule.
d. Field tests.
e. Internal audits of inventory.
.f Support of complaint department.
g. Opportunity cost of lost sales because of bad reputation for quality.
h. Product liability.
/. Quality circles.
j. Quality training.
k. Reinspection.
I. Revision of computer programs due to software errors.
m. Rework labor and overhead.
n. Scrap.
o. Supplier verification.
p. Technical support provided to vendors.
q. Testing and inspection of equipment.
r. Testing and inspection of purchased raw materials.
s. Utilities used by inspection area.
t. Warranty repairs.
EXERCISES
E8-21. Product Pricing: Single Product (L02)
Presented is the 2009 contribution income statement of Colgate Products.
COLGATE PRODUCTS
Sales (12,000 units) . $1,440,000

Less variable costs
Cost of goods sold . $480,000
Less fixed costs

Manufacturing overhead .. 520,000
Selling and administrative. 210,000 (730,000)
During the coming year, Colgate expects an increase in variable manufacturing costs of $8 per unit and in
fixed manufacturing costs of $48,000.
Required
a. If sales for 20 I0 remain at 12,000 units, what price should Colgate charge to obtain the same profit as
last year?
b. Management believes that sales can be increased to 16,000 units if the selling price is lowered to
$107. Is this action desirable?
c. After considering the expected increases in costs, what sales volume is needed to earn a profit of
$98,000 with a unit selling price of $1 07?
E8-22. Cost-Based Pricing and Markups with Variable Costs (L02)

Compu Services provides computerized inventory consulting. The office and computer expenses are
$600,000 annually. The consulting hours available for the year total 20,000, and the average consulting
hour has $30 of variable costs.
Required
a. If the company desires a profit of $80,000, what should it charge per hour?
b. What is the markup on variable costs if the desired profit is $120,000?
c. If the desired profit is $60,000, what is the markup on variable costs to cover (J) unassigned costs
and (2) desired profit?
E8-23. Computing Markups (L02)
The predicted 2009 costs for Osaka Motors are as follows:
Manufacturing Costs Selling and Administrative Costs
Variable . $100,000 Variable . $300,000

Fixed . 220,000 Fixed . 200,000 !
Average total assets for 2009 are predicted to be $6,000,000.

Required
a. If management desires a 12 percent rate of return on total assets, what are the markup percentages for
total variable costs and for total manufacturing costs')
b. If the company desires a 10 percent rate of return on total assets, what is the markup percentage on
!otal manufacturing costs for (I) unassigned costs and (2) desired profit?
E8-24. Product Pricing: Two Products (L02)

Quality Data manufactures two products, CD-ROMs and zjp disks, both on the same assembly lines and
packaged 10 disks per pack. The predicted sales are 400,000 packs of CD-ROMs and 500,000 packs of zip
disks. The predicted costs for the year 2009 are as follows:
Variable Costs Fixed Costs
Materials . $200,000 $500,000

Other . 250,000 800,000
Each product uses 50 percent of the materials costs. Based on manufacturing time, 40 percent of the other
costs are assigned to the CD-ROMs, and 60 percent of the other costs are assigned to the zip disks. The
management of Quality Data desires an annual profit of $150.000.
Required
a. What price should Quality Data charge for each disk pack if management believes the zip disks sell
for 20 percent more than the CD-ROMs?
b. What is the total profit per product using the selling prices detennined in part a?
c. Based on your answer to requirement (b), how should the company evaluate the status of the two
products?
E8-2S. Benchmarking (L05)

Your company is developing a new product for the computer printer industry. You have talked to several material
vendors about being able to supply quality components for the new product. The product designers are satisfied
with the company's ability to make the product in the current facilities. Numerous potential customers also have
been surveyed, and most have indicated a willingness to buy the product if the price is competitive.
Required
What are some means of benchmarking the development and production of your new product?
E8-26. Target Costing (L03)

Oregon Equipment Company wants to develop a new log-splitting machine for rural homeowners. Market
research has detennined that the company could sell 5,000 log-splitting machines per year at a retail price of
$600 each. An independent catalog company would handle sales for an annual fee of $2,000 plus $50 per unit
sold. The cost of the raw materials required to produce the log-splitting machines amounts to $80 per unit.
Required
If company management desires a return equal to 10 percent of the final selling price, what is the target
unit cost?
E8-27. A Quality Costs Report: Manufacturing Firm C

CompTech had November sales totaling $4,200,000 and incurred the following quality-related costs:
Spoiled work-in-process inventory disposal . $23,000

Downtime due to quality problems . 44,000
Field test of new computer . 84,000
Support of a customer complaint department . 22,000
Product liability insurance . 8,000
Quality training . 12,000
Reinspection . 3,000
Rework labor and overhead . 18,000
New vendor verification and facility inspections . 28,000
Technical support provided to vendors . 4,000
Equipment inspection . 33,000
Test and inspection of purchased parts . 42,000
Warranty repairs . 15,000
Required
Prepare a quality cost report for November with appropriate classifications.
E8-28. A Quality Cost Report: Food Processor

Assume that Hormel Meat Packers incurred the following costs during July:
Livestock inspection at auction yard . $ 4,800

Livestock inspection upon delivery . 6,000
Inspector training-finished products . 2,000
Redesign of processing procedures and sequence . 10,000
Inspection and testing of packing procedure . 8,200
Product liability insurance . 4,000
Product returns . 7,400
Scrap disposal . 6,600
Downtime due to spoiled products . 12,000
Contract negotiations with large vendor . 1,500
Rework labor due to processing errors . 4,900
Sales for July totaled $4,000,000, and the company's return on investment is expected to be 15 percent for
the year on an asset base of $1 0,000,000.
Required
Prepare a quality cost report for July with appropriate classifications.
PROBLEMS
P8-29. Product Pricing: Two Products (L02)
Earthlink, Inc. (ElNK) Earthlink, Int:., provides a variety of computer-related services to its clients. Two of the many services offered
by each office are Web page design (WPD), and electronic interchange development (EID) services. Assume
that each office is expected to earn a 20 percent return on the assets invested. Earthlink has invested $5 million
in the Atlanta office since its opening. The annual costs for the coming year are expected to be as follows:
Consulting support . $600,000 $850,000

Sales and administration . 100,000 950,000
The two services expend about equal costs per hour, and the predicted hours for the coming year are 50,000
for WPD and 30,000 for EID.
Required
a. If markup is based on variable costs, how much revenue must each service generate in the Atlanta
office to provide the profit expected by corporate headquarters? What is the anticipated revenue per
hour for each service?
b. If the markup is based on total costs, how much revenue must each service generate to provide the
expected profit?
c. Explain why answers in requirements (a) and (b) are either the same or different.
d. Comment on the advantages and disadvantages of using a cost-based pricing model.
P8-30. Target Costing (L03)

Redback Networks, Redback Networks, Inc., provides networking services and related systems hardware to its customers.
Inc. (RBAK) Assume that it is developing a new networking system that small businesses can use. To attract small business
owners, Redback must keep the price low without giving up too many of the features of larger networking
systems. A marketing research study conducted on the company's behalf found that the price range must be
$25,000 to $30,000. Management has determined a target price to be $26,000. The company's minimum
profit percentage of sales is normally 20 percent, but the company is willing to reduce it to IS percent to get
the new product on the market. The fixed costs for the first year are anticipated to be $14,000,000. If sales
reach 1,200 installed networks, the company needs to know how much it can spend on variable costs, which
are primarily related to installation.
Required
a. What is the amount of total cost allowed if the 15 percent profit target is allowed and the sales target
is met? Show the amount for fixed and for variable costs.
b. What is the amount of total costs allowed if the 20 percent normal profit target is desired at the 1,200
sales target? Show the amount for fixed and for variable costs.
c. Discuss the advantages of using a target costing model versus using cost-based pricing.
P8-31. Continuous Improvement (Kaizen) Costing (L04)

Matzumi manufactures cameras. At its Pacific plant, cost control has become a concern of management. The
actual costs per unit for the years 2009 and 2010 were as follows:
2009 2010
Direct materials
Plastic case . $ 4.00 $ 3.90
Lens set . 17.00 17.20
Electrical component set . 6.00 5.40
Film track . 11.00 10.00
Direct labor . 32.00 (1.6 hours) 30.00 (1.5 hours)
Indirect manufacturing costs
Variable . 7.50 7.10
Fixed . 2.00 (100,000 1.90 (120,000
unit base) unit base)
The company manufactures all of the camera components except the lens sets, which it purchased from
several vendors. The company has used target costing in the past but has not been able to meet the very
competitive global pricing. Beginning in 2010, the company implemented a continuous improvement
program that requires cost reduction targets.
Required
a. If continuous improvement (Kaizen) costing sets a first-year target of a 10 percent reduction of the
2009 base, how successful was the company in meeting 2010 per unit cost reduction targets? Support
your answer with appropriate computations.
b. Evaluate and discuss Matlllmi 's use of Kaizen costing.
P8-32. Continuous Improvement (Kaizen) Costing (L04)

Assume that GE Capital, a division of General Electric, has been displeased with the costs of servicing its General Electric (GEl
consumer loans. Assume that it has decided to implement a Kaizen-based cost improvement program. For
2009, GE Capital incurred the following costs:
Loan processing . $14,500,000

Customer relations . 3,500,000
Printing, mailing, and postage .. 800,000
For the next two years, GE Capital expects an increase in consumer loans of 4 percent annually with related
increases in costs.
Required
a. If the company has a continuous improvement of I percent each year, develop a budget for the next
two years for the consumer loan department.
b. Identify some possible ways that GE Capital can achieve the Kaizen costing goal.
c. Discuss the potential benefits and limitations of GE's Kaizen costing model.
P8-33. Price Setting: Multiple Products (L02)
Snap Tools Company's predicted 2009 variable and fixed costs are as follows:
Manufacturing . $400,000 $260,000

Selling and administrative . 100,000 50,000
Total $500,000 $310,000
Snap Tools produces a wide variety of small tools. Per-unit manufacturing cost infonnation about one of
these products, the Type-A Clamp, is as follows:
Direct materials $ 8
Direct labor. . . . . . . . . . . . . . . . . . 7
Manufacturing overhead
Variable " . . . . . .. . 6
Fixed. .. . .. .. . . . . . . .. .. . . . 6
Total manufacturing costs . . . . .. $27
Variable selling and administrative costs for the Type-A Clamp is $3 per unit. Management has set a 2009
target profit of $150,000 on the sale of Type-A Clamps.
Required
a. Determine the markup percentage on variable costs required to earn the desired profit.
b. Use variable cost markup to determine a suggested selling price for the Type-A Clamp.
c. For the Type-A Clamp, break the markup on variable costs into separate parts for fixed costs and
profit. Explain the significance of each part.
d. Determine the markup percentage on manufacturing costs required to earn the desired profit.
e. Use the manufacturing costs markup to determine a suggested selling price for the Type-A Clamp.
.f. Evaluate the variable and the manufacturing cost approaches to determine the markup percentage.
P8-34. Price Setting: Multiple Products (L02)

Chesapeake Tackle Company produces a wide variety of commercial fishing equipment. In the past, product
managers set prices using their professional judgment. John Marlin, the new controller, bel ieves this practice
has led to the significant underpricing of some products (with lost profits) and the significant overpricing
of other products (with lost sales volume). You have been asked to assist Marlin in developing a corporate
approach to pricing. The output of your work should be a cost-based formula that can be used to develop
initial selling prices for each product. Although product managers are allowed to adjust these prices to meet
competition and to take advantage of market opportunities, they must explain such deviations in writing.
The following 2009 cost information from the accounting records is available:
Manufacturing Costs Selling and Administrative Costs
Variable . $350,000 $ 50,000

Fixed . 150,000 200,000
In 2009, Chesapeake reported earnings of $80,000. However, the controller believes that proper pricing
should produce earnings of at least $120,000 on the same sales mix and unit volume. Accordingly, you are
to use the preceding cost infOlmation and a target profit of $120,000 in developing a cost-based pricing
formula. Selling and administrative expenses are not currently associated with individual products. However,
you have obtained the following unit production cost information for the Tigershark Reel:
Variable manufacturing costs. . .. $120

Fixed manufacturing costs. . . . . . 60
Total $180
Required
a. Determine the standard markup percentage for each of the following cost bases. Round answers to
three decimal places.
1. Full costs, including fixed and variable manufacturing costs, and fixed and variable selling and
administrative costs.
2. Manufacturing costs plus variable selling and administrative costs.
3. Manufacturing costs.
4. Variable costs.
5. Variable manufacturing costs.
b. Explain why the markup percentages become progressively larger from requirement (a), parts (I)
through (5).
c. Determine the initial price of a Tigershark Reel using the manufacturing cost markup and the variable
manufacturing cost markup.
d. Do you believe the controller's approach to product pricing is reasonable? Why or why not?
A
P8-35. Predicting External Failure Costs lO
Several years ago. Intel Corporation offered to replace any Pentium processor that had a "floating-point
divide flaw" with an updated version of the Pentium processor. This offer came in response to pressure from
computer manufacturers, the communications media, and the general public. Intel's management remained
convinced, however, that the floating-point divide flaw was a minor issue that should not cause a problem
for most users. Intel estimated that the replacement of each chip would cost about $200, including service
fees. Intel sold a total of 5.3 million flawed Pentium chips before the problem was identified. The following
information is available about the response rate to product recalls:
The response rate in automobile recalls, where safety is an issue, averages 68 percent.
Sears reports that the response rate to a recall of a toaster with a safety defect might be as high as
40 percent, but it would be much lower without a safety issue.
An independent analyst predicted that 30 to 40 percent of the Pentium processors had been sold to
companies and that half of them would not ask for replacements. The analyst also estimated that
90 percent of individual consumers would not ask for a replacement because the flaw does not affect
the applications they run.
Required
Based on the preceding infolmation, develop several alternative predictions of the external failure cost of
replacing flawed Pentium processors. If you were to select one estimate, what would it be? Are there any
other external failure costs that should be considered?
P8-36. A Preparing and Analyzing Quality Cost Reports

Assume that Black & Decker Company, concerned about competitive pressures, implemented a program in
2009 to reduce inventory levels, improve productivity, improve on-time delivery of goods to customers, and
reduce customer complaints about quality. To help evaluate the success of these efforts, management requested
a quality cost report for the year ended December 31, 2009. After a detailed review of the accounting records
and several interviews with key personnel, you have developed the following data for 2009:
Sales . $5,100,000
Inspection of purchased raw materials . 60,000
Inspection of finished goods . 110,000
Rework , . 80,000
Disposal cost of spoiled goods . 30,000
Reinspection of finished goods . 12,000
Development of design-for-manufacture program . 5,000
Out-of-warranty adjustments . 50,000
Warranty adjustments . 60,000
Returns and allowances . 10,000
Indirect costs of inspection department. . 25,000
Development of quality control training programs . 9,000
Downtime due to quality problems . 210,000
Required
a. Prepare a quality control cost report with appropriate classifications.
b. Management is concerned about the success of the recently implemented program. The vice president
of finance observed, "Although sales were essentially unchanged from 2008, profits declined.
Furthermore, the decline in profits appears entirely due to increases in inspection, downtime,
rework, and similar costs. Increases in these costs far exceeded the cost savings from lower customer
complaints." Prepare a response to the concerns expressed by the vice president of finance.
P8-37. A Quality Cost Trend Analysis

The following information pertains to quality costs and total sales for Garrick Company for the years 2005
through 2009.
10 Based on Jim Carlton, "Humble Pie: Intel to Replace Its Pentium Chips." The Wall Streel Journal, December 21, 1994, pp. BI, B6
2005 2006 2007 2008 2009
Prevention ............. $ 20,000 $ 40,000 $ 25,000 $ 10,000 $ 5,000

Appraisal .............. 10,000 10,000 10,000 5,000 5,000
Internal failure ........... 50,000 55,000 40,000 20,000 10,000
External failure .......... 50,000 25,000 15,000 55,000 55,000
Sales .................. 1,000,000 1,500,000 1,500,000 1,200,000 1,000,000
Required
a. Prepare a quality cost trend analysis graph based on total dollars of quality costs in each category.
b. Prepare a quality cost trend analysis graph based on quality costs as a percent of total sales.
c. Compare the graphs prepared for requirements (a) and (b). Which is more meaningful? Why?
d. Based on the graphs, can any conclusions be made about the company's quality control program?
P8-38. A Activity-Cost Analysis: Quality Costs and Non-Value-Added Costs

Maine Manufacturing has developed the following activity cost data for its purchasing and manufacturing
activities:
Prepare purchase order and receive order . $ 35.00/order

Unpack and inspect incoming goods . 0.50/unit purchased
Move in-process goods . 2.50/unit in job
Hold in-process goods (no work being performed) . 0.50/unit in job per day
Set up machine . 50.00/machine per job
Operate machine A . 80.00/hour
Operate machine B . 50.00/hour
Perform rework . 150.00/hour
Inspect work in process or finished goods . 1.50/unit
Pack and ship finished goods . 5% of previous costs plus $25.00 per job
Maine produces only to fill customer orders. Because suppliers deliver on 24-hours' notice, it does not
maintain raw materials inventories. Materials are purchased in the required quantities as needed, unpacked
and inspected, and sent immediately to the shop floor. Finished goods are inspected, packed, and immediately
shipped to customers. The following infonnation is available for Job 91-Z24, which consisted of 20 units
of a special machine part:
Activity
Prepare purchase order 91-B34

Material M1 . 100 units $1,200 purchase price
Material J2 . 300 units 300 purchase price
Prepare purchase order 91-B35
Material N5 . 50 units $ 800 purchase price
Move materials for job to Machine A
Store at Machine A 1 day
Set up Machine A
Run Machine A. . 4 hours
Set up Machine B
Move job to Machine B
Run Machine B . 12 hours
Move job to inspection
Inspect goods . 20 units
Move job to rework station
Store at rework station . 2 days
Perform rework . 2.5 hours
Move job to inspection
Inspect reworked goods . 5 units
Move to packing and shipping
Pack and ship finished goods
Required
a. Use activity cost data to determine the total cost of Job 91-Z24. Round computations to the nearest
cent.
b. Determine the quality costs associated with Job 91-Z24. Assume that 40 percent of the costs of
unpacking and inspecting incoming goods are attributable to inspection.
c. Determine the cost of non-value-added activities associated with Job 91-Z24.
CASES
C8-39. Telephone Pole Rental Rates (L02, L03)
Most utility poles carry electric and telephone lines. In areas served by cable television, they also carry
television cables. However, cable television companies rarely own any utility poles. Instead, they pay utility
companies a rental fee for the use of each pole on a yearly basis. The determination of the rental fee is
a source of frequent disagreement between the pole owners and the cable television companies. In one
situation, pole owners were arguing for a $7 annual rental fee per pole; this was the standard rate the electric
and telephone companies charged each other for the use of poles.
"We object to that," stated the representative of the cable television company. "With two users, the $7
fee represents a rental fee for one-half the pole. This fee is too high because we only use about six inches of
each 40-foot pole."
"You are forgetting federal safety regulations," responded a representative of the electric company.
"They specify certain distances between different types of lines on a utility pole. Television cables must be
a minimum of 40 inches below power lines and 12 inches above telephone lines. If your cable is added to
the pole, the total capacity is reduced because this space cannot be used for anything else. Besides, we have
an investment in the poles; you don't. We should be entitled to a fair return on this investment. Furthermore,
speaking of fair, your company should pay the same rental fee that the telephone company pays us and we
pay them. We do not intend to change this fee."
In response, the cable television company representative made two points. First, any fee represents
incremental income to the pole owners because the cable company would pay all costs of moving existing
lines. Second, because the electric and telephone companies both strive to own the same number of poles
in a service area, their pole rental fees cancel themselves. Hence, the fee they charge each other is not
relevant.
Required
Evaluate the arguments presented by the cable television and electric company representati ves. What factors
should be considered in determining a pole rental fee?
C8·40. Target Costing (L03)

The president of Himatzi Electronics was pleased with the company's newest product, the HE Versatile CVD.
The product is portable and can be attached to a computer to play or record computer programs or sound,
attached to an amplifier to play or record music, or attached to a television to play or record TV programs. It
can even be attached to a camcorder to record videos directly on compact disks rather than on tape. It also can
be used with a headset to play or record sound. The proud president announced that this unique and innovative
product would be an important factor in reestablishing the North American consumer electronics industry.
Based on development costs and predictions of sales volume, manufacturing costs, and distribution
costs, the cost-based price of the HE Versatile CVD was determined to be $380. Following a market-
skimming strategy, management set the initial selling price at $450. The marketing plan was to reduce the
selling price by $50 during each of the first two years of the product's life to obtain the highest contribution
possible from each market segment.
The initial sales of the HE Versatile CVD were strong, and Himatzi Electronics found itself adding
second and third production shifts. Although these shifts were expensive, at a selling price of $450, the
product had ample contribution margin to remain highly profitable. The president was talking with the
company's major investors about the desirability of obtaining financing for a major plant expansion when
the bad news arrived. A foreign company had announced that it would shortly introduce a similar product
that would incorporate new design features and sell for only $250. The president was shocked. "Why," she
remarked, "it costs us $300 to put a complete unit in the hands of customers."
Required
How could the foreign competitor profitably sell a similar product for less than the manufacturing costs to
Himatzi Electronics? What advice do you have for the president concerning the HE Versatile CVD? What
advice would you have to help the company avoid similar problems in the future?
C8-41. Benchmarking (LOS)

Your company is developing a new product for the computer printer industry. You have talked to several
material vendors about being able to supply quality components for the new product. The product designers
are satisfied with the company's ability to make the product in the current facilities. Numerous potential
customers also have been surveyed, and most have indicated a willingness to buy the product if the price
is competitive.
Required
What are some means of benchmarking the development and production of your new product?
C8-42. A Electronic Scanning Errors

Law enforcement officials and the general public are concerned about errors in electronic checkout scanning
systems. Consider the following:
A survey by Vermont's attorney general found that local outlets of Ames Department Stores, Inc.,
and Mac}'s Department Slures had serious errors in their scanning systems.
Michigan's attorney general announced the detection of errors in scanning systems at Sears and
Wal-Mart stores.
An official of the Morris County New Jersey Office of Weights and Measures found many mistakes
at the checkout counter of a Bradlces, Inc., store. II
While authorities and retailers say the mistakes are the result of human error rather than fraud, experts
believe electronic scanning errors (typically caused by the failure to update price data in computers)
represent a serious problem. It most likely occurs when merchandise is placed on sale. Making the problem
worse is the fact that electronic scanning allows stores to save money by not placing a price sticker on each
item of merchandise. Some communities have responded to concerns about scanning errors by requiring
local merchants to continue attaching stickers to each item so that customers can review their bill when they
unpack their pllfchases.
Required
o. Identify some costs that merchants are likely to incur because of scanning errors.
b. Are these costs related to prevention, appraisal, internal failure, or external failure?
c. Mention several actions a merchant can take to reduce the costs identified in requirement (a).
Classify the costs of each action as prevention, appraisal, internal failure, or external failure.
C8-43. A Costs of Defective Work
The production manager and the plant controller of Nampa Limited are disagreeing on the importance and
extent of using quality cost reports as part of the normal monthly reporting operations of the Boise plant.
The Boise operations are very materials intensive, with most per-unit costs being the actual cost of the
materials used. Defective units require substantial replacement of most of the original materials.
The production manager argues that the cost of preparing the report (including major efforts to collect
the data) exceeds the benefits to be received. He argues that other than the cost of rework of defective
(nonquality) units, the other quality costs are negligible and the quality cost reports would not add anything
to the decision model that he does not already know.
The controller disagrees with this assessment of quality cost reports and presents the production
manager a list of possible categories that could be used to classify the cost of quality. However, knowing
that the production manager is not receptive to more information on quality costs, the controller is planning
to provide the manager a list of costs identified as the cost of nonquality work.
Required
Using the production manager's example of rework as a nonquality cost, assist the controller in developing
a list of nonquality costs in addition to rework.
C8-44. A Ethics and Quality of Design

In a short period of time, high concentrations of carbon monoxide in the body can cause death. Over
a long period, low concentrations can cause a variety of health problems. The U.S. Consumer Product
Safety Commission, concerned about health problems resulting from carbon monoxide, encourages all
homeowners to buy carbon monoxide detectors. The City of Chicago even passed an ordinance mandating
the installation of carbon monoxide detectors.
In accordance with Commission guidelines, First Alert, a well-known manufacturer of smoke detectors,
designed a carbon monoxide detector to warn when relatively low levels of carbon monoxide were present.
\I Based on Catherine Yank and Willy Stern, "Maybe They Should Call Them Scammers," Business Week, January 16, 1995,
pp.32-33.
First Alert had sold more than 3 million detectors at about $45 each. Most other manufacturers set their
detectors so that only life-threatening amounts of carbon monoxide would trigger an alarm. After nearly
10,000 false carbon monoxide alarms sounded within a 48-hour period, Chicago officials were so angry
that they threatened to sue First Alert. Although the false alarms were blamed on an unusual temperature
inversion that trapped auto exhausts and other pollutants near the ground, officials charged that the First
Alert detectors were too sensitive. A fire department representative in another city noted that five of six false
carbon monoxide alarms were caused by First Alert detectors.
Despite recommending an increase in the alarm threshold standard set by the Consumer Products
Safety Commission, Underwriters Laboratories. Inc., indicated that First Alert detectors warranted its
endorsement. First Alert endorsed Underwriters Laboratories' proposed standards although the Carbon
Monoxide Safety and Health Association, a manufacturers' trade group, proposed a standard with an even
higher alarm threshold.
Required
Discuss the issues management of First Alert faced in setting the design standards for its carbon monoxide
detector. What arguments can be made in favor of setting relatively low alarm thresholds and in favor of
setting relatively high alarm thresholds? Are any ethical issues involved in setting alarm standards? How
should First Alert respond to the public relations problem caused by the "false" alarms?
9
Operational Budgeting
•
and Profit Pia nl g
LEARNING OBJECTIVES
LO 1 Discuss the importance of budgets.

(p.288)
L02 Describe basic approaches to

budgeting. (p. 289)
Managers use budgeting to integrate the various components of the firm
L03 Explain the relations among elements and provide insights into the appropriate scale of operations for future
of a master budget and develop a months or years. By linking marketing, operations, and financial informa-
basic budget. (p. 293) tion, an effective budget aids managers in their planning activities.
The sales forecast is a key starting point in the budget process. Man-
L04 Explain and develop a basic agers estimate the volume of goods and/or services that customers will
manufacturing budget. (p. 301) purchase. These volumes, in turn, drive the level of activities and resulting
costs the firm will incur.
LOS Describe the relationship between To effectively forecast sales, managers must evaluate leading eco-
budget development and manager nomic indicators, potential changes in consumer preferences, and pos-
behavior. (p. 304) sible changes in competition. Macroeconomic variables such as income
levels and interest rates provide basic information for sales forecasters.
Many firms and industry segments rely on specialized economic indica-
tors that signal upcoming activity levels. The volume of corrugated boxes
is one such leading indicator.
During a recent economic expansion, corrugated box production
increased 27 percent. Known commonly as cardboard boxes, these cor-
rugated boxes lead expansionary times because manufacturers usually
increase their box orders before expanding production. Although 1,500
firms make these boxes, four firms dominate the industry: Smurfit-Stone
(With 20 percent market share), Weyerhaeuser (12 percent), International
Paper (1 0 percent), and Georgia Pacific (9 percent). Industry associations
track the volumes of corrugated boxes shipped by these firms, and man-
agers monitor this leading indicator.
286
Over time, consumers' preferences change. As a result, some product volumes soar while others slide.
One shift in consumer tastes concerned the relative demand for carbonated versus noncarbonated drinks.
Consumers have shifted their interest from carbonated soda to noncarbonated juice drinks and water, and
the latter market has grown 15 times faster than the traditional soda market. Industry estimates suggest that
water and juice drinks will make up more than 50 percent of soft-drink growth in the next 5 years. At7-Eleven
stores, two-thirds of the cooler space reserved for nonalcoholic drinks is devoted to noncarbonated juice and
bottled water. This trend impacts the budgets of bottlers of all types within the industry.
The competitive environment can also change. As one example, many nonprofit charities and civic orga-
nizations rely on Christmas tree sales as a major fund raising activity. In recent years, retailers such as Wal-
Mart, Home Depot, Target, and many supermarkets have added Christmas trees to their garden centers dur-
ing the holiday season. These stores offer expanded shopping hours and prices that often beat the nonprofit
organizations by $10-$15 per tree. Although nonprofit managers complain, retailers contend that nonprofits
have a natural advantage because of the public's appreciation for their services.
Overall, budgets benefit managers by providing insight into the impact of the inevitable adjustments
_ required as circumstances change. The budget, however, is no better than the quality of the sales forecast
upon which the budget is built. Managerial accounting helps managers with the general relations within a
budget and provides guidelines to assess the quality of the sales forecast.
Source: The Wall Street Journal, 10-K Reports.'
I Based on Kelly Greene, "Boy Scout Troops Face Stiff Competition from Big Retailers Selling Cheap Trees," The Wall Street Journal (In-
teractive Edition), December 19,2000; Carol Hymowitz, "Managers Must Adjust Quickly in Changing Economic Environment," The Wall
Street Journal (Interactive Edition) January 9, 2001; Betsy McKay, "Consumers' Appetite for Soda Is Going Flat," The Wall Street Journal
(Interactive Edition), September 19, 2000; and Dan Morse, "Sales of Corrugated Boxes Offer One Measure of Economy's Health," The
Wall Street Journal (Interactive Edition), February 12,2001.
287
288 Chapter 9 I Operational Budgeting and Profit Planning
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.. Output/Input Approach Sales Budget
• Production Budget
• Employee Participation
• Activity-Based
• Purchases Budget
• Manufacturing Cost Budgeting Periods
Approach
• Selling Expense Budget Budget Forecasts
u
•
Incremental Approach
• General and
• Ethics
Minimum Level
Approach
Administrative Expense
Budget • that
Developin\y Budgets
Work
I Outcomes Approach = Cash Budget
u Budgeted Financial
Statements
• Finalizing the BUdget
The process of projecting the operations of an organization and their financial impact into the future is
called budgeting. A budget is a formal plan of action expressed in monetary terms. The purpose of this
chapter is to examine the concepts, relationships, and procedures used in budgeting. Our emphasis is on
operating budgets, which concern the development of detailed plans to guide operations throughout the
budget period. We consider the reasons that organizations budget and alternative approaches to budget
development. We also examine budget assembly and consider issues related to manager behavior and the
budgeting process.
REASONS FOR BUDGETING

L01 Discuss Operating managers frequently regard budgeting as a time-consuming task that diverts attention from cur-
the importance of rent problems. Indeed, the development of an effective budget is a difficult job. It is also a necessary one.
budgets. Organizations that do not plan are likely to wander aimlessly and ultimately succumb to the swirl of cur-
rent events. The formal development of a budget helps to ensure both success and survival. As discussed
below, budgeting compels planning; it improves communications and coordination among organizational
elements; it provides a guide to action; and it provides a basis of performance evaluation.
Formal budgeting procedures require people to think about the future. Without the discipline of for-
mal planning procedures, busy operating managers would not find time to plan. Immediate needs would
consume all available time. Formal budgeting procedures, with specified deadlines, force managers to
plan for the future by making the completion of the budget another immediate need. Budgeting moves an
organization from an informal "reactive" style to a formal "proactive" style of management. As a result,
management and other employees spend less time solving unanticipated problems and more time on posi-
tive measures and preventative actions.
When operating responsibilities are divided, it is difficult to synchronize activities. Production must
know what marketing intends to sell. Purchasing and personnel must know the factory's material and labor
requirements. The treasurer must plan to ensure the availability of the cash to support receivables, inven-
tories, and capital expenditures. Budgeting forces the managers of these diverse functions to communicate
their plans and coordinate their activities. It helps ensure that plans are feasible (Can purchasing obtain ad-
equate inventories to support projected sales?) and that they are synchronized (Will inventory be available
in advance of an advertising campaign?). The final version of the budget emerges after an extensive (often
lengthy) process of communication and coordination. As examined in the Research Insight that follows,
recent advances in computer software allow organizations to better coordinate budget development.
Chapter 9 I Operational Budgeting and Profit Planning 289
RESEARCH INSIGHT Data Warehousing Gives Managers Control
A multi-user bUdgeting system provides shared access to a single database (data warehouse) through
which all involved in the budgeting process can access common revenue and expense definitions, use
similar layouts, use the same encoding and decoding structures, and share budget projections. This
type of budgeting system allows the budget manager more control over the process while providing
executives with better overviews. Characteristics of a good multi-user budgeting system include:
1. Support for changes to hierarchy so that different levels of bUdgets can be examined.
2. Shared access to common data warehouses.
3. Automatic mapping of imported data for use in multiple applications.
4. Numerous "what-if" functions.
This system is effective only if the data warehouse is well designed and managed. The design team
for and management of a data warehouse should include the following technical personnel who are
available to monitor and maintain the system:
1. Technical data warehouse designer (creates the database and maintains it).
2. Systems analyst/programmer (continually evaluates and creates new programs as needed).
3. End-user analyst (evaluates and monitors user needs).
4. Database administrator (creates physical database and monitors performance).
5. Technical support (maintains system integrity and reliability).
A successful data warehouse consists of a group of technologies that integrates the operational in-
formation of all budget centers into a single database. This allows managers access to the data and
gives them the ability to generate budgets to their own specifications. 2
Once the budget has been finalized, the various operating managers know what is expected of them,
and they can set about doing it. If employees do not have a guide to action, their efforts could be wasted
on unproductive or even counterproductive activities.
After employees accept the budget as a guide to action, they can be held responsible for their portion
of the budget. When results do not agree with plans, managers attempt to determine the cause of the diver-
gence. This information is then used to adjust operations or to modify plans. More generally, budgeting
is an important part of management by exception, whereby management directs attention only to those
activities not proceeding according to plan. Without the budget, management might spend an inordinate
amount of time seeking explanation of past activities and not enough time planning future activities. The.
process of developing a budgeting system could produce unexpected benefits.
GENERAL AP ROAC ES TO BUDGETING

Before an organization can develop operating budgets, management must decide which approaches to L02 Describe
budget planning will be used for the various revenue and expenditure activities and organizational units. basic approaches
Widely used planning approaches to budgeting include the input/output, activity-based, incremental, and to budgeting.
minimum level approaches.
Output! nput Approach

The output/input approach budgets physical inputs and costs as a function of planned unit-level activi-
ties. This approach is often used for service, merchandising, manufacturing, and distribution activities that
have defined relationships between effort and accomplishment. If each unit produced requires 2 pounds
of direct materials that cost $5 each, and the planned production volume is 25 units, the budgeted inputs
and costs for direct materials are 50 pounds (25 units X 2 pounds per unit) and $250 (50 pounds X $5 per
pound).
2 Guy Haddleton, "10 Rules for Selecting Budget Management Software," Managemenl Accounting. January 1998, pp. 24, 26-27;
and Marc Levine and Joel Siegel, "What the Accountant Must Know about Data Warehousing," The CPA Journal. January 2001,
pp. 37, 39-42.
The budgeted inputs are a function of the planned outputs. The output/input approach starts with the
planned outputs and works backward to budget the inputs. It is difficult to use this approach for costs that
do not respond to changes in unit-level cost drivers.
ctivity-Based Approach
The activity-based approach is a type of output/input method, but it reduces the distortions in the trans-
formation through emphasis on the expected cost of the planned activities that will be consumed for a
process, department, service, product, or other budget objective. Overhead costs are budgeted on the basis
of the cost objective's anticipated consumption of activities, not based only on some broad-based cost
driver such as direct labor hours or machine hours.
The amount of each activity cost driver used by each budget objective (for example, product or ser-
vice) is determined and multiplied by the cost per unit of the activity cost driver. The result is an estimate
of the costs of each product or service based on cost drivers such as assembly-line setup or inspections,
as well as the traditional volume-based drivers such as direct labor hours or units of direct materials
consumed. Activity-based budgeting predicts costs of budget objectives by adding all costs of the activ-
ity cost drivers that each product or service is budgeted to consume. In evaluating the proposed budget,
management would focus their attention on identifying the optimal set of activities rather than just the
output/input relationships.
Incremental Approach
The incremental approach budgets costs for a coming period as a dollar or percentage change from the
amount budgeted for (or spent during) some previous period. This approach is often used when the rela-
tionships between inputs and outputs are weak or nonexistent. For example, it is difficult to establish a
clear relationship between sales volume and advertising expenditures. Consequently, the budgeted amount
of advertising for a future period is often based on the budgeted or actual advertising expenditures in a pre-
vious period. If budgeted advertising expenditures for 2008 were $200,000, the budgeted expenditures for
2009 would be some increment, say 5 percent, above $200,000. In evaluating the proposed 2009 budget,
management would accept the $200,000 base and focus attention on justifying the increment.
The incremental approach is widely used in government and not-for-profit organizations. In seeking a
budget appropriation, a manager using the incremental approach need only justify proposed expenditures
in excess of the previous budget. The primary advantage of the incremental approach is that it simplifies
the budget process by considering only the increments in the various budget items. A major disadvantage
is that existing waste and inefficiencies could escalate year after year.
Mini u Level A roach

As the portion of non-variable costs increased for most companies throughout the twentieth century, an
increasing portion of costs was budgeted using the less precise incremental approach. This lack of good
budgetary controlled to further increases in costs. Management attempted to better control costs by em-
ploying a number of variations on the incremental approach. The minimum level approach is representa-
tive of these attempts to control the growth of costs not responding to unit-level drivers.
Using the minimum level approach, an organization establishes a base amount for budget items and
requires explanation or justification for any budgeted amount above the minimum (base). This base is
usually significantly less than the base used in the incremental approach. It likely is the minimum amount
necessary to keep a program or organizational unit viable. For example, the corporate director of product
development would need some basic amount to avoid canceling ongoing projects. Additional increments
might also be included, first to support the current level of product development and second to undertake
desirable new projects.
Some organizations, especially units of government, employ a variation of the minimum level ap-
proach, identified as zero-based budgeting. Under zero-based budgeting every dollar of expenditure
must be justified. The essence of zero-based budgeting is breaking an organizational unit's total budget
into program packages with related costs. Management then ranks all program packages on the basis of the
perceived benefits in relationship to their costs. Program packages are then funded for the budget period
using this ranking. High-ranking packages are most likely to be funded and low-ranking packages are least
likely to be funded.
Budgetingfor objectives is a variation on the minimum level approach that combines elements of ac-
tivity-based and zero-based budgeting with a need to live within fixed financial constraints. The Business
Insight that follows examines the implementation of budgeting for objectives by the city management of
Fort Collins, Colorado.
The minimum level approach improves on the incremental approach by questioning the necessity for
costs included in the base of the incremental approach, but it is very time consuming. All three approaches
are often used within the same organization. A pharmaceutical company might use the output/input or the
activity-based approach to budget distribution expenditures, the incremental approach to budget adminis-
trative salaries, and the minimum level approach to budget research and development.
BUSINESS INSIGHT Fort Collins Budgets for Outcomes
When Daren Atteberry became city manager of Fort Collins, Colorado, he was faced with declining
tax revenues and inflation in the cost of providing city services. Using an incremental approach to
budgeting that focused on budget allocations to city departments, department bUdgets had been cut
by six percent, services reduced, and employee compensation frozen for three years. Clearly it was
time for a change.
Responding to the financial mess, city officials put away the bUdget axe and adopted "Budgeting
for Objectives (BFa)." Instead of starting with the previous year's budget and justifying incremental
changes, BFa starts by asking what results matter most to citizens. The Government Finance Of-
ficers Association outlines the steps in budgeting for objectives as follows:
1. Determine how much money is available.

2. Prioritize the results.
3. Allocate resources among high priority results.
4. Conduct analysis to determine what strategies, programs, and activities will best achieve the
desired results.
5. Budget available dollars to the most significant programs and activities.
6. Set measures of annual progress, monitor, and close the feedback loop.
7. Check what actually happened.
This.'results-oriented approach considers processes and activities that cut across the city's depart-
mentalized organization structure, resulting in changes in what is done and in how objectives are ac-
complished. Evaluating this new approach, Fort Collins Mayor Doug Hutchinson observed "Previous
budget processes focused primarily on funding city departments, rather than on proViding services
to citizens. With BFa, council had an unprecedented level of involvement, setting the priorities and
identifying the outcomes that matter most to our citizens."
Source: Camille Cates Barnett and Darin Atteberry, "Your Budget: From Axe to Aim," Public Management, May
2007" pp 6-12.
MID-CHAPTER REVI,EW
To illustrate the various approaches to budgeting discussed above, assume that Alpha Company manufactures
two products, Beta and Gamma. Last period, Alpha produced 18,000 units of Beta and 45,000 units of Gamma
at a total unit cost of $38 for Beta and $32 for Gamma. During the current period, overall costs are expected to
rise about 3.5 percent over the last period. Total estimated overhead costs of $408,500 for the next period include
the cost of assembly-line setups, engineering and maintenance, and inspections. Total estimated assembly hours
is 50,000 hours; therefore, the estimated overhead cost per assembly hour is $8.) 7. Other predicted data for the
next period follow:
Beta Gamma
Direct materials (per unit) . $20.00 $14.50

Direct labor hours of assembly time (per unit) . 0.5 0.8
Assembly labor cost (per hour) . $18 $18
Total estimated production (in units) . 20,000 50,000
Total setup hours . 1,000 1,500
Total engineering and maintenance hours . 500 600
Total inspections . 650 580
Setup cost (per setup hour) , . $25 $25
Engineering and maintenance (per hour) . $35 $35
Inspection cost (per inspection) . $250 $250
Required
a. Calculate Alpha's budgeted cost per unit to produce Beta and Gamma dUling the next period, assuming
it uses an output/input approach and budgets overhead cost based only on assembly hours.
b. Repeat a., assuming Alpha uses an activity-based approach and budgets overhead cost based on
budgeted activity costs.
c. Repeat a., assuming Alpha uses an incremental approach for budgeting overhead cost.
d. Explain how the minimum level approach differs from the above methods.
Solution
a. Under the output/input approach, the output of units dictates the expected cost inputs. Here budgeted
overhead costs are based on the number of budgeted assembly hours.
Beta Gamma
Direct materials (20,000 x $20) . . . . . . . . . . . . . . . . . . . .. $400,000

(50,000 x $14.50) , . $ 725,000
Direct assembly labor (20,000 x 0.5 x $18) . . . 180,000
(50,000 x 0.8 x $18) . 720,000
Overhead (20,000 x 0.5 x $8.17)................... 81,700
(50,000 x 0.8 x $8.17) . 326,800
Total budgeted cost. . . . . . . . . . . . . . . . . . . . . . . . . . .. $661,700 $1,771,800
Unit Cost . $33.085 $35.436
b. Under the activity-based approach, budgeted overhead costs are based on expected activities to produce
the products, not only on assembly hours.
Direct materials (20,000 x $20) . $400,000

(50,000 x $14.50) . $ 725,000
Direct assembly labor (20,000 x 0.5 x $18) . 180,000
(50,000 x 0.8 x $18) . 720,000
Setup (1,000 hours x $25) . 25,000
(1,500 hours x $25) . 37,500
Engineering and Maintenance (500 hours x $35) . 17,500
(600 hours x $35) . 21,000
Inspections (650 inspections x $250) . 162,500
(580 inspections x $250) . 145,000
Total budgeted cost. . . . . . . $785,000 $1,648,500
-- --
Unit cost . $39.25 $32.97
Chapter 9 I Operational Budgeting and Pro1it Planning 293
c. Under the incremental approach to budgeting, the cost per unit would be budgeted at last period's cost,
plus an increment for expected additional costs in the current period. Based on last period's actual cost
of $38 for Beta and $32 for Gamma, and using the 3.5 percent overall expected increase in costs, the
current period's budgeted cost would be $39.33 for Beta and $33.12 for Gamma.
d. Under the minimum level approach, the company begins with either a zero or very low cost estimate,
and then requires all additional costs beyond this minimum to be justified by the production managers.
This approach forces managers to evaluate thoroughly all elements of cost each period.
MASTER BUDGET
The culmination of the budgeting process is the preparation of a master budget for the entire organization L03 Explain the
that considers all intenelationships among organization units. The master budget groups together all relations among
budgets and supporting schedules and coordinates all financial and operational activities, placing them elements of a
into an organization-wide set of budgets for a given time period. master budget
Because it explicitly considers organizational interrelationships, the master budget is more complex and develop a
than budgets developed for products, services, organization units, or specific processes. The elements of basic budget.
the master budget depend on the nature of the business, its products or services, processes and organiza-
tion, and management needs.
A major goal of developing a master budget is to ensure the smooth functioning of a business through-
out the budget period and the organization's operating cycle. As shown in Exhibit 9.1, the operating cycle
involves the conversion of cash into other assets, which are intended to produce revenues in excess of their
costs. The cycle generally follows a path from cash, to inventories, to receivables (via sales or services),
and back to cash. There are, of course, intermediate processes such as the purchase or manufacture of
inventories, payments of accounts payable, and the collection of receivables. The master budget is merely
a detailed model of the firm's operating cycle that includes all internal processes.
Operating Cycle of a Manufacturer or Merchandiser
{
Purchasing or
Collections Cash Manufaoturing
.. ....
Accounts
Inventory
Receivable
Most for-profit organizations begin the budgeting process with the development of the sales bud-
get and conclude with the development of budgeted financial statements. Exhibit 9.2 depicts the annual
budget assembly process in a retail merchandising organization. Most of the budget data flow from sales
toward cash and then toward the budgeted financial statements.
To illustrate the procedures involved in budget assembly, a monthly budget for the second quarter
of 2009 is developed for Blue Mountain Sports (BMS), a retail organization specializing in outdoor
clothing and equipment. The assembly sequence fol-

EXHIBIT 9.2 Budget Assembly for a Merchandiser
lows the overview illustrated in Exhibit 9.2. Each ele-
ment of the budget process in Exhibit 9.2 is illustrated
Sales in a separate exhibit. Because of the numerous ele-
Budget ments in the budget process illustrated for BMS, you
(Exhibit 9.4)
will find it useful to refer to Exhibit 9.2 often.
The activities of a business can be summarized un-
1 1 der three broad categories: operating activities, financ-
Purchases Selling Expense General and
ing activities, and investing activities. To simplify the
Budget Budget Administrative illustration, assume that Blue Mountain Sports engaged
(Exhibit 9.5) (Exhibit 9.6) Expense Budget in no investing activities during the budget period and
(Exhibit 9.7)
I that the only anticipated financing activity is short-term
borrowing. Normal profit-related activities performed
1 in conducting the daily affairs of an organization are
I
I
Cash Budget
(Exhibit 9.8)
I called operating activities. The operating activities of
Blue Mountain Sports include the following:
1. Purchasing inventory intended for sale.
2. Selling goods or services.
3. Purchasing and using goods and services classified
Special Budgets:
Taxes. Dividends. Capital po- as selling expenses.
Improvements, etc. 4. Purchasing and using goods and services classified
as general and administrative expenses.
In addition to preparing the budget for each operat-
Pro Forma Statements: ing activity, companies prepare a C<}sh budget for cash
Income Statement receipts and disbursements related to their operating ac-
(Exhibit 9.9) and
tivities as well as for financing and investing activities.
Balance Sheet
(Exhibit 9.10) The importance of cash planning makes this budget a
vital part of the total budget process. Management must,
for example, be aware in advance of the need to borrow
and have some idea when borrowed funds
can be repaid.
EXHIBIT 9.3 Initial Balance Sheet
The balance sheet for April 1, 2009,
BLUE MOUNTAIN SPORTS the start of the second quarter, is presented
Balance Sheet in Exhibit 9.3. It contains information used
April 1, 2009 as a starting point in preparing the various
Assets budgets. To reduce complexity, we use
Current assets the output/input approach to budget vari-
Cash . $ 15,000 able costs and assume that the budgets for
Accounts receivable, net . 59,200 other costs were previously developed us-
Merchandise Inventory . 157,000 $231,200
ing the incremental approach. Budgets to
Fixed assets be prepared include those for sales, pur-
Buildings and equipment . $460,000 chases, selling expense, general and ad-
Less accumulated depreciation . (124,800) 335,200
ministrative expense, and cash.
Land . 60,000 395,200
Total assets . $626,400
Sa'es Budget
Liabilities and Stockholders' Equity
Current liabilities The sales budget includes a forecast of
Accounts payable . $ 84,000 sales revenue, and it can also contain a
Taxes payable' . 35,000 $119,000 forecast of unit sales and sales collec-
Stockholders' equity tions. Because sales drive almost all
Capital stock . 350,000 other activities in a for-profit organiza-
Retained earnings . 157,400 507,400 tion, developing a sales budget is the
Total liabilities and stockholders' equity . $626,400 starting point in the budgeting process.
Managers use the best available informa-
'Quarterly income taxes are paid within 30 days of the end of each quarter. tion to accurately forecast future market
conditions. These forecasts, when considered along with merchandise available, promotion and advertis-
ing plans, and expected pricing policies, should lead to the most dependable sales budget. The sales budget
of BMS is in Exhibit 9.4.
EXHIBIT 9.4 sales Budget
BLUE MOUNTAIN SPORTS

Sales Budget
For the Second Quarter Ending June 30, 2009
April May June Quarter Total July
Sales. . . . . . . . . . . . . . . . . . . . . . . .. $190,000 $228,000 $250,000 $668,000 $309,000
The information in the sales budget along with predictions of the expected portion of cash sales and
the timing of collections from credit sales are used to calculate cash receipts. In the event of a projected
cash shortfall, management could consider ways to increase cash sales or to accelerate the collection of
receipts from credit sales.
Pur hases Budget

The purchases budget indicates the merchandise that must be acquired to meet sales needs and ending
inventory requirements. It can be referred to as a merchandise budget if it contains only purchases of mer-
chandise for sale. However, for a manufacturer it would include purchase of raw materials. The purchases
budget, shown in Exhibit 9.5, includes only purchases of merchandise.
EXHIBIT 9.5 Purchases BUdget

Purchases BUdget
Budgeted sales (Exhibit 9.4) ...... $190,000 $228,000 $250,000 $668,000 $309,000
Current cost of goods sold' ...... $114,000 $136,800 $150,000 $400,800

Desired ending inventory" ....... 168,400 175,000 192,700 192,700
Total needs ................... 282,400 311,800 342,700 593,500
Less beginning inventory.......... (157,000) (168,400) (175,000) (157,000)
Purchases ........ " .......... $125,400 $143,400 $167,700 $436,500
'Cost of goods sold is 60 percent of selling price

"Fifty percent of inventory required for next month's budgeted sales plus base inventory of $100,000.
April: ($228,000 May sales x 0.60 cost x 0.50 desired ending inventory) + $100,000
May: ($250,000 June sales x 0.60 cost x 0.50 desired ending inventory) + $100,000
June :($309,000 July sales x 0.60 cost x 0.50 desired ending inventory) + $100,000
"'Fifty percent of current month sales plus base inventory of $100,000. Note monthly beginning inventory.
Same as previous month's ending inventory.
In reviewing BMS's purchases budget, note the following:
Because BMS sells a wide variety of items, the purchases budget is expressed in terms of sales
dollars, with the cost of merchandise averaging 60 percent of the selling price. Management also
keeps detailed records for budgeting the number of units of items carried. An organization that only
sold a small number of items might present the sales budget in units as well as dollars.
Management desires to have 50 percent of the inventory needed to fill the following month's sales
in stock at the end of the previous month.
To provide for a possible delay in the receipt of inventory and to meet variations in customer
demand, BMS maintains an additional base inventory of $100,000.
The total inventory needs equal current sales plus desired ending inventory, including the base
inventory.
Budgeted purchases are computed as total inventory needs less the beginning inventory.
The information in the purchases budget and the information on expected timing of payments for
purchases are used to budget cash disbursements for purchases. In the event of a projected cash short-
fall, management can consider ways to delay the purchase of inventory or the payment for inventory
purchases.
Semng Expense ulj1g._

The selling expense budget presents the expenses the organization plans to incur in connection with
sales and distribution. In the selling expense budget, Exhibit 9.6, the budgeted variable selling expenses
are determined as a percentage of budgeted sales dollars. The budgeted fixed selling expenses are based
on amounts obtained from the manager of the sales department. To simplify the presentation of the cash
budget, assume BMS pays its selling expenses in the month they are incurred.
EXHIBIT 9.6 Selling Expense Budget

Selling Expense Budget
April May June Quarter Total

--
Budgeted sales (Exhibit 9.4)........................ $190,000 $228,000 $250,000 $668,000
I
Variable selling expenses

Setup/Display (1 % sales) ........................ $ 1,900 $ 2,280 $ 2,500 $ 6,680
Commissions (2% sales) ........................ 3,800 4,560 5,000 13,360
Miscellaneous (1 % sales) ........................ 1,900 2,280 2,500 6,680
Total ........................................ 7,600 9,120 10,000 26,720
--
Fixed selling expenses
Advertising ................................... 2,250 2,250 2,250 6,750
Office ....................................... 1,250 1,250 1,250 3,750
Miscellaneous ................................. 1,000 1,000 1,000 3,000
Total ........................................ 4,500 4,500 4,500 13,500
Total selling expenses ............................ $ 12,100 $ 13,620 $ 14,500 $ 40,220
General n A rI"", i n i strative ense dge

The general and administrative expense budget presents the expenses the organization plans to incur in
connection with the general administration of the organization. Included are expenses for the accounting
department, the computer center, and the president's office, for example. Blue Mountain's general and
administrative expense budget is presented in Exhibit 9.7.
The depreciation of $2,000 per month is a noncash item and is not carried forward to the cash bud-
get. No variable general and administrative costs are included because most expenditures categorized as
general and administrative are related to top-management operations that do not vary with unit-level cost
drivers. To simplify the presentation of the cash budget, assume that general and administrative expenses,
except depreciation, are paid in the month they are incurred.
EXHIBIT 9.7 General and Administrative Expense Budget

General and Administrative Expense BUdget
General and administrative expenses

Compensation . $25,000 $25,000 $25,000 $75,000
Insurance . 2,000 2,000 2,000 6,000
Depreciation . 2,000 2,000 2,000 6,000
Utilities . 3,000 3,000 3,000 9,000
Miscellaneous . 1,000 1,000 1,000 3,000
Total general and administrative expenses . $33,000 $33,000 $33,000 $99,000
Ca get
The cash budget summarizes all cash receipts and disbursements expected to occur during the budget
period. Cash is critical to survival. Income is like food and cash is like water. Food is necessary to survive
and prosper over time, but you can get along without food for a short period of time. You cannot survive
very long without water. Hence, cash budgeting is very important, especially in a small business, such as
the one considered in tfie following Business Insight.
BUSINESS INSIGHT Going Broke Getting Rich
Frank used his own cash plus some borrowed from his bank to start a business. In the first two years,
Frank's company showed a small operating loss that he considered acceptable. In the third year, it
showed a profit of more than $100,000. Frank thought this was great until the accountant told him that
the company did not have enough cash to pay income taxes. Frank did not believe his accountant
until the differences between income and cash flow were explained and the accountant showed him
a cash flow statement for his business. Because income is not the same as cash inflow, cash budgets
are critical to all businesses, especially small ones. Managers who do not understand cash flow can
really have problems, even when profits are evident. Cash can be tied up in inventory purchased in
anticipation of sales growth. When sales are on account, additional cash is tied up in receivables
rather than being available to pay bills. Worse, the money Frank borrowed to start the business might
come due just as the business starts to turn a profit. Managers must understand the operating cycle
and relationship between income and cash flows. For Frank, a cash bUdget would show the cash
generated by operations, the cash outflow needed for paying back his loan, and the amount of cash
tied up in inventory and receivables. 3
After it makes sales predictions, an organization uses information regarding credit terms, collections
policy, and prior collection experience to develop a cash collections budget. Collections on sales normally
include receipts from the current period's sales and collections from sales of prior periods. An allowance
for bad debts, which reduces each period's collections, is also predicted. Other items often included are
cash sales, sales discounts, allowances for volume discounts, and seasonal changes of sales prices and col-
lections. BMS's cash budget is in Exhibit 9.8. Note the following important points:
Management estimates that one-half of all sales are for cash and the other half are on the company's
credit card. (When sales are on bank credit cards, the collection is immediate, less any bank user
fee; however, charges using Blue Mountain's credit card are collected by the company from the
customer.) Twenty-five percent of the credit card sales are collected in the month of sale, and 74
3 Gary Gibbs, "Managing Cash Flow: A Constant Business Challenge," Wichita Business Journal. December 1997, pp. 8b-14b.
298 Chapter 9 I Operational BUdgeting and Profit Planning
EXHIBIT 9.8 Cash Budget

Cash Budget
Budgeted sales (Exhibit 9.4) . $190,000 $228,000 $250,000 $668,000
Cash balance, beginning . $ 15,000 $ 15,770 $ 44,850 $ 15,000

Collections on sales
Cash sales (50% sales) . 95,000 114,000 125,000
creon safes
Current month (25% credit sales) . 23,750 28,500 31,250
Prior month (74% credit sales) . 59,200- 70,300 84,360
-- ---
Total . 177,950 212,800 240,610 631,360
-- ---
Cash available for operations . 192,950 228,570 285,460 646,360
Disbursements
Purchases (Exhibit 9.5)
Current month (20% purchases) . 25,080 28,680 33,540
Prior month (80% purchases) ................•... 84,000" 100,320 114,720
--
Total. . 109,080 129.000 148,260 386,340
Selling expenses (Exhibit 9.7) . 12,100 13,620 14,500 40,220
General & Administrative Expenses
(Exhibit 9.7, excluding depreciation) . 31,000 31,000 31,000 93,000
Taxes (Exhibit 9.3) . 35,000 35,000
--
Total . (187,180) (173,620) (193,760) (554,560)
Excess (deficiency) cash available over disbursements . 5,770 54,950 91,700 91,800
Short-term financing'"
New loans , . 10,000 10,000
Repayments . (10,000) (10,000)
Interest . (100) - (100)
-
Net cash from financing . 10,000 (10,100) - (100)
Cash balance, ending . $ 15,770 $ 44,850 $ 91,700 $ 91,700
'April 1 accounts receivable.

'-April 1 accounts payable.
"'Loans are obtained in $1,000 increments at the start of the month to maintain a minimum balance of $15,000 at all times.
Repayments are made at the end of the month, as soon as adequate cash is available. Interest of 12 percent per year (1 percent per
month) is paid when the loan is repaid.
percent are collected in the following month. Bad debts are budgeted at I percent of credit sales.
This resource flow is graphically illustrated as follows:
Sales < 50 percent cash
50 percent credit
-E25 percent collected in current month
74 percent collected in next month
1 percent uncollected
Payments for purchases are made 20 percent in the month purchased and 80 percent in the next
month.
Information on cash expenditures for selling expenses and for general and administrative expenses
is based on budgets for these items. The monthly cash expenditures for general and administrative
expenses are $31,000 rather than $33,000. The $2,000 difference relates to depreciation, which does
not require use of cash.
Blue Mountain's accountant provided tax information. Income taxes are determined on the basis of
predicted taxable income following IRS rules. Estimated tax payments are made during the month
following the end of each quarter. Hence, the taxes payable on April 1 are paid during April.
Chapter 9 I Operational Budgeting and Profrt Planning 299
The cash budget shows cash operating deficiencies and surpluses expected to occur at the end of
each month; this is used to plan for borrowing and loan payment.
The cash maintenance policy for Blue Mountain specifies that a minimum balance of $15,000 is to
be maintained.
BMS has a line of credit with a bank, with any interest on borrowed funds computed at the simple
interest rate of 12.0 percent per year, or 1.0 percent per month. All necessary borrowing is assumed
to occur at the start of each month in increments of $1,000. Repayments are assumed to occur at the
end of the month. Interest is paid when loans are repaid.
The cash budget indicates Blue Mountain needs to borrow $10,000 in April. The $10,000 plus
interest is repaid in May.
If Blue Mountain had any cash disbursements for dividends or capital expenditures they would be
included in the cash budget. These items, along with information on income taxes, would be shown in
special budgets.
B .dgete Fi ancia St temen s

The preparation of the master budget culminates in the preparation of budgeted financial statements.
Budgeted financial statements are pro forma statements that reflect the "as-if' effects of the budgeted
activities on the actual financial position of the organization. That is, the statements reflect the results of
operations assuming all budget predictions are correct. Spreadsheets that permit the user to immediately
determine the impact of any assumed changes facilitate developing budgeted financial statements. The
budgeted income statement can follow the functional format traditionally used for financial accounting
or the contribution format introduced in Chapter 3. In either case, the balance sheet amounts reflect the
corresponding budgeted entries.
Exhibit 9.9 presents the budgeted income statement for the quarter ending June 30, 2009. If all predic-
tions made in the operating budget are correct, BMS will produce a net income of $51,540 for the quarter.
Almost every item on the budgeted income statement comes from one of the budget schedules.
EXHIBIT 9.9 Budgeted Income statement

Budgeted Income Statement
Sales (EXhibit 9.4) . $668,000

Cost of goods sold:'
Beginning inventory (Exhibit 9.3) . $157,000
Purchases (Exhibit 9.5) . 436,500
Cost of merchandise available . 593,500
Ending inventory (Exhibit 9.5) . (192,700) (400,800)
Gross profit. . 267,200
Other expenses: .
Bad debt (1 % of credit sales)" . 3,340
Selling (Exhibit 9.6) . 40,220
General and administrative (Exhibit 9.7) . 99,000 (142,560)
Income from operations . 124,640
Interest expense (Exhibit 9.8) . (100)
Net income from operations . 124,540
Allowance for income taxes'" . (73,000)
'Also computed at sales x 0.6

"$668,000 x 0.5 credit sales x 0.01 bad debts
•"Provided by accounting
The budgeted balance sheet, presented in Exhibit 9.10 shows Blue Mountain's financial position as
of June 30, 2009, assuming that all budget predictions are correct. Sources of the budgeted balance sheet
data are included as part of the exhibit.
EXHIBIT 9.10 Budgeted Balance Sheet

Balance Sheet
June 30, 2009
Assets:
Current assets
Cash (Exhibit 9.8) . $ 91,700
Accounts receivable, net" . 92,500
Merchandise inventory (Exhibit 9.5 and 9.9) . 192,700 $376,900
Fixed assets
Buildings and equipment (Exhibit 9.3) . $460,000
Less accumulated depreciation
(Exhibit 9.3 plus depreciation Exhibit 9.7) . (130,800) 329,200
Land (Exhibit 9.3) . 60,000 389,200
Total assets . $766,100
Liabilities and Stockholders' Equity

Current liabilities
Accounts payable" . $134,160
Taxes payable (Exhibit 9.9) . 73,000 $207,160
Stockholders' equity
Capital stock (Exhibit 9.3) . 350,000
Retained earnings (Exhibit 9.3 plus net income Exhibit 9.9) .. 208,940 558,940
Total liabilities and stockholders' equity . $766,100
"June credit sales collected in July, $250,000 x 0.50 x 0.74.

"June purchases paid in July, $167,700 x 0.80.
Finalizing Budae
After studying the BMS example, you might conclude that developing the master budget is a mechanical
process. That is not the case. Understanding the basics of budget assembly is not the end; it is a tool to
assist in efficient and effective budgeting. Before finalizing the budget, the following two questions must
be addressed:
Is the proposed budget feasible?

Is the proposed budget acceptable?
To be feasible, the organization must be able to actually implement the proposed budget. Without
the line of credit, Blue Mountain's budget is not feasible because the company would run out of cash
sometime in April. Knowing this, management can take timely corrective action. Possible actions in-
clude obtaining equity financing, issuing long-term debt, reducing the amount of inventory on hand
at the end of each quarter, or obtaining a line of credit. Other constraints that would make the budget
infeasible include the availability of merchandise and, in the case of a manufacturing organization,
production capacity.
Once management determines that the budget is feasible, they still need to determine if it is accept-
able. To evaluate acceptability, management might consider various financial ratios, such as return on
assets. They might compare the return provided by the proposed budget with past returns, industry aver-
ages, or some organizational goal.
BUDGET DEVELOPMENT IN MANUFACTURING

ORGANIZATIONS
The importance of inventory in various organizations was introduced in Chapter 5 where Exhibit 5.1 L04 Explain and
(page 131) summarized inventory and related expense accounts for service, merchandising, and manu- develop a basic
facturing organizations. Recall that service organizations usually have a low percentage of their assets manufacturing
invested in inventory, usually consisting of the supplies needed to facilitate operations. In contrast, mer- cost budget.
chandising organizations usually have a high percentage of their total assets invested in inventory, with
the largest inventory investment in merchandise purchased for resale. The preceding illustration of the
development of a master budget was for a merchandising organization.
Pr duct' n B 9 t
Because manufacturing organizations convert raw materials into finished goods that are sold to custom-
ers, there are additional steps in developing their master budget. Contrast the assembly of a budget for a
merchandiser in Exhibit 9.2 with the assembly of a budget for a manufacturer in Exhibit 9.11. The man-
agement of a manufacturing organization must determine the production volume required to support sales
and finished goods ending inventory requirements (production budget). Then, based on available inven-
tories or raw materials and the raw materials required for production, management develops a purchases
budget.
EXHIBIT 9.11 Budget Assembly for a Manufacturer _ , ---1
Sales
Budget
(units and dollars)
! 1
-
Production Selling General and
Budget Expense Administrative
(units) Budget Expense Budget
I I
!
Purchases Budget
(units and dollars)
I [ Manufacturing cost budget
(materials, labor, overhead)
1 iI
I
Cash Budget
J
Special Budgets:
Taxes, Dividends,
Capital Improvements, etc.
I Pro Forma Statements; Income

I Statement and Balance Sheet
'I--- I
a fa ri 9 d t
In addition to a selling expense budget and a general and administrative expense budget, management
needs also to develop a manufacturing cost budget, which is similar in design to a statement of cost of
goods manufactured (see Exhibit 5.6, page 143) except that it is prepared in advance of production rather
than after production. Reflecting these additional steps, the cash budget includes payments for direct
labor and manufacturing overhead, based on information in the manufacturing cost budget, and payments
for purchases of raw materials based on the purchases budget. Note cash disbursements are for materials
purchased rather than materials used in production.
Continuing our Blue Mountain Sports example, assume that management is considering the option of
manufacturing a high-quality backpack, tentatively named the "Trekpack" as an alternative to purchasing
a similar item from an outside vendor. Unit variable and monthly fixed cost estimates associated with the
manufacture of Trekpacks follow:
Unit costs:
Direct materials:
Fabric: 2 square years at $10 per yard . $20
Hardware kits (buckles, straps, etc.) . 5 $ 25
Direct labor 0.5 hours at $30 per hour . 15
Variable overhead, per unit . 8
Total variable costs per unit . ~
Fixed costs per month (rent, utilities, supervision) ........•......... $6,000
Because management anticipates an average monthly production volume of 500 Trekpacks, the average
fixed cost per unit, a predetermined overhead rate, is $12 ($6,000/500).
For budgeting purposes, management uses a standard cost, a budget per unit of product, for valuing
inventories and forecasting the cost of goods sold. The standard cost of a Trekpack is $60:
Direct materials $25

Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Fixed overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Standard cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60
Management, planning to introduce this new product in May, developed the sales budget shown in
Exhibit 9.12. In this case, because unit information is necessary to determine production requirements, the
sales budget is expressed in units as well as dollars.
EXHIBIT 9.12 sales Budget

Sales Budget (Trekpacks)
Sales - Units . o 400

- 500 900 600
-
----
- -----
Sales - Dollars ($100 each) . o $40,000 $50,000 $90,000 $60,000
Introducing Trekpacks in May requires some April production. To meet the initial sales requirement
for the start of each month, management desires end-of-month inventories equal to 40 percent of the fol-
lowing month's budgeted sales. The sales budget and ending inventory plans, along with information on
beginning inventories, is used to develop the production budget in Exhibit 9.13.
The production budget, along with information on beginning inventories of raw materials and
planned ending inventory levels (500 square yards of fabric and 200 kits) is then used to budget the
purchases in Exhibit 9.14 for raw materials in units and dollars. The production budget, along with
EXHIBIT 9.13 Production Budget

Production Budget (Trekpacks)
Budgeted Sales .................................... 0 400 500 900

Desired ending inventory
40% following month sales ........................... 160 200 240 240
- - -
Total requirements .................................. 160 600 740 1,140
Less beginning inventory ............................. 0 (160) (200) 0
Budgeted production ................................ 160 440 540 1,140
standard variable and predicted fixed cost information is also used to develop the manufacturing cost
budget in Exhibit 9.15.
EXHIBIT 9.14 Purchase Budget

Purchases Budget
Fabric:
Current needs (2 yards per unit) .................. 320 880 1,080 2,280
Desired ending inventory (500 yards) .............. 500 500 500 500
--- ---
Total requirements ............................. 820 1,380 1,580 2,780
Less beginning inventory ........................ -0 -500 -500 -0
---
Fabric purchases in yards ..................... 820 880 1,080 2,780
Assembly kits:
Current needs (1 per unit) ....................... 160 440 540 1,140
Desired ending inventory (200 kits) ................ 200 200 200 200
Total requirements ............................. 360 640 740 1,340
Less beginning inventory ........................ -0 -200 -200 -0
---
Kit purchases in units........................... 360 440 540 ~
Purchases (Dollars)
Fabric at $1 0 per yard .......................... $ 8,200 $ 8,800 $10,800 $27,800
Kits at $5 each ................................ 1,800 2,200 2,700 6,700
--- --- --- ---
Total purchases in dollars .......................... $10,000 $11,000 $13,500 $34,500
Because it does not require the introduction of new concepts, the cash budget and the pro-forma
financial statements for Blue Mountain Spons with the manufacturing of Trekpacks are not presented.
Keep in mind that the cash budget will include disbursements for purchases shown in Exhibit 9.14 and
for direct labor, variable overhead, and fixed overhead shown in Exhibit 9.15. A pro-forma functional
income statement using absorption costing will include the predicted cost of goods sold for Trekpacks at a
$60 standard cost per unit. A contribution income statement using variable costing would include the cost
of goods sold for Trekpacks at a $48 standard cost per unit with all fixed manufacturing costs expensed
in the period incurred. Finally, the pro-forma balance sheet will include standard costs of any June raw
EXHIBIT 9.15 Manufacturing Cost Budget

Manufacturing Cost Budget
Direct materials
Fabric used in production (production x 2 yards x $10) ... $ 3,200 $ 8,800 $10,800 $22,800
Kits used in production (production x 1 kit x $5) ......... 800 2,200 2,700 5,700
--- --- --- ---
Total ............................................ 4,000 11,000 13,500 28,500
Direct labor (production x 1/2 hour x $30) ................ 2,400 6,600 8,100 17,100
Manufacturing overhead
Variable ($8 per unit) ............................... 1,280 3,520 4,320 9,120
Fixed ........................................... 6,000 6,000 6,000 18,000
--- --- --- ---
Total ............................................ 7,280 9,520 10,320 27,120
--- --- ---
Total manufacturing costs ............................. $13,680 $27,120 $31,920 $72,720
materials (500 square yards at $10 per yard and 200 kits at $5 each), work in process (none), and finished
goods. Any unpaid liabilities for purchases of raw materials, direct labor, and manufacturing overhead
would also be shown under current liabilities. Note that completing the cash budget and the pro-forma
statements requires information on the timing of payments for the purchases of raw materials, direct labor,
and manufacturing overhead.
BUDGET DEVELOPMENT AND MANAGER

BEHAVIOR
LOS Describe Organizations are composed of individuals who perform a wide variety of activities in pursuit of the
the relationship organization's goals. To accomplish these goals, management must recognize the effects that budgeting
between budget and performance evaluation methods have on the behavior of the organization's employees.
development and
manager behavior.
Em yee Pariric;patio
Budgeting should be used to promote productive employee behavior directed toward meeting the organi-
zation's goals. While no two organizations use exactly the same budgeting procedures, two approaches to
employee involvement in budgeting represent possible end points on a continuum. These approaches are
sometimes referred to as top-down and bottom-up methods.
With a top-down or imposed budget, top management identifies the primary goals and objectives for
the organization and communicates them to lower management levels. Because relatively few people are
involved in top-down budgeting, an imposed budget saves time. It also minimizes the slack that manag-
ers at lower organizational levels are sometimes prone to build into their budgets. However, this nonpar-
ticipative approach to budgeting can have undesirable motivational consequences. Personnel who do not
participate in budget preparation might lack a commitment to achieve their part of the budget.
With a bottom-up or participative budget, managers at all levels-and in some cases, even nonman-
agers-are involved in budget preparation. Budget proposals originate at the lowest level of management
possible and are then integrated into the proposals for the next level, and so on, until the proposals reach
the top level of management, which completes the budget.
Participation helps ensure that important issues are considered and that employees understand the
importance of their roles in meeting the organization's goals. It also provides opportunities for problem
solving and fosters employee commitment to agreed-upon goals. Hence, budget predictions are likely to
be more accurate, and the people responsible for the budget are more likely to strive to accomplish its
objectives. These self-imposed budgets reinforce the concept of participative management and should
strengthen the overall budgeting process.
Budgetary Slack May Provide Flexibility for Innovation

BUSINESS INSIGHT
and Improve Control in Unstructured Environments
When one of the authors became responsible for budgeting and financial control of a business
school, department budgets were developed using the incremental approach. There were two major
problems. First, there was inadequate information on the activities and programs financed by col-
lege funds. Second, department heads with budget authority frequently requested additional funds
for special projects and overspent their budget, causing the college to dip into discretionary funds
contributed by alumni and friends.
Practicing what is taught in this book, the author implemented different approaches to budget-
ing different costs. For example average salary increases were budgeted on an incremental basis,
instructional supplies and photocopying were budgeted using the output/input approach, and vari-
ous student and alumni events were budgeted per event using budgeting for objectives. Funds were
then allocated to the budget of the department responsible for the activity or event. This approach
demystified the bUdgeting process and allowed personnel to understand what was accomplished
with college's funds.
The availability of dollars in regular budgets almost always expires at the end of the budget year,
leading managers to spend all of their funds, and even a bit more. To provide flexibility for department
managers to undertake new initiatives during the year, each department was provided an additional
budget allocation, funded by college alumni and friends for unspecified discretionary items. If the
manager spent more than the regular budget, the overspending would be taken from the allocated
discretionary funds. If the manager spent less than the regular budget plus the allocated discretionary
funds, the unspent discretionary funds were carried forward to the following year.
The availability of the discretionary funds reduced the tendency of managers to make special
requests throughout the year. Interestingly, department managers saw the discretionary funds as a
savings account that they were reluctant to spend without good reason. The result was a significant
decline in overspending of the regular budget.
Participative approaches to budgeting have a few disadvantages. Because they require the involve-
ment of many people, the preparation period is longer than that for an imposed budget. Another disad-
vantage is the tendency of some managers to intentionally understate revenues or overstate expenses to
provide budgetary slack. A manager might do this to reduce his or her concern regarding unfavorable
performance reviews or to make it easier to obtain favorable performance reviews. If a department consis-
tently produces favorable variances (actual results versus budget) with little apparent effort, this might be
a symptom of budgetary slack. On the other hand, as discussed in the preceding Business Insight, budget-
ary slack can produce favorable results under certain circumstances.
'. . • You are the Chief Financial Officer
As the CFO of a relatively new and fast-growing entrepreneurial enterprise, you and the other top
managers have previously emphasized technical and marketing innovation and creativity over plan-
ning and budgeting. But now with growing competition and the maturing of the company's products,
you recognized that a culture of better financial planning must be established if the company is to
succeed in the long run. You feel that the financial staff have the best expertise and understanding of
the business to prepare effective budgets, but you are concerned about the motivational effects of
excluding the lower-level managers from the process and are seeking advice. [Answer, p. 313]
udgeting Periods
Although most organizations use a one-year budget period, some organizations budget for shorter or
longer periods. In addition to fixed-length budget periods, two other types of budget periods commonly
used are life cycle budgeting and continuous budgeting.
When a fixed time period is not particularly relevant to planning, an organization can use life cycle
budgeting, which involves developing a budget for a project's entire life. An ice cream vendor at the
beach might develop a budget for the season. A general contractor might budget costs for the entire (mul-
tiple-year) time required to construct a building.
Under continuous budgeting, the budget (sometimes called a rolling budget) is based on a moving
time frame. For example, an organization on a continuous four-quarter budget system adds a quarter to the
budget at the end of each quarter of operations, thereby always maintaining a budget for four quarters into
the future. Under this system, plans for a full year into the future are always available, whereas under a
fixed annual budget, operating plans for a full year ahead are available only at the beginning of the budget
year. Because managers are constantly involved in this type of budgeting, the budget process becomes an
active and integral part of the management process. Managers are forced to be future oriented throughout
the year rather than just once each year.
Forecasts
Budget preparation requires the development of a variety of forecasts. The sales forecast is based on a
variety of interrelated factors such as histOlical trends, product innovation, general economic conditions,
industry conditions, and the organization's strategic position for competing on the basis of price, product
differentiation, or market niche. Many organizations first determine the industry forecast for a given prod-
uct or service and then extract from it their sales estimations.
Although the sales forecast is primary to most organizations, there are many other forecasts of varying
importance that must be made, including (a) the collection period for sales on account, (b) percent of uncol-
lectable sales on account, (c) cost of materials, supplies, utilities, and so forth, (d) employee turnover, (e) time
required to perform activities, (f) interest rates, and (g) development time for new products or services.
thics
Because most wrongful activities related to budgeting are unethical, rather than illegal, organizations of-
ten have difficulty dealing with them. However, when managers' actions cross the gray area between ethi-
cal and fraudulent behavior, organizations are not reluctant to dismiss employees or even pursue legal ac-
tions against them. 4
Although most managers have a natural inclination to be conservative in developing their budgets, at
some level the blatant padding or building slack into the budget becomes unethical. In an extreme case,
it might even be considered theft if an inordinate level of budgetary slack creates favorable performance
variances that lead to significant bonuses or other financial gain for the manager. Another form of falsify-
ing budgets occurs when managers include expense categories in their budgets that are not needed in their
operations and subsequently use the funds to pad other budget categories. The deliberate falsification of
budgets is unethical behavior and is grounds for dismissal in most organizations.
Ethical issues might also arise in the reporting of performance results, which usually compares actual
data with budgeted data. Examples of unethical reporting of actual performance data include misclas-
sification of expenses, overstating revenues or understating expenses, postponing or accelerating the re-
cording of activities at the end of the accounting period, or creating fictitious activities. The views of the
former CEO of Phillips Petroleum on this type of behavior and the competitive environment from which
it is often motivated are summarized in the following Business Insight.
Developing Budgets that Work

It is important for management to understand that budgets are not perfect. Mistakes in prediction and
judgment are made, and unforeseen circumstances often develop, necessitating modification of the bud-
get. Unless top management is willing to recognize that changes in the budget are needed, support for
the budget at lower levels will quickly erode. If an organization is to receive maximum benefit from the
budget process, support for the budget at the top management level, as well as at lower levels, must be
maintained. Achieving this support could be the most difficult challenge facing an organization undertak-
ing budgeting for the first time. Lower-level managers are not likely to respect the budget and the related
performance reports if they perceive a lack of commitment by top management. Disregard for the budget
by top management can quickly destroy the effectiveness of the budget throughout the organization.
4 Fraud Sur"ey Resu!rs 1993, (New York: KPMG Peat Marwick, 1993).
BUSINESS INSIGHT The Heart of Every Decision
The retired CEO of Phillips Petroleum stated, "What we are all called upon to do, whatever profes-
sional field we have chosen, is to make ethics the heart of every decision we make, from boardroom
to the mailroom." He cites several examples of managers making the wrong decisions, one involving
a budget-related situation. Specifically, a plant manager at a glass container plant, inflated the results
of operations, not slightly, but by 33 percent over actual levels. When the plant manager confessed
to his wrongdoings, he stated that the actual results were so unfavorable that he "was afraid the
company would close the aging plant, throwing [him] and 300 employees out of work." The former
CEO admitted, "It's a lot harder to resist temptation when honesty and integrity could mean the end
of your job, your company, even your town." Still, he says that organizations must establish policies
of operations that do not cause direct conflicts with managers' decisions, a concept he labeled "the
moral dimension of competitiveness." An example is an executive order to a manager to cut costs but
not to cut customer satisfaction. Organizations should provide guidelines and expectations of ac-
tions, not blatant orders for which the means and goals seem to conflicts
Managers who follow the suggestions listed here are more likely to be successful in using budgets as
a positive motivational tool for accomplishing organizational goals through people.
1. Emphasize the importance of budgeting as a planning device.

2. Encourage wide participation in budget preparation at all levels.
3. Demonstrate that the budget has the complete support of top management.
4. Recognize that the budget is alterable; modifications may be required if conditions change.
5. Use budget performance reports to identify poor performers and to recognize good performance.
6. Conduct budget training to provide managers information about the purposes of budgets and to
dispel any erroneous misconceptions.
Properly used, an operating budget is an effective mechanism for motivating employees to higher lev-
els of performance and productivity. Improperly developed and administered, budgets can foster feelings
of animosity toward management and the budget process. Behavioral research has generally concluded
that when employees participate in the preparation of budgets and believe that the budgets represent fair
standards for evaluating their performance, they receive personal satisfaction from accomplishing the
goals set in the budgets.
CHAPTER-END REVIEW 1: BUDGET FOR A

MERCHANDISING ORGANIZATION
Stumphouse Cheese Company is a wholesale distributor of blue cheese and ice cream. The following informa-
tion is available for April 2009.
Estimated sales
Blue cheese. . 160,000 hoops at $10 each
Ice cream . . . . . . . . . .. 240,000 gallons at $5 each
Estimated costs
Blue cheese . . . . . . . .. $8 per hoop
Ice cream . . . . . . . . . .. $2 per gallon
Beginning Ending
Desired inventories
Blue cheese ........•.. 10,000 12,000
Ice cream . 4,000 5,000
5 C. J. Silas, "The Moral Dimension of Competitiveness," Management Accounting, December 1994, p. 72.
Financial infonnation follows:

• Beginning cash balance is $400,000.
• Purchases of merchandise are paid 60 percent in the current month and 40 percent in the following month.
Purchases totaled $1,800,000 in March and are estimated to be $2,000,000 in May.
o Employee wages, salaries, and commissions are paid for in the current month. Employee expenses for April
totaled $156,000.
• Overhead expenses are paid in the next month. The accounts payable amount for these expenses from
March is $80,000 and for May will be $90,000. April's overhead expenses total $80,000.
• Sales are on credit and are collected 70 percent in the current period and the remainder in the next period.
March's sales were $3,000,000, and May's sales are estimated to be $3,200,000. Bad debts average I per-
cent of sales.
o Selling and administrative expenses are paid monthly and total $450,000, including $40,000 of depreciation.
• All unit costs for April are the same as they were in March.
Required
Prepare the following for April:
a. Sales budget in dollars.
b. Purchases budget.
c. Cash budget.
d. Budgeted income statement.
Solution to Chapter-End Review 1

a.
STUMPHOUSE CHEESE COMPANY
Sales Budget
For Month of April 2009
Units Price Sales
Blue cheese . 160,000 $10 $1,600,000

Ice cream . 240,000 5 1,200,000
Total . $2,800,000
b.
Purchases Budget
Blue Cheese Ice Cream Total
Units
Sales needs . 160,000 240,000
Desired ending inventory . 12,000 5,000
Total . 172,000 245,000
Less beginning inventory . (10,000) (4,000)
Purchases . 162,000 241,000
Dollars
Sales needs . $1,280,000 $480,000
Desired ending inventory 96,000 10,000
Total . 1,376,000 490,000
Purchases needed . $1,296,000 $482,000 $1,778,000
c.
Cash Budget
Cash balance, beginning . $ 400,000

Current month's sales ($2,800,000 x 0.70) $1,960,000
Previous month's sales ($3,000,000 x 0.29). . . . . . . . . . . . . . 870,000 2,830,000
Cash available from operations . 3,230,000
Less budgeted disbursements
March purchases ($1,800,000 x 0040) . 720,000
April purchases ($1,778,000 x 0.60) . 1,066,800
Labor . 156,000
Overhead (March) . 80,000
Selling and administrative
($450,000 - $40,000 depreciation). . . . . . . . . . . . . . . . . . . . . 410,000 (2,432,800)
Cash balance, ending . $ 797,200
d.
Sales (sales budget) . $2,800,000

Allowance for bad debts . (28,000)
Net sales . 2,772,000
Costs of merchandise sold
Blue cheese (160,000 x $8) . $1,280,000
Ice cream (240,000 x $2) . 480,000 $1,760,000
Wages and salaries . 156,000
Overhead . 80,000
Selling and administrative . 450,000 686,000 (2,446,000)
CHAPTER-END REVIEW 2: BUDGET FOR A

MA UFACTURER
Handy Company manufactures and sells two industrial products in a single plant. The new manager wants to
have quarterly budgets and has prepared the following infOlmation for the first quarter of 2009:
BUdgeted sales
Drills . 60,000 at $100 each
Saws....................... . ........•... 40,000 at $125 each
Budgeted inventories
Beginning Ending
Drills, finished . 20,000 units 25,000 units
Saws, finished . 8,000 units 10,000 units
Metal, direct materials . 32,000 pounds 36,000 pounds
Plastic, direct materials . .. . . 29,000 pounds 32,000 pounds
Handles, direct materials . 6,000 each 7,000 each
continued
r 310 Chapter 9 I Operational Budgeting and Profit Planning
continued from previous page
Standard variable costs per unit

Drills Saws
Direct materials
Metal . 5 pounds x $8.00 $40.00 4 pounds x $8.00 $32.00
Plastic . 3 pounds x $5.00 15.00 3 pounds x $5.00 15.00
Handles . 1 handle x $3.00 3.00
Total . 58.00 47.00
Direct labor............. 2 labor hours x $12.00 24.00 3 labor hours x $16.00 48.00
Variable manufacturing
Overhead. . . . . . . . . . .. 2 hours x $1.50 3.00 3 hours x $1.50 4.50
Total . $85.00 $99.50
Fixed factory overhead is $214,000 per quarter (including noncash expenditures of $156,000) and is allocated on
I total units produced. Financial information follows:
• Beginning cash balance is $1,800,000.
II • Sales are on credit and are collected 50 percent in the current period and the remainder in the next period.
Last quarter's sales were $8,400,000. There are no bad debts.
• Purchases of direct materials and labor costs are paid for in the quarter acquired.
• Manufacturing overhead expenses are paid in the quarter incurred.
• Selling and administrative expenses are all fixed and are paid in the quarter incurred. They are budgeted at
$340,000 per quarter, including $90,000 of depreciation.
Required
For the first quarter of 2009, prepare the following:
a. Sales budget in dollars.
h. Production budget in units.
c. Purchases budget.
d. Manufacturing cost budget.
e. Cash budget.
f Budgeted contribution income statement. (Hint: See Chapter 3.)
Solution Chapter-End Review 2

a.
HANDY COMPANY
Sales Budget
For First Quarter of 2009
Units Price Sales
Drills . 60,000 $100 $ 6,000,000

Saws . 40,000 125 5,000,000
Total . $11,000,000
h.
HANDY COMPANY
Production Budget
Drills Saws
Budget sales . 60,000 40,000

Plus desired ending inventory . 25,000 10,000
Total inventory requirements . 85,000 50,000
Budgeted production . 65,000 42,000
c.
HANDY COMPANY
Purchases Budget
Drills Saws Total
Metal purchases
Production units (production budget) . . . . . . 65,000 42,000
Metal (pounds). . . . . . . . . . . . . . . . . . . . . . . . . . x 5 x 4
Production needs (pounds). . . . . . . . . . . . .. 325,000 168,000 493,000
Desired ending inventory (pounds) . . . . . . . . . . . . . . 36,000
Total metal needs (pounds) . 529,000
Less beginning inventory (pounds) . (32,000)
Purchases needed (pounds) . 497,000
Cost per pound . x $8
Total metal purchases . . . . . . . . . . . . . . . . . . . ............ . . $3,976,000
Plastic purchases
Production units (production budget) . . . . . . . . . . . . 65,000 42,000 107,000
Plastic (pounds) . x3
Production needs (pounds) . 321,000
Desired ending inventory (pounds) . 32,000
Total plastic needs (pounds) . . . . . . .............. . . 353,000
Less beginning inventory (pounds) ........ . . (29,000)
Purchases needed (pounds) . 324,000
Cost per pound . x $5
Total plastic purchases . $1,620,000
Handle purchases
Production units (production budget) . . . . . . . . . . . . 65,000 65,000
Handles . x 1
Production needs . 65,000
Desired ending inventory . 7,000
Total handle needs . 72,000
Less beginning inventory . (6,000)
Purchases needed . 66,000
Cost per handle . x $3
Total handle purchases . $198,000
Total purchases
Metal ...................................•................... $3,976,000
Plastic . 1,620,000
Handles , . 198,000
Total purchases . $5,794,000
d.
HANDY COMPANY
Drills Saws Total
Direct materials
Metal
Production units (production budget) . 65,000 42,000
Metal per unit of product (pounds) . X5 x4
Production needs for metal (pounds) . 325,000 168,000
Unit cost . x $8 x $8
Cost of metal issued to production . $2,600,000 $1,344,000 $3,944,000
continued
312 Chapter 9 I Operational Budgeting and Profrt Planning
HANDY COMPANY
Drills Saws Total
Plastic
Production units (production budget) . 65,000 42,000
Plastic (pounds) . x3 x3
--
Production needs for plastic (pounds) . 195,000 126,000
Unit cost. . x $5 x $5
Cost of plastic issued to production . $ 975,000 $ 630,000 1,605,000
-- --
Handles
Production units (production budget) . 65,000
Handles . x 1
--
Production needs for handles . 65,000
Unit cost. . x $3
Cost of handles issued to production . $ 195,000 195,000
Total . 5,744,000
Direct labor
Budgeted production . 65,000 42,000
Direct labor hours per unit . x2 x3
Total direct labor hours . 130,000 126,000
Labor rate . x $12 x $16
Labor expenditures . $1,560,000 $2,016,000 3,576,000
Variable factory overhead

Direct labor hours . 130,000 126,000
Variable factory overhead rate . x $1.50 x $1.50
Total variable overhead . $ 195,000 $ 189,000 384,000
Fixed factory overhead . 214,000

Total . $9,918,000
e.
HANDY COMPANY
Cash Budget
Cash balance, beginning . $ 1,800,000

Current quarter's sales ($11,000,000 x 0.50) . $5,500,000
Previous quarter's sales ($8,400,000 x 0.50) . 4,200,000 9,700,000
Cash available from operations . 11,500,000
Less budgeted disbursements
Materials (purchases budget) . 5,794,000
Labor (manufacturing cost budget) . . . . . . . . . 3,576,000
Manufacturing overhead (manufacturing
cost budget) ($598,000 - 156,000) . 442,000
Selling and administrative
($340,000 - $90,000 depreciation) . 250,000 (10,062,000)
Cash balance, ending . $ 1,438,000
f.
HANDY COMPANY
Sales (sales budget) . $11,000,000

Less variable costs of goods sold
Drills (60,000 X $85.00) . $5,100,000
Saws (40,000 X $99.50) . 3,980,000 (9,080,000)
Gross profit. . 1,920,000
Less fixed costs
Manufacturing overhead . 214,000
Selling and administrative expenses. . . . . 340,000 (554,000)
Net income . $ 1,366,000
GUIDAN E ANSWER
'. . • You are the Chief Financial Officer
You seem to be leaning toward using a top-down approach to budgeting. While this method may produce an ef-
fective set of benchmarks for planning and evaluation, it does not maximize the benefits of budgeting. A key ele-
ment in any effective budgeting system is that it must be embraced by the managers whose performance will be
evaluated by it. If the budget is imposed from the top down, it is far less likely to be embraced by managers than
if they have participated from the beginning of the budget development process. The most effective budgeting
systems are those that are strongly embraced by managers at all levels, which is most readily achieved through
a participative (bottom-up) approach.
Q9-1. What are the primary phases in the planning and control cycle?
Q9-2. Does budgeting require formal or informal planning? What are some advantages of this style of
management?
Q9-3. Identify the advantages and disadvantages of the incremental approach to budgeting.
Q9-4. Explain the minimum level approach to budgeting.
Q9-5. How does activity-based budgeting predict a cost objective's budget?
Q9-6. Explain the continuous improvement concept of budgeting.
Q9-7. Which budget brings together all other budgets? How is this accomplished?
Q9-8. What budgets are normally used to support the cash budget? What is the net result of cash budget
preparations?
Q9-9. Define budgeted financial statements.
Q9-10. Identify the two budgets that are part of the master budget of a manufacturing organization but not part
of the master budget of a merchandising organization.
Q9-11. Contrast the top-down and bottom-up approaches to budget preparation.
Q9-12. Is budgetary slack a desirable feature? Can it be prevented? Why or why not?
Q9-13. Why are annual budgets not always desirable? What are some alternative budget periods?
Q9-14. Explain how continuous budgeting works.
Q9-15. In addition to the sales forecast. what forecasts are used in budgeting?
Q9-16. Why should motivational considerations be a part of budget planning and utilization? List several ways
to motivate employees with budgets.
MINI EXERCISES
M9-17. Department Budget Using OutputlInput Approach (L02)
The following data are from the general records of Department 16 for October.
Each unit of product requires 6 direct labor hours, 20 liters of direct materials, and I container.
Each unwasted liter of material processed requires $13 of manufacturing overhead.
Average wages for direct laborers are $15 per hour.
Direct materials currently cost $3 per liter.
Containers cost $9 each.
Direct material waste amounts to 10 percent of materials started in process.
Required
Prepare an October department budget for Department 16 if planned production is 2,000 units of output.
M9-18. Department Budget Using Incremental Approach (L02)

Assume that the Assembly Department of Applied Materials' Texas plant prepares its budget using the
incremental approach for both fixed and variable costs. For 2010 assume that the following costs were
incurred for the production of 100,000 units.
Direct materials . $240,000

Direct labor . 600,000
Supervision . 90,000
Depreciation, equipment (straight line) . 34,000
Variable overhead ($1.20 per unit) . 120,000
Assume that each unit takes one-half hour to assemble.

Required
Prepare a budget for the Assembly Department that allows for a 4 percent inflation rate if the Texas plant
sets a production level of 140,000 for 20 II.
M9-19. Purchases Budget in Units and Dollars (L03)

Budgeted sales of The Music Shop for the first six months of 2010 are as follows:
Month Unit Sales Month Unit Sales
January. . . . . . . . . .. 130,000 April. . 210,000

February. . . . . . . . .. 160,000 May . 180,000
March. . . . . . . . . . .. 200,000 June . 240,000
Beginning inventory for 2010 is 40,000 units. The budgeted inventory at the end of a month is 40 percent
of units to be sold the following month. Purchase price per unit is $5.
Required
Prepare a purchases budget in units and dollars for each month, January through May.
M9-20. Cash Budget (L03)
Wilson's Retail Company is planning a cash budget for the next three months. Estimated sales revenue is
as follows:
Month Sales Revenue Month Sales Revenue
January . $300,000 March . $200,000

February . 225,000 April . 175,000
All sales are on credit; 60 percent is collected during the month of sale, and 40 percent is collected during
the next month. Cost of goods sold is 80 percent of sales. Payments for merchandise sold are made in the
month following the month of sale. Operating expenses total $41,000 per month and are paid during the
month incurred. The cash balance on February 1 is estimated to be $30,000.
Required
Prepare monthly cash budgets for February, March, and April.
M9-21 Production and Purchases Budgets in Units (L04)

At the end of business on June 30, 2009, the Wooly Rug Company had 100,000 square yards of rugs and
400,000 pounds of raw materials on hand. Budgeted sales for the third quarter of 2009 are:
Month Sales
July . 200,000 sq. yards

August . 180,000 sq. yards
September . 150,000 sq. yards
October . 160,000 sq. yards
The Wooly Rug Company wants to have sufficient square yards of finished product on hand at the end of each
month to meet 40 percent of the following month's budgeted sales and sufficient pounds of raw materials
to meet 30 percent of the following month's production requirements. Five pounds of raw materials are
required to produce one square yard of carpeting.
Required
Prepare a production budget for the months of July, August, and September and a purchases budget in units
for the months of July and August.
M9-22 Manufacturing Cost Budget (L04)

Huntsville Products produces a product with the following standard costs:
Unit costs:
Direct materials:
Wood: 20 square feet at $3 . $60
Hardware kits (screws, etc) . 2 $ 62
Direct labor 0.5 hours at $26 per hour . 13
Variable overhead, per unit . 5
Total variable costs per unit . ~
Fixed costs per month (rent, utilities, supervision) .
Management plans to produce 8,000 units in April 2010.
Required
Prepare a manufacturing cost budget for April 2010.
EXERCISES
E9-23. Activity-Based Budget (L02)
Merrit Industries Inc. has the following budget information available for February:
Administration . $40,000
Advertising . $15,000
Assembly . V2 hour per unit x $8
Direct materials . 2 pounds per unit x $3
Inspection . $200 per batch of 1,000 units
Manufacturing overhead . $2 per unit
Manufactured units . 20,000
Product development . $15,000
Sales units . 20,000 units x $30
Setup cost . $10 per batch of 1,000 units
Required
Prepare a February activity-based budgeted income statement.
316 Chapter 9 I Operational Budgeting and Profrt Planning
E9-24. Product and Department Budgets Using Activity-Based Approach IL02)

The following data are from the general records of the Loading Department of Bowman Freight Company
for November.
Cleaning incoming trucks, 20 minutes.
Obtaining and reviewing shipping documents for loading truck and instructing loaders, 30 minutes.
Loading truck, I hour and 30 minutes.
Cleaning shipping dock and storage area after each loading, 10 minutes.
Employees perform both cleaning and loading tasks and are currently averaging $16 per hour in
wages and benefits.
The supervisor spends 10 percent of her time overseeing the cleaning activities; 60 percent
overseeing various loading activities; and the remainder of her time making general plans and
managing the department. Her current salary is $4,000 per month.
Other overhead of the department amounts to $lO,OOO per month, 20 percent for cleaning and 80
percent for loading.
Required
Prepare an activities budget for cleaning and loading in the Loading Department for November, assuming
20 working days and the loading of an average of 14 trucks per day.
E9-25. Activity-Based Budgeting IL02l

St. Mary's Hospital is preparing its budget for the coming year. It uses an activity-based approach for all
costs except physician care. Its emergency room has three activity areas with cost drivers as follows:
I. Reception-paperwork of incoming patients. Cost driver is the number of forms completed.
2. Treatment-initial diagnosis and treatment of patients. Cost driver is the number of diagnoses
treated.
3. Cleaning-general cleaning plus preparing treatment facilities for next patient. Cost driver is the
number of people visiting emergency room (patients plus person(s) accompanying them).
Cost Budgeted Amount of Cost Driver

Activity Driver
Area Rates Outpatients Admitted Patients
Reception. . . . . . .. $30 7,400 forms 5,500 forms

Treatment. . . . . . . . 90 7,000 diagnoses 4,400 diagnoses
Cleaning. . . . . . . . . 12 6,400 people 2,400 people
Required
a. Prepare the total budgeted cost for each activity.
b. How might you adjust the budget approach if you found that outpatients were kept in the emergency
room for one hour on average while admitted patients remained for two hours?
c. What advantage does an activity-based approach have over the hospital's former budgeting method
of basing the next year's budget on the last year's actual amount plus a percentage increase?
E9-26. Sales Budget (L03l

Summer Fun T-Shirt Shop has very seasonal sales. For 2009, management is trying to decide whether to
establish a sales budget based on average sales or on sales estimated by quarter. The unit sales for 2009 are
expected to be 10 percent higher than 2008 sales. Unit shirt sales by quarter for 2008 were as follows:
Children's Women's Men's Total
Winter quarter.......... 200 200 100 500

Spring quarter ......... 200 250 200 650
Summer quarter ........ 400 300 200 900
Fall quarter ............ 200 250 100 550
-- - --
Total .. ............. 1,000 1,000 600 2,600
Children's T-shirts sell for $5 each, women's sell for $9, and men's sell for $lO.
Chapter 9 I Operational Budgeting and Pront Planning 317
Required
Assuming a 10 percent increase in sales, prepare a sales budget for each quarter of 2009 using the following:
a. Average quarterly sales. (Hint: Winter quarter children's shirts are 275 [1,000 X 1.10 7 4].)
b. Actual quarterly sales. (Hint: Winter quarter children's shirts are 220 [200 X 1.10].)
c. Suggest advantages of each method.
E9-27. Sales Budget (L03'

Assume that Datek, a leader in on-line stock trading, is preparing for a surge in growth with a new set of
stock trading fees. The following information is available:
Category Number of Shares Current Fee New Fee as of July Revenue
A ........ 0-10,000 $ 11 $ 10 $1,210,000

B . . . . . . .. 10,001-50,000 50 40 50,000
C ........ 50,001 and above 200 150 20,000
With the new fees, Datek expects to take many big-volume traders from its competitors. Anticipated monthly
growth is expected to be 10 percent, 20 percent, and 30 percent, respectively, for each category for the first
three months after the new rates go into effect.
Required
a. What are the anticipated revenues per month for July and August?
b. Is the new fee structure satisfactory? Explain.
E9-28. Cash Budget (L03)

Peruvian Tea Company began July with a cash balance of $145,000. A cash receipts and payments budget
for each six-month period is prepared in advance. Sales have been estimated as follows:
Month Sales Revenue Month Sales Revenue
May . $120,000 September . $ 80,000

June . 140,000 October . 100,000
July . 80,000 November . 100,000
August . 60,000 December . 110,000
All sales are on credit with 75 percent collected during the month of sale, 20 percent collected during the
next month, and 5 percent collected during the second month following the month of sale. Cost of goods
sold averages 70 percent of sales revenue. Ending inventory is one-half of the next month's predicted cost
of sales. The other half of the merchandise is acquired during the month of sale. All purchases are paid for
in the month after purchase. Operating costs are estimated at $20,000 each month and are paid for during
the month incurred.
Required
Prepare monthly cash budgets for the six months from July to December. (Hint: Prepare monthly purchases
budgets for June through November.)
E9-29. Cash Receipts (L03)

The sales budget for Perrier Inc. is forecasted as follows:
Month Sales Revenue
May . $120,000
June . 160,000
Ju~ . 180,000
August . 120,000
To prepare a cash budget, the company must determine the budgeted cash collections from sales. Historically,
the following trend has been established regarding cash collection of sales:
60 percent in the month of sale.

20 percent in the month following sale.
15 percent in the second month following sale.
5 percent uncollectible.
The company gives a 2 percent cash discount for payments made by customers during the month of
sale. The accounts receivable balance on April 30 is $24,000, of which $7,000 represents uncollected March
sales and $17,000 represents uncollected April sales.
Required
Prepare a schedule of budgeted cash collections from sales for May, June, and July. Include a three-month
summary of estimated cash collections.
E9-30. Cash Disbursements (L03)
Montana Timber Company is in the process of preparing its budget for next year. Cost of goods sold has
been estimated at 70 percent of sales. Lumber purchases and payments are to be made during the month
preceding the month of sale. Wages are estimated at 15 percent of sales and are paid during the month of
sale. Other operating costs amounting to 10 percent of sales are to be paid in the month following the month
of sale. Additionally, a monthly lease payment of $12,000 is paid to BMI for computer services. Sales
revenue is forecast as follows:
Month Sales Revenue
February . $100,000
March . 160,000
April . 180,000
May . 210,000
June . 180,000
July . 230,000
Required
Prepare a schedule of cash disbursements for April, May, and June.
E9-31. Cash Disbursements (L03)
Assume that Waycross Manufacturing manages its cash flow from its home office. Waycross controls cash
disbursements by category and month. In setting its budget for the next six months, beginning in July, it
used the following managerial guidelines:
Category Guidelines
Purchases. . . . . .. Pay half in current and half in following month.

Payroll. . . . . . . . .. Pay 80 percent in current month and 20 percent in following month.
Loan payments. .. Pay total amount due each month.
Predicted activity for selected months follow:
Category May June July August
Purchases . $ 30,000 $ 44,000 $ 48,000 $ 50,000

Payroll. . 100,000 110,000 120,000 100,000
Loan payments . 10,000 10,000 15,000 15,000
Required
Prepare a schedule showing cash disbursements by account for July and August.
E9-32. Budgeted Income Statement (L03)

Pendleton Company, a merchandising company, is developing its master budget for 2010. The income
statement for 2009 is as follows:
PENDLETON COMPANY
Income Statement
For Year Ending December 31, 2009
Gross sales . $750,000

Less estimated uncollectible accounts . (7,500)
Net sales . 742,500
Cost of goods sold . (430,000)
Gross profit. . 312,500
Operating expenses
(including $25,000 depreciation) . (200,500)
Net income . $112,000
The following are management's goals and forecasts for 2010:

l. Selling prices will increase by 8 percent, and sales volume will increase by 5 percent.
2. The cost of merchandise will increase by 4 percent.
3. All operating expenses are fixed and are paid in the month incurred. P,ice increases for operating
expenses will be 10 percent. The company uses straight-line depreciation.
4. The estimated uncollectibles are I percent of budgeted sales.
Required
Prepare a budgeted functional income statement for 2010.
E9-33. Budgeted Income Statement (L03)

Dakota Mfg. is planning a budget for the next fiscal year. The estimate of sales revenue is $1,000,000 and
of cost of goods sold is 70 percent of sales revenue. Depreciation on the office building and fixtures is
budgeted at $50,000. Salaries and wages should amount to 15 percent of sales revenue. Advertising has
been budgeted at $80,000, and utilities should amount to $25,000. Income tax is estimated at 40 percent of
operating income.
Required
Prepare a budgeted income statement for the next fiscal year.
E9-34 Production and Purchases Budgets IL04)

At the beginning of October, the Comfort Cushion Company had 2,400 cushions and 7,740 pounds of raw
materials on hand. Budgeted sales for the next three months are:
Month Sales
October . 8,000 cushions

November . 10,000 cushions
December . 12,000 cushions
Comfort Cushion wants to have sufficient raw materials on hand at the end of each month to meet 25 percent
of the following month's production requirements and sufficient cushions on hand at the end of each month
to meet 30 percent of the following month's budgeted sales. Three pounds of raw materials, at a standard
cost of $0.60 per pound, are required to produce each cushion.
Required:
a. Prepare a production budget for October and November.
b. Prepare a purchases budget in units and dollars for October.
E9-35. Production and Purchases Budgets (L04)

Budgeted sales for the Avalanche Plow Company for the next several months are:
Month Sales
September . 4,500
October , . 6,000
November . 9,000
December . 9,400
At the beginning of September, 1,200 units of finished goods were in inventory. Plans are to have an
inventory of finished goods equal to 40 percent of the following month's sales. Each unit of finished goods
requires 200 pounds of raw materials at a cost of $10 per pound. Management wishes to maintain month-
end inventories of raw materials equal to one-fourth of the following month's needs. Five hundred thousand
pounds of raw materials were on hand at the start of September.
Required:
a. Prepare a production budget for September, October, and November.
h. Prepare a purchases budget in units and dollars for September and October.
PROBLEMS
P9-36. Cash Budget (L03)
Cash budgeting for Carolina Apple, a merchandising finn, is perfonned on a quarterly basis. The company
is planning its cash needs for the third quarter of 2009, and the following infonnation is available to assist
in preparing a cash budget. Budgeted income statements for July through October 2009 are as follows:
July August September October
Sales ................... $18,000 $24,000 $28,000 $36,000

Cost of goods sold ........ (10,000) (14,000) (16,000) (20,000)
Gross profit. ............. 8,000 10,000 12,000 16,000
Less other expenses
Selling ................ 2,300 3,000 3,400 4,200
Administrative .......... 2,600 3,000 3,200 3,600
--- --- --- ---
Total ................. (4,900) (6,000) (6,600) (7,800)
Net income .............. $ 3,100 $ 4,000 $ 5,400 $ 8,200
--- -
Additional information follows:

I. Other expenses, which are paid monthly, include $1,000 of depreciation per month.
2. Sales are 30 percent for cash and 70 percent on credit.
3. Credit sales are collected 20 percent in the month of sale, 70 percent one month after sale, and 10
percent two months after sale. May sales were $15,000, and June sales were $16,000.
4. Merchandise is paid for 50 percent in the month of purchase; the remaining 50 percent is paid in the
following month. Accounts payable for merchandise at June 30 totaled $6,000.
5. The company maintains its ending inventory levels at 25 percent of the cost of goods to be sold in the
following month. The inventory at June 30 is $2,500.
6. An equipment note of $5,000 per month is being paid through August.
7. The company must maintain a cash balance of at least $5,000 at the end of each month. The cash
balance on June 30 is $5,100.
8. The company can borrow from its bank as needed. Borrowings and repayments must be in multiples
of $100. All borrowings take place at the beginning of a month, and all repayments are made at the
end of a month. When the principal is repaid, interest on the repayment is also paid. The in:erest rate
is 12 percent per year.
Required
a. Prepare a monthly schedule of budgeted operating cash receipts for July, August, and September.
b. Prepare a monthly purchases budget and a schedule of budgeted cash payments for purchases for
July, August, and September.
c. Prepare a monthly cash budget for July, August, and September. Show borrowings from the
company's bank and repayments to the bank as needed to maintain the minimum cash balance.
P9-37. Cash Budget (L03)

The Peoria Supply Company sells for $30 one product that it purchases for $20. Budgeted sales in total
dollars for next year are $720,000. The sales information needed for preparing the July budget follows:
Month Sales Revenue
May . $30,000
June '" . 42,000
Ju~ . 48,000
August . 50,000
Account balances at July 1 include these:
Cash . $20,000
Merchandise inventory . 16,000
Accounts receivable (sales) . 23,000
Accounts payable (purchases) . 15,000
The company pays for one-half of its purchases in the month of purchase and the remainder in the following
month. End-of-month inventory must be 50 percent of the budgeted sales in units for the next month. A 2
percent cash discount on sales is allowed if payment is made during the month of sale. Experience indicates
that 50 percent of the billings will be collected during the month of sale, 40 percent in the following month,
8 percent in the second following month, and 2 percent will be uncollectible. Total budgeted selling and
administrative expenses (excluding bad debts) for the fiscal year are estimated at $186,000, of which one-
half is fixed expense (inclusive of a $20,000 annual depreciation charge). Fixed expenses are incurred
evenly during the year. The other selling and administrative expenses vary with sales. Expenses are paid
during the month incurred.
Required
a. Prepare a schedule of estimated cash collections for July.
b. Prepare a schedule of estimated July cash payments for purchases. (Round calculations to the nearest
dollar.)
c. Prepare schedules of July selling and administrative expenses, separately identifying those requiring
cash disbursements.
d. Prepare a cash budget in summary form for July.
P9-38. Budgeting Purchases, Revenues, Expenses, and Cash in a Service Organization (L03)
Round Lake Medical Center is located in a summer resort community. During the summer months the center
operates an out-patient clinic for the treatment of minor injuries and illnesses. The clinic is administered as
a separate department within the hospital. It has its own staff and maintains its own financial records. All
patients requiring extensive or intensive care are referred to other hospital departments.
An analysis of past operating data for the out-patient clinic reveals the following:
Staff: Seven full-time employees with total monthly salaries of $40,000. On a monthly basis, one
additional staff member is hired for every 500 budgeted patient visits in excess of 3,000, at a cost of
$4,000 per month.
Facilities: Monthly facility costs, including depreciation of $2,000, total $9,000.
Supplies: The supplies expense averages $10 per patient visit. The center maintains an end-of-
month supplies inventory equal to ten percent of the predicted needs of the following month, with a
minimum ending inventory of $3,000, which is also the desired inventory at the end of August.
Additional variable patient costs, such as medications, are charged directly to the patient by the
hospital pharmacy.
Payments: All staff and maintenance expenses are paid in the month the cost is incurrent. Supplies
are purchased at cost directly from the hospital with an immediate transfer of cash from the clinic
cash account to the hospital cash account.
Collections: The average bill for services rendered is $55. Of the total bills, 40 percent are paid in
cash at the time the service is rendered, 10 percent are never paid, and the remaining 50 percent are
covered by insurance. In the past, insurance companies have disallowed 20 percent of the claims filed
and paid the balance two months after services are rendered.
May 30 status: At the end of May, the clinic had $12,000 in cash and supplies costing $3,000.
Budgeted patient visits for next summer are as follows:
Month Patient visits
June , . 2,000
July . 3,500
August . 4,000
Required:
For the Round Lake Out-patient Clinic:
a. Prepare a supplies purchases budget for June, July, and August, with a total column.
b. Prepare a revenue and expense budget for June, July, and August with a total column.
c. Prepare a cash budget for June, July and August with a total column. Hint: See requirement d.
d. Explain why you were unable to develop a feasible cash budget and make any appropriate
recommendations for management's consideration.
P9-39. Developing a Master Budget for a Merchandising Organization (L03)

Peyton Department Store prepares budgets quarterly. The following information is available for use in
planning the second quarter budgets for 2010.
PEYTON DEPARTMENT STORE

Balance Sheet
March 31, 2010
Assets Liabilities and Stockholders' Equity
Cash . $ 3,000 Accounts payable . $26,000

Accounts receivable . 25,000 Dividends payable . 17,000
Inventory . 30,000 Rent payable . 2,000
Prepaid insurance . 2,000 Stockholders' equity . 40,000
Fixtures . 25,000
Total assets . $85,000 Total liabilities and equity . $85,000
Actual and forecasted sales for selected months in 2010 are as follows:
Month Sales Revenue
January $60,000
February 50,000
March 40,000
April 50,000
May 60,000
June 70,000
July 90,000
August 80,000
Monthly operating expenses are as follows:
Wages and salaries . $25,000

Depreciation . 100
Utilities . 1,000
Rent . 2,000
Cash dividends of $17,000 a.re declared during the third month of each quarter and are paid during the first
month of the following quarter. Operating expenses, except insurance, rent, and depreciation are paid as
incurred. Rent is paid during the following month. The prepaid insurance is for five more months. Cost
of goods sold is equal to 50 percent of sales. Ending inventories are sufficient for 120 percent of the next
month's sales. Purchases during any given month are paid in full during the following month. All sales
are on account, with 50 percent collected during the month of sale, 40 percent during the next month, and
10 percent during the month thereafter. Money can be borrowed and repaid in multiples of $1,000 at an
interest rate of 12 percent per year. The company desires a minimum cash balance of $3,000 on the first of
each month. At the time the principal is repaid, interest is paid on the portion of principal that is repaid. All
borrowing is at the beginning of the month, and all repayment is at the end of the month. Money is never
repaid at the end of the month it is borrowed.
Required
a. Prepare a purchases budget for each month of the second quarter ending June 30, 2010.
b. Prepare a cash receipts schedule for each month of the second quarter ending June 30, 2010. Do not
include borrowings.
c. Prepare a cash disbursements schedule for each month of the second quarter ending June 30, 2010.
Do not include repayments of borrowings.
d. Prepare a cash budget for each month of the second quarter ending June 30, 2010. Include budgeted
borrowings and repayments.
e. Prepare an income statement for each month of the second quarter ending June 30, 2010.
/. Prepare a budgeted balance sheet as of June 30, 2010.
P9-40. Developing a Master Budget for a Manufacturing Organization (L04)

Jacobs Incorporated manufactures a product with a selling price of $50 per unit. Units and monthly cost
data follow:
Variable:
Selling and administrative . $ 5 per unit sold
Direct materials . 10 per unit manufactured
Direct labor . 10 per unit manufactured
Variable manufacturing overhead . 5 per unit manufactured
Fixed:
Selling and administrative . $20,000 per month
Manufacturing (including depreciation of $10,000) . 30,000 per month
Jacobs pays all bills in the month incurred. All sales are on account with 50 percent collected the month of
sale and the balance collected the following month. There are no sales discounts or bad debts.
Jacobs desires to maintain an ending finished goods inventory equal to 20 percent of the following
month's sales and a raw materials inventory equal to 10 percent of the following month's production.
January 1,2011, inventories are in line with these policies.
Actual unit sales for December and budgeted unit sales for January, February, and March of 20 II are as
follows:
JACOBS INCORPORATED
Sales Budget
For the Months of January, February, and March 2011
Month December January February March
Sales - Units . 6,250 5,000 10,000 8,000

Sales - Dollars . $312,500 $250,000 $500,000 $400,000
Additional information:
The January I beginning cash is projected as $5,000.
For the purpose of operational budgeting, units in the January I inventory of finished goods are
valued at variable manufacturing cost.
Each unit of finished product requires one unit of raw materials.
Jacobs intends to pay a cash dividend of $10,000 in January
ReqUired:
a. A production budget for January and February.
b. A purchases budget in units for January.
c. A manufacturing cost budget for January.
d. A cash budget for January.
e. A budgeted contribution income statement for January.

f Management is concerned that their supplier of raw materials will have a strike. Determine the
budget implications if management plans to increase the January end raw materials inventory to 100
percent of February's production needs. Offer any recommendations you believe appropriate.
P9-41. Developing a Master Budget for a Manufacturing Organization: Challenge Problem (L04)
Banana Computer Accessories assembles a computer networking device from kits of imported components.
You have been asked to develop a quarterly and annual operating budget and pro-forma income statements
for 20 I O. You have obtained the following information:
Beginning-of-year balances
Cash . $40,000.00
Accounts receivable (previous quarter's sales) . $15,000.00
Raw materials . 300 kits
Finished goods . 400 units
Accounts payable . $40,000.00
Borrowed funds . $10,000.00
Desired end-of-year inventory balances
Raw materials . 500 kits
Finished goods . 200 units
Desired end-of-quarter balances
~~ . $10,000.00
Raw materials as a portion of the following
quarter's production . 0.2
Finished goods as a portion of the following
quarter's sales . 0.15
Manufacturing costs
Standard cost per unit Units Unit price Total
Raw materials . 1 kit $40.00 $40.00
Direct labor hours at rate . 0.8 hour $20.00 16.00
Variable overhead/labor hour . 0.8 hour $10.00 8.00
Total standard variable cost $64.00
Fixed cost per quarter

Cash . $40,000.00
Depreciation . 10,000.00
Total . $50,000.00
Selling and administrative costs

Variable cost per unit . $5.00
Fixed costs per quarter
Cash . $20,000.00
Depreciation 5,000.00
Total . $25,000.00
Interest rate per quarter . 0.04

Portion of sales collected
Quarter of sale . 0.75
Subsequent quarter . 0.24
Bad debts . 0.01
Portion of purchases paid
Quarter of purchase . 0.75
Subsequent quarter .............................•... 0.25
Unit selling price . $110.00
Sales forecast
Quarter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . First Second Third Fourth
Unit sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400 1,500 2,000 3,100
Additional information
All cash payments except purchases are made quarterly as incurred.
All borrowings occur at the start of the quarter.
Chapter 9 I Operational Budgeting and Pront Planning 325
All repayments on borrowings occur at the end of the quarter.

All interest on borrowed funds is paid at the end of each quarter.
Borrowings and repayments may be made in any amount.
Required:
o. A sales budget for each quarter and the year. Hint: Use of spreadsheet software strongly
recommended for this problem.
b. A production budget for each quarter and the year.
c. A purchases budget for each quarter and the year.
d. A manufacturing cost budget for each quarter and the year.
e. A selling and administrative expense budget for each quaIter and the year.
f A cash budget for each quarter and the year.
g. A pro-forma contribution income statement for each quarter and the year.
CASES
C9-42. Behavioral Implications of Budgeting (LOS)
Andrea Rawls, controller of Data Scientific, believes that effective budgeting greatly assists in meeting
the organization's goals and objectives. She argues that the budget serves as a blueprint for the operating
activities during each reporting period, making it an impOitant control device. She believes that sound
management evaluations can be based on the comparisons of performance and budgetary schedules and that
employees respond more favorably when they participate in the budgetary process. Jeff Cooke, treasurer
of Data Scientific, agrees that budgeting is essential for overall organization success, but he argues that
human resources are too valuable to spend much time planning and preparing the budgetary process. He
thinks that the roles people play in budgetary preparation are not important in the final analysis of a budget's
effectiveness.
Required
Contrast the participative versus imposed budgeting concepts and indicate how the ideas of Rawls and
Cooke fit the two categories.
C9-43. Behavioral Considerations and Budgeting (L05)

Scott Weidner, the controller in the Division of Social Services for the state, recognizes the importance of the
budgetary process for planning, control, and motivation purposes. He believes that a properly implemented
participative budgeting process for planning purposes and a management by exception reporting procedure
based on that budget will motivate his subordinates to improve productivity within their particular
departments. Based on this philosophy, Weidner has implemented the following budget procedures.
An appropriation target figure is given to each department manager. This amount is the maximum
.funding that each department can expect to receive in the next fiscal year.
Department managers develop their individual budgets within the following spending constraints as
directed by the controller's staff.
I. Expenditure requests cannot exceed the appropriation target.
2. All fixed expenditures should be included in the budget; these should include items such as
contracts and salaries at current levels.
3. All government projects directed by higher authority shuulu be illduded j[J the budget jlJ their
entirety.
The controller consolidates the departmental budget requests from the various departments into one
budget that is to be submitted for the entire division.
Upon final budget approval by the legislature, the controller's staff allocates the appropliation to
the various departments on instructions from the division manager. However, a specified percentage
of each department's appropriation is held back in anticipation of potential budget cuts and special
funding needs. The amount and use of this contingency fund are left to the discretion of the division
manager.
Each department is allowed to adjust its budget when necessary to operate within the reduced
appropriation level. However, as stated in the original directive, specific projects authorized by
higher authority must remain intact.
The final budget is used as the basis of control for a management by exception form of reporting.
Excessive expenditures by account for each department are highlighted on a monthly basis.
Department managers are expected to account for all expenditures over budget. Fiscal responsibility
is an important factor in the overall performance evaluation of department managers.
Weidner believes that his policy of allowing the department managers to participate in the budget process
and then holding them accountable for their performance is essential, especially during these times of
limited resources. He also believes that department managers will be positively motivated to increase the
efficiency and effectiveness of their departments because they have provided input into the initial budgetary
process and are required to justify any unfavorable performances.
Required
a. Explain the operational and behavioral benefits that generally are attributed to a participative
budgeting process.
b. Identify deficiencies in Weidner's participative budgetary policy for planning and perfonnance
evaluation purposes. For each deficiency identified, recommend how the deficiency can be corrected.
(CMA Adapted)
C9-44. BUdgetary Slack with Ethical Considerations (LOS)
Alene Adams was promoted to department manager of a production unit in Dallas Industries three years
ago. She enjoys her job except for the evaluation measures that are based on the department's budget. After
three years of consistently poor annual evaluations based on a set annual budget, she has decided to improve
the evaluation situation. At a recent budget meeting of junior-level managers, the topic of budgetary slack
was discussed as a means to maintain some consistency in budgeting matters. As a result of this meeting,
Adams decided to take the following steps in preparing the upcoming year's budget:
I. Use the top quartile for all wage and salary categories.
2. Select the optimistic values for the estimated production ranges for the coming year. These are
provided by the marketing department.
3. Use the average of the three months in the current year with poorest production efficiency as
benchmarks of success for the coming year.
4. Base equipment charges (primarily depreciation) on replacement values furnished by the purchasing
department.
S. Base other fixed costs on current cost plus an inflation rate estimated for the coming year.
6. Use the average of the ten newly hired employees' performance as a basis of labor efficiency for the
coming year.
Required
a. For each item on Adams' list, explain whether it will create budgetary slack. Use numerical examples
as necessary to illustrate.
b. Given the company's use of static budgets as one of the performance evaluation measures of its
managers, can the managers justify the use of <milt-in budgetary slack?
c. What would you recommend as a means for Adams to improve the budgeting situation in the
company? Provide some specific examples of how the budgeting process might be improved.
C9-45. Budgetary Slack with Ethical Considerations (LOS)

Norton Company, a manufacturer of infant furniture and carriages, is in the initial stages of preparing the
annual budget for next year. Scott Ford recently joined Norton's accounting staff and is interested to learn
as much as possible about the company's budgeting process. During a recent lunch with Marge Atkins, sales
manager, and Pete Granger, production manager, Ford initiated the following conversation:
Ford: Since I'm new around here and am going to be involved with the preparation of the annual budget,
I'd be interested to learn how the two of you estimate sales and production numbers.
Atkins: We start out very methodically by looking at recent history, discussing what we know about
current accounts, potential customers, and the general state of consumer spending. Then we add that
usual dose of intuition to come up with the best forecast we can.
Granger: I usually take the sales projections as the basis for my projections. Of course, we have to make
an estimate of what this year's closing inventories will be, which is sometimes difficult.
Ford: Why does that present a problem? There must have been an estimate of closing inventories in the
budget for the current year.
Granger: Those numbers aren't always reliable since Marge makes some adjustments to the sales
numbers before passing them on to me.
Ford: What kind of adjustments?
Atkins: Well, we don't want to fall short of the sales projections, so we generally give ourselves a little
breathing room by lowering the initial sales projection anywhere from 5 to 10 percent.
Granger: So, you can see why this year's budget is not a very reliable starting point. We always have
to adjust the projected production rates as the year progresses; of course, this changes the ending
inventory estimates. By the way, we make similar adjustments to expenses by adding at least 10
percent to the estimates; I think everyone around here does the same thing.
Required
a. Marge Atkins and Pete Granger have described the use of budgetary slack.
I. Explain why Atkins and Granger behave in this manner, and describe the benefits they expect to
realize from the use of budgetary slack.
2. Explain how the use of budgetary slack can adversely affect Atkins and Granger.
b. As a management accountant, Scott Ford believes that the behavior described by Marge Atkins and
Pete Granger could be unethical and that he might have an obligation not to support this behavior.
Explain why the use of budgetary slack could be unethical.
(CMA Adapted)
.. • .... 10
Standard Co ts a d
rformance Report
LEARNING OBJECTIVES
LO 1 Explain responsibility accounting.

(p.330)
L02 Differentiate between static and flexible

budgets for performance reporting.
(p.333) Passed over as successor to Jack Welch as CEO of General Electric,
Robert Nardelli left to accept the top job at Home Depot. Believing "facts
L03 Determine and interpret direct materials, are friendly," he brought with him a desire to measure almost everything
direct labor, and overhead cost and to hold executives strictly accountable for performance. To enhance
variances. (p. 337) financial performance by reducing costs, he replaced thousands of expe-
rienced full-time employees with large numbers of part-time employees.
L04 Calculate revenue variances and Managers not meeting performance targets were also replaced. Indeed,
prepare a performance report for a between 2001 and 2007, 98 percent of Home Depot's top 170 executives
revenue center. (p. 345) were new, with more than half coming from outside the company.
Driven by a strategy that included cost cutting, as well as a housing
and home improvement boom, Home Depot sales rose from $46 billion in
2000 to $81.5 billion in 2005. Gross profit also increased from 30 percent
to 33.8% of sales and profits more than doubled to $5.8 billion. Unfortu-
nately, Home Depot's stock price did not show similar improvements, even
though the stock prices of arch rival Lowes continued to build higher. And,
the 2000 to 2005 financial improvements may have come with a long-term
price.
Employees were alienated by cost cutting and the "replacement" of
full-time employees with part-time help. Customers were alienated by the
decline in customer service. Do-it-yourself customers complained that the
Depot went from great help to "no help." Meanwhile, Lowes was making
great strides in customer service and building strong customer relations.
328
--- - - - ------------------1
By late 2006, Home Depot and Nardelli were under pressure from sales and profit declines. Nardelli was
also under pressure from employees, investors, and financial analysts for what they regarded as his arrogant
style, lack of stock performance, and excessive compensation. When Nardelli left in early 2007, employees'
cell phones lit up with text-messaged happy-faces. Per Matthew Fassler, a Goldman Sachs analyst, Nardelli's
numbers were good but "this retail organization never embraced his leadership style." Harvard Business
School professor Boris Groysberg, observing that Nardelli came from General Electric, noted that "GE people
are good at getting structure, systems, and strategy right, but they don't always understand soft issues like
culture."
Later in 2007, new Home Depot CEO Frank Blake announced plans to commit $2.2 billion to efforts to
improve stores, customer service, and sales. According to Blake, "We plan to continue our reinvestment plans
for the long-run health of the business, understanding that it will put short-term pressure on earnings."
Understanding and properly using financial performance reports is necessary for the organization to
succeed. This chapter introduces the fundamentals of responsibility accounting and the measurement of
financial performance. However, as underscored by events at Home Depot, while an understanding of
financial performance is necessary for success, it is not sufficient. In addition to financial performance,
managers must consider a myriad of quantifiable and non-quantifiable, short-term and long-term factors.
Some of these other factors are incorporated into the balanced scorecard, considered in Chapter 11. 1
I "Out at Home Depot," Brian Grow; Dean Foust; Emily Thornton; Raben Farzad; Jena McGregor; Susan Zegal; and Eamon Javers,
Business Week, January 15,2007, pp. 56-62. "Being Mean Is So Last Millennium," Diane Brady, Business Week, January 15,2007, p. 62.
"Nardelli's Tear-Down Job," John Hollon, Workforce Management, January 15,2007, p. 34. "Home Depot: Blues for Big Orange," Busi-
ness Week Online, May 16,2007, p. 16.
329
330 Chapter 10 I Standard Costs and Performance Measurement
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Performance Reporting
and Organization
• Development of Flexible
Budgets
• Establishing and Using
Standards for Direct
• Inclusion of Controllable
Costs
Structures L Flexible BUdgets Materials
• Revenue Centers as
Types of Responsibility
Centers Li
Emphasize Performance
Standard Costs and
Standards for Direct
Profit Centers
Performance Reports Labor

Standards for Variable
Overhead
• Fixed Overhead
Variances
Management accounting tools aid in the assessment of the performance of the firm as a whole and all of its
various components. Feedback in the form of performance reports is essential if the benefits of budgeting
and other types of planning are to be fully realized. Managers must know how actual results compare with
current budgets and standards to control current operations and to improve future operations. These per-
formance reports should be prepared in accordance with the concept of responsibility accounting, which
is the structuring of performance reports addressed to individual (or group) members of an organization
to emphasize the factors they c o n t r o l . "
This chapter focuses on responsibility accounting and performance assessment. We examine respon-
sibility accounting and identify various types of responsibility centers. We then take a close look at perfor-
mance assessment for cost centers. We conclude by considering performance reports for revenue centers.
Responsibility accounting for major business segments is considered in Chapter 11.
RESPONSIBILITY ACCOUNTING
L01 Explain Performance reports that include comparisons of actual results with plans or budgets serve as assessment
responsibility tools and attention-directors to help managers determine and control activities. According to the concept
accounting. of management hy exception, the absence of significant differences indicates that activities are proceeding
as planned whereas the presence of significant differences indicates a need to either take corrective action
or revise plans. These evaluations and actions are made within the framework of an organization's overall
mission, goals, and strategies as discussed in Chapter I.
Responsibility accounting may focus on specific organization components or various aspects of the
value chain that are accountable for the accomplishment of specific activities or objectives. Performance
reports are customized to emphasize the activities of each specific organizational unit or value chain
element. For example, a financial performance report addressed to the head of a production department
contains manufacturing costs controllable by the department head; it does not contain costs (such as ad-
vertising, sales commissions, or the president's salary) that the head of the production department cannot
control. Including noncontrollable costs in the report distracts the manager's attention from the control-
lable costs, thereby diluting a manager's efforts to deal with controllable items. Lower-level managers
could also become frustrated with the entire performance reporting system if they believe upper-level
managers expect them to control costs they cannot influence. However, some companies insist on report-
ing all related revenues and expenses (controllable and non-controllable) in the same report. When this is
the case, the noncontrollable items should be clearly labeled.
A poorly designed responsibility accounting system can lead to unethical practices by manag-
ers in key positions. If too much pressure is placed on managers to meet performance targets, they
Chapter 10 I Standard Costs and Performance Measurement 331
sometimes take actions that are not in the best interest of the organization. The Business Insight that
follows presents examples of such actions involving a vice president of Bausch & Lomb and the CEO
of Sunbeam who forced sales into one year to the detriment of the companies' sales the following year.
The designers of an organization's responsibility accounting system need to be aware of the potential
pressures that such a system can place on managers. The decision-making model of the organization
should be such that managers are not influenced to make undesirable decisions just to receive bonuses
or promotions.
BUSINESS INSIGHT Ethics and Responsibility Accounting

------,,;...--------------"
A few years ago, the contact lens division of Bausch & Lomb, Inc., was experiencing lower-than-
anticipated sales levels. The head of the division called a meeting of its independent distributors
and told them that the company had changed its sales strategy. Effective immediately, each dis-
tributor would have to boost its inventory of contact lenses if it wanted to remain a distributor of
Bausch & Lomb products. The strategy was for distributors to buy only in very large quantities
(some as much as a two-year supply) with prices increased by amounts up to 50 percent. Also, the
distributors had to place these large orders by year-end. As one distributor stated, "When your No.
1 vendor says you'd better take it or else, what're you going to do?" All but two of Bausch & Lomb's
distributors complied with the new sales strategy demands; and those two were subsequently
dropped as customers.
Initially the strategy paid off; the sales in the last few days of the year totaled about $25 million
and amounted to one-half of the division's profit for the entire year. The division manager was de-
lighted. However, the long-term results were not favorable. By the following mid-year, the company
announced that the high inventories of its distributors would severely reduce sales and profits for that
year. The profit decline was approximately 37 percent. After the announcement, the company's stock
fell from $50 to $32. The manager was forced to step down, and stockholders filed a class-action
lawsuit accusing the company of falsely inflating sales and earnings.
History repeated itself when the CEO of Sunbeam followed the Bausch & Lomb plan to force
sales to show how well his management style (firing employees and closing plants) was working.
Sunbeam instituted a "bill and hold" plan that called for products to be produced in large quantities
and sold to customers for delivery at a later date. While this made the financial report for that first year
very favorable, it had a detrimental effect on the next year's report. In late March of that following year,
Sunbeam acknowledged that first-quarter income would be below expectations, and in fact, a loss.
Stockholders qUickly filed lawsuits charging deception, and the CEO was fired. 2
Performance Reporting and Organization Structures

Before implementing a responsibility accounting system, all areas of authority and responsibility within
an organization must be clearly defined. Organization charts and other documents should be examined to
determine an organization's authority and responsibility structure. Organization structure is the arrange-
ment of lines of responsibility within the organization. These structures vary widely. Some companies
have functional-based structures along the lines of marketing, production, research, and so forth; other
companies use products, services, customers, or geography as the basis of organization. When an attempt
is made to implement a responsibility accounting system, management could find instances of overlap-
ping duties, authority not commensurate with responsibility, and expenditures for which no one appears
responsible. These circumstances can make the development of a responsibility accounting system dif-
ficult. General Electric overcame many of these problems with the use of teams and a new measurement
tool as explained in the next Business Insight. (For discussions and examples of organization structures,
consult a basic principles of management text.)
2 "Numbers Game at Bausch & Lomb?" Business Week, December 19, 1994, pp. IOS-IO; and "How Al Dunlap Self·Destructed,"
Business Week, July 6, 1995, pp. 5S--{)!, 64.
BUSINESS INSIGHT GE's Six Sigma
General Electric strives to improve quality without ignoring costs and its managers are responsible
for controlling the combination of quality and costs. Its responsibility accounting program, called Six
Sigma, has increased its annual productivity by over 200 percent and its operating margin by 4 per-
centage points. Six Sigma, is a means of measuring quality (through errors or defects) for any activ-
ity. For each activity, a target for improvement is set and a manager is assigned the responsibility to
achieve the target. The reporting system centers on the rate of improvement as measured by reduced
defects or errors. The program has five basic steps:
1. Define: Teams work to define problems related to a process or service.
2. Measure: Determine what is wrong with the existing process or service.
3. Analyze: Determine reasons for what is wrong.
4. Improve: Define and develop a plan of action.
5. Control: Ensure changes are installed and used effectively; keep problems from recurring.
GE is pleased with the system because it improved quality and saved millions in operating expenses. 3
Although performance reports can be developed for areas of responsibility as narrow as a single
worker, the basic responsibility unit in most organizations begins with the department and progresses to
division and corporate levels. In manufacturing plants, separate performance reports can be used for re-
sponsibility centers comprising production or service departments or manufacturing cells. In large univer-
sities, separate responsibility centers are set up for individual academic departments (such as accounting,
psychology, and mathematics) and staff and service departments (such as human resources, food service,
and maintenance). When a large department performs a number of diverse and significant activities, re-
sponsibility accounting can be further refined so that a single department contains several responsibility
centers with pelformance reports prepared for each.
Types of sponsibili enters

Under responsibility accounting, performance reports are prepared for departments, segments of depart-
ments, or groupings of departments that operate under the control and authority of a responsible manager.
Each organizational unit for which performance reports are prepared is identified as a responsibility cen-
ter. For the purpose of evaluating their financial performance, responsibility centers can be classified as
cost centers, revenue centers, profit centers, or investment centers.
Cost Center
A cost center is a responsibility center whose manager is responsible for managing only costs; there is
no revenue responsibility. A cost center can be as small as a segment of a department or large enough to
include a major aspect of the organization, such as all manufacturing activities. Typical examples of cost
centers include the following:
Organization Cost Center
Manufacturing plant ..... Tooling department

Assembly activities
Retail store . Inventory control function
Maintenance department
Hospital . Radiology
Emergency room
College . History department
Registrar's office
City government . Public safety (police and fire)
Road maintenance
JSridhar Seshadri and Gregory T. Lucier, "GE Takes Six Sigma beyond the Bottom Line," Strategic Finance, May 2001,
pp.40-46.
Revenue Center
A revenue center is a responsibility center whose manager is responsible for the generation of sales rev-
enues. Even though the basic performance report of a revenue center emphasizes sales, revenue centers
are likely to be assigned responsibility for the controllable costs they incur in generating revenues. If
revenues and costs are evaluated separately, the center has dual responsibility as a revenue center and as a
cost center. If controllable costs are deducted from revenues to obtain some bottom-line contribution, the
center is, in fact, being treated more like a profit center than a revenue center.
Profit Center
A profit center is a responsibility center whose manager is responsible for revenues, costs, and resulting
profits. It could be an entire organization, but it is more frequently a segment of an organization such as
a product line, marketing territory, or store. In the context of performance evaluation, the word "profit"
does not necessarily refer to the bottom line of an income statement; instead, it likely refers to the profit
center's contribution to common corporate costs and profit. Profit is computed as the center's revenues
less all costs associated with operating the center. In addition to a center's profits, other measures of
performance can include quality assessments, service ratings, and operating efficiencies. Having limited
authority regarding the size of total assets, the profit center manager is not held responsible for the rela-
tionship between profits and assets.
Investment Center
An investment center is a responsibility center whose manager is responsible for the relationship
between its profits and the total assets invested in the center. Investment center managers have a high
degree of organization autonomy. In general, the management of an investment center is expected to
earn a target profit per dollar invested. Investment center managers are evaluated on the basis of how
well they use the total resources entrusted to their care to earn a profit. An investment center is the
broadest and most inclusive type of responsibility center. Managers of these centers have more author-
ity and responsibility than other managers and are primarily responsible for planning, organizing, and
controlling firm activities. Because of their authority regarding the size of corporate assets, they are
held responsible for the relationship between profits and assets. Investment centers are discussed fur-
ther in Chapter II.
PERFORMANCE REPORTING FOR

OS CE TERS
Financial performance reports for cost centers include a comparison of actual and budgeted (or al- L02 Differentiate
lowed) costs and identify the difference as a variance. Allowed costs in performance reports are the between static
flexible budget amounts for the actual level of activity. The variance is favorable if actual costs are less and flexible
than budgeted (or allowed) costs and unfavorable if actual costs are more than budgeted (or allowed) budgets for
costs. These comparisons are made in total and individually for each type of controllable cost assigned performance
to the cost center. reporting.
eve opme t f Fie ible e

A budget that is based on a prediction of sales and production is called a static hudget. The operating
budget explained in Chapter 9 is a static budget. Budgets can also be set for a series of possible produc-
tion and sales volumes, or budgets can be adjusted to a particular level of production after the fact. These
budgets, based on cost-volume relationships, are called flexible budgets; they are used to determine
what costs should have been for an attained level of activity. For example, if the college cafeteria budgets
$15,000 for food during April for 5,000 meals but provides 6,000 meals, the budget needs to be adjusted
by the original food budget rate of $3 ($15,000/5,000 meals). Otherwise, the amount spent on food will
not be a fair evaluation of the cost per the original budget. If $17,500 was spent on food during the month,
the analysis might appear as follows:
Budget Item Actual Budget Difference
Static analysis
Food $17,500 5,000 meals x $3 = $15,000 $2,500 over budget
Flexible analysis
Food. . . . . . . . . . . . .. $17,500 6,000 meals x $3 = $18,000 $500 under budget
The cafeteria manager is better evaluated based on what actually happened with the flexible budget
than with the static budget, especially if the manager had no control over how many student meals were
requested.
For a complete example of a flexible budget, assume that McMillan Company, which produces liigh-
quality computer carrying cases, has three departments: Production, Sales, and Administration. The focus
in this section is on the development of financial performance reports for the Production Department. The
flexible budget cost-estimating equations for total monthly production costs of cases are based on produc-
tion standards for variable and fixed costs. The standards follow:
Variable costs
Direct materials-2 pounds per unit at $5 per pound, or $10 per unit
Direct labor-0.25 hour per unit at $24 per hour, or $6 per unit
Variable overhead - 2 pounds per unit at $4 per pound, or $8 per unit
Fixed costs-$52,OOO
If management plans to produce 10,000 cases in July, the budgeted manufactuling costs are
$292,000:
McMILLAN COMPANY
For Month of July
Manufacturing costs
Variable costs
Direct materials (10,000 x 2 pounds X $5) . $100,000
Direct labor (10,000 X 0.25 hours X $24) .. 60,000
Variable overhead (10,000 X 2 pounds X $4) .. 80,000
Fixed costs . 52,000
Total . $292,000
Flexible Budgets Emphasize Performance

If actual production happened to equal 10,000 units the performance of the Production Department in con-
trolling costs could be based on a comparison of actual and budgeted manufacturing costs. If production
was at some volume other than that planned in the original manufacturing budget, however, it would be
inappropriate to compare actual manufacturing costs with the costs predicted in the original static budget.
Doing so would intermix two separate Production Department responsibilities, namely, the manufacturing
responsibility for production volume and the financial responsibility for cost control.
The Oliginal budget for production volume and related costs was set on the basis of predicted needs
for sales and inventory requirements, taking into consideration materials, labor, and facilities constraints
and costs. In the absence of any changes, the Production Department is evaluated by comparing the ac-
tual and budgeted costs. If, however, production needs change, perhaps due to an unexpected increase
or decrease in sales volume, the Production Department should attempt to make appropriate changes.
When the actual production volume is anything other than the originally budgeted amount, the Production
Department's financial responsibility for costs should be based on the actual level of production.
For the purpose of evaluating the financial performance of cost centers, a flexible budget is tailored,
after the fact, to the actual level of activity. A flexible budget variance is computed for each cost as the
difference between the actual cost and the flexible budget cost of producing a given quantity of product or
service. Assume that actual production for July totaled 11,000 units rather than 10,000 units. Examples of a
performance report for July manufacturing costs based on static and flexible budgets are presented in Exhibit
10.1. When the Production Department's financial performance is evaluated using the static budget, the ac-
tual cost of producing 11,000 units is compared to the budgeted cost of producing 10,000 units. The result is
a series of unfavorable static budget variances totaling $20,000.
EXHIBIT 10.1 Flexible BUdgets and Performance Evaluation
McMILLAN COMPANY
Production Department Performance Report
For Month of July
Based on Static Budget Based on Flexible Budget
Original Static Budget Flexible Flexible Budget

Actual Budget Variance Actual Budget* Variance
Volume . 11,000 10,000 11,000 11,000
Unit level costs

Direct materials . $108,000 $100,000 $ 8,000 U $108,000 $110,000 $2,000 F
Direct labor . 70,000 60,000 10,000 U 70,000 66,000 4,000 U
Variable overhead . 81,000 80,000 1,000 U 81,000 88,000 7,000 F
Fixed costs . 53,000 52,000 1,000 U 53,000 52,000 1,000 U
Totals . $312,000 $292,000 $20,000 U $312,000 $316,000 $4,000 F
'Flexible budget manufacturing costs: (Actual ievel x Budgeted unit cost)

Direct materials (11 ,000 units x 2 pounds x $5)
Direct labor (11,000 units x 0.25 labor hour x $24)
Variable overhead (11,000 units x 2 pounds x $4)
When the Production Department's financial performance is evaluated by comparing actual costs
with costs allowed in a flexible budget drawn up for the actual production volume however the results are
mixed. Direct materials have a $2,000 favorable variance. Direct labor has a $4,000 unfavorable variance.
The variable overhead variance is $7,000 favorable. The fixed overhead variance remains $1,000 unfavor-
able since the static and flexible fixed budgets stay the same. The net flexible budget variance is $4,000
favorable, a substantial change from the static variance of $20,000 unfavorable.
Flexible budget variances provide a much better indicator of performance than static budget vari-
ances that do not consider the increased level of production (11,000 units rather than 10,000 units). When
production increases by, say, 10 percent, the static budget variances would be unfavorable. Likewise,
when actual production is substantially below the planned level of activity, the static variances are usually
favorable. While it is important to isolate and determine the cause of any variation between planned and
actual production, the financial-based performance report is not the appropriate place to mix volume-
created variances with those related to the actual production levels.
MID-CHAPTER REVIEW
Ron Gilette received the following performance report from the accounting department for his first month as
plant manager for a new company. Ron's supervisor, the vice president of manufacturing, has concerns that the
report does not provide an accurate picture of Ron's performance in the area of cost controL
Actual Budgeted Variance
Units ................... 10,000 12,000 2,000U

-- --
Costs
Direct materials ............ $ 299,000 $ 360,000 $ 61,000 F
Direct labor ................ 345,500 432,000 86,500 F
Variable factory overhead ..... 180,000 216,000 36,000 F
Fixed factory overhead ...... 375,000 360,000 15,000 U
Total costs ................ $1,199,500 $1,368,000 $168,500 F
Required
Prepare a revised budget that better reflects Ron Gilette's performance.
Solution
The pelformance report prepared by the accounting department was based on a "static" budget. A better basis
for evaluating Ron Gilette's performance is to compare actual performance with a flexible budget. By dividing
the budgeted sales and variable costs amounts by 12,000 units, the budgeted unit variable costs amounts can be
delermined as follows:
Direct materials cost. . . . . . . . . . .. $360,000 -;- 12,000 units = $30 per unit
Direct labor. . . . . . . . . . . . . . . . . .. $432,000 -;- 12,000 units = $36 per unit
Variable factory overhead. . . . . . .. $216,000 -;- 12,000 units = $18 per unit
Using these budgeted unit values, a flexible budget can be prepared as follows:
Flexible
Actual Budget Variance
Units . 10,000 10,000
Costs
Direct materials . $ 299,000 $ 300,000 $ 1,000 F
Direct labor . 345,500 360,000 14,500 F
Variable factory overhead . 180,000 180,000
Fixed factory overhead . 375,000 360,000 15,000 U
Total plant costs . $1,199,500 $1,200,000 $ 500 F
The plant did not produce the number of units originally budgeted. Therefore, from a cost control standpoint, a
flexible budget is a better basis for evaluating Ron's performance because it compares the actual cost of produc-
ing 10,000 units with a budget also based on 10,000 units. Based on the flexible budget, his performance is still
quite good; however, it is much less favorable than it appeared using a static budget.
Standard osts and PerfOt"rn~r,,·"o eports

A standard cost indicates what it should cost to provide an activity or produce one batch or unit of prod-
uct under planned and efficient operating conditions. In a standard costing environment, the flexible bud-
get is based on standard unit costs. Traditionally, standard costs have been developed from an engineering
analysis or from an analysis of historical data adjusted for expected changes in the product, production
technology, or costs. When standards are developed using historical data, management must be careful to
ensure that past inefficiencies are excluded from current standards.
To obtain the full benefit of standard costs, the standards must be based on realistic expectations. The
standard cost for direct labor for McMillan Company is $6.00 per unit, (computed as 0.25 direct labor
hours X $24 per hour). Some organizations intentionally set "tight" standards to motivate employees
toward higher levels of production. The management of McMillan Company might set their standards for
direct labor at 0.22 hours per unit rather than at the expected 0.25 hours per unit, hoping that employees
will strive toward the lower time and, consequently, the lower cost of $5.28 ($24 X 0.22). The use of
tight standards often causes planning and behavioral problems. Management expects them to result in
unfavorable variances. Accordingly, tight standards should not be used to budget input requirements and
cash flows because management expects to incur more labor costs than the standards allow. The use of
tight standards can have undesirable behavioral effects if lower-level managers and employees find that a
second set of standards is used in the "real" budget or if they are constantly subject to unfavorable perfor-
mance reports. These employees could come to distrust the entire budgeting and performance evaluation
system, or they may quit trying to achieve any of the organization's standards.
Tight standards are more likely to occur in an imposed budget and less likely to occur in a participa-
tion budget for which employees are actively involved in preparing. In a participation budget, the prob-
lems may be to avoid loose standards that are easily attained and to avoid overstating the costs required to
produce a product. Loose standards may fail to properly motivate employees and can make the company
uncompetitive due to costs and prices that are higher than those of competitors.
VARIA CE A ALYSIS FOR COSTS

To use and interpret standard cost variances properly, managers must understand both the standard- L03 Determine
setting process and the framework for computing and analyzing standard cost variances. While these and interpret
are preliminary tools for decision analysis regarding activities and operations, they nevertheless give direct materials,
managers a starting point in assessing the efficiency (or lack thereof) of activities. The variances alone direct labor, and
do not explain, however, why the activity is different from expectations. Underlying causes of variances overhead cost
must be investigated before final judgment is passed on the effectiveness and efficiency of an operation variances.
or acti vity.
Standard cost variance analysis provides a system for examining the flexible budget variance,
which is the difference between the actual cost and flexible budget cost of producing a given quantity
of product or service. Actual cost is determined from the organization's financial transactions. Flexible
budget cost is determined by multiplying standard quantities allowed for the output times the standard
price per unit. In other words, the flexible budget can be computed as actual output times the standard unit
cost. Recall that standard unit cost represents what it should cost to produce a completed unit of product
or service under efficient operating conditions. To determine standard unit cost, management establishes
separate quantity and price (or rate) standards for each input production component. For a company us-
ing activity-based costing, each manufacturing activity could have its own standard costs that focus on
underlying concepts and cost drivers, and companies even develop their own set of variances as discussed
in the following Business Insight.
Standard cost variance analysis identifies the general causes of the total flexible budget variance
by breaking it into separate price and quantity variances for each production component. Two possible
reasons that actual cost could differ from flexible budget cost for a given amount of output produced are
(1) a difference between actual and standard prices paid for the production components-the price vari-
ance-and (2) a difference between the actual quantity and the standard quantity allowed for the produc-
tion components-the quantity variance. Variances have different names for different cost categories as
follows:
Cost Component Price Variance Name Quantity Variance Name
Direct materials Materials price variance Materials quantity variance

Direct labor Labor rate variance Labor efficiency variance
Variable overhead Variable overhead Variable overhead efficiency variance
spending variance
BUSINESS INSIGHT Flexibility in Standard Costing
The variances in this book are not the only ones used by managers. Many companies develop their
own variances to meet the needs of their managers when confronted with unusual activities. Such
is the case with Parker Brass. Two concerns of the production managers at Parker Brass are the
timing of product cost information and providing an effective cost control system. As managers were
struggling with new and different decisions, they decided that additional information was needed.
They developed three new variances: standard run quantity variance, materials substitution variance,
and method variance.
The standard run quantity variance measures the amount of setup cost that was not recovered
because the batch size was smaller than the predetermined optimal batch size. Because the company
had been including setup cost with labor, the managers were having difficulty explaining all of the labor
variances. By pulling out the amounts related to batch sizes, the remainder of the analysis became
easier to explain. The materials substitute variance is relevant when the standard materials have to be
substituted because of lack of inventory or because a customer wants something different than normal.
This often helps explain both materials price variances and usage variances so these two variances do
not have to be used to justify all differences between standard and actual cost. The method variance
is used when different machines or processes can be used to produce the same output. For example,
if a process requires three labor hours and two machine hours but due to machine demand by other
products, the process can be completed with seven labor hours and one machine hour, the resulting
standard versus actual cost variances will be different even when all costs are perfectly controlled.
When managers know that the accounting system is flexible, there is more coordination between
those who develop the system and those who use it. Parker Brass modified its standard costing system
to better meet the needs of its managers without disrupting the traditional cost accounting system. 4
Fixed overhead is excluded from the unit standard costs because, within the relevant range of normal
activity, it does not vary with the volume of production. To facilitate product costing, however, many or-
ganizations develop a standard fixed overhead cost per unit.
In the following sections, we analyze the flexible budget cost variances for materials, labor and
variable overhead. Our illustration of variance analysis is based on the following July activity and costs
of McMillan Company's Production Department.
McMILLAN COMPANY-PRODUCTION DEPARTMENT

Actual ManUfacturing Costs
For Month of July
Actual units completed . 11,000
Manufacturing costs
Unit level costs
Direct materials (24,000 pounds X $4.50) $108,000
Direct labor (2,800 hours x $25.00) . 70,000
Variable overhead . 81,000
Fixed overhead costs . 53,000
Total . $312,000
Note that detailed information on actual pounds and an actual rate is not provided for variable overhead.
That is because variable overhead represents a pool of related costs driven by a number of factors rather
than a single cost with a single driver, as is often the case for materials and labor. Although the basis used
in budgeting variable overhead may, and should, have a high correlation with actual variable overhead,
4David Johnsen and Parvez Sopariwala, "Standard Costing [s Alive and Well at Parker Brass, Managemelll Accounting Quarterly,
Winter 2000, pp. 12-20.
it is a surrogate for the multiple cost elements that comprise variable overhead. Issues related to variable
overhead are discussed in greater detail later in this chapter.
Establishing and Using Standards for Direct

aterials
The two basic elements contained in the standards for direct materials are the standard price and the stan-
dard quantity. Materials standards indicate how much an organization should pay for each input unit of
direct materials and the quantity of direct materials it allows to produce one unit of output. The standard
price per unit of direct materials should include all reasonable costs necessary to acquire the materials.
These costs include the invoice price of materials, less planned discounts plus freight, insurance, special
handling, and any other costs related to the acquisition of the materials. The standard quantity represents
the number of units of raw materials allowed for the production of one unit of finished product. This
amount should include the amount dictated by the physical characteristics of the process and the product,
plus a reasonable allowance for normal spoilage, waste, and other inefficiencies. The quantity standard
can be determined by engineering analysis, professional judgment, or by averaging the actual amount used
for several periods. An average of actual past materials usage may not be a good standard because it could
include excessive wastes and inefficiencies in the standard quantity.
Direct Materials Variances

The materials price variance is the difference between the actual materials cost and the standard cost
of actual materials inputs. The materials quantity variance is the difference between the standard cost
of actual materials inputs and the flexible budget cost for materials. The direct materials variances for
McMillan Company follow.
Standard Cost Variance Analysis
Input component: Direct materials Output: 11,000 cases
Standard Cost of
Actual Cost Actual Inputs Flexible Budget Cost
Actual quantity (AO) . 24,000 Actual quantity (AO) . 24,000 Standard quantity allowed (SO) . 22,000'
Actual price (AP) . x $4.50 Standard price (SP) . x $5.00 Standard price (SP) . x $5.00
$108,000 $120,000 $110,000
Materials price Materials quantity

variance $12,000 F variance $10,000 U
'- Total flexible budget materials variance $2,000 F
'11,000 units x 2 pounds per unit
McMiJlan Company had a favorable materials price variance of $12,000 because the actual cost of
materials used ($108,000) was less than the standard cost of actual materials used ($120,000). Stated
another way, for the materials actually used, the total price paid was $12,000 less than the price allowed
by the standards. The price variance can also be viewed as the actual quantity (AQ) used times the differ-
ence between the actual price (AP) and the standard price (SP). McMillan Company paid $0.50 per pound
below the standard price for 24,000 pounds for a total savings of $12,000. This is readily shown using the
formula approach:
Materials price variance = AQ(AP - SP)

= 24,000($4.50 - $5.00)
= 24,000 x $0.50
= $12,000 F
The unfavorable quantity variance of $10,000 occurred because the standard cost of actual materi-
als used, $120,000 (24,000 X $5), was higher than the cost of materials allowed by the flexible budget,
$110,000 (22,000 X $5). A total of 22,000 pounds of materials is allowed to produce 11,000 units of fin-
ished outputs. This is computed as 11,000 finished units times 2.0 pounds of direct materials per unit. The
materials quantity variance can also be computed as the standard price (SP) per pound times the difference
between the number of pounds actually used (AQ) and the number of pounds allowed (SQ). This is also
readily shown using the formula approach:
Materials quantity variance = SP(AQ - SQ)

= $5(24,000 - 22,000)
= $5 x 2,000
= $10,000 U
Interpreting Materials Variances
After computing variances, managers must understand how to use them in making decisions relevant to
the items being evaluated. Afavorable materials price variance indicates that the employee responsible
for materials purchases paid less per unit than the price allowed by the standards. This could result from
receiving discounts for purchasing more than the normal quantities, effective bargaining by the employee,
purchasing substandard-quality materials, purchasing from a distress seller, or other factors. Ordinarily,
when a favorable price variance is reported, the employee's performance is interpreted as favorable. How-
ever, if the favorable price variance results from the purchase of materials of lower than standard quality
or from a purchase in more than desirable quantities, the employee's performance would be questionable.
Consistent and highly favorable variances could indicate situations that are undermining the responsibility
accounting system by building slack into the standards or using incorrect data. These situations should be
thoroughly investigated for causes and corrections.
An unfavorable materials price variance means that the purchasing employee paid more per unit
for materials than the price allowed by the standards. This could be caused by failure to buy in suf-
ficient quantities to receive normal discounts; purchase of higher-quality materials than called for in
the product specifications; failure to place materials orders on a timely basis, thereby requiring a more
expensive shipping alternative; uncontrollable price changes in the market for the materials; failure to
bargain for the best available prices; or other factors. It should be emphasized that an unfavorable vari-
ance does not always mean that the employee performed unfavorably. Many noncontrollable factors
surround the purchasing function due to timing problems, changing vendors, and changes in materials
required by production.
Afavorable materials quantity variance means that the actual quantity of raw materials used was
less than the quantity allowed for the units produced. This could result from factors such as less materials
waste than allowed by the standards, better than expected machine efficiency, direct materials of higher
quality than required by the standards, and more efficient use of direct materials by employees. An unfa-
vorable materials quantity variance occurs when the quantity of raw materials used exceeds the quantity
allowed for the units produced. This could result from incurring more waste than provided for in the
standards, poorly maintained machinery requiring larger amounts of raw materials, raw materials of lower
quality than required by the standards, or poorly trained employees who were unable to use the materials
at the level of efficiency required by the standards.
Establishin and s'n Standards "for Direc bor

To evaluate management performance in controlling labor costs by using a standard cost system, it is
necessary to determine the standard labor rate for each hour allowed and the standard time allowed to
produce a unit. Setting labor rate standards can be quite simple or extremely complex. If only one class
of employee is used to make each product and if all employees have the same wage rate, determining the
standard cost is relatively easy: Simply adopt the normal wage rate as the standard labor rate. If several
different classes of employees are used to make each unit of product, separate efficiency and rate stan-
dards could be established for each class.
The standard labor time per unit can be determined by an engineering approach or an empirical obser-
vation approach. When using an engineering approach, industrial engineers ascertain the amount of time
required to produce a unit of finished product by applying time and motion methods or other available
techniques. Normal operating conditions are assumed in arriving at the labor standard. Therefore, allow-
ances must be made for normal machine downtime, employee personal breaks, and so forth. Under the
empirical approach, the long-run average time required in the past to produce a unit under normal operat-
ing conditions is used as a basis for the standard. Use of normal operating conditions automatically factors
inefficiencies such as machine downtime and employee breaks into the standard.
Direct Labor Variances

Using the general variance model that was used for materials, we can compute the labor rate and effi-
ciency variances. The labor rate (spending) variance is the difference between the actual cost and the
standard cost of actual labor inputs. The labor efficiency variance is the difference between the standard
cost of actual inputs and the flexible budget cost for labor.
McMillan Company's labor standards provide for 0.25 hour of labor per unit produced at $24 per
hour. During July, 2,800 hours were used at a cost of $25 per hour. Using these data, the labor rate (price)
variance and labor efficiency (quantity) variance can be computed as shown in the following illustration.
Input component: Direct labor Output: 11,000 cases
Standard Cost of
Actual hours (AH) . 2,800 Actual hours (AH) . 2,800 Standard hours allowed (SH) . 2,750'
Actual rate (AR) . x $25 Standard rate (SR) . x $24 Standard rate (SR) . x $24
$70,000 $67,200 $66,000
Labor rate Labor efficiency

variance $2,800 U variance $1,200 U
' - - - - - - - - - - Total flexible budget labor variance $4,000 U
'11,000 units x 0.25 hour per unit
The labor rate variance can also be computed in formula form as the actual number of hours used
times the difference between the actual rate and the standard rate. The symbols are the same as in the
diagram.
Labor rate variance = AH(AR - SR)

= 2,800($25 - $24)
= 2,800 x $1
= $2,800 U
This computation of the labor rate variance shows that the company paid $1 more than the standard rate
for each of the 2,800 hours worked.
Since 11,000 units of product were finished during the period and 0.25 hour of labor was allowed for
each unit, the total number of standard hours allowed was 2,750. The labor efficiency variance can also be
computed as the standard rate times the difference between the actual labor hours and the standard hours
allowed for the output achieved:
Labor efficiency variance = SR(AH - SH)

= $24(2,800 - 2,750)
= $24 x 50
= $1,200 U
This computation of the labor efficiency variance indicates that the company used 50 more labor hours
than the budget permitted for a total of $1,200 more than the standards allowed. Since our illustration
avoids the use of more complicated evaluations with multiple drivers, a multiple driver example is pro-
vided in the following Business Insight. The approach in this illustration can be used for direct labor or
variable overhead.
BUSINESS INSIGHT MUltiple Cost Drivers
Highly structured activity-based reporting systems usually require the performance reports to indicate
all relevant cost drivers associated with the activities being evaluated. This is popular for automated
settings such as those of Hewlett-Packard, Advanced Micro Devices, AT&T, and IBM. In these
manufacturing environments, labor, as a cost driver, does not dominate. The manufacture and as-
sembly of products are completed in distinct stages, each somewhat independent of others. To illus-
trate this type of setting, assume that an operating department has three automated processes
performing three different tasks. The variances for each activity follow: 5
Input component: Materials fabrication Output: 100 units
Activity Actual Cost Standard Cost of Actual Inputs Flexible Budget Cost
Cutting ... $ 3,400 160 cuts x $20.00 = $ 3,200 150 cuts x $20.00 = $ 3,000
Shaping .. 7,100 8,000 turns x $ 0.90 = 7,200 8,100 turns x $ 0.90 = 7,290
Fitting .... 18,000 80,000 fittings x $ 0.20 = 16,000 63,700 fittings x $ 0.20 = 12,740
$28,500 $26,400 $23,030
Activity spendings Activity efficiencies

Cutting $ 200 U Cutting $ 200 U
Shaping . 100 F Shaping . 90 F
Fitting . 2,000 U Fitting . 3,260 U
Total spending Total efficiency ....
variance .... $2,100 U variance. . . . . .. $3,370 U
Total flexible budget variance $5,470 U
Interpreting Labor Variances

The possible explanations for labor rate variances are rather limited. An unfavorable labor rate variance
can be caused by the use of higher paid laborers than the standards provided. Also, a new labor union
contract increasing wages could have been implemented after the standards were set. In this case, the
standards should have been revised to account for the wage rate change. In a nonunion situation when a
negotiated contract does not control wages, a manager could arbitrarily increase employee wages above
the standard rate. This also can cause an unfavorable labor rate variance. Afavorable labor rate variance
occurs if lower paid workers were used or if actual wage rates declined.
Unfavorable labor efficiency variances occur when workers or machines require more than the
number of hours allowed by the standards to produce a given amount of output. This could be caused
by a management decision to use poorly trained workers or poorly maintained machinery or by down-
time resulting from the use of low-quality materials. Low employee morale and generally poor work-
ing conditions could also adversely affect the efficiency of workers, resulting in an unfavorable labor
efficiency variance.
A favorable labor efficiency variance occurs when fewer hours are used than are allowed by the
standards. This above-normal efficiency can be caused by the company's use of higher skilled (and higher
paid) workers, better machinery, or raw materials of higher quality than the standards provided. High
~ James M. Reeve. "Projects, Models, and Systems-Where Is ABM Headed?" Journal O/COSI Managemenl, Summer 1996, pp. 5-16.
employee morale, improved job satisfaction, or generally improved working conditions could also ac-
count for the above-normal efficiency of the workers.
Establishing an Using Standards for Variable

Ov rhead
The traditional unit-level approach usually separates overhead costs into fixed and variable elements for
control purposes. This separation is necessary because the variance between actual costs and expected
costs is caused by different factors for fixed and variable costs. Unlike direct materials costs, which
represent specific cost components, manufacturing overhead represents groups of different costs. Conse-
quently, setting standards is often more difficult for overhead costs than it is for materials costs. For mixed
manufacturing overhead costs (those that have variable and fixed components), an estimation technique,
such as the high-low method, regression analysis (least-squares), or scatter diagram, is often used to
separate the fixed and variable overhead components. (These techniques were discussed in Chapter 2.) If
management concludes that the observations used in estimating variable costs reflect normal operating
conditions, managers will probably adopt the estimate as the standard variable cost.
Because it includes many heterogeneous costs, manufacturing overhead poses a unique problem
in measuring standard quantity and standard price. Direct materials have a natural physical measure of
quantity such as tons, barrels, pounds, and liters. Similarly, labor or assembly is measurable in hours.
However, no single quantity measure is common to all overhead items. Overhead is a cost group that
can simultaneously include costs measurable in hours, pounds, liters and kilowatts.
The most frequent approach to dealing with the problem of multiple quantity measures in variable
manufacturing overhead is to use an artificial (substitute) measure of quantity for all items in a given
group. Typical substitute measures are machine hours, units of finished product, direct labor hours, and
direct labor dollars. The variable overhead standard is then stated in terms of this single-factor base,
and the amount of variable overhead budgeted is based on this artificial activity measure. Alternatively,
variable overhead spending and efficiency variances might be developed for two or more of the types of
costs included in variable overhead. Although multiple measure approaches may be more accurate they
are more complex. Because the concepts are the same as for the single measure approach, only the single
measure approach is illustrated.
Variable Overhead Variances

The variable overhead spending variance is the difference between the actual variable overhead cost and
the standard variable overhead cost for the actual inputs of the measurement base. The variable overhead
efficiency variance is the difference between the standard variable overhead cost for the actual inputs of
the measurement base and the flexible budget cost allowed for variable overhead based on outputs.
For McMillan Com pany, tbe actual variable overhead for waterproofing and inspection is $81,000.
This represents the actual cost of overbead items such as indirect materials and indirect labor. Since actual
variable overhead is expected to vary with pounds of direct materials used, the standard cost of actual
inputs is calculated as actual pounds of direct materials (AP) times the standard variable overhead rate per
pound (SRP):
Standard cost of actual inputs = (AP x SRP)
= 24,000 x $4
= $96,000
The flexible budget cost for variable overhead allowed for the actual outputs is based on the 22,000
pounds of direct materials allowed (SP) for the units produced during the period (11 ,000 units X 2 pounds).
The allowed quantities are multiplied by the standard variable overhead rate (SRP). The resulting variable
overhead flexible budget cost is $88,000:
Flexible budget cost = (SP x SRP)
= 22,000 x $4
= $88,000
Using these data, the variable overhead spending (price) variance and the variable overhead efficiency
(quantity) variance follow.
Input component: Variable overhead Output: 11 ,000 cases
Actual Standard Cost of

Costs Actual Inputs Flexible Budget Cost
$81,000 Actual pounds (AP) . 24,000 Pounds allowed (SP) . 22,000'

Standard rate (SRP) . x $4 Standard rate (SRP) . x $4
Total . $96,000 Total . $88,000
Variable overhead Variable overhead

f------- spending variance efficiency variance
$15,000 F $8,000 U
Total flexible budget variable overhead variance $7,000 F
'11,000 X 2 Ibs.
An alternative to the computation of the variable overhead effectiveness variance follows:
Variable overhead efficiency variance = SRP(AP - SP)

= $4(24,000 - 22,000)
= $8,000 U
This approach emphasizes that the 2,000 extra pounds used should have increased variable overhead by
$8,000 at the standard rate of $4 per pound.
Interpreting Variable Overhead Variances

Afavorable spending variance encompasses all factors that cause actual expenditures to be less than the
amount expected for the actual inputs of the measurement base, including consumption and payment.
Conversely, an unfavorable spending variance results when the actual expenditures are more than ex-
pected for the inputs of the measurement base. This is caused by consuming more overhead items than
expected, or by paying more than the expected amount for overhead items consumed, or by both. Thus,
the term spending variance is used instead of price variance.
The key to understanding the variable overhead spending variance is recognizing that the amount of
variable overhead cost allowed is determined by the level of the measurement bases used. Any deviation
from this spending budget--due to uncontrolled or mismanaged variable overhead price or quantity vari-
ables---causes a spending variance to occur.
The variable overhead efficiency variance measures the difference between the standard variable
overhead cost for the actual quantity of the measurement base and the standard variable overhead cost for
the allowed quantity of the measurement base. This variance measures the amount of variable overhead
that should have been saved (or incurred) because of the efficient (or inefficient) use of the measurement
base. It provides no information about the degree of efficiency in using variable overhead items such as
indirect materials and indirect labor. This information is reflected in the spending variance.
.1·"1U,,
• You Are the Vice President of Manufacturing
Your company has had a practice for many years of budgeting variable overhead costs based on
direct labor hours. The managerial accountants have argued that if direct labor hours are controlled,
variable overhead costs will take care of themselves since direct labor hours drive variable overhead
costs. You (and your plant managers) have become very skeptical of this policy because in reGent
years variable overhead variances have been very erratic-sometimes being large favorable amounts
and other times being large unfavorable amounts. You are beginning to plan for the coming budget
year. How do you think you should budget variable overhead and evaluate managers who control
these costs? [Answer, p. 353]
Fixed v rhea Varia cas

By definition, the quantity of goods and services purchased by fixed expenditures is not expected to change
in proportion to short-run changes in the level of production. For example, in the short run, the production
level does not affect the amount of depreciation on buildings, the number of fixed salaried employees, or
the amount of real property subject to property taxes. Whether the organization produces 10,000 or 15,000
cases, the same quantity of fixed overhead is expected to be incurred, as long as the production level is
within the relevant range of activity provided by the current fixed overhead items. Therefore, an efficiency
variance is ordinarily not computed for fixed overhead costs.
Even though the components of fixed overhead are not expected to be affected by the production
activity level in the short run, the actual amount spent for fixed overhead items can differ from the amount
budgeted by management. For example, higher than budgeted supervisors' salaries could be paid, longer
than normal working shifts could cause heating or cooling costs to exceed budget, and price increases
could cause the amounts paid for equipment to be higher than expected. Fixed overhead costs in excess
of the amount budgeted are reflected in the fixed overhead budget variance. The fixed overhead budget
variance is, simply, the difference between budgeted and actual fixed overhead. Using the fixed costs of
McMillan Company as an example:
Fixed overhead budget variance = Actual fixed overhead - Budgeted fixed overhead
= $53,000 - $52,000
= $1,000 U
The fixed overhead budget variance is always the same as the total fixed overhead flexible budget variance.
Because budgeted fixed overhead is the same for all outputs within the relevant range, the budget variance
explains the total flexible budget variance between actual and allowed fixed overhead. Similar to variable
overhead, fixed overhead variances can be caused by a combination of price and quantity factors.
PERFORMA CE REPORTS FOR

REVENUE CENTERS
The financial performance reports for revenue centers include a comparison of actual and budgeted rev- L04 Calculate
enues. Controllable costs can be deducted from revenues to obtain some bottom-line contribution margin. revenue variances
If the center is then evaluated on the basis of this contribution, it is being treated as a profit center. and prepare a
If the organization is to meet its budgeted profit goal for a period, with its budgeted fixed and vari- performance
able costs, the organization's revenue centers must meet their original revenue budgets. Consequently, the report for a
original budget (a static budget) rather than a flexible budget is used to evaluate the financial performance revenue center.
of revenue centers.
Assume that McMillan Company's July sales budget called for the sale of 10,000 units at $40.00 each.
If McMillan Company actually sold 11,000 units at $38.50 each, the total revenue variance is $23,500
favorable:
Actual revenues (11,000 x $38.50) . $423,500

Budgeted revenues (10,000 x $40) . (400,000)
Revenue variance . $ 23,500 F
The revenue variance is the difference between the budgeted sales volume at the budgeted selling price
and the actual sales volume at the actual selling price. Because actual revenues exceeded budgeted rev-
enues, the revenue variance is favorable. It can be presented as follows:
Revenue variance = (Actual volume x Actual price) - (Budgeted volume x Budgeted price)
The separate impact of changing prices and volume on revenue is analyzed with the sales price and
sales volume variances. The sales price variance is computed as the change in selling price times the
actual sales volume:
Sales price variance = (Actual selling price - Budgeted selling price) x Actual sales volume
For McMillan, the sales price variance for July follows:

Sales price variance = ($38.50 - $40.00) x 11,000 units
= $16,500 U
The sales volume variance indicates the impact of the change in sales volume on revenues,
assuming there was no change in selling price. The sales volume variance is computed as the difference
between the actual and the budgeted sales volumes times the budgeted selling price:
Sales volume variance = (Actual sales volume - Budgeted sales volume) x Budgeted selling price
For McMillan, the sales volume variance for July follows:

Sales volume variance = (11,000 units - 10,000 units) x $40
= $40,000 F
The net of the sales price and the sales volume variances is equal to the revenue variance:
Sales price variance . $16,500U

Sales volume variance . 40,000 F
Revenue variance ..............•..•........ $23,500 F
Interpretation of these variances is subjective. In this case, we could say that if the increase in sales
volume had not been accompanied by a decline in selling price, revenues would have increased $40,000
instead of $23,500. The $1.50 per unit decline in selling price cost the company $16,500 in revenues.
Alternatively, we might note that a $1.50 reduction in the unit selling price was more than offset by an
increase in sales volume. An economic analysis could explain the relationship as volume being sensitive
to price (price elasticity).
In any case, variances are merely signals that actual results are not proceeding according to plan. They
help managers identify potential problems and opportunities. An investigation into their cause(s) could
even indicate that a manager who received a favorable variance was doing a poor job, whereas a manager
who received an unfavorable variance was doing an outstanding job. Consider McMillan Company's fa-
vorable revenue variance. This occurred because actual sales exceeded budgeted sales by 1,000 units (10
percent), which on the surface indicates good performance. But what if the total market for the company's
products exceeded the company's forecast by 15 percent? In this case, McMillan Company's sales volume
falls below its expected percentage share of the market; the favorable variance could occur (despite a poor
marketing effort) because of strong customer demand that competitors could not fill. As detailed in the
following Business Insight, budgeting an erroneously high sales volume can lead to excess production,
high inventory levels, errors in developing standard costs, unanticipated financial losses, and cash flow
problems.
Inclusion of ControUable Costs

Controllable costs should also be considered when evaluating the overall pelformance of revenue centers.
A failure to consider costs could encourage uneconomic selling practices, such as excessive advertis-
ing and entertaining, and spending too much time on small accounts. The controllable costs of revenue
centers include variable and fixed selling costs. These costs are sometimes further classified into order-
getting and order-filling costs. Order-getting costs are incurred to obtain customers' orders (for example,
advertising, salespersons' salaries and commissions, travel, telephone, and entertainment). Order-filling
costs are incurred to place finished goods in the hands of purchasers (for example, storing, packaging, and
transportation).
The performance of a revenue center in controlling costs can be evaluated with the aid of a flexible
budget drawn up for the actual level of activity. Assume that the McMillan Company's July budget for
the Sales Department calls for fixed costs of $10,000 and variable costs of $5 per unit sold. If the actual
BUSINESS INSIGHT Chrysler Hits Financial Pothole Because of Sales variances
When Cerberus Capital management acquired an 80.1 percent controlling ownership interest in
Chrysler from the former DaimlerChrysler AG in August of 2007, analysts speculated that their goal
was to "spiff up" the company and sell it or its shares for at a profit. One of the new owner's first
actions was to appoint Robert Nardelli (see the introduction to this chapter, pages 328-329), chief
executive officer.
Nardelli found a mess that required his structure and systems skills as well as his focus on
financial performance. Cost savings efforts were falling short of their targets. The company lagged
on improving fuel efficiency, and the characteristics of some models (e.g wind noise and the use of
plastic) was unacceptable to Nardelli. Worst of all, although Chrysler had significant unfavorable sales
valiances, it was not adequately adjusting production volume and costs.
Chrysler's 2007 sales budget anticipated sales of approximately 2.8 million cars while, by late
October 2007, actual sales were running at an annual rate of 2.6 million units, for an unfavorable sales
volume variance of 200,000 units. What's more, to even achieve the 2.6 million unit volume, Chrysler
increased sales (at lower prices) to rental companies, a tactic that reduces future resale values of
automobiles sold to traditional customers.
As a consequence of the unfavorable sales variances, Chrysler was not generating the cash
required to finance current operations, upgrade current vehicles, and develop new vehicles, espe-
cially vehicles using hybrid technology. Other consequences included facilities and costs geared to a
higher level of production than appropriate for current sales (that is, the fixed costs were appropriate
for a production volume significantly higher than the actual sales volume), and excess inventories with
related inventory carrying costs.
Using a more people-oriented approach than at Home Depot, Nardelli worked with managers,
employees, dealers, and others to implement what he regarded as needed changes, including: re-
vised sales forecasts, union agreements allowing Chrysler to significantly reduce labor costs, elimi-
nating some unprofitable product, and eliminating shifts at five plants. To further reduce fixed costs
and obtain cash to support operations and invest in innovation, Nardelli plans to sell plant, property,
and equipment with a book value of more than $1 billion. Commenting on the planned sale, he noted
that publically held companies hesitate to dispose of assets at less than book value because of the
resulting book loss. However, because Chrysler is privately owned by Cerberus Capital, "cash is
king." Looking ahead, Nardelli believes, "We have a solid strategic direction to return the company to
long-term profitability. "6
fixed and variable selling expenses for July are $9,500 and $65,000, respectively, the total cost variances
assigned to the Sales Department, detailed in Exhibit 10.2, are $9,500 unfavorable. In evaluating the Sales
Department's performance as both a cost center and a revenue center, management would consider these
cost variances as well as the revenue variances. Although the revenue variances are based on the original
budget, the cost variances are based on the flexible budget.
Revenue Centers as Profit Centers

Even though we have computed revenue and cost variances for McMillan's Sales Department, we are still
left with an incomplete picture of this revenue center's performance. Is the Sales Department's perfor-
mance best represented by the $23,500 favorable revenue variance, by the $9,500 unfavorable cost vari-
ance, or by the net favorable variance of $l4,000 ($23,500 F - $9,500 U)? Actually, it is inappropriate to
attempt to obtain an overall measure of the Sales Department's performance by combining these separate
revenue and cost variances. The combination of revenue and cost variances is appropriate only for a profit
center; so far, we have left out one important cost that must be assigned to the Sales Department before it
can be treated as a profit center. That cost is the standard variable cost of goods sold.
6"Chrysler Faces Financial Pinch, Sees Asset Sales," Josee Valcourt and Neal E. Boudette, The Wall Street Journal, December 21,
2007, pp. AI, A 10; "Chrysler CEP Reassures on Financial Health," The Wall Street Journal, December 24, 2007, p. A8.
EXHIBIT 10.2 sales Department Perfonnance Report for Controllable Costs
McMILLAN COMPANY
Sales Department Performance Report for Controllable Costs
For Month of July
Based on Flexible BUdget
Flexible Flexible Budget

Actual Budget* Variance
Units . 11,000 11,000
Selling expenses
Variable '" ..................•... $65,000 $55,000 $10,000 U
Fixed . 9,500 10,000 500 F
Total . $74,500 $65,000 $ 9,500 U
• Flexible budget formulas:

Variable selling expenses ($5 per unit)
Fixed selling expenses( $10,000 per month)
As a profit center, the Sales Department acquires units from the Production Department and sells
them outside the firm. Its total responsibilities include revenues, the standard variable cost of goods sold,
and actual selling expenses. The Sales Department is assigned the standard, rather than the actual, vari-
able cost ofgoods sold. Because the Sales Department does not control production activities, it should not
be assigned actual production costs. Doing so results in passing the Production Department's variances
on to the Sales Department. Fixed manufacturing costs are not assigned to the Sales Department because
short-run variations in sales volume do not normally affect the total amount of these costs.
To evaluate the Sales Department as a profit center, the net sales volume variance must be computed.
The net sales volume variance indicates the impact of a change in sales volume on the contribution
margin given the budgeted selling price and the standard variable costs. It is computed as the difference
between the actual and the budgeted sales volumes times the budgeted unit contribution margin.
Net sales volume variance = (Actual volume - Budgeted volume) x Budgeted contribution margin
Using the $40 budgeted selling price, the standard variable manufacturing costs, and the standard
variable selling expenses, the budgeted contribution margin is $11.00:
Sales . $40.00
Direct materials . $10.00
Direct labor . 6.00
Variable manufacturing overhead . 8.00
Selling . 5.00 (29.00)
Contribution margin . $11.00
The net sales volume variance is computed as follows:

Net sales volume variance = (11,000 - 10,000) x $11.00
= $11,000 F
As a profit center, the Sales Department has responsibility for the sales price variance, the net sales
volume variance, and any cost variances associated with its operations. As shown in Exhibit 10.3, the
Sales Department variances, as a profit center, net to $10,000 unfavorable:
6"Chrysler Faces Financial Pinch, Sees Asset Sales," Josee Valcourt and Neal E. Boudette, The Wall Street Journal, December 21,
2007, pp. AI, AIO; "Chrysler CEP Reassures on Financial Health," The Wall Street Journal, December 24, 2007, p. A8.
EXHIBIT 10.3 sales Department Profit Center Performance Report
McMILLIAN COMPANY
Sales Department Profit Center Performance Report
For Month of July
Sales price variance . $16,500 U

Net sales volume variance. . . . • . . . . . . . . . . • . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 F
Selling expense variance . 9,500 U
Sales Department variances, net . $15,000 U
In an attempt to improve their overall performance, managers often commit themselves to unfavorable
variances in some areas, believing that these variances will be more than offset by favorable variances in
other areas. When the Sales Department is evaluated as a revenue center, the favorable sales volume variance
more than offsets the price reductions and the higher selling expenses. The more complete evaluation of the
Sales Department as a profit center (with a $15,000 unfavorable variance) gives a very different impression
than the evaluation of the Sales Department as a pure revenue center (with a $23,500 favorable variance) or
as a revenue center responsible only for its own direct costs with net favorable variances of $14,000, com-
puted as $23,500 F minus $9,500 U.
CHAPTER-END REVIEW
The flexible budget performance report for Sunset Enterprises Inc. for March follows. The company manufac-
tures only one product, folding chairs.
Flexible Flexible
Actual Budget Budget
Costs Cost Variances
Output units . 5,000 5,000
Direct materials . $104,125 $100,000 $ 4,125 U

Direct labor . 82,400 75,000 7,400 U
Variable manufacturing overhead
Category 1 . 31,000 30,000 1,000 U
Category 2 . 18,000 20,000 2,000 F
Fixed manufacturing overhead . 42,000 40,000 2,000 U
Total . $277,525 $265,000 $12,525U
The standard unit cost for folding chairs follows:
Direct materials (4 pounds x $5.00 per pound). . . . . . .. $20

Direct labor (1.25 hours x $12.00 per hour). .......... 15
Variable overhead, Category 1 (1.25 hours x $4.80) . . . . 6
Variable overhead, Category 2 ($4 per finished unit) . . 4
Total standard variable cost per unit . . . . . . . . . . . . . . .. $45
Actual cost of materials is based on 21,250 pounds of direct materials purchased and used at $4.90 per pound;
actual cost of assembly is based on 7,000 labor hours. Variable overhead is applied on labor hours for Category
I and finished units for Category 2.
Required
a. Calculate all standard cost variances for direct materials and direct labor.
h. Calculate all standard cost variances for variable manufacturing overhead.
Solution
a.
Input component: Direct materials Output: 5,000 units
Standard Cost of
Actual quantity Actual quantity Standard quantity

(A 0) . . . . . . . . . . . .. 21,250 (AO) . . . . . . . . . . 21,250 allowed (SO) ..... 20,000'
Actual price (AP). . . .. x $4.90 Standard price (SP) . .. x $5.00 Standard price (SP) x $5.00
$104,125 $106,250 $100,000
~
Materialsprice
variance $2,125 F
~ variance
Materials quantit~
$6,250 U
Total flexible budget materials variance $4,125 U
"5,000 units x 4 pounds per unit produced
Input component: Direct labor Output: 5,000 units
Actual Standard Cost of

Costs Actual Inputs Flexible Budget Cost
$82,400 Actual hours (AH) . 7,000 Standard hours allowed (SH) . 6,250'
Standard rate (SR) . x $12 Standard rate (SR) . x $12
Total . $84,000 Total. . $75,000
Labor rate Labor efficiency

f - - - - variance $1,600 F ! variance $9,000 U
I Total flexible budget labor variance $7,400 U I
"5,000 units x 1.25 hours per unit
b.
Input component: Variable overhead Output: 5,000 units
Standard Cost of
Actual Costs Actual Inputs Flexible Budget Cost
Category 1 . $31,000 Actual labor hours . 7,000 Standard hours

Category 2 . 18,000 Standard rate . x $4.80 allowed . 6,250
Standard rate . x $4.80
Total . $49,000 Driver total . $33,600
Driver total. . $30,000
Finished units. . . . . . . . 5,000
Standard rate x $4.00 Finished units. 5,000
Driver total. . . . . . . . .. $20,000 Standard rate. . . . .. x $4.00
J
Total $53,600 Driver total $20,000
~
Total. $50,000
Variable overhead Variable overhead

spending variance effiCiency variance
$4,600 F $3,600 U
Total flexible budget variable overhead variance $1,000 F

A P PEN 0 I X 1 0 A: Fixed Overhead Variances

By definition, the quantity of goods and services purchased by fixed expenditures is not expected to change in propor-
tion to short-run changes in the level of production. For example, in the short run, the production level does not affect
the amount of depreciation on buildings, the number of fixed salaried employees, or the amount of real property sub-
ject to property taxes. Whether the organization produces 10,000 or 15,000 cases, the same quantity of fixed overhead
is expected to be incurred, as long as the production level is within the relevant range of activity provided by the cur-
rent fixed overhead items. Therefore, an effectiveness variance is ordinarily not computed for fixed overhead costs.
Even though the components of fixed overhead are not expected to be affected by the production activity level
in the short run, the actual amount spent for fixed overhead items can differ from the amount budgeted by manage-
ment. For example, higher than budgeted supervisors' salaries could be paid, 10nger-than-nOlmal working shifts could
cause heating or cooling costs to exceed budget, and price increases could cause the amounts paid for equipment to
be higher than expected. Fixed overhead costs in excess of the amount budgeted are reflected in the fixed overhead
budget variance. The fixed overhead budget variance is the difference between budgeted and actual fixed overhead.
Using the facility-level fixed costs of McMillan Company as an example:
Fixed overhead budget variance = Actual fixed overhead - Budgeted fixed overhead
= $31,000 - $32,000
= $1,000 F
The fixed overhead budget variance is always the same as the total fixed overhead flexible budget variance.
Because budgeted fixed overhead is the same for all outputs within the relevant range, the budget variance explains
the total flexible budget variance between actual and allowed fixed overhead. Similar to variable overhead, fixed
overhead variances can be caused by a combination of price and quantity factors.
Recall that predetermined overhead rates are computed by dividing the predicted overhead costs for the period by
the predicted activity of the period. The motivation for using a standard fixed overhead rate is the same as the motiva-
tion for using a predetermined overhead rate; namely, quicker product costing and assigning identical fixed costs to
identical products, regardless of when they are produced during the year.
When a standard fixed overhead rate is used, total fixed overhead costs assigned to production behave as variable
costs. As production increases, the total fixed overhead assigned to production increases. Because total budgeted fixed
overhead does not vary, differences arise between budgeted and assigned fixed overhead, and managers often inquire
about the cause of the differences.
The standard fixed overhead rate is computed as the budgeted fixed costs divided by some budgeted standard
level of activity. Assume McMillian applies fixed manufactUling overhead on the basis of machine hours and that
0040 machine hours are required to produce one carrying case. Further assume that the budgeted production is 10,000
carrying cases per month, a level that requires 4,000 (10,000 X 0040) machine hours. The standard fixed overhead
rate per machine hour is $8.
Standard fixed overhead rate = Budgeted total fixed overhead -;- Budgeted activity level
= $32,000 -;- 4,000 hours
= $8 per machine hour
The total fixed overhead assigned to production is computed as the standard rate of $8 multiplied by the standard
hours allowed for the units produced. Therefore, the assigned fixed overhead cost equals the budgeted monthly fixed
overhead cost only if the allowed activity equals the budgeted activity of 4,000 hours. If the company operates less
than 4,000 hours, the fixed overhead assigned to production is less than the $32,000 budgeted; if it operates more than
4,000 hours, the fixed overhead assigned to production is more than the amount budgeted.
Even though total fixed overhead is not affected by production below or above the standard activity level, the
fixed overhead assigned to production increases at the rate of $8 per allowed machine hour. The difference between
total budgeted fixed overhead and total standard fixed overhead assigned to production is called the fixed overhead
volume variance. This variance is sometimes referred to as the capacity variance, a term that emphasizes the maxi-
mum output of an operation. The fixed overhead volume variance indicates neither good nor poor performance by the
production personnel. Instead, it indicates the difference between the activity allowed for the actual output and the
budget level used as the denominator in computing the standard fixed overhead rate.
To explain the difference between actual fixed overhead and standard fixed overhead assigned to production,
two fixed overhead variances are computed: the fixed overhead budget variance and the fixed overhead volume vari-
ance. The fixed overhead budget variance represents the difference between actual fixed overhead and budgeted fixed
overhead. The budget variance is caused by a combination of price and quantity factors related to the use of fixed
overhead goods and services (e.g., depreciation, insurance, supervisors' salaries). The $1,000 favorable budget vari-
ance for McMillan was caused either by using fewer quantities of fixed overhead goods and services, or by paying
lower prices than expected for those items, or both.
The volume variance represents the difference between budgeted and assigned fixed overhead and is caused by a
difference between the activity level allowed for the actual output and the budgeted activity used in computing the fixed
overhead rate. For McMillan, actual July output of 11,000 units resulted in 4,400 allowed machine hours and applied
fixed overhead of $35,200 (11,000 units X 0.40 hours X $8). The $3,200 favorable fixed overhead volume variance
(budgeted costs of $32,000 minus applied costs of $35,200) indicates that the activity level allowed for the actual output
was more than the budgeted activity level. As previously stated, this variance ordinarily cannot be used to control costs.
If the budgeted activity is based on production capacity, an unfavorable variance alerts management that facilities are
underutiJized, and a favorable variance alerts management that facilities are utilized above their expectations. A summary
standard cost variance analysis for fixed costs is shown below.
Input component: Fixed manufacturing overhead Output: 11,000 cases
Actual Cost Budgeted Cost Budgeted Cost Assigned
Actual hours (AH) . NA* Budgeted hours (BH) . 4,000' Standard hours allowed (SH) .. 4,400t
Actual rate (AR) . x NA Standard rate (SR) . x8 Standard rate (SR) x $8
$31,000 $32,000 $35,200
Fixed overhead
budget variance
$1,000 F:j: l Fixed overhead
volume variance
$3,200 F
Total fixed manufacturing overhead variance $4,200 F
• Not applicable
t11 ,000 units x DAD
:j:Also the flexible budget fixed overhead variance
A P PEN D I X 1 0 B: Reconciling Budgeted and Actual

Income
Using a contribution format, it is possible to reconcile the difference between budgeted and actual net income for an
entire organization. This is done by assigning all costs and revenues to responsibility centers and summarizing the
financial performance of each responsibility center. McMillan Company's budgeted and actual income statements, in
a contribution format, for July are presented in Exhibit 10.4.
EXHIBIT 10.4 Budgeted and Actual Income Statements: Contribution Format
McMILLAN COMPANY
For Month of July
Sales (10,000 units x $40) . $400,000

Less variable costs
Variable cost of goods sold .
Direct materials (10,000 units x $10) . $100,000
Direct labor (10,000 units x $6) . 60,000
Manufacturing overhead (10,000 x $8) . 80,000 $240,000
Selling (10,000 units x $5) . 50,000 (290,000)
---
Less fixed costs
Manufacturing overhead ........................•...... 52,000
Selling . 10,000
Administrative . 4,000 (66,000)
continued
EXHIBIT 10.4 Budgeted and Actual Income Statements: Contribution Format
McMILLAN COMPANY
Actual Income Statement
For Month of July
Sales (11,000 units x $38.50) . $423,500

Less variable costs
Variable cost of goods sold
Manufacturing overhead . 81,000 $259,000
Selling . 65,000 (324,000)
Less fixed costs
Selling . 9,500
McMillan Company contains three responsibility centers: a Production Department, a Sales Department, and
an Administration Department. The Sales Department vatiances in Exhibit 10.3 net to $15,000 U. The Production
Department's variances in Exhibit 10.1 net to $4,000 F. The only variance for the Administration Department is the
$200 difference between actual and budgeted fixed administrative costs ($3,800 actual - $4,000 budget). Because
the Administration Department is a discretionary cost center, this variance is best identified as being underbudget.
For consistency in the perfonnance reports, however, it is labeled favorable. By assigning all variances to these three
responsibility centers, the reconciliation of budgeted and actual income is as shown in Exhibit 10.5.
EXHIBIT 10.5 Reconciliation of Budgeted and Actual Income
McMILLAN COMPANY
Reconciliation of Budgeted and Actual Income
For Month of July
Budgeted net income . $44,000

Sales department variances (Exhibit 10.3) . 15,000 U
Production department variances (Exhibit 10.1) . 4,000 F
Administration department variances ($3,800 actual - $4,000 budgeted) .............•......... 200 F
Actual net income . $33,200
G IDANCE ANSWER
• • You Are the Vice President of Manufacturing
It appears that direct labor hours may no longer be a reliable basis for budgeting variable overhead in your com-
pany. If actual variable overhead costs do not appear to correlate closely with direct labor hours, this could be an
indication that the components of variable overhead have changed since direct labor hours was selected as the
cost driver. Your cost accountants should consider other unit-level cost drivers for budgeting variable overhead
costs. However, an activity-based costing method using multiple overhead cost pools with separate cost drivers
might provide a more reliable basis for budgeting and controlling variable overhead costs.
- ------
QIO-l. What is responsibility accounting? Why should noncontrollable costs be excluded from performance
reports prepared in accordance with responsibility accounting?
QIO-2. How can responsibility accounting lead to unethical practices?
QIO-3. Responsibility accounting reports must be expanded to include what nonfinancial areas? Give some
examples of nonfinancial measures.
QIO-4. What is a cost center? Give some examples.
QIO-S. How is a cost center different from either an investment or a profit center?
QIO-6. What problems can result from the use of tight standards?
QIO-7. What is a standard cost variance, and what is the objective of variance analysis?
QIO-8. Standard cost variances can usually be broken down into two basic types of variances. Identify and
describe these two types of variances.
QIO-9. Identify possible causes for (l) a favorable materials price variance; (2) an unfavorable materials price
variance; (3) a favorable materials quantity variance; and (4) an unfavorable materials quantity variance.
QIO-IO. How is standard labor time detennined? Explain the two ways.
QIO-ll. In the standard cost system, what is the appropriate treatment of a change in wage rates (per new labor
union contract) that dominate the cost of labor?
QIO-12. Explain the difference between the revenue variance and the sales price variance.
QIO-13. Explain the net sales volume variance and list its components.
QIO-14. Explain the difference between how the actual costs and the slGndard cost of aClual inputs are
computed in variable overhead analysis.
QIO-lS. Explain what the net sales volume variance measures.
MINI EXERCISES
MIO-16. Flexible Budgets and Performance Evaluation (L02)
Presented is the January performance report for the Production Department of Dover Company.
DOVER COMPANY
Production Department Performance Report
For Month of January
Volume . 30,000 28,000
Manufacturing costs
Direct materials . $ 89,600 $ 82,000 $ 7,600 U
Direct labor . 165,000 140,000 25,000 U
Variable overhead . 62,000 56,000 6,000 U
Fixed overhead . 27,500 28,000 500 F
Total . $344,100 $306,000 $38,100 U
Required
G. Evaluate the pelformance report.
b. Prepare a more appropriate pe!t'ormance report.
EIO-17 Materials Variances (L03)

North Wind manufactures decorative weather vanes that have a standard materials cost of two pounds of
raw materials at $1.50 per pound. During September 10,000 pounds of raw materials costing $1.55 per
pound were lIsed in making 4,800 weather vanes.
Required
Determine the materials price and quantity variance.
MlO-18. Materials Variances (L03)

Assume that Lenscrafters uses standard costs to control the materials in its made-to-order sunglasses. Lenscrafters
The standards call for 2 ounces of material for each pair of lenses. The standard cost per ounce of material
is $15. During July, the Palm Beach location produced 4,800 pairs of sunglasses and used 8,800 ounces
of materials. The cost of the materials during July was $15.20 per ounce, and there were no beginning or
ending inventories.
Required
a. Determine the flexible budget materials cost for the completion of the 4,800 pairs of glasses.
h. Determine the actual materials cost incurred for the completion of the 4,800 pairs of glasses and
compute the total materials variance.
c. How much of the total variance was related to the price paid to purchase the materials?
d. How much of the difference between the answers to requirements (a) and (b) was related to the
quantity of materials used?
MIO-19. Direct Labor Variances (L03)

Assume that Nortel manufactmes specialty electronic circuitry through a unique photoelectronic process. One Nortel (NT)
of the primary products, Model ZX40, has a standard labor time of 0.5 hour and a standard labor rate of$13.50
per hour. During February, the following activities pertaining to direct labor for ZX40 were recorded:
Direct labor hours used . 2,180

Direct labor cost . $34,000
Units of ZX40 manufactured . 4,600
Required
a. Determine the labor rate variance.
b. Determine the labor efficiency variance.
c. Determine the total flexible budget labor cost variance.
MIO-20 Significance of Direct Labor Variances (L03)

The Morgan Company's April budget called for labor costs of$125,OOO. Because the actual labor costs were
exactly $125,000, management concluded there were no labor variances.
Required:
Comment on management's conclusion.
MIO-21 Variable Overhead Variances (L03)
Assume that the best cost driver that Sony has for variable factory overhead in the assembly department is Sony
machine hours. During April, the company budgeted 480,000 machine hours and $5,000,000 for its Texas
plant's assembly department. The actual variable overhead incurred was $5,200,000, which was related to
500,000 machine hours.
Required
a. Determine the variable overhead spending variance.
h. Determine the variable overhead effectiveness variance.
MIO-22. Sales Variances (L04)
Presented is information pertaining to an item sold by Winding Creek General Store:
Actual Budget
Unit sales ................................•. 150 125
Unit selling price . $26 $25

Unit standard variable costs . (20) (20)
Unit contribution margin . $ 6 $ 5
Revenues . $3,900 $3,125

Standard variable costs . (3,000) (2,500)
Contribution margin at standard costs . $ 900 $ 625
Required
Compute the revenue, sales price, and the sales volume variances.
MI0-23 A Fixed Overhead Variances (L03)

Phillips Petroleum Assume that Phillips Petroleum uses a standard cost system for each of its refineries. For the Tulsa
refinery, the monthly fixed overhead budget is $21,000,000 for a planned output of 10,000,000 barrels. For
September, the actual fixed cost was $22,000,000 for 10,800,000 barrels. The Tulsa refinery's capacity is
11,900,000 barrels.
Required
a. Determine the fixed overhead budget variance.
b. If fixed overhead is applied on a per-barrel basis, determine the volume variance.
MI0·241l Reconciling Budgeted and Actual Income
Upstate Supply Company has three responsibility centers: sales, production, and administration. The
following information penains to the November activities of Upstate Supply:
Budgeted contribution income . $16,000

Actual contribution income . 27,000
Sales price variance . $24,000 F
Sales volume variance . 40,000 F
Net sales price variance . 6,000 F
Sales department variable expense variance . 18,000 U
Sales department fixed expense variance . 1,000 U
Administration department variances . o
Production department variances . o
Required:
Prepare a reconciliation of budgeted and actual contribution income.
EXERCISES
EI0-25. Direct Labor Variances (L03)
Springs Industries, Assume that Spdngs Industl·ies. Inc., operates its Charlotte plant using a combination of hourly and
Inc.
incentive wage programs for production employees. The guaranteed minimum wage is $14 per hour but
with incentive outputs, the wage can increase to $22 per hour. For dye processing, the standard output per
hour is 1,000 pounds of yarn processed and dyed. During June, the dye process had an average wage rate of
$ 16 with 920,000 pounds of dyed yarn completing production. Production hours totaled 950.
Required
a. Compute rate and efficiency variances using the minimum wage as the standard.
b. Compute rate and efficiency variances using the maximum wage with incentives as the standard.
c. Why does changing the standard used for the hourly rate change the efficiency variance?
d. Explain which set of variances is most useful for management.
EI0-26. Variable Overhead Variances (L031

India Leaf Company bases standard variable overhead cost on direct labor hours as the cost driver. Standard
variable overhead cost has been set at $15 per unit of output based on $5 of variable overhead per direct
labor hour for 3 hours allowed to produce I finished unit. Last month, 4,300 direct labor hours were used,
and 1,400 units of output were manufactured. The following actual variable overhead costs were incurred:
Indirect materials . $ 4,500

Indirect labor . 8,400
Utilities . 5,800
Miscellaneous . 3,600
Total variable overhead . $22,300
Required
a. Determine the variable overhead spending variance.
b. Determine the variable overhead efficiency variance.
c. How is the variable overhead efficiency variance related to labor efficiency?
d. If the company used smaller quantities of indirect materials than those reflected in the standards, in
which variance would the resulting cost savings be reflected? Explain.
EIO-27. Causes of Standard Cost Variances (Comprehensive) (L03)

Following are ten unrelated situations that would ordinarily be expected to affect one or more standard cost
variances:
I. A saJaried production supervisor is given a raise, but no adjustment is made in the labor cost
standards.
2. The materials purchasing manager gets a special reduced price on raw materials by purchasing a train
carload. A warehouse had to be rented to accommodate the unusually large amount of raw materials.
The rental fee was charged to Rent Expense, a fixed overhead item.
3. An unusually hot August caused the company to use 25,000 kilowatts more electricity than provided
for in the variable overhead standards.
4. The local electric utility company raised the charge per kilowatt-hour. No adjustment was made in
the variable overhead standards.
5. The plant manager traded in his leased company car for a new one in July, increasing the monthly
lease payment by $1 SO.
6. A machine malfunction on the assembly line (caused by using cheap and inferior raw materials)
resulted in decreased output by the machine operator and higher than normal machine repair costs.
Repairs are treated as variable overhead costs.
7. The production maintenance supervisor decreased routine maintenance checks, resulting in lower
maintenance costs and lower machine production output per hour. Maintenance costs are treated as
fixed costs.
8. An announcement that vacation benefits had been increased resulted in improved employee morale.
Consequently, raw materials pilferage and waste declined, and production efficiency increased.
9. The plant manager reclassified her secretary to administrative assistant and gave him an increase in
salary.
10. A union contract agreement calling for an immediate 5 percent increase in production worker wages
was signed. No changes were made in the standards.
Required
For each of these situations, indicate by letter which of the following standard cost variances would be
affected. More than one variance will be affected in some cases.
a. Materials price variance.
b. Materials quantity variance.
c. Labor rate variance.
d. Labor efficiency variance.
e. Variable overhead spending variance.
f Variable overhead efficiency variance.
g. Fixed overhead budget variance.
EIO-28 Sales Variances (L04)

Assume that Casio Computer Company. lTD. sells handheld communication devices for $110 during Casio Computer
August as a back-to-school special. The normal selling price is $1 SO. The standard variable cost for each Company, LTD.
device is $70. Sales for August had been budgeted for 400,000 units nationwide; however, due to the
slowdown in the economy, sales were only 350,000.
Required
Compute the revenue, sales price, sales volume variance, and net sales volume variance.
EIO-29 A Fixed Overhead Variances (L03)
Huntsville Company uses standard costs for cost control and internal reporting. Fixed costs are budgeted at
$7,500 per month at a normal operating level of 10,000 units of production output. During October, actual
fixed costs were $8,000, and actual production output was 9,500 units.
Required
a. Determine the fixed overhead budget variance.
b. Assume that the company applied fixed overhead to production 011 a per-unit basis. Determine the
fixed overhead volume variance.
c. Was the fixed overhead budget variance from requirement (a) affected because the company operated
below the normal activity level of 10,000 units? Explain.
d. Explain the possible causes for the volume variance computed in requirement (b). How is reporting
of the volume variance useful to management?
PROBLEMS
PIO-30. Multiple Product Performance Report (L02)
Storage Products manufactures two models of DVD storage cases: regular and deluxe. Presented is standard
cost information for each model:
Cost Components Regular Deluxe
Direct materials
Lumber . 2 board feet x $3 = $ 6.00 3 board feet x $3 = $ 9.00
Assembly kit . 2.00 2.00
Direct labor . 1 hour x $4 4.00 1.25 hours x $4 5.00
Variable overhead .. 1 labor hr. x $2 2.00 1.25 labor hrs. x $2 2.50
Total . $14.00 $18.50
Budgeted fixed manufacturing overhead is $15,000 per month. During July, the company produced 5,000
regular and 3,000 deluxe storage cases while incurring the following manufacturing costs:
Direct materials . $ 80,000

Variable overhead .. 14,000
Fixed overhead . 17,500
Total . $147,500
Required
Prepare a flexible budget performance report for the July manufacturing activities.
PIO-31. Computation of Variable Cost Variances (L03)

The following information pertains to the standard costs and actual activity for Tyler Company for
September:
Standard cost per unit

Direct materials .... 4 units of material A x $2.00 per unit
1 unit of material B x $3.00 per unit
Direct labor . 3 hours x $8.00 per hour
Activity for September

MaterialS purchased
Material A . 4,500 units x $2.05 per unit
Material B . 1,100 units x $3.10 per unit
Materials used
Material A . 4,150 units-
Material B . 1,005 units
Direct labor used . 2,950 hours x $8.20 per hour
Production output . 1,000 units
There were no beginning direct materials inventories.
Required
a. Determine the materials price and quantity variances.
b. Determine the labor rate and efficiency variances.
PIO-32. Variance Computations and Explanations (L03)
Outdoor Company manufactures camping tents from a lightweight synthetic fabric. Each tent has a standard
materials cost of $20, consisting of 4 yards of fabric at $5 per yard. The standards call for 2 hours of
assembly at $12 per hour. The following data were recorded for October, the first month of operations:
Fabric purchased. . . . . . . . . . . . . . . . . . . . . . . .. 9,000 yards x $4.90 per yard

Fabric used in production of 1,700 tents 7,000 yards
Direct labor used. . . . . . . . . . . . . . . . . . . . . . . .. 3,600 hours x $12.50 per hour
Required
a. Compute all standard cost variances for materials and labor.
b. Give one possible reason for each of the preceding variances.
c. Determine the standard variable cost of the 1,700 tents produced, separated into direct materials and
labor.
PIO-33. Determining Unit Costs, Variance Analysis, and Interpretation (L02,31

Big Dog Company, a manufacturer of dog food, produces its product in I,OOO-bag batches. The standard cost
of each batch consists of 8,000 pounds of direct materials at $0.30 per pound, 48 direct labor hours at $8.50
per hour, and variable overhead cost (based on machine hours) at the rate of $10 per hour with 16 machine
hours per batch. The following variable costs were incurred for the last I ,DOO-bag batch produced:
Direct materials . 8,300 pounds costing $2,378 were purchased and used
Direct labor . 45 hours costing $450
Variable overhead . $225
Machine hours used . 18 hours
Required
a. Determine the actual and standard variable costs per bag of dog food produced, separated into direct
materials, direct labor, and variable overhead.
b. For the last I ,OOO-bag batch, determ ine the standard cost variances for direct matelials, direct labor,
and variable overhead.
c. Explain the possible causes for each of the variances determined in requirement (b).
PIO-34. Computation of Variances and Other Missing Data (L03)

The following data for O'Keefe Company pertain to the production of 300 units of Product X during
December. Selected data items are omitted.
Direct materials (all materials purchased were used during period)

Standard cost per unit: (a) pounds at $3.20 per pound
Total actual cost: (b) pounds costing $5,673
Standard cost allowed for units produced: $5,760
Materials price variance: (c)
Materials quantity variance: $96 U
Direct labor
Standard cost: 2 hours at $7.00
Actual cost per hour: $7.25
Total actual cost: (d)
Labor rate variance: (e)
Labor efficiency variance: $140 U
Variable overhead
Standard costs: (f) hours at $4.00 per direct labor hour
Actual cost: $2,250
Variable overhead spending variance: (g)
Variable overhead efficiency variance: (h)
Required
Complete the missing amounts lettered (a) through (h).
PIO-35 Flexible Budgets and Performance Evaluation (L03)

Anna Van Degna, supervisor of housecleaning for Hotel Del1, was surprised by her summary performance
report for March given below.
HOTEL DELL
Housekeeping Performance Report
For the Month of March
Actual Budget Variance %Variance
$164,423 $154,000 $10,423 U 6.768% U
Anna was disappointed. She thought she had done a good job controlling housekeeping labor and towel
usage, but her performance report revealed an unfavorable variance of $10,423. She had been hoping for a
bonus for her good work, but now expected a series of questions from her manager.
The cost budget for housekeeping is based on standard costs. At the beginning of a month, Anna receives a
report from Hotel Dell's Sales Department outlining the planned room activity for the month. Anna then schedules
labor and purchases using this information. The budget for the housekeeping was based on 8,000 room nights.
Each room night is budgeted based on the following standards for various materials, labor, and overhead:
Shower supplies . 3 bottles @ $0.25 each

Towels' . 1 @ $2.00
~un~ . 10 Ibs. @ $0.35 a lb.
Labor . V2 hour @ $12.00 an hour
VOH . $6.00 per labor hour
mH . $4 a room night (based on 8,000 room nights)
'Replacements for towels evaluated by housekeeping as inappropriate for cleaning and reuse.
With 8,900 room nights sold, actual costs and usage for housekeeping during April were:
$6,890 for 26,500 bottles of shower supplies.

$15,563 for 7,900 towels.
$31,329 for 88,500 lbs. of laundry.
$51,591 for 4,350 labor hours.
$25,839 in total VOH.
$33,211 in FOH.
Required:
a. Develop a complete budget column for the above performance report presented to Anna. Break it
down by expense category. The following format, with additional lines for expense categories, is
suggested:
Account Actual Budget Variance
Shower Supplies $ 6,890 ? ?
Total . $164,423 $154,000 $10,423 U
b. Evaluate the usefulness of the cost center performance report presented to Anna.
c. Prepare a more logical performance report where standard allowed is based on actual output. Also,
split each variance into its price/rate/spending and quantity/efficiency components (except fixed of
course). The following format, with additional lines for expense categories, is suggested:
Price/Rate/ Quantity/
Flexible Total Spending Efficiency
Account Actual Budget Variance Variance Variance
Shower Supplies ...... $ 6,890 ? ? ? ?
Total ................ $164,423 ? ?
d. Explain to Anna's boss what your report suggests about Anna's department performance.
e. Identify additional non-financial performance measures management might consider when evaluating
the performance of the housekeeping department and Anna as a manager.
PlO-36 Flexible Budget Performance Evaluation with Process Costing (LOS.

Note: This problem requires knowledge of process costing concepts covered in Chapter 5
The Waldorf Company produces a single product on a continuous basis. On July 1,400 units, 75 percent
complete as to materials and 50 percent complete as to conversion, were in process. During January, 1,000
units were started and 1,200 units were completed. The July 31 ending work-in-process inventory contained
200 units, 50 percent complete as to materials and 25 percent complete as to conversion.
Waldorf uses standard costs for planning and control. The following standard costs are based on a
monthly volume of 800 equivalent units with fixed budgeted at $6,000 per month.
Direct materials [(2 square meter per unit x $8.00 per meter) x 800] . $12,800
Direct labor [(1.5 hours per unit x $20 per hour) x 800] . 24,000
Variable overhead [(1.5 labor hours per unit x $5.00 per hour) x 800] . 6,000
Fixed manufacturing overhead . 6,000
Actual July production costs were:

Required:
a. Determine the equivalent units of materials and conversion manufactured during July.
b. Based on the July equivalent units of materials and conversion, prepare a July performance report for
the Waldorf Company.
c. Explain the treatment of overhead in the July performance report.
'PIO-37. Measuring the Effects of Decisions on Standard Cost Variances (Comprehensive) (LOS.
The following five unrelated situations affect one or more standard cost variances for materials, labor
(assembly), and overhead:
I. Lois Jones, a production worker, announced her intent to resign to accept another job paying $1.20
more per hour. To keep Lois, the production manager agreed to raise her salary from $7.00 to $8.50
per hour. Lois works an average of 175 regular hours per month.
2. At the beginning of the month, a supplier of a component used in our product notified us that,
because of a minor design improvement, the price will be increased by 15 percent above the current
standard price of $100 per unit. As a result of the improved design, we expect the number of
defective components to decrease by 80 units per month. On average, 1,200 units of the component
are purchased each month. Defective units are identified prior to use and are not returnable.
3. In an effort to meet a deadline on a rush order in Department A, the plant manager reassigned several
higher-skilled workers from Department B, for a total of 300 labor hours. The average salary of the
Department B workers was $1.85 more than the standard $7.00 per hour rate of the Department A
workers. Since they were not accustomed to the work, the average Department B worker was able to
produce only 36 units per hour instead of the standard 48 units per hour. (Consider only the effect on
Department A labor variances.)
4. Rob Celiba is an inspector who earns a base salary of $700 per month plus a piece rate of 20 cents
per bundle inspected. His company accounts for inspection costs as manufacturing overhead.
Because of a payroll department error in June, Rob was paid $500 plus a piece rate of 30 cents per
bundle. He received gross wages totaling $1,100.
5. The materials purchasing manager purchased 5,000 units of component K2X from a new source at
a price $12 below the standard unit price of $200. These components turned out to be of extremely
poor quality with defects occurring at three times the standard rate of 5 percent. The higher rate of
defects reduced the output of workers (who earn $8 per hour) from 20 units per hour to 15 units
per hour on the units containing the discount components. Each finished unit contains one K2X
component. To appease the workers (who were irate at having to work with inferior components), the
production manager agreed to pay the workers an additional $0.25 for each of the components (good
and bad) in the discount batch. Variable manufacturing overhead is applied at the rate of $4 per direct
labor hour. The defective units also caused a 20-hour increase in total machine hours. The actual cost
of electricity to run the machines is $2 per hour.
Required
For each of the preceding situations, determine which standard cost variance(s) will be affected, and
compute the amount of the effect for one month on each variance. Indicate whether the effect is favonlble or
unfavorable. Assume that the standards are not changed in response to these situations. (Round calculations
to two decimal places.)
PIO-38 A • Fixed Overhead Budget and Volume Variance

Lucky Seven Company assigns fixed overhead costs to inventory for external reporting purposes by using
a predetermined standard overhead rate based on direct labor hours. The standard rate is based on a nomlal
activity level of 10,000 standard allowed direct labor hours per year. There are five standard allowed hours
for each unit of output. Budgeted fixed overhead costs are $200,000 per year. During 2009, the company
produced 2,200 units of output, and actual fixed costs were $210,000.
Required
a. Determine the standard fixed overhead rate used to assign fixed costs to inventory.
b. Determine the amount of fixed overhead assigned to inventory in 2009.
c. Determine the fixed overhead budget variance.
PIO-39 B • Profit Center Performance Report

Record Rack is a store that specializes in the sale of recordings of classical music. Due to a recent upsurge
in the popularity of J. S. Bach's works, Record Rack has established a separate room, Bach's Concert
Room, dealing only in recordings of Bach music. The CDs are purchased from a wholesaler for $4.25 each.
Although the standard retail price is $7.75 per CD, the manager of Bach's Concert Room can undertake
price reductions and other sales promotions in an attempt to increase sales volume. With the exception of
the cost of CDs, the operating costs of Bach's Concert Room are fixed. Presented are the budgeted and the
actual August contribution statements of Bach's Concert Room.
RECORD RACK-BACH'S CONCERT ROOM

Budgeted and Actual Contribution Statements
For Month of August
Actual Budget
Unit sales . 4,200 4,000
Unit selling price . $7.25 $7.75
Sales revenue . $30,450 $31,000

Cost of goods sold . (17,850) (17,000)
Gross profit. . . . . . 12,600 14,000
Operating costs . (5,000) (6,000)
Contribution to corporate costs and profits . $ 7,600 $ 8,000
Required
Compute variances to assist in evaluating the performance of Bach's Concert Room as a profit center. Was
the performance satisfactory? Explain.
PIO-40B • Profit Center Performance Report

Taco Town operates fast food restaurants in the food courts of shopping malls. It's main product is a burrito
that requires beans (direct material) and food preparation (direct labor). The April budget for Taco Town's
Riverside Mall restaurant was:
Sales 21,000 burritos at $0.99 each
Standard food cost of $0.20 per burrito (1/3 pound @ $0.60 per pound)
Standard direct labor of $0.30 per burrito (1/30th hour@ $9.00 per hour)
Fixed occupancy expenses (equip and rent) of $7,000
Actual April performance of the Riverside Mall restaurant was:
Sales 18,000 burritos at $1.02 each
Food cost of $3, 136 for 5,600 pounds
Direct labor cost of $6,720 for 800 hours
Fixed occupancy expenses of $7,200
In early May, the manager received the following financial performance report:
TACO TOWN- RIVERSIDE MALL

Performance Report
For the Month of April
Actual Budgeted Variance
Revenues . $18,360 $20,790 $2,430 U

Food Cost . (3,136) (4,200) 1,064 F
Labor Cost . (6,720) (6,300) 420 U
Occupancy . (7,200) (7,000) 200 U
Profit . $ 1,304 $ 3,290 $1,986 U
Required:
a. Partition variance into variances for I) selling price and net sales volume, 2) food variances for price
and quantity, and 3) labor variances for rate and efficiency.
b. Using the results of your analysis, prepare an alternative reconciliation of budgeted and actual profit.
Be sure to include the occupancy variance.
c. Explain why the total variances for sales, food, and labor in your reconciliation differ from those
originally presented to the restaurant manager.
PIO-41 B• Comprehensive Performance Report

Presented are the budgeted and actual contribution income statements of International Books Ltd. for
October. The company has three responsibility centers: a Production Department, a Sales Department, and
an Administration Department. Both the Production and Administration Departments are cost centers, and
the Sales Department is a profit center.
INTERNATIONAL BOOKS, LTD.

Budgeted Contribution Income Statement
For Month of October
Sales (900 x $300) . $270,000

Less variable costs
Variable cost of goods sold
Direct materials (900 x $50) . . . . . . . . . . $45,000
Direct labor (900 x $20) . . . . . . . . . . . . . . . . . 18,000
Manufacturing overhead (900 x $30). . . . . . . 27,000 $ 90,000
Selling (900 x $70) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,000 (153,000)
Less fixed costs
Selling . 50,000
INTERNATIONAL BOOKS, LTD.

Actual Contribution Income Statement
For Month of October
Sales (1,000 x $330) . $330,000

Less variable costs
Cost of goods sold
Manufacturing overhead . 35,000 $110,000
Selling . 100,000 (210,000)
Less fixed costs
Selling . 65,000
Net income (loss) . $ (5,000)
(
Required
a. Prepare a performance report for the Production Department that compares actual and allowed costs.
b. Prepare a performance report for selling expenses that compares actual and allowed costs.
c. Determine the sales price and the net sales volume variances.
d. Prepare a report that summarizes the performance of the Sales Department.
e. Determine the amount by which the Administration Department was over or under budget.
/. Prepare a report reconciling budgeted and actual net income. Your report should focus on the
performance of each responsibility center.
CASES
CIO-42. Discretionary Cost Center Performance Reports (L01)
TruckMax had been extremely profitable, but the company has been hurt in recent years by competition
and a failure to introduce new consumer products. In 2006, Tom Lopez became head of Consumer Products
Research (CPR) and began a number of product development projects. Although the group had good ideas
that led to the introduction of several promising products at the start of 2008, Lopez was criticized for poor
cost control. The financial performance reports for CPR under his leadership were consistently unfavorable.
Management was quite concerned about cost control because profits were low, and the company's cash
budget indicated that additional borrowing would be required throughout 2008 to cover out-of-pocket costs.
Because of his inability to exert proper cost control, Lopez was relieved of his responsibilities in 2008, and
Gabriella Garcia became head of Consumer Products Research. Garcia vowed to improve the performance
of CPR and scaled back CPR's development activities to obtain favorable financial performance reports.
By the end of 2009, the company had improved its market position, profitability, and cash position. At
this time, the board of directors promoted Garcia to president, congratulating her for the contribution CPR
made to the revitalization of the company, as well as her success in improving the financial performance of
CPR. Garcia assured the board that the company's financial performance would improve even more in the
future as she applied the same cost-reducing measures that had worked so well in CPR to the company as a
whole.
Required
a. For the purpose of evaluating financial performance, what responsibility center classification should
be given to the Consumer Products Research Department? What unique problems are associated with
evaluating the financial performance of this type of responsibility center?
b. Compare the performances of Lopez and Garcia in the role as head of Consumer Products Research.
Did Garcia do a much better job, thereby making her deserving of the promotion? Why or why not?
CIO-43. Developing Cost Standards for Materials and Labor (L02)
After several years of operating without a formal system of cost control, DeWalt Company, a tools
manufacturer, has decided to implement a standard cost system. The system will first be established for
the department that makes lug wrenches for automobile mechanics. The standard production batch size is
100 wrenches. The actual materials and labor required for eight randomly selected batches from last year's
production are as follows:
Materials Used Labor Used

Batch (in pounds) (in hours)
1 . 504.0 10.00
2 . 508.0 9.00
3 . 506.0 9.00
4 . 521.0 5.00
5 . 516.0 8.00
6 . 518.0 7.00
7 . 520.0 6.00
8 . 515.0 8.00
Average . 513.5 7.75
Management has obtained the following recommendations concerning what the materials and labor quantity
standards should be:
The manufacturer of the equipment used in making the wrenches advertises in the toolmakers' trade
journal that the machine the company uses can produce 100 wrenches with 500 pounds of direct
materials and 5 labor hours. Company engineers believe the standards should be based on these facts.
The accounting department believes more realistic standards would be 505 pounds and 5 hours.
The production supervisor believes the standards should be 512 pounds and 7.75 hours.
The production workers argue for standards of 522 pounds and 8 hours.
Required
a. State the arguments for and against each of the recommendations, as well as the probable effects of
each recommendation on the quantity variance for materials and labor.
n. 'whlch recommenoa'tlOn prov'loes the best com'o"lI1at"lOn o~ cost contro'l ana motivation to rne
production workers') Explain.
CIO-44. Behavioral Effect of Standard Costs (L01, 2, 3)

Delaware Corp. has used a standard cost system for evaluating the performance of its responsibility center
managers for three years. Top management believes that standard costing has not produced the cost savings
or increases in productivity and profits promised by the accounting department. Large unfavorable variances
are consistently reported for most cost categories, and employee morale has fallen since the system was
installed. To help pinpoint the problem with the system, top management asked for separate evaluations
of the system by the plant department manager, the accounting department manager, and the personnel
department manager. Their responses are summarized here.
Plan! Manager-The standards are unrealistic. They assume an ideal work environment that does not
allow materials defects or errors by the workers or machines. Consequently, morale has gone down and
productivity has declined. Standards should be based on expected actual prices and recent past averages for
efficiency. Thus, if we improve over the past, we receive a favorable variance.
Accounting MGlJa/ier-The goal of accounting reports is to measure performance against an absolute
standard and the best approximation of that standard is ideal conditions. Cost standards should be comparable
to "par" on a golf course. Just as the game of golf uses a handicap system to allow for differences in
individual players' skills and scores, it could be necessary for management to interpret variances based on
the circumstances that produced the variances. Accordingly, in one case, a given unfavorable variance could
represent poor perfOimance; in another case, it could represent good perfOimance. The managers are just going
to have to recognize these subtleties in standard cost systems and depend on upper management to be fair.
Personnel Manager-The key to employee productivity is employee satisfaction and a sense of
accomplishment. A set of standards that can never be met denies managers of this vital motivator. The
current standards would be appropriate in a laboratory with a controlled environment but not in the factory
with its many variables. If we are to recapture our old "team spirit," we must give the managers a goal that
they can achieve through hard work.
Required
Discuss the behavioral issues involved in Delaware Corp. 's standard cost dilemma. Evaluate each of the
three responses (pros and cons) and recommend a course of action.
CIO-4S 8 • Evaluating a Companywide Performance Report

Mr. Micawber, the production supervisor, bursts into your office, carrying the company's 2009 pelfOimance
report and thundering, "There is villainy here, sir' And I shall get to the bottom of it. I will not stop searching
until I have found the answer l Why is Mr. Heep so down on my department? I thought we did a good job last
year. But Heep claims my production people and I cost the company $3I,5OO! I plead with you, sir, explain
this performance report to me." Trying to calm Micawber, you take the report from him and ask to be left
alone for 15 minutes. The report is as follows:
CRUPP COMPANY, LIMITED

Performance Report
For Year 2009
Unit sales . 7,500 5,000
Sales . $262,500 $225,000 $37,500 F

Less manufacturing costs
Direct materials. . . . . . . . . . . . 55,500 47,500 8,000 U
Direct labor . 48,000 32,500 15,500 U
Manufacturing overhead . 40,000 32,000' 8,000 U
Total . (143,500) (112,000) (31,500)U
Gross profit. . 119,000 113,000 6,000 F
Less selling and administrative expenses
Selling (all fixed) . 60,000 40,000 20,000 U
Administrative (all fixed) . 55,000 50,000 5,000 U
---
Total . (115,000) (90,000) (25,OOO)U
Net income . $ 4,000 $ 23,000 $19,000 U
Performance summary
Budgeted net income . $23,000
Sales department variances
Sales revenue. . . . . . . . . . . . . . . . . . . . . . . . . . $ 37,500 F
Selling expenses. . . . . . . . . . . . . . . . . . . . . . . . 20,000 U $17,500 F
Administration department variances . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 U
Production department variances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,500 U 19,000 U
Actual net income . $ 4,000
'Includes fixed manufacturing overhead of $22,000.
Required
a. Evaluate the perfonnance report. Is Mr. Heep correct, or is there "villainy here"?
h. Assume that the Sales Department is a profit center and that the Production and Administration
Departments are cost centers. Detennine the responsibility of each for cost, revenue, and income
variances, and prepare a report reconciling budgeted and actual net income. Your report should focus
on the perfonnance of each responsibility center.
... • ~
11
egment Reporting,
Transfer Pricing, and
alanced Scorecard
LEARNING OBJECTIVES
L 01 Define a strategic business segment,

and prepare and use segment reports.
(p.370)
L02 Explain transfer pricing and assess

alternative transfer-pricing methods. Most companies begin with a fairly simple business model that involves
(p.374) the production and/or sale of a limited line of goods and services. The
Coca-Cola Company began as a producer of a single fountain drink, Ford
L03 Determine and contrast return on Motor Company began as a producer of one automobil,.e model (all in the
investment, residual income, and same color), and McDonald's began with a very limited menu in a tiny
economic value added. (p. 379) fast food restaurant. As companies become successful and profitable at
doing a few things very well, they almost invariably begin to expand their
L04 Describe the balanced scorecard business by adding new products and by entering new markets. Most suc
as a comprehensive performance cessful, large, complex businesses started with a simple business model.
measurement system. (p. 385) The classic example is the World's largest company, Wal-Mart, which
traces its beginning in 1950 to a single 5-and-1 O-cent store in Bentonville,
Arkansas (Population: 2,900).
In 1962, about the same time that Kresge's, F. W. Woolworth, and W.
1. Grant (all well established national companies known for their 5-and-10
cent stores) were shifting to a discount store concept with the opening of
Kmart, Woolco and Grant City Stores, Sam Walton opened the first Wal
Mart discount store aimed at small-town markets that had been ignored by
the large discounters. The concept spread quickly to the rest of the region
and the country. In 1978, Wal-Mart stores branched out into several new
areas, including pharmacy, auto service, and jewelry. In 1983, the com
pany opened its first Sam's Club store, a membership-based discount
warehouse club. By the company's twenty-fifth anniversary in 1987, there
were 1,198 stores with sales of $15.9 billion and 200,000 associates.
368
In 1988, Wal-Mart opened the first Wal-Mart Supercenter store, which featured everything contained in
a standard Wal-Mart discount store and a tire and oil change shop, optical center, one-hour photo processing
lab, portrait studio, and numerous alcove shops (banks, cellular telephone stores, hair and nail salons, video
rental stores, and fast food outlets). By 2001, Wal-Mart had sales of $220 billion and operated in all 50 states
and several foreign countries. It had overtaken Exxon as the largest company on the Fortune 500 list.
When Sam Walton began that first 5-and-10 cent store in 1950, he personally managed virtually every
aspect of the business from hiring employees, to ordering inventory, to managing the cashiers. However,
even in that small store, he needed to know which departments and product lines were the most profitable.
As the company grew and the Wal-Mart stores were created, understanding the business and its various
departments, divisions, and segments, became even more complicated and even more important. Not only
were new departments within each store created, but geographic divisions were organized. As the company
evolved, additional information was needed to evaluate the business departments and segments. The open
ing of Sam's Club stores and Wal-Mart Supercenters, and Wal-Mart's international expansion, added more
unique business units. In its 2007 corporate annual report, Wal-Mart identified three major business segments:
Wal-Mart Stores, Sam's Club Stores, and International. However, in the description of Wal-Mart's business
segments it states, "The Wal-Mart Stores segment includes the Company's supercenters, discount stores and
neighborhood markets in the United States, as well as walmart.com. The Sam's Club segment includes the'
warehouse membership clubs in the United States as well as samsclub.com. The International segment con
sists of the Company's operations outside of the United States." Even this expanded description in the annual
report would not come close to approximating the level of organizational detail for which Wal-Mart reports
information for internal management purposes. There is virtually no limit to the number of ways a company of
Wal-Mart's size can be examined. This chapter will look at some of the models that companies use to evaluate
their various strategic business segments.
Source: http://www.walmartslores.com/AbouIUs/7603.aspx.
369
370 Chapter 11 I Segment Reporting, Transfer Pricing, and Balanced Scorecard
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Multilevel Segment
Income Statements
• Management
Considerations
• Return on Investment
• Balanced Scorecard
Framework
• Investment Center
• Interpreting Segment
Reports
U Determining Transfer Income
• Balanced Scorecard and
Prices
• Investment Center Asset
Base
Strategy
I: Residual Income
• Economic Value Added
Organizations that maintain multiple product lines or that operate in several industries or in multiple markets
often adopt a decentralized organization structure in which managers of major business units or strategic seg
ments enjoy a high degree of autonomy. Examples of strategic business segments include the Chrysler Group
of DaimlerChrysler and the Asia Pacific Group of The Coca-Cola Company. Sometimes companies es
tablish segments within segments such as at Coca-Cola, whose Asia Pacific Group has separate business
units for individual countries (Japan, Korea, etc.). In organizations such as DaimlerChrysler and Coca-Cola,
upper management typically sets specific performance and profitability objectives for each segment and al
lows the manager of the segment the decision-making freedom to achieve those objectives.
This chapter explains the ways that an organization evaluates strategic business segments. It also con
siders transfer pricing and some of the problems that occur when one segment provides goods or services
to another segment in the same organization.
STRATEGIC BUSINESS SEGMENTS

AND SEGMENT REPORTING
L01 Define a A strategic business segment has its own mission and set of goals. Its mission influences the decisions
strategic business that top managers make in both short-run and long-run situations. The organization structure dictates
segment, and to a large extent the type of financial segment reporting and other measures used to evaluate the seg
prepare and use ment and its managers. In decentralized organizations, for example, the reporting units (typically called
segment reports. divisions) normally are quasi-independent companies, often having their own computer system, cost
accounting system, and administrative and marketing staffs. With this type structure, top management
monitors the segments to ensure that these independent units are functioning for the benefit of the entire
organization.
Although segment reports are nOimally produced to coincide with managerial lines of responsibility,
some companies also produce segment reports for smaller slices of the business that do not represent sepa
rate responsibility centers. These parts of the business are not significant enough to be identified as "strate
gic" business units as defined, but management could want information about them on a continuing basis.
For example, AT&T has several strategic business units, including residential, small business, enter
plise, and wireless. Financial reports are prepared for each of these units. Within the residential division,
AT&1' can also prepare segment reports on a more detailed basis to determine the profitability of its smaller
segments, such as single-line and multi-line customers.
The point is that segment reporting is not constrained by lines of responsibility. A segment report can
be prepared for any part of the business for which management believes more detailed information is use
ful in managing that portion of the business.
Segment reports are income statements for portions or segments of a business. Segment reporting is
used primarily for internal purposes, although generally accepted accounting principles also require some
Chapter 11 I Segment Reporting, Transfer Pricing, and Balanced Scorecard 371
disclosure of segment information for public corporations. Even though there are many different types of
segment reports, at least three steps are basic to the preparation of all segment reports:
I. Identify the segments.
2. Assign direct costs to segments.
3. Allocate indirect costs to segments.
The format of segment income statements varies depending on the approach adopted by a company
for reporting income statements internally. The income statement formats illustrated earlier in this text,
including the functional format and the contribution format, can be used for segment reporting. Data avail
ability can, however, dictate the format used. Regardless of the format adopted, it is essential that costs be
separable into those directly traceable to the segments and those not directly traceable to segments.
Determining the segment reporting structure is often a more difficult decision than choosing the for
mat for the segment income statements. Companies must decide whether to structure segment reporting
along the lines of responsibility reporting, and whether segment reports will be prepared only on one level
or on several levels.
For example, consider the hypothetical case of Digital Communications Company (DCC) that has
two market divisions, three products, and two geographic territories. DCC's two divisions include the
National Division (serving large national accounts) and the Regional Division (serving smaller regional
and local accounts). DCC's three product lines are fiber optic cable, twisted pair cable, and coaxial cable.
The company is organized into two geographic territories, Atlantic and Pacific. If DCC were using only
a single-level segment reporting approach for all three groupings, one report would show the total com
pany income statement broken down into the two divisions, a second report would show the total com
pany income statement broken down into the three products, and a third report would show the total
company income statement broken down into the two geographic territories.
Multilevel Segment Inca eState ents

If top management of DCC wants to know how much a particular product is contributing to the income
of one of the two divisions or how much income a particular product in one of its two geographic territo
ries contributes, it is necessary to prepare multilevel segment income statements. Since DCC sells three
products and operates through two divisions in two territories, many combinations of divisions, products,
and telTitories could be used in structuring the company's multilevel segment reporting. The goal is not to
slice and dice the revenue and cost data in as many ways as possible but to provide useful and meaningful
information to management. Therefore, deciding what type of reporting structure is most useful in manag
ing the company is important.
This decision will be constrained to a great extent by data availability and cost. If there were no data
constraints, DCC could look at the company's net income for every possible combination of division,
product, and territory. The more data required to support a reporting system, however, the more costly it is
to maintain the system, so management must determine the value and the cost of the additional informa
tion and make an appropriate cost-benefit judgment.
Panel A of Exhibit 11.1 illustrates multilevel segment reporting for DCC in which the first level
shows the total company income statement segmented into the two market divisions, National Accounts
and Regional Accounts. Panel B of Exhibit 11.1 shows a second-level report for DCC in which the Na
tional Division's segment income statement is broken down into its three product lines, fiber optic cable,
twisted pair cable, and coaxial cable. Panel C then provides a third-level income statement for the National
Division's fiber optic sales in each of the company's two geographic territories, the Atlantic and Pacific
territories. The example in Exhibit 11.1 shows only part of the segment reports for DCC. The complete
three-level set of segment reports would also break down the Regional Accounts Division into its product
lines and all product lines for both divisions into geographic territories.
In the DCC example in Exhibit 11.1, the first reporting level is the company's divisions, its second
reporting level is product lines, and the third is geographic territories. Another approach could be to struc
ture the segment reports with product lines as the first level, geographic territories as the second level, and
divisions as the third level. Still another approach would be to make product lines the first level, divisions
the second level, and geographic territories the third level.
EXHIBIT 11.1 Multilevel segment Reports
Panel A: First-Level Segment Report of Digital Communications Company-For Divisions (in thousands)
Segments (Divisions)
National Regional Company

Accounts Accounts Total
Sales . $100,000 $ 200,000 $300,000

Less variable costs . (55,000) (95,000) (150,000)
Contribution margin. . . . . . . . . . . . . . . . . . . . 45,000 105,000 150,000
Less direct fixed costs. . . . . . . . . . . . . . . . . .. . . (20,000) (60,000) (80,000)
Division margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 25,000 45,000 70,000
Less allocated segment costs . (10,000) (25,000) (35,000)
Division income . $ 15,000 $ 20,000 35,000
Less unallocated common costs ............................. .•. ...................... (12,000)
Net income , . $ 23,000
Panel B: Second-Level Segment Report of the National Division-For Products (in thousands)
Segments (Products)
National
Fiber Twisted Accounts
Optic Pair Coaxial Total
Sales............ . . $30,000 $40,000 $30,000 $100,000
Less variable costs. . . (15,000) (19,000) (21,000) (55,000)

Contribution margin . 15,000 21,000 9,000 45,000
Less direct fixed costs . (9,000) (4,000) (2,000) (15,000)
Product margin. . . . . . . 6,000 17,000 7,000 30,000
Less allocated segment costs . (5,000) (4,000) (1,000) (10,000)
Product income . $ 1,000 $13,000 $ 6,000 20,000
Less unallocated common costs . (5,000)
National Division income .....................•..................................... $ 15,000
Panel C: Third-Level Segment Report of the Fiber Optic Product Line in

the National Division-For Geographic Territories (in thousands)
Fiber
Segments (Territories)
Optic
Atlantic Pacific Total
Sales......... . . $20,000 $10,000 $30,000

Contribution margin . 9,000 6,000 15,000
Less direct fixed costs . (3,000) (4,000) (7,000)
Territory margin . 6,000 2,000 8,000
Less allocated segment costs .....•.....•..•........... (2,000) (3,000) (5,000)
Territory income . $ 4,000 $(1,000) 3,000
Less unallocated common costs . (2,000)
Fiber optic income . $ 1,000
Regardless of how many different ways the company segments the income statements, at least one
set of segment reports follows the company's responsibility reporting system; therefore, one of the seg
ment reports has the operating divisions as the first level. If each division has a product manager for each
product, the division segment reports are broken down by products. Finally, if each product within each
division has a territory manager, the product segment reports are broken down by territories.
ter eti
Exhibit 11.1 reports costs in four categories: variable costs, direct fixed costs, allocated common costs,
and unallocated common costs. Variable costs vary in proportion to the level of sales and are subtracted
from sales in calculating contribution margin. Direct segment fixed costs are non variable costs directly
traceable to the segments incurred for the specific benefit of the respective segments. Segment margin
equals the contribution margin minus the direct segment fixed costs. For DCC, segment margins are
referred to as division margins, product margins, and territory margins. Segment margins represent the
amount that a segment contributes directly to the company's profitability in the short run.
Common segment costs are incurred for the common benefit of all related segments shown on a seg
ment income statement. In some cases, allocating some common costs is reasonable even though they can
not be directly traced to the various segments based on benefits received. For example, if segments share
common space, allocating all space-related costs to the segments based on building space occupied could
be appropriate. If there is no reasonable basis for allocating common costs, they should not be allocated to
the segments. In Panel C of Exhibit 11.1, if advertising costs to promote the company's fiber optic prod
ucts on national television could not be reasonably allocated to the two geographic territories, they would
be charged to the fiber optic product line as an unallocated common cost, not to the individual territories.
If some portion of common costs can be reasonably allocated to the segments, those allocated costs
are subtracted from the segment margins to determine segment income. Hence, segment income repre
sents all revenues of the segment minus all costs directly or indirectly charged to it.
To properly interpret segment income, we should ask whether segment income represents the amount
by which net income of the company will change if that segment is discontinued. For example, if DCC
discontinues the coaxial product line in the National Division, does this mean that DCC's net income will
decrease by $6 million? Also, does it mean that if the National Division stops selling fiber optic cable in
the Pacific territory, DCC's net income will increase by $1 million?
The answer to these questions depends on whether the costs allocated to the segments are avoidable.
Avoidable common costs are allocated common costs that eventually can be avoided (that is, can be elimi
nated) if a segment is discontinued. If all allocated common costs are avoidable, the effect of discontinuing
the segment on corporate profitability equals the amount of segment income. In most cases, the short-term
impact of discontinuing a segment equals the segment margin because allocated costs are capacity costs
that cannot be adjusted in the short run. Over time, the company should be able to adjust capacity and elimi
nate some, or possibly all, of the allocated common costs or find productive uses for that capacity in other
segments of the business. The unallocated common costs cannot be changed readily in the short term or the
long term without causing major disruptions to the company and its strategy. Therefore, over the long term,
the impact of discontinuing a segment should be, approximately, it's segment income.
If DCC discontinues selling fiber optic cable in the Pacific territory (see Exhibit 11.1, Panel C) the shOl1
term effect on the company's profits will probably be a $2 million reduction of profits, which equals the
Pacific territory's margin. The revenues and costs that make up the Pacific telTitory margin would all be lost
iffiber optic sales were discontinued in the Pacific territory, but the $3 million of common costs allocated to
the Pacific territory would continue, at least in the short term. Over the long term, however, after adjusting
the capacity for selling this product in the Pacific territory and eliminating the $3 million of allocated com
mon costs, the effect of discontinuing fiber optics in the Pacific territory on profits should be an increase of
about $1 million, which is the amount of the segment loss for fiber optics in the Pacific territory.
To summarize, generally, segment margin is relevant for measuring the short-term effects of decisions
to continue or discontinue a segment; however, segment income is relevant for measuring the long-term
effects of decisions to continue or discontinue.
MID-CHAPTER REVIEW
Refer to the Digital Communications (DCC) example in Exhibit 11.1, Panel B. The following additional infor
mation is provided for the Coaxial product line in the National Division:
Sales-Atlantic territory . $12,000

Sales-Pacific territory . 18,000
Direct fixed cost-Atlantic territory . 500
Direct fixed cost-Pacific territory . 800
Allocated segment costs-Atlantic territory . 200
Allocated segment costs-Pacific territory . 600
Required:
a. Prepare a geographic territory segment report of the Coaxial product line ill the National division.
b. Explain why the total of the Territory Margins for geographic segments of the Coaxial product line does
not equal the product margin of the Coaxial product segment in Panel 8 of Exhibit 11.1.
Solution
a.
Segments (Territories)
Coaxial
Atlantic Pacific Total
Sales . $12,000 $18,000 $30,000

Less direct fixed costs . (500) (800) (1,300)
Territory margin . 3,100 4,600 7,700
Less allocated segment costs . (200) (600) (800)
Territory income . $ 2,900 $ 4,000 6,900
Less unallocated common costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (900)
Fiber optic income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $ 6,000
b. The Product Margin for the Coaxial product line in Panel 8 was $7,000 and reflected $2,000 of direct
fixed costs that were attributable to that product line in the National Division. However, when the
Coaxial product segment income statement is further segmented into geographic segments, only $1,300
of the $2,000 could be directly traced to the two geographic territories. Therefore, $700 of costs that
were direct costs at the product segment level became common costs (either allocated or unallocated)
at the territory segment level. This reflects the general notion that as segmentation is extended down to
lower and lower levels, the total amount of common costs increase and direct costs decrease. Hence,
segmentation rarely is extended to more than three levels.
TRANSFER PRICING
LQ2 Explain To determine whether each division is achieving its organizational objectives, managers must be account
transfer pricing able for the goods and services they acquire, both externally and internally. When goods or services are
and assess exchanged internally between segments of a decentralized organization, the way that the transferor and
alternative the transferee will report the transfer must be determined, either by negotiations between the two segments
transfer-pricing or by corporate policy. A transfer price is the internal value assigned a product or service that one divi
methods. sion provides to another. The transfer price is recognized as revenue by the division providing goods or
services and as expense (or cost) by the division receiving them. Transfer-pricing transactions normally
occur between profit or investment centers rather than between cost centers of an organization; however,
managers often consider cost allocations between cost centers as a type of transfer price. The focus in this
chapter is on transfers between responsibility centers that are evaluated based on profits.
Management Consideration
The desire of the selling and buying divisions of the same company to maximize their individual perfor
mance measures often creates transfer-pricing problems. Acting as independent units, divisions could take
actions that are not in the best interest(s) of the organization as a whole. The three examples that follow
illustrate the need for organizations to maintain a corporate profit-maximizing viewpoint while attempt
ing to allow divisional autonomy and responsibility.
OmniTech, Inc., has five divisions, some of which transfer products and product components to other
OmniTech divisions. The BioTech Division manufactures two products, Alpha and Beta. It sells Alpha
externally for $50 per unit and transfers Beta to the GenTech Division for $60 per unit. The costs associ
ated with the two products follow:
Product
Alpha Beta
Variable costs
Direct materials $15 $14
Direct labor. . . . . . . . . . . . . . . . . . . . . . . 5 10
Variable manufacturing overhead. . . . . . 5 16

Selling. . . . . . . . . . . . . . . . . . . . . . . . . . . 4 0
Fixed Costs
Fixed manufacturing overhead. . . . . . . . 6 15
Total . . . . . . . . . . . . . . . . . . . . . . . . $35 $55
An extemal company has just proposed to supply a Beta substitute product to the GenTech Division at a
price of $52. From the company's viewpoint, this is merely a make or buy decision. The relevant costs are the
differential outlay costs of the alternative actions. Assuming that the fixed manufacturing costs of the BioTech
Division are unavoidable, the relevant costs of this proposal from the company's perspective are as follows:
Buy $52
Make
Direct materials. . ... ... .•. . .. . .. ... . . . . $14
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Variable manufacturing overhead. . . . . . . . . . 16 (40)

Difference. . .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . .. $12
From the corporate viewpoint, the best decision is for the product to be transferred since the relevant
cost is $40 rather than to buy it from an external source for $52. The decision for the GenTech Division
management is basically one of cost minimization: Buy from the source that charges the lowest price. If
BioTech is not willing to transfer Beta at a price of $52 or less, the GenTech management could go to the
external supplier to maximize the division's profits. (Although GenTech's managers are concerned about
the cost of Beta, they are also concerned about the quality of the goods. If the $52 product does not meet
its quality standards, GenTech could decide to buy from BioTech at the higher price. For this discussion,
assume that the internal and external products are identical; therefore, acting in its best interest, GenTech
purchases Beta for $52 from the external source unless BioTech can match the price.)
Prior to GenTech's receipt of the external offer, BioTech had been transferring Beta to GenTech for $60.
BioTech must decide whether to reduce the contribution margin on its transfers of Beta to GenTech and,
therefore, lower divisional profits or to try to find an alternative use for its resources. Of course, corporate
management could intervene and require the internal transfer even though it would hurt BioTech's profits.
As the second example, assume that the BioTech Division has the option to sell an equivalent amount
of Beta externally for $60 per unit if the GenTech Division discontinues its transfers from BioTech. Now
the decision for BioTech's management is simple: Sell to the buyer willing to pay the most. From the cor
pOl'ate viewpoint, it is best for BioTech to sell to the external buyer for $60 and for GenTech to purchase
from the external provider for $52.
376 Chapter 11 I Segment Reporting, Transfer Pricing, and Balanced SCorecard
To examine a slightly different transfer-pricing conflict, assume that the BioTech Division can sell
all the Alpha that it can produce (it is operating at capacity). Also assume that there is no external market
for Beta, but there is a one-to-one trade-off between the production of Alpha and Beta, which use equal
amounts of the BioTech Division's limited capacity.
The corporation still regards this as a make or buy decision, but the costs of producing Beta have
changed. The cost of Beta now includes an outlay cost and an opportunity cost. The outlay cost of Beta
is its variable cost of $40 ($14 + $10 + $16), as previously computed. Beta's opportunity cost is the net
benefit foregone if the BioTech Division's limited capacity is used to produce Beta rather than Alpha:
Selling price of Alpha. . . . . . . . . . . . . . . . . . . . . . . . . . . . $50

Outlay costs of Alpha
Direct materials. . . .... ... . . . .. . . . . ... $15
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Variable manufacturing overhead. . . . . . . . . . 5
Variable selling . . . . . . . . . . . . . . . . . . . . . . . .
4 (29)
- -
Opportunity cost of making Beta. . . . . . . . . . . . . . . . . .. $21
Accordingly, the relevant costs in the make or buy decision follow.
Make
Outlay cost of Beta. . . . . . . . . . . . . . . . . . . .. $40
Opportunity cost of Beta. . . . . . . . . . . . . . . . 21 $61
Buy $52
From the corporate viewpoint, GenTech should purchase Beta from the outside supplier for $52 be
cause in this case it costs $61 to make the product. If there were no outside suppliers, the corporation's
relevant cost of manufacturing Beta would be $61. This is another way of saying that the GenTech Divi
sion should not acquire Beta internally unless its revenues cover all outlay costs (including the $40 in the
BioTech Division) and provide a contribution of at least $21 ($61 - $40). From the corporate viewpoint,
the relevant costs in make or buy decisions are the external price, the outlay costs to manufacture, and the
opportunity cost to manufacture. The opportunity cost is zero if there is excess capacity.
Determining Transfer Prices

As illustrated, the transfer price of goods or services can be subject to much controversy. The most widely
used and discussed transfer prices are covered in this section. See the following Business Insight box for
a discussion of transfer pricing. Although a price must be agreed upon for each item or service transferred
between divisions, the selection of the pricing method depends on many factors. The conditions surround
ing the transfer determine which of the alternative methods discussed subsequently is selected.
Although no method is likely to be ideal, one must be selected if the profit or investment center
concept is used. In consideling each method, observe that each transfer results in a revenue entry on the
supplier's books and a cost entry on the receiver's books. Transfers can be considered as sales by the sup
plier and as purchases by the receiver.
Market Price
When there is an existing market with established prices for an intermediate product and the transfer ac
tions of the company will not affect prices, market prices are ideal transfer prices. If divisions are free to
buy and sell outside the firm, the use of market prices preserves divisional autonomy and leads divisions
to act in a manner that maximizes corporate goal congruence. Unfortunately, not all product transfers
have equivalent external markets. Furthermore, the divisions should carefully evaluate whether the market
price is competitive or controlled by one or two large companies. When substantial selling expenses are
associated with outside sales, many firms specify the transfer price as market price less selling expenses.
The internal sale may not require the incurrence of costs to get and fill the order.
BUSINESS INSIGHT Citigroup's Transfer-Pricing Problems
Fortune magazine interviewed the CEO of Citigroup in connection with its annual "Fortune 500"
article. Citigroup is a diversified financial company that includes such major financial brands as Prim
erica, Salomon Smith Barney, Citibank, and Travelers. Following is an excerpt from that article dis
cussing some problems of decentralization and transfer pricing at Citigroup.
In a company of Citi's size and complexity, there are dozens of issues-business overlaps, competitive
threats, regulations-that cut across divisions. In an institution that promotes cross-selling, for example,
there is always the question of how the financial spoils are divided up between the two divisions-a matter
that goes under the name "transfer pricing." For example, suppose that a Salomon Smith Barney financial
consultant sells a mutual fund "manufactured" by Citi's investment management division. What's the price
that the 1M division receives? The answer, since it determines profit, is extremely important to executives
getting paid (and paying their people) according to what their own bottom line looks like .... [The CEO)
says testily that he wishes people "would think about doing the business first, and worry about who gets
the credit second." But, trying to mediate, he also has his financial people studying plans for internally
double-counting revenues, so as to make profits (or losses) accrue to both parties involved in a cross
selling event.'
To illustrate using the OmniTech example, assume that product Alpha of the BioTech Division can be
sold competitively at $50 per unit or transferred to a third division, the Quantum Division, for additional
processing. Under most situations, the BioTech Division will never sell Alpha for less than $50, and the
Quantum Division will likewise never pay more than $50 for it. However, if any variable expenses related
to marketing and shipping can be eliminated by divisional transfers, these costs are generally subtracted
from the competitive market price. In our illustration in which variable selling expenses are $4 for Alpha,
the transfer price could be reduced to $46 ($50 - $4). A price between $46 and $50 would probably be
better than either extreme price. To the extent that these transfer prices represent a nearly competitive situ
ation, the profitability of each division can then be fairly evaluated.
Variable Costs
If excess capacity exists in the supplying division, establishing a transfer price equal to variable costs leads
the purchasing division to act in a manner that is optimal from the corporation's viewpoint. The buying
division has the corporation's variable cost as its own variable cost as it enters the external market. Unfor
tunately, establishing the transfer price at variable cost causes the supplying division to report zero profits
or a loss equal to any fixed costs. If excess capacity does not exist, establishing a transfer price at variable
cost would not lead to optimal action because the supplying division would have to forego external sales
that include a markup for fixed costs and profits. If Beta could be sold externally for $60, the BioTech
Division would not want to transfer Beta to the GenTech Division for a $40 transfer price based on the
following variable costs:
Direct materials ..... . . . . . . . . . . . . . . .. $14

Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . 10
Variable manufacturing overhead. . . . . . . . 16
Total variable costs. . . . . . . . . . . . . . . . . .. $40
The BioTech Division would much rather sell outside the company for $60, which covers variable costs
and provides a profit contribution margin of $20:
Selling price of Beta. . . . . . . . .. $60

Variable costs. . . . . . . . . . . . . .. (40)
Contribution margin . . . . . . . . .. $20
I Carol J. Loomis. "The Fortune 500, No.6 Sandy Weill's Monster." Fortune, April 16. 2001
Variable Costs Plus Opportunity Costs

From the organization's viewpoint, this is the optimal transfer price. Because all relevant costs are in
cluded in the transfer price, the purchasing division is led to act in a manner optimal for the overall com
pany, whether or not excess capacity exists.
With excess capacity in the supplying division, the transfer price is the variable cost per unit. Without
excess capacity, the transfer price is the sum of the variable and opportunity costs. Following this rule in
the previous example, if the BioTech Division had excess capacity, the transfer price of Beta would be
set at Beta's variable costs of $40 per unit. At this transfer price, the GenTech Division would buy Beta
internally, rather than externally at $52 per unit. If the BioTech Division cannot sell Beta externally but
can sell all the Alpha it can produce and is operating at capacity, the transfer plice per unit would be set at
$61, the sum of Beta's variable and opportunity costs ($40 + $21). (Refer back two pages.) At this transfer
price, the GenTech Division would buy Beta externally for $52. In both situations, the management of the
GenTech Division has acted in accordance with the organization's profit-maximizing goal.
There are two problems with this method. First, when the supplying division has excess capacity,
establishing the transfer price at vmiable cost causes the supplying division to report zero profits or a loss
equal to any fixed costs. Second, determining opportunity costs when the supplying division produces sev
eral products is difficult. If the problems with the previously mentioned transfer-pricing methods are too
great, three other methods can be used: absorption cost plus markup, negotiated prices, and dual prices.
Absorption Cost Plus Markup

According to absorption costing, all variable and fixed manufacturing costs are product costs. Pricing in
ternal transfers at absorption cost eliminates the supplying division's reported loss on each product that can
occur using a variable cost transfer price. Absorption cost plus markup provides the supplying division a
contribution toward unallocated costs. In "cost-plus" transfer pricing, "cost" should be defined as standard
cost rather than as actual cost. This prevents the supplying division from passing on the cost of inefficient
operations to other divisions, and it allows the buying division to know its cost in advance of purchase.
Even though cost-plus transfer prices may not maximize company profits, they are widely used. Their pop
ularity stems from several factors, including ease of implementation, justifiability, and perceived fairness.
Once everyone agrees on absorption cost plus markup pricing rules, internal disputes are minimized.
Negotiated Prices
Negotiated transfer prices are used when the supplying and buying divisions independently agree on a
price. As with market-based transfer prices, negotiated transfer prices are believed to preserve divisional
autonomy. Negotiated transfer prices can lead to some suboptimal decisions, but this is regarded as a small
price to pay for other benefits of decentralization. When they use negotiated transfer prices, some corpora
tions establish arbitration procedures to help settle disputes between divisions. However, the existence of
an arbitrator with any real or perceived authority reduces divisional autonomy.
Negotiated prices should have market prices as their ceiling and variable costs as their floor. Although
frequently used when an external market for the product or component exists, the most common use of
negotiated prices occurs when no identical-product external market exists. Negotiations could start with
a floor price plus add-ons such as overhead and profit markups or with a ceiling price less adjustments
for selling and administrative expenses and allowances for quantity discounts. When no identical-product
external market exists, the market price for a similar completed product can be used, less the estimated
cost of completing the product from the transfer stage to the completed stage.
Dual Prices
Dual prices exist when a company allows a difference in the supplier's and receiver's transfer prices for
the same product. This method allegedly minimizes internal squabbles of division managers and problems
of conflicting divisional and corporate goals. The supplier's transfer price normally approximates market
price, which allows the selling division to show a "normal" profit on items that it transfers internally. The
receiver's price is usually the internal cost of the product or service, calculated as variable cost plus op
portunity cost. This ensures that the buying division will make an internal transfer when it is in the best
interest of the company to do so.
In most cases, a market-based transfer price achieves the optimal outcome for both the divisions and
the company as a whole. As discussed earlier, an exception occurs when a division is operating below full
capacity and has no altemative use for its excess capacity. In this case, it is best for the company to have
an internal transfer; therefore, to ensure that the receiving division makes an internal transfer, the company
must require the internal transfer as long as its price does not exceed the established market rate. The only
time an external price is more attractive when excess capacity exists is when the external price is below
the variable cost of the providing internal division, and that scenario is highly unlikely.
A potential transfer-pricing problem exists when divisions exchange goods or services for which no
established market exists. For example, suppose that a company is operating its information technology
(IT) service department as a profit center that transfers services to other profit center departments using a
cost-plus transfer price. If the departments using IT services can choose to use those services or to repli
cate them inside their departments, users might not make a decision that is best for the company. It could
be best for the company to have all IT services come from the IT department, but other profit centers could
believe that they can provide those services for themselves at lower cost. In this case, the company must
decide how important it is to maintain the independence of its profit center. In the interest of maintaining a
strong profit center philosophy, top management can decide that it is acceptable to suboptimize by allow
ing profit centers to provide IT services for themselves.
The ideal transfer-pricing arrangement is seldom the same for both the providing and receiving divisions
for every situation. In these cases, what is good for one division is likely not to be good for the other division
resulting in no transfer, even though a transfer could achieve corporate goals. These conflicts are sometimes
overcome by having a higher-ranking manager impose a transfer price and insist that a transfer be made.
Managers in organizations that have a policy of decentralization, however, often regard these orders as
undermining their autonomy. Therefore, the imposition of a price could solve the corporate profit optimi
zation problem but create other problems regarding the company's organization strategy. Transfer pricing
thus becomes a problem with no ideal solutions.
The previous discussion has focused on the challenges of establishing transfer prices that motivate man
agers to make decisions that are beneficial to their divisions as well as the overall company. However, recent
research, discussed in the following Research Insight box, concluded that there are often price benefits when
dealing with outside vendors, if the company has the option of acquiring the goods or services internally.
RESEARCH INSIGHT Transfer Pricing and External Competition
Researchers found that a firm can glean benefits from discussing transfer-pricing problems with ex
ternal suppliers. Though transfer prices above marginal cost introduce interdivision coordination
problems, they also reduce a firm's willingness to pay outside suppliers. Knowing that costly internal
transfers will eat into demand, the supplier is more willing to set lower prices. Such supplier dis
counts can make decentralization worthwhile for the firm. The benefit of decentralization is shown to
be robust in both downstream and upstream competition. 2
I V STMENT CENTER EVAL ATION

M ASURES
Three of the most common measures of investment center performance, return on investment, residual in Loa Determine
come, and economic value added, are discussed in the following sections. Several supporting components and contrast
of these measures that help clarify the applications are also presented. return on
investment,
Retu n on Investment residual income
and economic
Return on investment (ROI) is a measure of the earnings per dollar of investment. (This assumes that value added.
financing decisions are made at the corporate level rather than the division level. Hence, the corporation's
investment in the division equals the division's asset base. The return on investment of an investment cen
ter is computed by dividing the income of the center by its asset base (usually total assets):
ROI = Investment center income

Investment center asset base
2"Ani I Arya and Brian Mittendorf, "Interacting Supply Chain Distortions: The Pricing ofInternal Transfers and External Procure
ment," The Accounting Review, May 2007.
380 Chapter 11 I Segment Reporting, Transfer Pricing, and Balanced SCorecard
ROI can be disaggregated into investment turnover times the return-on-sales ratio:
ROI = Investment turnover x Return-on-sales
where
Sales
Investment turnover = Investment center asset base
and
Return-on-saJes = Investment center income

Sales
When investment turnover is multiplied by retum-on-sales, the product is the same as investment
center income divided by investment center asset base:
ROI = Sales x Investment center income = Investment center income

Investment center base Sales Investment center asset base
Once ROI has been computed, it is compared to some previously identified peIiormance criteria.
These include the investment center's previous ROI, overall company ROI, the ROI of similar divisions,
or the ROI of nonaffiliated companies that operate in similar markets. The breakdown of ROI into invest
ment turnover and return-on-sales is useful in determining the source of variance in overall peIiormance.
To illustrate the computation and use of ROI, the following information is available concerning the
2009 operations of North American Steel:
Division Net Assets Sales Divisional Income
Maine ........... $8,000,000 $12,000,000 $1,440,000

Alberta .......... 4,000,000 8,000,000 960,000
Missouri ......... 7,500,000 5,000,000 1,650,000
Tijuana .......... 3,800,000 5,700,000 1,026,000
Using this information and the preceding equations, a set of Dupont performance measures can be
presented as shown in Exhibit 11.2. To illustrate, Maine Division earned a return on its investment base
of 18 percent ($1,440,000 --;- $8,000,000), consisting of an investment turnover of 1.50 ($12,000,000.;
$8,000,000) and a return-on-sales of 0.12 ($1,440,000 .;- $12,000,000). Using such an analysis, the com
pany has three measurement criteria with which to evaluate the peIiormance of Maine Division: (1) ROJ,
(2) investment turnover, and (3) return-on-sales.
For 2009, North American chose to evaluate its divisions based on company ROI and its interrelated
components of investment turnover and return-on-sales. Because each division is different in size, the
company evaluation standard is not a simple average of the divisions but is based on desired relationships
between assets, sales, and income.
Based on ROI, the Tijuana Division had the best peIiormance, the Alberta Division excelled in invest
ment turnover, and the Missouri Division had the highest return-on-sales. From Exhibit 11.2, the Tijuana
Division clearly had the best year because it was the only division that exceeded each of the company's
performance criteria. For 2009, each division equaled or exceeded the minimum ROI established by the
company even though the component criteria of ROI were not always achieved.
To properly evaluate each division, the company should study the underlying components of ROJ.
For the Maine Division, management would want to know why the minimum investment turnover was ex
ceeded while the return-on-sales minimum was not. The Maine Division could have incurred unfavorable
cost variances by producing inefficiently. As a result of inefficient production, the retum-on-sales declined
to a point below the minimum desired level. Evaluating a large operating division based on one financial
indicator is difficult. Management should select several key indicators of pelfonnance when conducting
periodic reviews of its operating segments.
A similar analysis of ROI and its components is useful for planning. In developing plans for 2010,
management wants to know the possible effect of changes in the major elements of ROI for the Maine
EXHIBIT 11.2 Performance Evaluation Data
NORTH AMERICAN STEEL
Performance Measures
For Year Ending June 30, 2009
Performance Measures
Investment
x Return-on-Sales ROI
Turnover
Operating unit
Maine. . . . . . . . . . . . . . . . . . . . . . 1.50 0.12 0.18
Alberta . . . . . . . . . . . . . . . . . . . .. 2.00 0.12 0.24
Missouri . . . . . . . . . . . . . . . . . . .. 0.67 0.33 0.22
Tijuana . . . . . . . . . . . . . . . . . . . . . 1.50 0.18 0.27
Company performance criteria

Projected minimums. . . . . . . . . . . 1.20 0.15 0.18
Division. Sensitivity analysis can be used to predict the impact of changes in sales, the investment center
asset base, or the investment center income.
Assuming the investment base is unchanged, a projected ROI can be determined for the Maine Divi
sion for a sales goal of $16,000,000 and an income goal of $1,600,000:
ROI = Sales x Investment center income

Investment center asset base Sales
= $16,000,000 x $1,600,000
$8,000,000 $16,000,000
= 2.0 x 0.10
= 0.20, or 20 percent.
ROI increased from 18 to 20 percent, even though the return-on-sales decreased from 12 to 10 percent.
The change in turnover from 1.5 to 2.0 more than offset the reduced return-on-sales.
Sensitivity analysis can involve changing only one factor or a combination of factors in the ROI
model. When more than one factor is changed, it is important to analyze exactly how much change is
caused by each factor.
Statistics such as ROI, investment turnover, and return-on-sales mean little by themselves. They take
on meaning only when compared with an objective, a trend, another division, a competitor, or an industry
average. Many businesses establish minimum ROIs for each of their divisions, expecting them to attain
or exceed this minimum return. The salaries, bonuses, and promotions of division managers can be tied
directly to their division's ROL Without other evaluation techniques, managers often strive for ROI maxi
mization, sometimes to the long-run detriment of the entire organization.
es r"'len Cen
Despite the relevance and conceptual simplicity of ROI, a division's ROI cannot be determined until man
agement decides how to measure divisional income and investment. Divisional income equals divisional
revenues less divisional operating expenses. Determining divisional revenues is usually a relatively easy
task since revenues are typically generated and recorded at the division level, but determining total operat
ing expenses for divisions is more complicated. Because many expenses are incurred at the corporate level
for the common benefit of the various operating divisions and to support corporate headquarters opera
tions, the cost assignment issues discussed early in this chapter affect investment center income.
Direct division expenses are always included in division operating expenses, but there are con
flicting viewpoints about how to deal with common corporate expenses. In corporate annual reports,
many companies are required to provide segment revenues and expenses segmented by product lines,
geographic territories, customer markets, and so on. Companies also show operating income for their
various segments in their annual reports, but they include a category called corporate or unallocated
for company expenses that cannot be reasonably allocated to the various segments. For example, the
Ericsson, Inc. annual report for a recent year includes the following breakdown of its operating income
by segments (stated in millions of Swedish kronas):
Networks , . 17,398 SEK

Professional Services . 6,394
Multimedia , . (135)
Phones , . 7,108
Unallocated . (119)
Total operating income . 30,646 SEK
"Unallocated" typically includes costs for corporate staffs, certain goodwill writeoffs, and nonoperational
gains and losses.
For internal segment reporting, some companies do not allocate corporate costs that cannot be associ
ated closely with individual segments. Other companies insist on allocating all common corporate costs to
the operating divisions to emphasize that the company does not earn a profit until revenues have covered
all costs. Some top managers believe that since only operating divisions produce revenues, they should
also bear all costs, including corporate costs. These managers want to ensure that the sum of the division
income for the various segments equals the total income for the company.
Division managers do not control corporate costs; therefore, these costs are seldom relevant in evalu
ating a division manager's performance. To deal with this conflict, some companies allocate some, or
possibly all, common corporate costs in reporting segment operating income, but for ROI calculation pur
poses exclude allocated corporate costs that are not closely associated with the divisions. These companies
include in the ROI calculation costs that represent an identifiable benefit to the divisions but not general
corporate costs that provide no identifiable benefits to the divisions. In practice, the treatment of corporate
costs for division performance evaluation varies widely.
nvestment Center Ass Base

Because the primary purpose for computing ROI is to evaluate the effectiveness of a division's operating
management in using the assets entrusted to them, most organizations define investment as the average
total assets of a division during the evaluation period. For most companies, the investment base is defined
as each division's operating assets. These normally include those assets held for productive use, such as ac
counts receivable, inventory, and plant and equipment. Nonproductive assets, such as land for a future plant
site, are not included in the investment base of a division but in the investment base for the company.
General corporate assets allocated to divisions should not be included in their bases. Although the di
visions might need additional administrative facilities if they were truly independent, they have no control
over the headquarters' facilities. The joint nature and use of corporate facility-level expenses make any
allocation arbitrary.
Other Valuation Issues

Once divisional investment and income have been operationally defined and ROI computations have been
made, the significance of the resulting ratios can still be questioned. Return on investment can be over
stated in terms of constant dollars because inflation as well as arbitrary inventory and depreciation pro
cedures cause an undervaluation of the inventory and fixed assets included in the investment center asset
base. Asset measurement is particularly troublesome if inventories are valued at last-in, first-out (LIFO)
cost and fixed assets were acquired many years ago. A division manager could hesitate to replace an old,
inefficient asset with a new, efficient one because the replacement could lower income and ROI through
an increased investment base and increased depreciation.
To improve the comparability between divisions with old and new assets when computing ROI, some
firms value assets at original cost rather than at net book value (cost less accumulated depreciation). This
procedure does not reflect inflation, however. An old asset that cost $120,000 ten years ago is still being
compared with an asset that costs $200,000 today. A better solution could be to value old assets at their
replacement cost, although obtaining replacement costs are often difficult to determine.
.. . • You are the Division Vice President
Division managers in your company are evaluated primarily based on division return on investment,
and you recently received financial reports for your division for the most recent period and discovered
that the ROI for your division was 14.5%; whereas, the target ROI for your division set by the CFO
and the CEO was 15%. What action can you take to try to avoid missing your performance target for
the next period? [Answer, p. 391J
al nc e
Residual income is an often-mentioned alternative to ROI for measuring investment center performance.
Residual income is the excess of investment center income over the minimum rate of return set by top
management. The minimum rate of retum represents the rate that can be earned on aitemative investments
of similar risks, which is the opportunity cost of the investment.
The minimum dollar return is computed as a percentage of the investment center's asset base. When
residual income is the primary basis of evaluation, the management of each investment center is encour-
aged to maximize residual income rather than ROt To illustrate the computation, assume that a company
requires a minimum return of 12 percent on each division's investment base. The residual income of a
division with an annual net operating income of $2,000,000 and an investment base of $15,000,000 is
$200,000 as computed here:
Division income. . . . . . . . . . . . . . . . . . . $2,000,000

Minimum return ($15,000,000 x 0.12) . . . . . . . . (1,800,000)
Residual income. . . . . . . . . . . . . . . . . . . . . . . .. $ 200,000
E nami Value dde

A variation of residual income, referred to as economic value added or EVA®, is also often used as a ba-
sis for evaluating investment center peIformance. (The term EVA is a registered trademark of the financial
consulting firm of Stern Stewart and Company.) EVA is equal to income after taxes less the cost of capital
employed. The three significant changes from the residual income computation in applying EVA are the
use of an organization's weighted average cost of capital as the minimum return, net assets as the evalua-
tion base, and after-tax income. Weighted average cost of capital is an average of the after-tax cost of all
long-term bOITowing and the cost of equity'; net assets are total assets less current liabilities. Economic
value is added only if a division's taxable income exceeds its net cost of investing.
Using the preceding situation, assume that the company has a cost of capital of 10 percent, $1 ,800,000 in
current liabilities, and a 30 percent tax rate. The economic value-added is $80,000, computed as follows:
Division income after taxes ($2,000,000 x 0.70) . $1,400,000

Cost of capital employed [($15,000,000 - $1,800,000) x 0.10j . (1,320,000)
Economic value added . $ 80,000
Another differentiating characteristic of the EVA model is that it usually corrects for potential distor-
tions in economic net income caused by generally accepted accounting principles (GAAP). In calculating
EVA, the user can abandon any accounting principles that are viewed as distorting the measurement of
wealth creation. In practice, EVA consultants have identified up to 150 different adjustments to GAAP
income and equity that must be made to restore equity and income to their true economic values. Most
.' Weighted Average Cost of Capital computalions are covered in introductory corporate finance textbooks.
companies use no more than about five adjustments (such as the capitalization of research and develop
ment cost and the elimination of goodwill write-offs).
Proponents of EVA argue that it is the best measure of managerial performance from the standpoinl
of maximizing the market value added to a firm through managerial decisions. They maintain that marke1
value added (MV A), which is the increase in market value of the firm for the period, is the definitive
measure of wealth creation and that MVA is maximized by maximizing EVA. By maximizing the exceS5
of economic net income over the cost of all outside capital invested in the firm, the firm should maximize
its MVA in the long run.
One might ask why we should use EVA to estimate managerial contribution to the maximization oj
MVA, when we could simply measure how much market value has been added to the firm by consider
ing changes in stock prices. In theory, measuring market success on stock price changes would work
but in practice this does not work well because of short-run changes in market prices caused by overall
market factors, not just firm-specific factors. Also, many firms are not publicly traded, which make5
determining market value changes difficult. Finally, companies want to measure managerial perfor·
mance over specific segments of a firm, as well as the firm as a whole, but market values for individual
segments are seldom available.
EVA provides a good operational metric for assessing managers' performance in terms of maximiz·
ing MVA over time. An advantage of EVA is that it is a model that can also be used to guide manageria
action. Companies that use EVA for evaluating performance use it in making a broad range of decisiom
such as evaluating capital expenditure proposals, adding or dropping a product line, or acquiring anothel
company. Only alternatives that provide economic value are accepted. The following Research Insighl
box discusses the impact of adopting an EVA financial management system on performances.
RESEARCH INSIGHT Evidence Supports EVA
Research has focused on the effectiveness of EVA in driving companies to superior performance.
Stern Stewart and Company tested the relationship between EVA and MVA for the largest companies
in the United States and found that EVA statistically explains about 50 percent of the total movement
in company MVA, whereas accounting earnings and cash flow explained about 18 percent and 22
percent respectively. Another stUdy found that low MVA and EVA numbers more than double the
chance that a company's CEO will be fired. For firms with MVAs above the median, 8.6 percent had
fired their CEO, but for firms with MVAs below the median, the firing rate was 20.0 percent. Also, the
CEO turnover rate was 9.0 percent when EVA was above the median and 19.3 percent when it was
below the median. 4
Whic I\JIpA\~urp Is B t.
Many executives view residual income or EVA as a better measure of managers' performance than ROI
They believe that residual income and EVA encourages managers to make profitable investments tha
managers might reject if being measured exclusively by ROI.
To illustrate, assume that three divisions of Color Company have an opportunity to make an invest
ment of $100,000 that requires $10,000 of additional current liabilities and that will generate a return 0
20 percent. The manager of the Paint Division is evaluated using ROI, the manager of the Ink Divisiol
is evaluated using residual income, and the manager of the Dye Division is evaluated using economi,
value added. The current ROI of each division is 24 percent. Each division has a cunent income 0
$120,000, a minimum return of 18 percent on invested capital, and a cost of capital of 14 percent. I
each division has a cunent investment base of $500,000, current liabilities of $40,000, and a tax rate a
30 percent, the effect of the proposed investment on each division's performance is as follows:
4 AI Ehrbar, "Using EVA to Measure Performance and Assess Strategy," Srraregy & Leadership, May/June 1999.
Chapter 11 I Segment Reporting. Transfer Pricing. and Balanced Scorecard 385
Current + Proposed Total
Paint Division
Investment center income $120,000 $ 20,000 $140,000
Asset base .
$500,000 $100,000 $600,000
ROI . 24% 20% 23.3%
Ink Division
Asset base . $500,000 $100,000 $600,000
Investment center income . $120,000 $ 20,000 $140,000

Minimum return (0.18 x base) . (90,000) (18,000) (108,000)
Residual income . $ 30,000 $ 2,000 $ 32,000
Dye Division
Assets . $500,000 $100,000 $600,000
Current liabilities . (40,000) (10,000) (50,000)
Evaluation base . $460,000 $ 90,000 $550,000
Investment center income . $120,000 $ 20,000 $140,000

Income taxes (30%) . (36,000) (6,000) (42,000)
Income after taxes . 84,000 14,000 98,000
Cost of capital (0.14 X base) . (64,400) (12,600) (77,000)
Economic value added . $ 19,600 $ 1,400 $ 21,000
The Paint Division manager will not want to make the new investment because it reduces the current
ROI from 24 percent to 23.3 percent. This is true, even though the company's minimum return is only 18
percent. Not wanting to explain a decline in the division's ROI, the manager will probably reject the op
portunity even though it could have benefited the company as a whole.
The Ink Division manager will probably be happy to accept the new project because it increases
residual income by $2,000. Any investment that provides a return more than the required minimum of 18
percent will be acceptable to the Ink Division manager. Given a profit maximization goal for the organiza
tion, the residual income method is preferred over ROI evaluations because it encourages division manag
ers to accept all projects with returns above the 18 percent cutoff. The same is true for the Dye Division
manager, although the EVA increase is not as high as that of the residual income because it has a different
base. However, the EVA is often considered a better evaluation tool than residual income because it is
believed to be a better measure of economic profit.
The primary disadvantage of the residual income and EVA methods as comparative evaluation tools is
that they measure performance in absolute terms. Although they can be used to compare period-to-period
results of the same division or with similar-size divisions, they cannot be used to compare the performance
of divisions of substantially different sizes. For example, the residual income of a multimillion dollar
sales division should be higher than that of a half-million-dollar sales division. Because most performance
evaluations and comparisons are made between units or alternative investments of different sizes, ROI
continues to be extensively used. The following Business Insight box discusses the use of multiple evalu
ation models for assessing IT projects.
BALANCED SCORECARD
Although financial measures have been emphasized throughout this text, several sections stress that other mea L04 Describe
sures, specifically qualitative measures, are important in evaluating managerial performance. This section ex the balanced
amines one popular method of performance evaluation using both financial and nonfinancial information. scorecard as a
We might ask: why not use just financial measures? First, no single financial measure captures all comprehensive
performance aspects of an organization. More than one measure must be used. Second, financial measures performance
have reporting time lags that could hinder timely decision making. Third, financial measures might not ac measurement
curately capture the infonnation needed for current decision making because of the delay that sometimes system.
386 Chapter 11 I segment Reporting, Transfer Pricing, and Balanced Scorecard
BUSINESS INSIGHT Methods used to Evaluate IT Projects at Harrah's
A recent article in Computer World discusses the methods used to evaluate IT project proposals
by IT managers and corporate executives. The article outlines the differences between "operational
projects" aimed at saving money, and "strategic projects" aimed at making money. Harrah's Enter
tainment was one of several companies cited in the article.
Harrah's Entertainment Inc. uses three metrics to prioritize IT projects: net present value, internal
rate of return, and economic value added. "Increased sales is usually the key benefit to be measured,
but the business sponsor of a project works with IT to measure softer benefits such as increased
guest visits at Harrah's hotels and casinos, customer satisfaction, and even employee satisfaction."
Using more than one metric has pros and cons, says Harrah's CIO Tim Stanley. "Using multiple
criteria to assess a project provides a robust framework for decisions," he says. "Each tool takes into
consideration the investment and the expected business value or return, and we are not limited to a
single point of view." But, he adds, "the prospect of sophisticated financial analyses can inhibit some
people from submitting ideas for consideration."5
occurs between making financial investments and receiving their results, For example, building a new
nuclear power plant can take several years with the investment in total assets increasing the entire time
without generating any revenues.
alanced Scorecar Framework

Comprehensive pe/fonnance measurement systems are one suggested solution. The basic premise is to
establish a set of diverse key performance indicators to monitor peJiormance. The balanced scorecard
is a performance measurement system that includes financial and operational measures related to a firm's
goals and strategies. The balanced scorecard comprises several categories of measurements, the most
common of which include the following:
Financial
Customer satisfaction
Internal processes
Innovation and learning
A balanced scorecard is usually a set of reports required of all common operating units in an or
ganization. To facilitate the periodic evaluation of performance, a cover sheet (or sheets for a large
operation) can be used to summarize the performance of each area using the established criteria for
each category.
For example, a chain of bagel shops might have a balanced scorecard that looks something like the
one in Exhibit 11.3. This balanced scorecard uses four categories for evaluation and includes financial
and nonfinancial information. Each category being monitored has information from the previous period
and the standard related to the category. The report should always include the current period, at least
one previous period, and some standard. Each store manager should attach documentation and an ap
propriate explanation as to the change in the measurements during the reporting period.
In making assessments with the evaluation categories, it is important to consider both trailing and
leading performance measures. Trailing measures look backward at historical data while leading mea
sures provide some idea of what to expect currently or in the near future. For example, in the financial
category, ROI is a trailing indicator while a budget of production units and costs for the next period is a
leading indicator. In the customer category, the number of sales invoices per store might tell us whether
each store is maintaining its customer base (a trailing indicator) while the number of product complaints
per 1000 invoices might be a leading indicator of customer satisfaction, quality control problems, and
future sales.
5 Gary Anthes, "What's Your Project Worth? Figuring it out isn'r easy. But you can'r manage what you don't measure," Computer
World, March 10, 2008.
Chapter 11 I Segment Reporting, Transfer Pricing, and Balanced SCorecard 387
EXHIBIT 11.3 Balanced Scorecard Illustration
Standard Prior Period Current Period
Key financial indicators

Cash flow . $ 25,000 $ 28,000 $ 21,000
Return on investment (ROI) . 0.18 0.22 0.19
Sales . $4,400,000 $4,494,000 $4,342,000
Key customer indicators
Average customers per hour . 75 80 71
Number of customer complaints per period . 22 21 17
Number of sales returns per period . 10 8 5
Key operating indicators
Bagels sold/produced per day ratio . 0.96 0.93 0.91
Daily units lost (burned, dropped, etc.) . 25 32 34
Employee turnover per period . 0.10 0.07 0.00
Key growth and innovation indicators
New products introduced during period . 1 1 o
Products discontinued during period . 1 1 1
Number of sales promotions . 3 3 2
Special offers, discounts, etc. . . 4 5 3
The use of balanced scorecard systems to monitor and assess managerial and organizational perfor
mance is increasing worldwide. The following Research Insight box provides more information on the
types of key performance indicators used by a group of firms.
RESEARCH INSIGHT Balanced Scorecard Yields Results
A survey of firms found that a balanced scorecard is more widely used by larger firms. Also, firms
having a higher proportion of new products are more likely to include in their scorecard measures re
lated to new products. However, no relation was found between market share of companies and
whether or not they used the balanced scorecard. Yet, results indicated that usage of the balanced
scorecard is associated with improved performance of companies regardless of company size, stage
of product life cycle, or market position. The following were the most commonly used key perfor
mance indicators of the surveyed firms: 6
Financial perspective: Internal perspective:
Operating income Labor efficiency variance
Sales growth Rate of material scrap loss
Return on investment Material efficiency variance
Customer perspective: Manufacturing lead time

Customer satisfaction Ratio of good output to total output
Number of customer complaints Percentage of defective products shipped
Market share
Percentage of shipments returned Innovation and learning perspective:
due to poor quality Number of new product launches
On-time delivery Number of new patents
Warranty repair cost Time to market new products
Customer response time
Cycle time from order to delivery
A balanced scorecard gives management a perspective of the organization's performance on a re

curring set of criteria. Since each reporting unit knows what reports are expected, no one is surprised
) Zahirul Hoque and Wendy James, "Linking Balanced Scorecard Measures to Size and Market Factors: Impact on Organizational
Performance," Journal of Monogemen/ Accoun/ing Research, Vol. 12,2000.
by changing monthly requests for data. Because the multiple perspectives provide management a broad
analysis of the organization's perfonnance, it allows them to determine how and where the goals and ob
jectives are either being achieved or not achieved.
For most management teams, the balanced scorecard highlights trade-offs between measures. For
example, a substantial increase in customer satisfaction can result in a short-run decrease in ROI because
the extra effort to please customers is expensive, thereby reducing ROI. A balanced scorecard can be
filtered down the organization with successively lower-level operating units having their own scorecards
that mimic those of the higher-level units. This provides all levels of management an opportunity to evalu
ate operations from more than just a financial perspective.
As with all management tools and techniques, the use of the balanced scorecard must be incorporated
with the other infonnation sources within the organization. Just as the accounting information system
cannot stand alone in managing a business, neither can the balanced scorecard. Some areas could need
extensive accounting information in great detail to make the best possible decision while other areas need
great detail in production or service integration to be at the right place at the right time. By using a multi
faceted approach to managing, the organization should be able to better establish an operating strategy that
coincides with its overall goals and objectives.
Balance core and tegy

When a balanced scorecard system is fully utilized to monitor and evaluate an organization's progress,
it becomes a system for operationalizing the organization's strategy. Having a goal to maximize share
holder value or generate a certain income does not constitute a strategy. Maximizing shareholder value
can be an overarching corporate goal, but it will not likely be realized without a well-developed strategy
that identifies and establishes a balanced set of goals on various dimensions of performance.
A balanced scorecard can be the primary vehicle for translating strategy into action and establish
ing accountability for performance. The balanced scorecard identifies the areas of managerial action
that are believed to be the drivers of corporate achievement. If the corporate goal is to increase ROI or
EVA, the balanced scorecard should include key performance indicators that drive ROI or EVA.
An interesting parallel to the successful management of a company can be drawn by considering
the key performance indicators the manager of a professional baseball team uses in setting goals and
evaluating progress. The manager of the New York Yankees does not just tell his players and manag
ers at the beginning of the baseball season that the team's goal is to win the World Series or even a
certain number of ball games. The win-loss record is only one metric used to set goals and evaluate
performance for a baseball team. The manager looks at many different drivers of success related to hit
ting, pitChing, and fielding, including the earned-run averages of the pitchers, the batting and on-base
averages of hitters, the number of errors per game by fielders, and the number of bases stolen by base
runners. At the end of the season, the manager measures success not just by whether the Yankees won
the World Series, but also by the batting average, number of home runs, and number of bases stolen
by individual players, and whether or not a team member won a Golden Glove award or the Cy Young
award. These are all measures by which to evaluate achievement and strategic accomplishment. By
achieving the goals for each of these areas of the game, the win-loss ratio will take care of itself. If the
win-loss results are not acceptable, then the manager adjusts his strategic goals with respect to the key
performance indicators (or the manager is dismissed).
Like a baseball team, a company can use a balanced scorecard to develop performance metrics for
managers from the top of the company to the lowest-level department. The scorecard becomes a vehicle
for communicating the factors that are key to the success of managers, factors that upper management
will monitor in evaluating the success of lower managers in carrying out the corporate strategy. To
make balanced scorecards more user friendly, several software companies have developed performance
monitoring dashboards, which are software programs that tabulate and display scorecard results using
graphics that mimic the instrument displays on an automobile dashboard.
The following Business Insight box shows a sample dashboard for a company's balanced scorecard
results.
Chapter 11 I Segment Reporting, Transfer Pricing, and Balanced SCorecard 389
BUSINESS INSIGHT Balanced Scorecard Software
Ergometrics LTD is a company from New Zealand that was formed to develop and market dash
board software. Ergometrics has developed performance monitoring dashboards that present bal
anced scorecard results. The following sample is for a hypothetical utility company:
r ~ Uhltly Company llalanced SCOIec,,,d I&J
uwty Company
Balanced Business Scorecard
'--Fi-na-n-c-ia-'- , ;:;.;::......._-.,
'_-==,=~---.
~
~ .... DYedillle $.000
!Innovation and Growth
o 15 0 10 o 10 0 20
Lost T.ro, Accident. % Sicknell GOYt Approved Ten., Training
Period Length Measurement Period

______ J~nlh ~I g ~at':'t IFebruary 98 l;)1,Il!!!!.I!'!i'!! _
By clicking on any of the four scorecard indicators, the manager monitoring performance can drill
down for more detail. Note that the period being examined can be changed to view performance for
any period in the dashboard databaseJ
CHAPTER-END REVIEW
Pareto International, a decentralized organization that manufactures specialty construction products, has three
divisions, Commercial, Industrial, and Residential. Corporate management desires a minimum return of IS per
cent on its investments and has a 20 percent tax rate with an average cost of capital of 12 percent. The divisions'
2009 results follcw (in thousands):
Division Income Investment Current Liabilities
Commercial $30,000 $200,000 $10,000

Industrial. ......... 50,000 250,000 30,000
Residential ........ 22,000 100,000 5,000
The company is planning an expansion project in 2010 that will cost $50,000,000 and return $9,000,000 per year.
It will result in a $10,000 increase in current liabilities.
Required
a. Compute the ROI for each division for 2009.
b. Compute the residual income for each division for 2009.
c. Compute the economic value added for each division for 2009
d. Rank the divisions according to their ROJ, residual income, and EVA.
e. Assume that other income and investments will remain unchanged. Determine the effect of the project
by itself. What is the effect on ROI, residual income, and economic value added if the new project is
added to each division?
7 As presented at http://www.ergometrics.comfbalscore3.htm
Solution
a. Return on investment =
Investment center income
Investment center asset base
Commercial Division = $30,000 -;- $200,000
= 0.15, 01' 15 percent
Industrial Division = $50,000 -;- $250,000
=
0.20, or 20 percent
Residential Division = $22,000 -;- $100,000

= 0.22, or 22 percent
b. Residual income = Investment center income - (Investment center asset base x Minimum return)
Commercial Division = $30,000 - (0.15 x $200,000)
= $0.00
Industrial Division = $50,000 - (0.15 x $250,000)
= $12,500
Residential Division = $22,000 - (0.15 x $100,000)
= $7,000
c. EVA = After tax income - (Net assets x Weighted average cost of capital)
Commercial Division = ($30,000 x 0.80) - [($200,000 - $10,000) x 0.12]
= $1,200
Industrial Division = ($50,000 x 0.80) - [($250,000 - $30,000) x 0.12]
= $13,600
Residential Division = ($22,000 x 0.80) - [($100,000 - $5,000) x 0.12]
= $6,200
d. ROI ranks the Residential Division first, the Industrial Division second, and the Commercial Division
third. Residual income ranks the Industrial Division first, the Residential Division second, and the
Commercial Division third. Because the investments for each division are different, it is somewhat
misleading to rank the divisions according to residual income. The Industrial Division had the highest
residual income, but it also had the largest investment. The Residential Division's residual income was
56 percent of the Industrial Division's income but only 40 percent of the investment of the Industrial
Division. This fact, along with the best ROI ranking, probably justifies the Residential Division being
evaluated as the best division of Pareto Company.
e. Return on investment:
Investment = $9,000 -;- $50')00
= 0.18, or 18 pel'cent
Commercial Division = ($30,000 + $9,000) -;- ($200,000 + $50,000)
= 0.156, or 15.6 percent
Industrial Division = ($50,000 + $9,000) -;- ($250,000 + $50,000)
= 0.1967, or 19.67 percent
Residential Division = ($22,000 + $9,000) -;- ($100,000 + $50,000)
= 0.2067, or 20.67 percent
ROI will increase for the Commercial Division but decrease for the Industrial and Residential Divisions,
even though the project's ROJ of 18 percent exceeds the company's minimum return of 15 percent.
Residual income:
Commercial Division = ($30,000 + $9,000) - [0.15 x ($200,000 +$50,000)]
= $1,500
Industrial Division = ($50,000 + $9,000) - [0.15 x ($250,000 + $50,000)]
= $14,000
Residential Division = ($22,000 + $9,000) - [0.15 x ($100,000 + $50,000)]
= $8,500
Because the project's ROI exceeds the company's minimum return, the residual income of all divisions
will increase.
Economic value-added:
Commerical Division = [($30,000 + $9,000) x 0.80] - [($200,000 + $50,000 - $20,000) x 0,12]
= $3,600
Industrial Division = [($50,000 + $9,000) x 0.80] - [($250,000 + $50,000 - $40,000) x 0.12]
= $16,000
Residential Division = [($22,000 + $9,000) x 0,80] - [($100,000 + $50,000 - $15,000) x 0.12]
= $8,600
The EVA does not shift the same way the residual income does because of the additional relationships
between the level of current liabilities and the tax rate. However, in this situation, all divisions have an
increase in EVA when the new investment is made.
GUIDANCE ANSWER
. .
• You are the Division Vice President
ROI is primarily a measure of the profitability of a division's assets, which is in turn a measure of how effectively
the investment in assets was used to generate sales. and how profitable those sales were. ROt is driven by
investment (or asset) turnover (which is division sales divided by assets) and return on sales (which is division
net income divided division sales). Therefore, increasing ROI is similar to a simultaneous balancing act involving
controlling sales, expenses, and asset investment. You can increase ROI by increasing sales more than expens
es, while holding asset investment constant, or by other combinations of these three variables that ultimately
increase ROI. If you adjust one of these variables, at the same time you must keep your eye on the other two
variables or you may not achieve your goal of increasing ROI.
DISCUSSION QUEST ON
Qll·!. What is the relationship between segment reports and product reports?
Qll-2. What is a reporting objective? How is it determined?
Qll-3. Can a company have more than one type of first-level statement in segment reporting?
Qll-4. Explain the relationships between any two levels of statements in segment reporting.
QU-S. Distinguish between direct and indirect segment costs.
Qll-6. What types of information are needed before management should decide to drop a segment?
Qll-7. In what types of organizations and for what purpose are transfer prices used?
QIl-8. What problems arise when transfer pricing is used?
QU-9. When do transfer prices lead to suboptimization? How can suboptimization be minimized? Can it be
eliminated? Why or why not?

Qll-10. For what purpose do organizations use return on investment? Why is this measure preferred to net
income?
QU-I!. What advantages does residual income and EVA have over ROI for segment evaluations?
QIl-12. Contrast the difference between residual income and EVA.
QU-13. Explain how a balanced scorecard helps with the evaluation process of internal operations.
QIl-14. How can a balanced scorecard be used as a strategy implementation tool?
MI EXERCISES
MIl-IS. Multiple Levels of Segment Reporting (L011
Gormet Appliances manufactures four different lines of household appliances: cooking, cleaning,
convenience, and safety. Each of the product lines is produced in all of the company's three plants:
Abbeyville, Bakersville, and Charlottesville. Marketing efforts of the company are divided into five regions:
East, West, South, North, and Central.
Required
a. Develop a reporting schematic that illustrates how the company might prepare single-level reports
segmented on three different bases.
b. Develop a segment reporting schematic that has three different levels. Be sure to identify each
segment's level. Briefly explain why you chose the primary-level segment.
MIl-16. Income Statements Segmented by Territory (L01)

Script, Inc., has two product lines. The September income statements of each product line and the company
are as follows:
392 Chapter 11 1 Segment Reporting, Transfer Pricing, and Balanced Scorecard
SCRIPT, INC.
Product Line and Company Income Statements
For Month of September
Pens Pencils Total
Sales . $25,000 $30,000 $55,000

Less variable expenses . (10,000) (12,000) (22,000)
Less direct fixed expenses . (9,000) (7,000) (16,000)
Product margin . $ 6,000 $11,000 17,000
Less common fixed expenses -.-.-. .-.-.- -.-.-.-.-.- . (6,000)
Pens and pencils are sold in two territories, Florida and Alabama, as follows:
Florida Alabama
Pen sales . $15,000 $10,000

Pencil sales . 9,000 21,000
Total sales . $24,000 $31,000
The preceding common fixed expenses are traceable to each territory as follows:
Florida fixed expenses . $2,000

Alabama fixed expenses . 3,000
Home office administration fixed expenses . 1,000
Total common fixed expenses . $6,000
The direct fixed expenses of pens, $9,000, and of pencils, $7,000, cannot be identified with either territory. The
company's accountants were unable to allocate any of the common fixed expenses to the various segments.
Required
a. Prepare income statements segmented by territory for September, including a column for the entire
firm.
b. Why are the direct expenses of one type of segment report not necessarily the direct expenses of
another type of segment report?
Mll-17. Income Statements Segmented by Products (L01)

Clay Consulting Firm provides three types of client services in three health-care-related industries. The
income statement for July is as follows:
CLAY CONSULTING FIRM

Income Statement
For Month of July
Sales . $900,000
Less variable costs . (605,000)
Less fixed expenses
Service . $70,000
The sales, contribution margin ratios, and direct fixed expenses for the three types of services are as
follows:
Hospitals Physicians Nursing Care
Sales . $350,000 $250,000 $300,000

Contribution margin ratio . 30% 40% 30%
Direct fixed expenses of services . $ 20,000 $ 18,000 $ 16,000
Allocated common fixed services expense . $ 1,000 $ 1,000 $ 1,500
Required
Prepare income statements segmented by client categories. Include a column for the entire firm in the
statement.
MIl-18. Internal or External Acquisitions: No Opportunity Costs (L02)

The Van Division of MotoCar Corporation has offered to purchase 180,000 wheels from the Wheel Division
for $42 per wheel. At a normal volume of 500,000 wheels per year, production costs per wheel for the Wheel
Division are as follows:
Direct materials $15

Direct labor. . . . . . . . . 10
Variable overhead. . . . 6
Fixed overhead. . . . . . .. 18
Total $49
The Wheel Division has been selling 500,000 wheels per year to outside buyers at $58 each. Capacity is
700,000 wheels per year. The Van Division has been buying wheels from outside suppliers at $55 per wheel.
Required
a. Should the Wheel Division manager accept the offer'? Show computations.
b. From the standpoint of the company, will the internal sale be beneficial?
MIl-19. Transfer Prices at Full Cost with Excess Capacity: Divisional Viewpoint (L02)
Wholesome Dairy's Cheese Division produces cheese that sells for $10 per unit in the open market.
The cost of the product is $8 (variable manufacturing of $5, plus fixed manufacturing of $3). Total fixed
manufacturing costs are $210,000 at the normal annual production volume of 70,000 units. The Overseas
Division has offered to buy 15,000 units at the full cost of $8. The Producing Division has excess capacity,
and the 15,000 units can be produced without interfering with the current outside sales of 70,000 units. The
total fixed cost of the Cheese Division will not change.
Required
Explain whether the Cheese Division should accept or reject the offer. Show calculations.
Mll-20. Transfer Pricing with Excess Capacity: Divisional and Corporate Viewpoints (L02)
Boyett A11 Company has a Print Division that is currently producing 100,000 prints per year but has a capacity
of 150,000 prints. The variable costs of each print are $30, and the annual fixed costs are $900,000. The prints
sell for $40 in the open market. The company's Retail Division wants to buy 50,000 prints at $28 each. The
Print Division manager refuses the order because the price is below variable cost. The Retail Division manager
argues that the order should be accepted because it will lower the fixed cost per print from $9 to $6.
Required
a. Should the Retail Division order be accepted? Why or why not?
b. From the viewpoints of the Print Division and the company, should the order be accepted if the
manager of the Retail Division intends to sell each print in the outside market for $42 after incurring
additional costs of $10 per print?
c. What action should the company take, assuming it believes in divisional autonomy?
MIl-21. ROI and Residual Income: Impact of a New Investment (L03)

The Mustang Division of Detroit Motors had an operating income of $900,000 and net assets of $4,000,000.
Detroit Motors has a target rate of return of 16 percent.
Required
a. Compute the return on investment.
h. Compute the residual income.
c. The Mustang Division has an opportunity to increase operating income by $200,000 with an
$850,000 investment in assets.
I. Compute the Mustang Division's return on investment if the project is undertaken. (Round your
answer to three decimal places.)
2. Compute the Mustang Division's residual income if the project is undertaken.
Mll-22. ROI: Fill in the Unknowns (L03)

Provide the missing data in the following situations:
North American Asian European

Division Division Division
Sales . ? $5,000,000 ?
Net operating income . $100,000 $ 200,000 $144,000
Operating assets . ? ? $800,000
Return on investment . 16% 10% ?
Return on sales . 0.04 ? 0.12
Investment turnover . ? ? 1.5
Mll-23. Selection of Balanced Scorecard Items (L04)

The International Accountants' Association is a professional association. Its current membership totals
110,000 worldwide. The association operates from a central headquarters in New Zealand but has local
membership chapters throughout the world. The local chapters hold monthly meetings to discuss recent
developments in accounting and to hear professional speakers on topics of interest. The association's
journal, International Accounlant, is published monthly with feature articles and topical interest areas. The
association publishes books and reports and sponsors continuing education courses. A statement of revenues
and expenses follows:
INTERNATIONAL ACCOUNTANTS' ASSOCIATION

Statement of Revenues and Expenses
For Year Ending November 30, 2009
Revenues ..... $30,275,000

Expenses
Salaries . $14,000,000
Other personnel costs . 3,400,000
Occupancy costs . 2,000,000
Reimbursement to local chapters . 800,000
Other membership services . 500,000
Printing and paper . 320,000
Postage and shipping . 114,000
General and administrative .. 538,000 (21,672,000)
Excess of revenues over expenses . $ 8,603,000

Membership dues are $200 per year, of which $50 is considered to cover a one-year subscription to the
association's joumal. Other benefits include membership in the association and chapter affiliation.
One-year subscriptions to Intel'l1alional Accounlanl are sold to nonmembers for $80 each. A total of
2,500 of these subscriptions were sold. In addition to subscriptions, the journal generated $200,000 in
advertising revenue. The cost per magazine was $20.
A total of 30,000 technical reports were sold by the Books and Reports Department at an average unit
selling price of $45. Average costs per publication were $12.
The association offers a variety of continuing education courses to both members and nonmembers.
During 2009, the one-day course, which cost participants an average of $75 each, was attended by
34,400 people. A total of 2,630 people took two-day courses at a cost of $125 per person.
General and administrative expenses include all other costs incurred by the corporate staff to operate
the association.
The organization has net capital assets of $44,000,000 and prefers to maintain a cost of capital of
10 percent.
Required
a. Give some examples of key financial pelformance indicators (no computations needed) that could be
part of a balanced scorecard for the IAA.
b. Give some examples of key customer and operating performance indicators (no computations
needed) that could be part of a balanced scorecard for IAA.
EXERCISES
Ell·24. Appropriate Transfer Prices: Opportunity Costs (L02)
Plains Peanut Butter Company recently acquired a peanut-processing company that has a nonnal annual
capacity of 4,000,000 pounds and that sold 2,800,000 pounds last year at a price of $2.00 per pound. The
purpose of the acquisition is to furnish peanuts for the peanut butter plant, which needs 1,600,000 pounds
of peanuts per year. It has been purchasing peanuts from suppliers at the market price. Production costs per
pound of the peanut-processing company are as follows:

Direct labor . 0.25
Variable overhead . 0.12
Fixed overhead at normal capacity . 0.20
Total . $1.07
Management is trying to decide what transfer price to use for sales from the newly acquired Peanut Division
to the Peanut Butter Division. The manager of the Peanut Division argues that $2.00, the market price, is
appropriate. The manager of the Peanut Butter Division argues that the cost price of $1.07 (or perhaps even
less) should be used since fixed overhead costs should be recomputed. Any output of the Peanut Division
up to 2,800,000 pounds that is not sold to the Peanut Butter Division could be sold to regular customers at
$2.00 per pound.
Required
a. Compute the annual gross profit for the Peanut Division using a transfer price of $2.00.
b. Compute the annual gross profit for the Peanut Division using a transfer price of $1.07.
c. What transfer price(s) will lead the manager of the Peanut Butter Division to act in a manner that will
maximize company profits?
Ell·25. Negotiating a Transfer Price with Excess Capacity (L02)

The Weaving Division of Carolina Textiles Inc. produces cloth that is sold to the company's Dyeing Division
and to outside customers. Operating data for the Weaving Division for 2009 are as follows:
To the Dyeing To Outside

Division Customers
Sales
450,000 yards x $5.00 . $2,250,000
300,000 yards x $6.00 . $1,800,000
Variable expenses at $2.00 . (900,000) (600,000)
Contribution margin . 1,350,000 1,200,000
Fixed expenses' . (750,000) (500,000)
Net income . $ 600,000 $ 700,000
'Allocated on the basis of unit sales.
The Dyeing Division has just received an offer from an outside supplier to supply cloth at $3.50 per yard.
The Weaving Division manager is not willing to meet the $3.50 price. She argues that it costs her $3.67 per
yard to produce and sell to the Dyeing Division, so she would show no profit on the Dyeing Division sales.
Sales to outside customers are at a maximum, 300,000 yards.
Required
a. Verify the Weaving Division's $3.67 unit cost figure.
b. Should the Weaving Division meet the outside price of $3.50 for Dyeing Division sales? Explain.
c. Could the Weaving Division meet the $3.50 price and still show a profit for sales to the Dyeing
Division? Show computations.
Ell-26. Dual Transfer Pricing IL02)

The Greek Company has two divisions, Beta and Gamma. Gamma Division produces a product at a variable
cost of $6 per unit, and sells 150,000 units to outside customers at $10 per unit and 40,000 units to Beta
Division at variable cost plus 40 percent. Under the dual transfer price system, Beta Division pays only the
variable cost per unit. Gamma Division's fixed costs are $250,000 per year. Beta Division sells its finished
product to outside customers at $23 per unit. Beta has variable costs of $5 per unit, in addition to the costs
from Gamma Division. Beta Division's annual fixed costs are $170,000. There are no beginning or ending
inventories.
Required
a. Prepare the income statements for the two divisions and the company as a whole.
b. Why is the income for the company less than the sum of the profit figures shown on the income
statements for the two divisions? Explain.
Ell-27. ROI and Residual Income: Basic Computations (L03)

Watkins Associated Watkins Associated Industries is a highly diversified company with three divisions: Trucking, Seafood,
Industries and Construction. Assume that the company uses return on investment, residual income, and economic
value added as three of the evaluation tools for division managers. The company has a minimum desired
rate of return on investment of 10 percent and a weighted average cost of capital of 7 percent with a 30
percent tax rate. Selected operating data for three divisions of the company follow.
Trucking Division Seafood Division Construction Division
Sales . $1,200,000 $750,000 $900,000

Operating assets . 600,000 250,000 350,000
Net operating income . 102,000 56,000 59,000
Current liabilities . 40,000 10,000 30,000
Required
a. Compute the return on investment for each division. (Round answers to three decimal places.)
b. Compute the residual income for each division.
c. Which divisional manager is doing the best job based on ROI? Based on residual income? Why?
Ell-28. ROI and Residual Income, and EV A with Different Bases IL03)
BMI Company has a target return on capital of 15 percent. The following financial information is available
for October ($ thousands):
Software Consulting Venture Capital

Division Division Division
(Value Base) (Value Base) (Value Base)
Book Current Book Current Book Current
Sales .............. $100,000 $100,000 $200,000 $200,000 $800,000 $800,000

Income ............ 12,000 10,000 16,000 17,000 50,000 52,000
Assets ............. 60,000 80,000 90,000 100,000 600,000 580,000
Current liabilities ..... 10,000 10,000 14,000 14,000 40,000 40,000
Required
a. Compute the return on investment using both book and current values for each division. (Round
answers to three decimal places.)
b. Compute the residual income for both book and current values for each division.
c. Compute the economic value added income for both book and current values for each division if the
tax rate is 30 percent and the weighted average cost of capital is 10 percent.
d. Does book value or current value provide a better basis for performance evaluation? Which division
do you consider the most successful?
811-29. Balanced Scorecard Preparation (L04)
The following information is in addition to that presented in Mini Exercise 11-23 for the International
Accountants' Association. For the year ended November 30, 2009, the organization had set a membership
goal of 100,000 members with the following anticipated results:
INTERNATIONAL ACCOUNTANTS' ASSOCIATION

Planned Revenues and Expenses
For Year Ending November 30, 2009
Revenues , .. , .. , , , , . $28,000,000
Expenses
Salaries ,., . $13,950,000
Other personnel costs , .. 3,450,000
Occupancy costs . 1,900,000
Reimbursement to local chapters. 780,000
Other membership services . 525,000
Printing and paper . 300,000
Postage and shipping. , . , . 103,000
General and administrative .. 550,000 (21,558,000)
Excess of revenues over expenses .... $ 6,442,000

Membership dues were increased from $180 to $200 at the beginning of the year.
One-year subscriptions to International Accountant were anticipated to be 2,400 units.
Advertising revenue was budgeted at $225,000. Each magazine was budgeted at $18.
A total of 28,000 technical reports were anticipated at an average price of $40 with average costs
of $11.
The budgeted one-day courses had an anticipated attendance of 32,000 with an average fee of $80. The
two-day courses had an anticipated attendance of 3,000 with an average fee of $125 per person.
The organization began the year with net capital assets of $40,000,000 with a planned cost of capital
of 10 percent.
Required
a. Prepare a balanced scorecard for IAA for November 2009 with calculated key performance indicators
presented in two columns for planned pelformance and actual performance-include key financial,
customer, and operating performance indicators.
b. Which of the evaluation areas you selected indicated success and which indicated failure?
c. Give some explanations of the successes and failures.
~1l-30. Balanced Scorecard (L04)

The following alphabetically ordered list of financial and nonfinancial performance melrics is provided for
BS, Inc.
Average call wait New product acceptance rate

Average customer survey rating New product revenue
Employee turnover ratio New product ROI
Expense as a % of revenue Net profit
Expense variance % Net profit margin
Fulfillment % Number of complaints
Headcount growth Number of defects reported
Industry quality rating Service error rate
Job offer acceptance rate Time to market on new products
Market share Unique repeat customer count
New customer count Year over year revenue growth
New customer sales value
Required:
G. Assign the above metrics to the four balanced scorecard categories of (1) Financial Success, (2)
Customer Satisfaction and Brand Improvement, (3) Business Process Improvement, (4) Learning and
Growth of Motivated Workforce.
b. Comment on the use of balanced scorecard versus a single financial measure such as ROI or EVA.
PROBLEMS
Pll-31. Multiple Segment Reports (LOi1
World Products Incorporated sells throughout the world in three sales territories: Europe, Asia, and the
Americas. For July, all $50,000 of administrative expense is traceable to the territories, except $10,000, which
is common to all units and cannot be traced or allocated to the sales territories. The percentage of product line
sales made in each of the sales territories and the assignment of traceable fixed expenses follow:
Sales Territory
Europe Asia The Americas Total
Cookware sales . 40% 50% 10% 100%

China sales . 40 40 20 100
Vases sales . 20 20 60 100
Fixed administrative expense . $15,000 $15,000 $10,000 $ 40,000
Fixed selling expense . $30,000 $60,000 $60,000 $150,000
The manufacturing takes place in one large facility with three distinct manufacturing operations. Selected
product-line cost data follow.
Cookware China Vases Total
Variable costs. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9 $ 9 $ 5
Depreciation and supervision. . . . . . . . . . . . . . . 15,000 15,000 12,000 $ 45,000'
Other mfg. overhead (common) . 10,000
Fixed administrative expense (common) . 50,000
Fixed selling expense (common) . 150,000
'Includes common costs of $3,000
The unit sales and selling prices for each product follow.
Unit Selling
Sales Price
Cookware . 10,000 $10

China . 20,000 15
Vases . 15,000 20
Required
G. Prepare an income statement for July segmented by product line. Include a column for the entire
firm.
b. Prepare an income statement for July segmented by sales territory. InClude a column for the entire
finn.
c. Prepare an income statement for July by product line for The Americas sales territory. Include a
column for the territory as a whole.
d. Discuss the value of multilevel segment reporting as a managerial tool. Compare and contrast the
benefits of the reports generated in parts G, b, and c.
Pll-32. Segment Reporting and Analysis (LOi1

Milwaukee Bakery Incorporated bakes three products: donuts, pies, and cakes. It sells them in the cities of
Chicago and Milwaukee. For March, the following income statement was prepared:
MILWAUKEE BAKERY, INCORPORATED

Territory and Company Income Statements
For Month of March
Chicago Milwaukee Total
Sales . $2,100 $500 $2,600

Cost of goods sold ....•..•............. (1,500) (300) (1,800)
Gross profit. . 600 200 800
Selling and administrative expenses . (400) (100) (500)
Net income . $ 200 $100 $ 300
Sales and selected variable expense data are as follows:
Products
Donuts Pies Cakes
Fixed baking expenses . $200 $140 $100

Variable baking expenses as a percentage of sales . 50% 50% 60%
Variable selling expenses as a percentage of sales . 4% 4% 5%
City of Chicago, sales . $800 $900 $400
City of Milwaukee, sales . $200 $100 $200
The fixed selling expenses were $260 for March, of which $160 was a direct expense of the Chicago market
and $100 was a direct expense of the Milwaukee market. Fixed administrative expenses were $130, which
management has decided not to allocate when using the contribution approach.
Required
a. Prepare a segment income statement for each sales territory for March. Include a column for the
entire Drm.
b. Prepare segment income statements for each product. InClude a column for the entire firm.
c. If the cake line is dropped and fixed baking expenses do not change, what is the product margin for
donuts and pies?
d. What other type of segmentation might be useful to Milwaukee Bakery. Explain.
Pll-33. Segment Reporting and Analysis (L01)

Accounting Publishers, Inc. has prepared income statements segmented by divisions, but management is
still uncertain about actual peIformance. Financial information for May is given as follows:
Textbook Professional Company

Division Division Total
Sales . $180,000 $410,000 $590,000

Less variable expenses
Manufacturing . 32,000 205,000 237,000
Selling and administrative . 4,000 20,500 24,500
Total . (36,000) (225,500) (261,500)
Less direct fixed expenses . (15,000) (220,000) (235,000)
Net income . $129,000 $(35,500) $ 93,500
Management is concerned about the Professional Division and requests additional analysis. Additional
information regarding May operations of the Professional Division is as foUows:
Accounting Executive Management
Sales . $140,000 $140,000 $130,000

Variable manufacturing expenses
as a percentage of sales . 60% 40% 50%
Other variable expenses
as a percentage of sales . 5% 5% 5%
Direct fixed expenses . $50,000 $75,000 $50,000
Allocated common fixed expenses . $5,000 $2,000 $7,000
The professional accounting books are sold to auditors and controllers. The current information on these
markets is as follows:
Sales Market
Auditors Controllers
Sales $30,000 $110,000

as a percentage of sales. . . . . . . . . . . . . . . . . . . . . . 60% 60%
Other variable expenses
as a percentage of sales. . . . . . . . . . . . . . . . . . . . . . 16% 2"10
Direct fixed expenses. . . . . . . . . . . . . . . . . . . . . . . . .. $ 5,000 $ 25,000
Allocated common fixed expenses $ 7,000 $ 8,000
Required
a. Prepare an income statement segmented by product for the Professional Division. Include a column
for the division as a whole.
b. Prepare an income statement segmented by market for the accounting books of the Professional
Division.
c. Evaluate which accounting books the Professional Division should keep or discontinue in the short run.
d. What is the correct long-run decision? Explain fully, including any possible risks associated with
your recommendation.
Pll-34. Segment Reports (L01j

The Entertainment Corporation produces and sells three products. The three products, CDs, DVDs, and
videotapes, are sold in a local market and in a regional market. At the end of the first quarter of 2009, the
following income statement was prepared:
ENTERTAINMENT CORPORATION
Territory and Company Income Statements
First Quarter of 2009
Local Regional Company
Sales . $1,000,000 $300,000 $1,300,000

Cost of goods sold . (775,000) (235,000) (1,010,000)
Gross profit. . 225,000 65,000 290,000
Selling expenses . 60,000 45,000 105,000
Administrative expenses . 40,000 12,000 52,000
Total . (100,000) (57,000) (157,000)
Net income . $ 125,000 $ 8,000 $ 133,000
Management has expressed special concern with the Regional Market because of the extremely poor return
on sales. This market was entered a year ago because of excess capacity. Management originally believed
that the return on sales would improve with time, but after a year, no noticeable improvement could be
seen from the results as reported in the preceding quarterly statement. In attempting to decide whether to
eliminate the Regional Market, the following information has been gathered:
Products
CD DVD Videotape
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $600,000 $500,000 $200,000

as a percentage of sales. . . . . . . . . . . . . . . 60% 70% 60%
Variable selling expenses
as a percentage of sales. . . . . . . . . . . . . . . 3% 2% 2%
Sales by Markets
Product Local Regional
CD . $450,000 $150,000
DVD . 350,000 150,000
Videotape . 150,000 50,000
All administrative expenses and fixed manufacturing expenses are common to the three products and the
two markets; these expenses are fixed for the period. The remaining selling expenses are fixed for the period
and separable by market. All fixed expenses are based on a prorated yearly amount.
Required
a. Prepare the quarterly income statement showing contribution margins by market (territories). Include
a column for the company as a whole.
b. Assuming there are no alternative uses for Entertainment Corporation's present capacity, would you
recommend dropping the regional market? Why or why not?
c. Prepare the quarterly income statement showing contribution margins by product. Include a column
for the company as a whole.
d. It is believed that a new product can be ready for sale next year if Entertainment Corporation decides
to go ahead with continued research. The new product can be produced by simply converting
equipment now used to produce videotapes. This conversion will increase fixed costs by $10,000 per
quarter. What must be the minimum contribution margin per quarter for the new product to make the
changeover financially feasible?
(CMA Adapted)
Pll-35. Segment Reports and Cost Allocations (L01)

Pacific Products, Inc. has three sales divisions. One of the key evaluation inputs for each division manager
is the performance of his or her division based on division income. The division statements for August are
as follows:
Kiwi Queensland Hawaii Total
Sales ....................... $400,000 $500,000 $450,000 $1,350,000

Cost of sales................. 200,000 240,000 230,000 670,000
Division overhead ............. 100,000 110,000 110,000 320,000
Division expenses............. (300,000) (350,000) (340,000) (990,000)
Division contribution ........... 100,000 150,000 110,000 360,000
Corporate overhead ........... (70,000) (90,000) (80,000) (240,000)
Division income .............. $ 30,000 $ 60,000 $ 30,000 $ 120,000
The Hawaii manager is unhappy that his profitability is the same as that of the Kiwi Division and one-half
that of the Queensland Division when his sales are halfway between these two divisions. The manager
knows that his division must carry more product lines because of customer demands, and many of these
additional product lines are not very profitable. He has not dropped these marginal product lines because of
idle capacity; all of the products cover their own variable costs. After analyzing the product lines with the
lowest profit margins, the divisional controller for Hawaii provided the following to the manager:
Sales of marginal products . $90,000

Cost of sales. . . . . . . . . . . . . . . . . . . . . . .. $50,000
Avoidable fixed costs. . . . . . . . . . . . . . . . . 20,000 (70,000)
Product margin . 20,000
Proportion of corporate overhead . (16,000)
Product income . $ 4,000
Although these products were 20 percent of Hawaii's total sales, they contributed only about 13 percent
of the division's profits. The controller also noted that the corporate overhead allocation was based on a
formula of sales and divisional contribution margin.
Required
a. Prepare a set of segment statements for August assuming that all facts remain the same except that
Hawaii's weak product lines are dropped and corporate overhead is allocated as follows: Kiwi,
$80,000; Queensland, $95,000; and Hawaii, $65,000. Does the Hawaii Division appear better after
this action? What will be the responses of the other two division managers?
b. Suggest improvements for Pacific Products' reporting process that will better reflect the actual
operations of the divisions. Keep in mind the utilization of the reporting process to assist in the
evaluation of the managers. What other changes could be made to improve the manager evaluation
process?
Pll-36. ROI and Residual Income: Impact of a New Investment (L03)

Business Equipment Inc. is a decentralized organization with four autonomous divisions. The divisions
are evaluated on the basis of the change in their return on invested assets. Operating results in the Retail
Division for 2009 follow:
BUSINESS EQUIPMENT INC.-RETAIL DIVISION

Income Statement
For Year Ending December 31, 2009
Sales . $3,125,000
Less variable expenses . (1,562,500)
Contribution margin . 1,562,500
Less fixed expenses . (1,000,000)
Net operating income . $ 562,500
Operating assets for the Retail Division currently average $2,500,000. The Retail Division can add a new
product line for an investment of $300,000. Relevant data for the new product line are as follows:
Sales . $800,000
Variable expenses (% of sales) . 0.60
Fixed expenses . $275,000
Increase in current liabilities . $ 20,000
Required
a. Determine the effect on ROI of accepting the new product line. (Round calculations to three decimal
places.)
h. If a return of 6 percent is the minimum that any division should earn and residual income is used to
evaluate managers, would this encourage the division to accept the new product line? Explain and
show computations.
c. If EVA is used to evaluate managers, should the new product line be accepted if the weighted average
cost of capital is 8 percent and the investment tax rate is 40 percent?
Pll-37. Valuing Investment Center Assets (L03)

Six Flags Theme Parks, Inc" operates theme parks in the United States, Mexico, and Europe. One of its Six Flags Theme
first theme parks, Six Flags over Georgia, was built in the 1960s in Atlanta on a large tract of land that has Parks. Inc. (SIX)
appreciated enormously over the years. Although most of the rides and other attractions have a fairly short
life, some of the major buildings that are still in use on the property have been fully depreciated since they
were built. Assume that Six Flags over Georgia operates as an investment center with total assets that have
a book value of $150 million and current liabilities of $20 million. Assume also that in 2009, this particular
theme park had sales of $60 million and pretax division income of $20 million. The replacement cost of all
the assets in this park is estimated to be $250 million. The company's cost of capital is 16 percent, and it
has a 35 percent tax rate.
Required
a. Calculate the RaJ, residual income, and EVA for Six Flags over Georgia using book value as the
valuation basis for the investment center asset base.
h. Repeat requirement (a) using replacement cost as the investment center asset value.
c. Which valuation, accounting book vallie or replacement cost do you think the company uses to
evaluate the managers of its various theme parks? Discuss.
Pll-38. Transfer Pricing with and without Capacity Constraints (L02)

National Carpet Company has just acquired a new backing division that produces a rubber backing, which it
sells for $2.10 per square yard. Sales are about 1,200,000 square yards per year. Since the Backing Division
has a capacity of 2,000,000 square yards per year, top management is thinking that it might be wise for the
company's Tufting Division to start purchasing from the newly acquired Backing Division. The Tufting
Division now purchases 600,000 square yards per year from an outside supplier at a price of $1.90 per
square yard. The current price is lower than the competitive $2. 10 price as a result of the large quantity
discounts. The Backing Division's cost per square yard follows.

Direct labor . 0.20
Variable overhead . 0.25
Fixed overhead (1,200,000 level) .. 0.10
Total cost . $1.55
Required
a. If both divisions are to be treated as investment centers and their pelformance evaluated by the RaJ
formula, what transfer price would you recommend? Why?
h. Detellnine the effect on corporate profits of making the backing.
c. Based on your transfer price, would you expect the RaJ in the Backing Division to increase,
decrease, or remain unchanged? Explain.
d. What would be the effect on the ROT of the Tufting Division using your transfer price? Explain.
e. Assume that the Backing Division is now selling 2,000,000 square yards per year to retail outlets.
What transfer price would you recommend? What will be the effect on corporate profits?
f. If the Backing Division is at capacity and decides to sell to the Tufting Division for $1.90 per square
yard, what will be the effect on the company's profits?
Pll-39. Transfer Pricing and Special Orders (L02)

New England Electronics has several manufacturing divisions. The Pacific Division produces a component
part that is used in the manufacture of electronic equipment. The cost per part for July is as follows:
Variable cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $ 90
Fixed cost (at 2,000 units per month capacity) . . . . . . . 60
Total cost per part . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $150
Some of Pacific Division's output is sold to outside manufacturers, and some is sold internally to the Atlantic
Division. The price per part is $180. The Atlantic Division's cost and revenue structure follow.
Selling price per unit. . $1,000

Less variable costs per unit
Cost of parts from the Pacific Division . $180
Other variable costs . 400 (580)
Contribution margin per unit . 420
Less fixed costs per unit (at 200 units per month) . (100)
Net income per unit . $ 320
The Atlantic Division received an order for 10 units. The buyer wants to pay only $500 per unit.
Required
a. From the perspective of the Atlantic Division, should the $500 price be accepted? Explain.
b. If both divisions have excess capacity, would the Atlantic Division's action benefit the company as a
whole? Explain.
c. If the Atlantic Division has excess capacity but the Pacific Division does not and can sell all of its
parts to outside manufacturers, what would be the advantage or disadvantage of accepting the ten-
unit order at the $500 price to the Atlantic Division?
d. To make a decision that is in the best interest of the company, what transfer-pricing information does
the Atlantic Division need?
Pll-40. Balanced Scorecard (L04)

The First Street Community Bank recently decided to adopt a balanced scorecard system of perfonnance
evaluation. Below is a list of primary perfonnance goals for four major performance categories that have
been identified by corporate management and the board of directors.
l. Financial Perspective-Maintain and grow the bank financially
a. Increase customer deposits
b. Manage financial risk
c. Provide profits for the stockholders
2. Customer Perspective - Maintain and grow the customer base
a. Increase customer satisfaction
b. Increase number of depositors & customer retention
c. Increase quality of deposits
3. Internal Perspective - Improve internal processes
a. Achieve best practices for processing transactions
h. Improve employee satisfaction
c. Improve employee promotion opportunities
4. Learning and Innovation - Improve market differentiation
a. Beat competitors in introducing new products
b. Become first mover in establishing customer benefit for customers
c. Become recognized as an innovator in the industry
Required:
a. For each of the 12 goals above suggest at least one measure of performance to measure the
achievement of the goal.
b. At what level of the organization should the balanced scorecard be implemented as a means of
evaluating performance? Explain.
CASES
Cll-41. Transfer Price Decisions (L02)
IBM Corporation The Consulting Division of IBM Curpol'atioll is often involved in assignments for which IBM computer
(IBM)
equipment is sold as part of a systems installation. The Computer Equipment Division is frequently a vendor
of the Consuiting Division in cases for which the Consulting Division purchases the equipment from the
Computer Equipment Division. The Consulting Division does not view itself as a sales aim of the Computer
Equipment Division but as a strong competitor to the major consulting firms of infonnation systems. The
Consulting Division's goal is to maximize its profit contribution to the company, not necessarily to see how
much IBM equipment it can sell. If the Consulting Division is truly an autonomous investment center, it has
the freedom to purchase equipment from competing vendors if the consultants believe that a competitor's
products serve the needs of a client better than the comparable IBM product in a particular situation.
Required
a. In this situation, should corporate management be concerned about whether the Consulting Division
sells IBM products or those of other computer companies? Should the Consulting Division be
required to sell only IBM products?
b. Discuss the transfer-pricing issues that both the Computer Equipment Division manager and the
Consulting Division manager should consider. If top management does not have a policy on pricing
transfers between these two divisions, what alternative transfer prices should the division managers
consider?
c. What is your recommendation regarding how the managers of the Consulting and Computer
Equipment Divisions can work together in a way that will benefit each of them individually and the
company as a whole?
Cll-42. Transfer Pricing at Absorption Cost (L02)

The Fabrication Division of Metro Sign Company produces large metal numbers that are sold to the Sign
Division. This division uses the numbers in constructing signs that are sold to highway departments of local
governments. The Fabrication Division contains two operations, stamping and finishing. The unit variable
cost of materials and labor used in the stamping operation is $100. The fixed stamping overhead is $800,000
per year. Current production (20,000 units) is at full capacity. The variable cost of labor used in the finishing
operation is $12 per number. The fixed overhead in this operation is $340,000 per year. The company uses
an absorption-cost transfer price. The price data for each operation presented to the Sign Division by the
Fabrication Division follow.
Stamping
Variable cost per unit . $100
Fixed overhead cost per unit ($800,000 -;- 20,000 units) . 40 $140
Finishing
Labor cost per unit . 12
Fixed overhead cost per unit ($340,000 -;- 20,000 units) . 17 29
Total cost per unit . $169
An outside company has offered to lease machinery to the Sign Division that would perform the finishing
part of the number manufacturing for $200,000 per year. With the new machinery, the labor cost per number
would remain at $12. If the Fabrication Division transfers the units for $140, the following analysis can be
made:
Current process
Finishing process costs (20,000 x $29) ... $580,000
New process
Machine rental cost per year . $200,000
Labor cost ($12 x 20,000 units) . 240,000 (440,000)
Savings . $140,000
The manager of the Sign Division wants approval to acquire the new machinery.
Required
a. How would you advise the company concerning the proposed lease?
b. How could the transfer-pricing system be modified or the transfer-pricing problem eliminated?
Cll-43. Transfer Pricing Dispute (L02)

MBR Inc. consists of three divisions that were formerly three independent manufacturing companies. Bader
Corporation and Roper Company merged in 2008, and the merged corporation acquired Mitchell Company
in 2009. The name of the corporation was subsequently changed to MBR Inc., and each company became a
separate division retaining the name of its former company.
The three divisions have operated as if they were still independent companies. Each division has
its own sales force and production facilities. Each division management is responsible for sales, cost of
operations, acquisition and financing of divisional assets, and working capital management. The corporate
406 Chapter 11 I Segment Reporting. Transfer Pricing, and Balanced Scorecard
management of MBR evaluates the performance of the divisions and division management on the basis of
return on investment.
Mitchell Division has just been awarded a contract for a product that uses a component manufactured
by the Roper Division and also by outside suppliers. Mitchell used a cost figure of $3.80 for the component
manufactured by Roper in preparing its bid for the new product. Roper supplied this cost figure in response
to Mitchell's request for the average variable cost of the component; it represents the standard variable
manufacturing cost and variable selling and distribution expenses.
Roper has an active sales force that is continually soliciting new prospects. Roper's regular selling price for
the component Mitchell needs for the new product is $6.50. Sales of this component are expected to increase.
The Roper management has indicated, however, that it could supply Mitchell the required quantities of the
component at the regular selling price less vaIiable selling and distribution expenses. Mitchell's management
has responded by offering to pay standard variable manufacturing cost plus 20 percent.
The two divisions have been unable to agree on a transfer price. Corporate management has never
established a transfer-pricing policy because interdivisional transactions have never occurred. As a
compromise, the corporate vice president of finance suggested a pliceequal to the standard full manufacturing
cost (i.e., no selling and distribution expenses) plus a 15 percent markup. The two division managers have
also rejected this price because each considered it grossly unfair.
The unit cost structure for the Roper component and the three suggested prices follow.
Standard variable manufacturing cost . $3.20

Standard fixed manufacturing cost . 1.20
Variable selling and distribution expenses . 0.60
$5.00
Regular selling price less variable selling and

distribution expenses ($6.50 - $0.60) . $5.90
Standard full manufacturing cost plus 15% ($4.40 x 1.15) . $5.06
Variable manufacturing plus 20% ($3.20 x 1.20) . $3.84
Required
a. What should be the attitude of the Roper Division's management toward the three proposed prices?
b. Is the negotiation of a price between the Mitchell and Roper Divisions a satisfactory method of
solving the transfer-pricing problem? Explain your answer.
c. Should the corporate management of MBR Inc. become involved in this transfer-price controversy?
Explain your answer.
(CMA Adapted)
12
apital Budgeting
Decisions
LEARNING OBJECTIVES
DIFFERENT MARKET PREDICTIONS
After completing this chapter, you should
be able to:
LEAD TO DIFFERENT STRATEGIC
INVESTMENTS
LO 1 Explain the role of capital budgeting in
long-range planning. (p. 411)
Predictions of future costs and revenues are key to managers' decisions
L02 Apply capital budgeting models, such on capital expenditures. In both the airline and aircraft manufacturing mar-
as net present value and internal rate of kets, estimates are that air travel will grow by 5 percent per year over the
return, that consider the time value of next decade or two. By 2025, airline fleets are expected to exceed 35,000
money. (p. 413) airliners, or more than double the current number. In this growth environ-
ment for commercial aviation, the two world leaders in the production of
L03 Apply capital budgeting models, large airliners-Airbus and Boeing-have different expectations about the
such as payback period and next generation of jet aircraft.
accounting rate of return, that do not Airbus, predicting the worldwide market for jumbo passenger jets at
consider the time value of money. about 1,500 planes, launched the development of the A380 in the year
(p.419) 2000. The double-deck A380 will carry 525 passengers up to 8,200 nauti-
cal miles (approximately 9,400 U.S. miles). Airbus states that the A380 will
L04 Evaluate the strengths and carry 30 percent more passengers, use 20 percent less fuel, and fly quieter
weaknesses of alternative capital than the Boeing 747-400-the only current plane in this size class. Yet, with
budgeting models. (p. 421) a wingspan of 262 feet and outboard engines that hang beyond the 150-foot
standard width of airport runways, there are limitations on the number of
LOS Discuss the importance of jUdgment, airports that can accommodate this massive jumbo jet.
attitudes toward risk, and relevant The first A380 (recall development started in 2000) was delivered to
cash flow information for capital Singapore Airways in late 2007. By 2008 the development costs of the
bUdgeting decisions. (p. 423) A380 were reported as $17.1 billion and Airbus stated that it needed to sell
420 units of the plane, that has a list price of $319.2 million, to break even.
L06 Determine the net present value At the time there were 177 firm orders for the A380, with the largest orders
of investment proposals with from Emirates, Quantas, Singapore Airways, Lufthansa, and Air France.
consideration of taxes. (p. 430)
408
Boeing Company has different expectations. It estimates that the airliner market in the next two or three
decades will require only about 500 jumbo jets. Forecasting a demand for smaller, fuel-efficient, long-range
aircraft that would provide increased opportunities for direct service between smaller distant cities, Boeing
formally launched development of the 787 Dreamliner in 2003. Unique in its use of composite materials to
reduce weight and improve passenger comfort, some experts claim the 290 passenger aircraft will have the
same fuel efficiency as a car carrying three passengers, but traveling at ten times the speed. Depending on
configuration, the list price of the 787 varies between $200 and $279 million. Its 208-foot wingspan will allow
the 787 to access more airports than the A380.
The first 787 is slated for delivery to All Nippon Airways in early 2009. By early 2008 Boeing had orders
for more than 800 Dreamliners from 55 customers, which Boeing claimed to be the "fastest-selling start for
any commercial airplane program."
As these decisions of Airbus and Boeing illustrate, managers face high stakes in capital expenditure deci-
sions. Expectations and plans often depend on marketing research information and unproved technology. No
analytical tools eliminate the inherent uncertainty of such decisions. Still, executives can use management
accounting methods to organize information about a particular decision to better evaluate the alternatives.'
I Mike Blair, "Banelling Along," Economist, September 29, 2007; Pat Shanahan, "Boeing's DreamJiner: Back on Course?," Business
Week Online, December 12,2007, p.l.; David Churchill, "Tile Giant Arrives," Business Travel World, November 2007, p.ll.; Thomas
Geoffrey, "Nothing But Blue Skies for 787," Air Transport World, August 2007, pp. 24-26; Carol Matlack, "Airbus A380: In Business at
Last," Business Week Online, October J6, 2007, p.9.; "Hold that Takeoff," Business Week, January 28,2008; www.airbus.com; and www.
boeing.com.
409
410 Chapter 12 I Capital Budgeting Decisions
CHAPTER
ORGANIZATION ~¥t+t-"'!f!·)'VJ
--- -
I I I
... ;;;
~
••
-=• •• • •
\!l\1l!l\X.WJm1W
Payback Periods
It -
Accounting Rate of Return

-
t.t.]mN'E~
•
. I.- It
Using Multiple Investment

Criteria
Evaluation Risk
Differential Analysis of
Project Cash Flows
Predicting Differential Costs
and Revenues for High-
Tech Investments
oJ Evaluating Mutually
Exclusive Investments
~ . . .- .
~ ~1:P11m
-:-
~ :;;;... .-
• Expected Cash Flows t: Depreciation Tax Shield
• Expected Cash Flows

Manager Behavior and r Investment Tax Credit
• Net Present Value
• Internal Rate of Return
Capital expenditures are investments of financial resources in projects to develop or introduce new prod-
ucts or services, to expand cunent production or service capacity, or to change current production or service
facilities. Capital expenditures are made with the expectation that the new product, process, or service will
generate future financial inflows that exceed the initial costs. Capital expenditure decisions affect structural
cost drivers. They are made infrequently but once made are difficult to change. They commit the organiza-
tion to the use of certain facilities and activities to satisfy customer needs. In making large capital expendi-
ture decisions, such as for the Airbus A380 or the Boeing 787, management is risking the future existence
of the company.
Although capital expenditure decisions are fraught with risk, management accounting provides the
concepts and tools needed to organize information and evaluate the alternatives. This systematic organiza-
tion and analysis is the essence of capital budgeting. This chapter introduces important capital budgeting
concepts and models, and it explains the proper use of accounting data in these models.
Capital budgeting is a process that involves identifying potentially desirable projects for capital
expenditures, evaluating capital expenditure proposals, and selecting proposals that meet minimum cri-
teria. A number of quantitative models are available to assist managers in evaluating capital expenditure
proposals.
The best capital budgeting models are conceptually similar to the short-range planning models used
in Chapters 3 and 4. They all emphasize cash flows and focus on future costs (and revenues) that differ
among decision alternatives. The major difference is that capital budgeting models involve cash flows
over several years, whereas short-range planning models involve cash flows for a year or less. When the
cash flows associated with a proposed activity extend over several years, an adjustment is necessary to
make the cash flows comparable when they are expected to occur at different points in time.
Chapter 12 I Capital Budgeting Decisions 411
The time value of money concept explains why monies received or paid at different points in
time must be adjusted to comparable values. The time value of money is introduced in Appendix A to
this chapter.
LONG-RANGE PLANNING AND CAPITAL

BUDGETING
Most organizations plan not only for operations in the current period but also for the longer term, perhaps L01 Explain
5, 10, or even 20 years in the future. Most planning beyond the next budget year is called long-range the role of capital
planning. budgeting in long-
Increased uncertainty and business alternatives add to the difficulty of planning as the horizon length- range planning.
ens. Even though long-range planning is difficult and involves uncertainties, management must make long-
range planning and capital expenditure decisions. Capital expenditure decisions will be made. The question
is: How will they be made? Will they be made on the basis of the best information available? Will care be
taken to ensure that capital expenditure decisions are in line with the organization's long-range goals? Will
the potential consequences, both positive
and negative, of capital expenditures be
considered? Will important alternative EXHIBIT 12.1 Capital BUdgeting Procedures
uses of the organization's limited financial
resources be considered in a systematic
manner? Will managers be held account- Effective capital bUdgeting reqUires a defined
mission, long-range goals, and a business strategy
able for the capital expenditure programs
they initiate? The alternative to a system-
atic approach to capital budgeting is the
haphazard expenditure of resources on
_1-------.
Identify potential capital
the basis of a hunch, immediate need, or expenditures
persuasion-without accountability by the
person(s) making the decisions.
The steps of an effective capital bud-
Determine whether a proposed expenditure fits
geting process are outlined in Exhibit mission, goals and business strategy
I 2.1. A basic requirement for a systematic
approach to capital budgeting is a defined
mission, a set of long-range goals, and a 1
business strategy. These elements provide Perform preliminary data gathering
and analysis using
focus and boundaries that reduce the types
financial models
of capital expenditure decisions manage-
ment considers. If, for example, KFC's
goal is to become the largest fast-food res-
taurant chain in North America, its man-
_-----'1------.
Increase analytical rigor and required level
agement should not consider a proposal to of approval as importance and size of
project increases
purchase and operate a bus line.
A well-defined business strategy
will likewise guide capital expenditure
decisions. If Cisco Systems is follow-
_1------,
Develop implementation plans for
ing a strategy to obtain technological approved projects
leadership, it might seriously consider a
proposal to meet customer needs by in-
vesting in innovative production facilities
Monitor implementation and revise
but would not consider a proposal to pur- implementation or project as required
chase and refurbish used (but seemingly -'
cost-efficient) equipment. In the follow-
ing Business Insight Heineken identified 1
reducing energy consumption as a strate- Conduct a post-audit review to assign responsibility
gic goal, thereby drawing attention to an (to keep initial projections realistic) and
improve future planning
aspect of business that might otherwise
go unnoticed.
Energy Reduction as a Corporate Goal Fosters Green Investments
With the manufacturing sector accounting for more than one-third of global energy use and energy
prices soaring, there are countless opportunities for green investments that reduce energy consump-
tion and costs. Yet, according to energy-expert Paul Waide of the International Energy Agency,
corporate structure can be an obstacle. No one person is in charge of minimizing energy use. "The
purchasing department might be looking for the cheapest motor to install in terms of upfront costs ...
The energy bill gets paid out of some other bUdget, so unless the company as a whole focuses on
the issue, nothing gets done."
Netherlands-based Heineken. Europe's largest beer maker. overcame this obstacle byestablish-
ing corporate goals for reducing energy consumption. The company plans to use 15 percent less en-
ergy in 2010 than it used in 2002. This direction from the top has been important in focusing attention
on projects that reduce energy consumption, according to Jasko Bakker, who leads environmental
initiatives for Heineken.
HSBC Holdings, an international bank, has committed $90 million to become more energy effi-
cient. with a seven percent targeted reduction in power consumption. HSBC investments to support
this goal include software that automatically turns off desktop computers if employees leave them on
at night and replacing computer monitors with more efficient models. 2
Management should also develop procedures for the review. evaluation. approval, and post-audit
of capital expenditure proposals. In a large organization, a capital budgeting committee that provides
guidance to managers in the formulation of capital expenditure proposals is key to these procedures.
This committee also reviews, analyzes, and approves or rejects major capital expenditure proposals.
Major projects often require the approval of top management and even the board of directors. The capital
budgeting committee should include persons knowledgeable in capital budgeting models; financing al-
ternatives and costs; operating procedures; cost estimation and prediction methods; research and devel-
opment efforts; the organization's goals and basic strategy; and the expectations of the organization's
stockholders or owners. A management accountant who is generally expert in data collection, retrieval,
and analysis is normally part of the capital budgeting committee.
Not all capital expenditure proposals require committee approval or are subject to formal evaluation.
With the approval of top management, the committee might provide guidelines indicating the type and
dollar amount of capital expenditures that managers at each level of the organization can make without
formal evaluation or committee approval, or both. The guidelines might state that expenditures of less
than $20,000 do not require committee approval and that only expenditures of more than $100,000 must
be evaluated using capital budgeting models.
Typically, managers at higher levels have greater discretion in making capital expenditures. In a
college or university, a department chairperson could have authority to purchase office and instructional
equipment with a maximum limit of $10,000 per year. A dean may have authority to renovate offices or
classrooms with a maximum limit of $50,000 per year, but the conversion of the power plant from one fuel
source to another at a cost of $400,000 could require the formal review of a capital budgeting committee
and final approval of the board of trustees.
The post-audit of approved capital expenditure proposals is an important part of a well-formulated
approach to capital budgeting. A post-audit involves the development of project performance reports
comparing planned and actual results. Project performance reports should be provided to the manager
who initiated the capital expenditure proposal, the manager assigned responsibility for the project (if a
different person), the project manager's supervisor, and the capital budgeting committee. These reports
help keep the project on target (especially dUling the initial investment phase), identify the need to re-
evaluate the project if the initial analysis was in error or significant environmental changes occur, and
improve the quality of investment proposals. When managers know they will be held accountable for the
results of projects they initiate, they are likely to put more care into the development of capital expendi-
ture proposals and take a greater interest in approved projects. Problems can occur when decision makers
are rewarded for undertaking major projects but are not held responsible for the consequences that occur
several years later.
2 Leila Abboud and John Biers, "Business Goes on an Energy Die[," Wall Street Journal, August 27. 2007, pp. Rl, R4.
A post-audit review of approved projects also helps the capital budgeting committee do a better job
in evaluating new proposals. The committee might learn how to adjust proposals for the biases of indi-
vidual managers, learn of new factors that should be considered in evaluating proposals, and avoid the
routine approval of projects that appear desirable by themselves but are related to larger projects that are
not meeting management's expectations. As summarjzed in the following Research Insight, an analysis
of the findings of post-audit reviews reveals that sales forecasting is the most error-prone element in the
financial analysis of capital budgeting.
RESEARCH INSIGHT Where the Errors Are
After conducting a study of post-audits of capital expenditures, Professors Sores, Coutinho, and
Martins reached the following conclusions:
• Forecasts of operating costs were remarkably accurate.
• There was a high degree of variability in the actual investments when compared to budgeted
investments, which may be related to delays in the execution of projects.
• Forecasts of sales were overstated seventy percent of the time, with actual sales, on average,
being nine percent below forecasted sales. 3
.. . • You Are the Vice President of Finance
You have recently accepted the position of VP of finance for a rapidly growing biotech company. Last
year the company made capital expenditures of $10 million and you anticipate that annual capital ex-
penditures will exceed $30 million in a couple of years. You believe it is time to develop a more formal
approach to making capital expenditure decisions. Where do you begin? [Answer p. 442J
CAPITAL BUDGETI G MODELS THAT

CONSIDER TIME VALUE OF MONEY
The capital budgeting models in this chapter have gained wide acceptance by for-profit and not-for-profit L02 Apply
organizations. Our primary focus is on the net present value and the internal rare of return models, which capital bUdgeting
are superior because they consider the time value of money. Later discussions will consider more tradi- models, such as
tional capital budgeting models, such as the payback period and the accounting rate of return that, while net present value
useful under certain circumstances, do not consider the time value of money. Although we briefly and internal rate
consider the cost of financing capital expenditures, we leave a detailed treatment of this topic, as wen of return, that
as a detailed examination of the sources of funds for financing investments, to books on financial consider the time
management. value of money.
ecte Cash
The focus of capital budgeting models that consider the time value of money is on future cash receipts
and future cash disbursements that differ under decision alternatives. It is often convenient to distinguish
between the following three phases of a project's cash flows:
Initial investment
Operation
Disinvestment
All cash expenditures necessary to begin operations are classified as part of the project's initial
investment phase. Expenditures to acquire property, plant, and equipment are part of the initial investment.
.1 10ao Oliveira Sores, Maria Cristina Coutinho, and Carlos Y. Martina, "Forecasting Errors in Capital Budgeting: A multi-firm Post-
audit Study, The Engineering Economisr, Vol 52, 2007, pp. 21-39.
Less obvious, but equally important, are expenditures to acquire working capital to purchase inventories
and recruit and train employees. Although the initial investment phase often extends over many years, in
our examples, we assume that the initial investment takes place at a single point in time.
Cash receipts from sales of goods or services, as well as normal cash expenditures for materials, labor,
and other operating expenses, occur during the operation phase. The operation phase is typically broken
down into one-year periods; for each period, operating cash expenditures are subtracted from operating
cash receipts to determine the net operating cash inflow or outflow for the period.
The disinvestment phase occurs at the end of the project's life when assets are disposed of for their sal-
vage value and any initial investment of working capital is recovered. Also included are any expenditures to
dismantle facilities and dispose of waste. Although this phase might extend over many years, in our examples,
we assume disinvestment takes place at a single point in time.
To illustrate the analysis of a project's cash flows, assume the management of Mobile Yogurt Shoppe
is considering a capital expenditure proposal to operate a new shop in a resort community in the Ozark
Mountains. Each Mobile Yogurt Shoppe is located in a specially constructed motor vehicle that moves
on a regular schedule throughout the community it serves. The predicted cash flows associated with the
project, which has an expected life of five years, are presented in Exhibit 12.2.
EXHIBIT 12.2 Analysis of a Project's Predicted Cash Flows
Initial investment (at time 0)

Vehicle and equipment . $ 90,554
Inventories and other working capital . 4,000
Total . $ 94,554
Operation (per year for 5 years)
Sales . $175,000
Cash expenditures
Food . $47,000
Labor . 65,000
Supplies . 9,000
Fuel and utilities _ . 8,000
Advertising . 4,000
Miscellaneous . 12,000 (145,000)
Net annual cash inflow . $ 30,000
Disinvestment (at the end of 5 years)
Sale of vehicle and equipment . $ 8,000
Recovery of investment in inventories and other
working capital . 4,000
Total . $ 12,000
Manager ehav;or and Expected Cash Flow

Accurately predicting the cash flows associated with a capital expenditure proposal is critical to prop-
erly evaluating the proposal. Managers might be overly optimistic with their predictions, and they are
sometimes tempted to modify predictions to justify capital expenditures. Perhaps they are interested in
personal rewards. They might also want to avoid a loss of prestige or employment for themselves or
to keep a local facility operating for the benefit of current employees and the local economy. Unfortu-
nately, if a major expenditure does not work out, not only the local plant but also the entire company
could be forced out of business. For example, under pressure to increase current sales, automobile leas-
ing companies could be tempted to overstate cash receipts during the disinvestment phase of a lease. The
following Business Insight considers the financial consequences of overstating residual values for auto-
mobile leases.
BUSINESS INSIGHT Manager Behavior and Expected Vehicle Value
To increase demand for their products, managers of automobile leasing companies have incentives to lower
monthly lease rates. Important factors in setting vehicles' lease rates include vehicle cost, interest rate, lease
period, and the residual value of the vehicle at lease-end. The most difficult item to predict is residual value.
That value, the future selling price of the vehicle, is a function of its condition, economic climate, actions of
competitors, and its popularity when the lease expires. If residual values are predicted to be high, the monthly
lease can be set low enough to attract customers and still earn a profit. Favorable lease terms help bring down
monthly payments of popular Ford Explorers and Jeep Grand Cherokees. With the profitability of leases sub-
stantially determined by residual values, a small decrease in market prices of used vehicles can yield a sub-
stantialloss. 4
et ese t Value
A project's net present value, usually computed as of the time of the initial investment, is the present
value of the project's net cash inflows from operations and disinvestment less the amount of the initial
investment. Chapter Appendix A contains an introduction to the time value of money, including net pres-
ent value fundamentals. In computing a project's net present value, the cash flows occulTing at different
points in time are adjusted for the time value of money using a discount rate that is the minimum rate of
return required for the project to be acceptable. Projects with positive net present values (or values at least
equal to zero) are acceptable, and projects with negative net present values are unacceptable. Two methods
to compute net present value follow.
Table Approach
Assuming that management uses a 12 percent discount rate, the net present value of the proposed invest-
ment in a Mobile Yogurt Shoppe is shown in Exhibit 12.3 (a) to be $20,400. Since the net present value
is more than zero, the investment in the Mobile Yogurt Shoppe is expected to be profitable, even when
adjusted for the time value of money.
We can verify the amounts and computations in Exhibit 12.3. Start by tracing the cash flows back to Ex-
hibit 12.2. Next, verify the 12 percent present value factors in Tables A.I and A.2 in chapter Appendix A. The
initial investment is assumed to occur at a single point in time (identified as time 0), the start of the project.
In net present value computations, all cash flows are restated in terms of their value at time O. Hence, time
ocash flows have a present value factor of 1. To simplify computations, all other cash flows are assumed to
occur at the end of years 1 through 5, even if they occurred during the year. Although further refinements
could be made to adjust for cash flows occuring throughout each year, such adjustments are seldom neces-
sary. Observe that net operating cash inflows are treated as an annuity, whereas cash flows for the initial
investment and disinvestment are treated as lump-sum amounts. If net operating cash flows varied from year
to year, we would treat each year's cash flow as a separate amount.
Spreadsheet Approach
Spreadsheet software contains functions that compute the present value of a series of cash flows. With
this software, simply enter a column or row containing the net cash flows for each period and the
appropriate formula. The discount rate of 0.12 is entered as part of the formula. Sample spreadsheet input
to determine the net present value of the proposed investment in a Mobile Yogurt Shoppe is shown on the
left in Exhibit 12.3 (b). The spreadsheet output is shown on the right, in Exhibit 12.3 (b).
Two cautionary notes follow:
I. The spreadsheet formula for the net present value assumes that the first cash flow occurs at time" I,"
rather than at time "0." Hence, we cannot include the initial investment in the data set analyzed by
the spreadsheet formula when computing the net present value. Instead, the initial investment is sub-
tracted from the present value of future cash flows.
2. Arrange the cash flows subsequent to the initial investment from top to bottom in a column, or left to
right in a row.
4 Kathleen Lansing. "Painful Math for Leasing Companies." Business Week, May 19, 1997, p. 38.
EXHIBIT 12.3 Net Present Value of a Project's Predicted Cash Flows

-------,
(a) Table approach:
Predicted 12% Present

Cash Year(s) Present Value
Inflows of Cash Value of Cash
(outflows) Flows Factor Flows
(A) (6) (C) (A) x (C)
Initial investment . $(94,554) 0 1.000 $ (94,554)

Operation . 30,000 1-5 3.605 108,150
Disinvestment 12,000 5 0.567 6,804
Net present value of all cash flows . $ 20,400
(b) Spreadsheet approach:

Input: Output:
A B A B
1 Year of cash flow Cash flow 1 Year of cash flow Cash flow
2 1 $30,000 2 1 $ 30,000
3 2 30,000 3 2 30,000
4 3 30,000 4 3 30,000
5 4 30,000 5 4 30,000
6 5 42,000 6 5 42,000
7 Present value =NPV(0.12,B2:B6) 7 Present value $114,952.41
8 Initial investment 8 Initial investment
at time 0 (94,554) at time 0 (94,554.00)
9 Net present value =B7+B8 9 Net present value $ 20,398.41
Internal Ra
The internal rate of return (IRR), often called the time-adjusted rate of return, is the discount rate that
equates the present value of a project's cash inflows with the present value of the project's cash outflows.
Other ways to describe IRR include: (1) The minimum rate that could be paid for the money invested in a
project without losing money, and (2) The discount rate that results in a project's net present value equal
ing zero.
All practical applications of the IRR model use a calculator or spreadsheet. Thus, we illustrate deter
mining an IRR with a spreadsheet. A table approach to determining a project's internal rate of return is
illustrated in Appendix B of this chapter.
With spreadsheet software, simply enter a column or row containing the net cash flows for each
period and the appropriate formula. Spreadsheet input for Mobile Yogurt Shoppe's investment proposal
is shown in Exhibit 12.4. The spreadsheet formula for the IRR assumes that the first cash flow occurs at
time "0."
The spreadsheet approach requires an initial prediction or guess of the project's internal rate of retum.
Although the closeness of the prediction to the final solution affects computational speed, for textbook
examples almost any number can be used. We use an initial estimate of 0.08 in all illustrations. Because
the IRR formula assumes that the first cash flow occurs at time 0, the initial investment is included in the
data analyzed by the IRR formula. Again, we must order the cash flows from top to bottom in a column
or left to right in a row. As shown on the right column in Exhibit 12.4, the spreadsheet software computes
the IRR as 20 percent.
Although a project's IRR should be compared to the discount rate established by management, such
a discount rate is often unknown. In these situations, computing the IRR still provides insights into a
project's profitability.
EXHIBIT 12.4 Spreadsheet Approach to Determining Internal Rate of Return

--_...I
Input: Output:
A B A B
1 Year of cash flow Cash flow 1 Year of cash flow Cash flow
2 0 $(94,554) 2 0 $(94,554)
3 1 30,000 3 1 30,000
4 2 30,000 4 2 30,000
5 3 30,000 5 3 30,000
6 4 30,000 6 4 30,000
7 5 42,000 7 5 42,000
8 IRR = IRR(B2:B7 ,0.08)* 8 IRR 0.20
'The formula is "=IRR(lnput data range, guess). " The guess, which is any likely rate of return, is used as an initial starting point in
determining the solution. We use 0.08 in all illustrations.
The calculated internal rate of return is compared to the discount rate established by management
to evaluate investment proposals. If the proposal's IRR is greater than or equal to the discount rate, the
project is acceptable; if it is less than the discount rate, the project is unacceptable. Because Mobile
Yogurt Shoppes has a 12 percent discount rate, the project is acceptable using the IRR model.
Although a computer and appropriate software quickly and accurately perform tedious computations,
computational ease increases the opportunity for inappropriate use. The ability to plug numbers into a
computer or calculator and obtain an output labeled NPV or IRR could mislead the unwary into believing
that capital budgeting models are easy to use. This is not true. Training and professional judgment are re
quired to identify relevant costs, to implement procedures to obtain relevant cost information, and to make
a good decision once results are available. Capital budgeting models are merely decision aids. Managers,
not models, make the decisions. To better illustrate underlying concepts, all subsequent textbook illustra
tions use a table approach.
Co ::jpital
When discounting models are used to evaluate capital expenditure proposals, management must deter
mine the discount rate (1) used to compute a proposal's net present value or (2) used as the standard for
evaluating a proposal's IRR. An organization's cost of capital is often used as this discount rate.
The cost of capital is the average cost an organization pays to obtain the resources necessary to make
investments. This average rate considers items such as the:
Effective interest rate on debt (notes or bonds).
Effective dividend rate on preferred stock.
Discount rate that equates the present value of all dividends expected on common stock over the life
of the organization to the current market value of the organization's common stock.
The cost of capital for a company that has no debt or preferred stock equals the cost of equity capital,
computed as follows:
't 'I Current annual dividend per common share

Cost 0 f eqm y capita = .
Current market pnce per common share
+ Expected dividend
growth rate
Procedures for determining the cost of capital for more complex capital structures are covered in fi
nance books. Investing in a project that has an internal rate of return equal to the cost of capital should not
affect the market value of the firm's securities. Investing in a project that has a return higher than the cost
of capital should increase the market value of a firm's securities. If, however, a firm invests in a project
that has a return less than the cost of capital, the market value of the firm's securities should fall.
--
The cost of capital is the minimum return acceptable for investment purposes. Any investment pro
posal not expected to yield this minimum rate should normally be rejected. Because of difficulties encoun
tered in detennining the cost of capital, many organizations adopt a discount rate or a target rate of return
without complicated mathematical analysis.
MID-CHAPTER REVIEW
Consider the following investment proposal:
Initial investment
Depreciable assets . $27,740
Working capital . 3,000
Operations (per year for 4 years)
Cash receipts . 25,000
Cash expenditures. . . . . . . . . . . . . . . . . . . . . . . . ..•.............. 15,000
Disinvestment
Salvage value of plant and equipment . 2,000
Recovery of working capital . 3,000
Required
Determine each of the following:
a. Net present value at a lO percent discount rate.
b. Internal rate of retum. (Refer to Appendix 12B if using the table approach.)
Sol'ution
Basic computations:
Initial investment
Total . $30,740
Operation
Cash receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $25,000
Cash expenditures (15,000)
Net cash inflow. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $10,000
Disinvestment
Sale of depreciable assets . $ 2,000
Total . $ 5,000
a. Net present value at a 10 percent discount rate:

(A) (B) (C) (A) X (C)
Initial investment. . $(30,740) 0 1.000 $(30,740)

Operation . 10,000 1-4 3.170 31,700
Disinvestment. . 5,000 4 0.683 3,415
-
Net present value of all
cash flows . $ 4,375
b. Internal rate of return:

Using a spreadsheet, the proposal's internal rate of return is readily determined to be 16 percent:
A 6
1 Year of cash flow Cash flow
2 0 $(30,740)
3 1 10,000
4 2 10,000
5 3 10,000
6 4 15,000
7 IRR 0.16
The table approach requires additional analysis. Because the proposal has a positive net present value
when discounted at 10 percent, its internal rate of retum must be higher than 10 percent. Through a
trial-and-error approach, the internal rate of return is determined to be 16 percent.

(A) (6) (C) (A) x (C)
Initial investment . $(30,740) o 1.000 $(30,740)

Operation . 10,000 1-4 2.798 27,980
Disinvestment. . 5,000 4 0.552 2,760
Net present value of all
cash flows . $ o
CAPITAL BUDGETING MOD LS THAT

DO NOT CONSIDER TIME VALUE OF MO EV
Years ago, capital budgeting models that do not consider the time value of money were more widely used L03 Apply
than discounting models. Although most large organizations use net present value or internal rate of return as capital budgeting
their primary evaluation tool, they often use nondiscounting models as an initial screening device. Further, as models, such as
discussed in the following Research Insight, nondiscounting models remain entrenched in small businesses. payback period
We consider two nondiscounting models, the payback period and the accounting rate of return. and accounting
rate of return, that
ayback Period do not consider
the time value of
The payback period is the time required to recover the initial investment in a project from operations. The money.
payback decision rule states that acceptable projects must have less than some maximum payback period des
ignated by management. Payback emphasizes management's concern with liquidity and the need to minimize
risk through a rapid recovery of the initial investment. It is frequently used for small expenditures having such
obvious benefits that the use of more sophisticated capital budgeting models is not required or justified.
When a project is expected to have equal annual operating cash inflows, its payback period is com
puted as follows:
Payback period = Initial investment

Annual operating cash intlows
For Mobile Yogurt Shoppe's investment proposal, outlined in Exhibit 12.2, the payback period is
3.15 years:
. d $94,554
P ay b ac k peno = $30,000
= 3.15
RESEARCH NSIGHT Size and Education Matter in Capital BudgetingS
Danielson and Scott, after surveying the owners of small business, concluded that small businesses
(an average of ten employees) use much less sophisticated methods in making capital expenditure
decisions than recommended by theory. In their survey the most frequently used approach to making
capital expenditure decisions was "gut feel" followed by payback period and the accounting rate of
return, with few firms using discounted cash flow methods. Commenting on their results, Danielson
and Scott observed that:
• Many small business owners have limited formal education and limited staff support. What's
more, the investments made by small business are often not discretionary. The firm either makes
the investment, say in a new delivery truck, or goes out of business.
• The use of payback appears to increase with the formal education of the business owner as well
as the use of basic budgeting techniques such as forecasting cash flows.
• The use of the accounting rate of return increases with the growth or expansion plans of small
firms, especially if the firm is required to provide banks with periodic financial information.
• Small businesses with owners having advanced degrees are most likely to use discounted cash
flow approaches. They are also most likely to have written business plans and most likely to
consider the tax implications of decisions.
Graham and Harvey surveyed chief financial officers (CFOs) of Fortune 500 firms as well as CFOs of
smaller firms belonging to the Financial Executives Institute (FEI). CFO's and members of the FEI are
likely to have formal education in capital bUdgeting and they are likely to network with finance profes
sionals through organizations such as the FE!.
Of the CFOs responding to the survey, 46 percent were at firms with sales of more than $1 billion.
The majority of respondents to the Graham-Harvey survey used multiple capital budgeting models:
• 75.7 percent used internal rate of return.
• 74.9 percent used net present value.
• More than 50 percent used payback.
• Approximately 20 percent used the accounting rate of return.
Even though the firms included in the Graham-Harvey study were much larger than those in the
Danielson-Scott stUdy, Graham and Harvey also noted that "small firms" (firms with sales of less than
$100 million) are less likely to use net present value than large firms.
Detennining the payback period for a project having unequal cash flows is slightly more complicated.
Assume that Alderman Company is evaluating a capital expenditure proposal that requires an initial in
vestment of $50,000 and has the following expected net cash inflows:
Net Cash
Year Inflow
1 . $15,000
2 .. 25,000
3 .. 40,000
4 . 20,000
5 . 10,000
To compute the payback period, we must determine the net unrecovered amount at the end of each
year. In the year of full recovery, the net cash inflows are assumed to occur evenly and are prorated based
on the unrecovered investment at the start of the year. Full recovery of Alderman Company's investment
proposal is expected to occur in Year 3:
5 Morris G. Danielson and Jonathan A. SCOli. 'The Capital Budgeting Decisions of Small Businesses." Journal ofApplied Finance.
Fall/Winter 2006. pp. 45-56. John R. Graham and Campbell R. Harvey, "The Theory and Practice of Corporate Finance: Evidence
from the Field," Journal of Financial Economics, May-June, 2001, pp: 187-243
Net Cash Unrecovered

Year Inflow Investment
0 . $ - 0 $50,000
1 . 15,000 35,000
2 . 25,000 10,000
3 . 40,000 o
Therefore, $10,000 of $40,000 is needed in Year 3 to complete the recovery of the initial investment.
This provides a proportion of 0.25 ($10,000 -:- $40,000) and a payback period of 2.25 years (2 years plus
0.25 of Year 3). This project is acceptable if management specified a maximum payback period of three
years. Because they occur after the payback period, the net cash inflows of Years 4 and 5 are ignored.
ti
The accounting rate of return is the average annual increase in net income that results from the acceptance
of a capital expenditure proposal divided by either the initial investment or the average investment in the
project. This method differs from other capital budgeting models in that it focuses on accounting income
rather than on cash flow. In most capital budgeting applications, accounting net income is approximated as
net cash inflow from operations minus expenses not requiring the use of cash, such as depreciation.
Consider Mobile Yogurt Shoppe's capital expenditure proposal whose cash flows were outlined in
Exhibit 12.2. The vehicle and equipment cost $90,554 and have a disposal value of $8,000 at the end of
five years, resulting in an average annual increase in net income of $13,489:
Annual net cash inflow from operations . $30,000

Less average annual depreciation [($90,554 - $8,000) -;- 5] . (16,511)
Average annual increase in net income .......................•............. $13,489
Considering the investment in inventories and other working capital, the initial investment is $94,554
($90,554 + $4,000), and the accounting rate of return on initial investment is 14.27 percent:
Accounting rate of return = Average ann~~1 i~crease in net income = $13,489 = 0.1427
on initial investment Imtlal Investment $94,554
The average investment, computed as the initial investment plus the expected value of any disin
vestment, all divided by 2, is $53,277 [($94,554 + $12,000) -:- 2]. The accounting rate of return on
average investment is 25.32 percent:
Accounting r~te of return = Average annual in~rease in net income = $13,489 = 0.2532
on average Investment Average Investment $53,277
When using the accounting rate of return, management specifies either the initial investment or aver
age investment plus some minimum acceptable rate. Management rejects capital expenditure proposaJs
with a lower accounting rate of return but accepts proposals with an accounting rate of return higher than
or equal to the minimum.
EVALUATION OF CAP TAL BUDGETING MO ELS

As a singJe criterion for evaluating capital expenditure proposals, capital budgeting models that consider L04 Evaluate
the time value of money are superior to models that do not consider it. The payback model concerns the strengths and
merely how long it takes to recover the initial investment from a project, yet investments are not made weaknesses of
with the objective of merely getting the money back. Indeed, not investing has a payback period of O. alternative capital
Investments are made to earn a profit. Hence, what happens after the payback period is more important budgeting models.
than is the payback period itself. The payback period model, when used as the sole investment criterion,
has a fatal flaw in that it fails to consider cash flows after the payback period. Despite this flaw, payback
is a rough-and-ready approach to getting a handle on investment proposals. Sometimes a project is so at

tractive using payback that, when its life is considered, no further analysis is necessary.
For total life evaluations, the accounting rate of return is superior to the payback period because it
does consider a capital expenditure proposal's profitability. Using the accounting rate of return, a project
that merely returns the initial investment will have an average annual increase in net income of 0 and an
accounting rate of retum of O. The problem with the accounting rate of return is that it fails to consider the
timing of cash flows. It treats all cash flows within the life of an investment proposal equally despite the
fact that cash flows occurring early in a project's life are more valuable than cash flows occurring late in
a project's life. Early period cash flows can earn additional profits by being invested elsewhere. Consider
the two investment proposals summarized in Exhibit 12.5. Both have an accounting rate of return of 5 per
cent, but Proposal A is superior to Proposal B because most of its cash flows occur in the first two years.
Because of the timing of the cash flows when discounted at an annual rate of 10 percent, Proposal A has a
net present value of $1,140 while Proposal B has a negative net present value of $(10,940).
EXHIBIT 12.5 Evaluating Capital Budgeting Models with Differences in Cash Row liming
Accounting rate of return analysis of Projects A and B
Project A Project 8
Predicted net cash inflow from operations

Year 1 . $ 50,000 $ 10,000
Year 2 .. '" . 50,000 10,000
Year 3 , . 10,000 50,000
Year 4 . 10,000 50,000
Total ..............•.........................•.... 120,000 120,000
Total depreciation . (100,000) (100,000)

Total net income . $ 20,000 $ 20,000
Project life . + 4 years + 4 years
Average annual increase in net income . $ 5,000 $ 5,000
Initial investment . + 100,000 + 100,000
Accounting rate of return on initial investment . 0.05 0.05
Net present value analysis of Project A

Initial investment . $(100,000) 0 1.000 $(100,000)

Operation . 50,000 1-2 1.736 86,800
Operation . 10,000 3-4 3.170-1.736 14,340
Net present value analysis of Project B


Operation . 10,000 1-2 1.736 17,360
Operation . 50,000 3-4 3.170-1.736 71,700
Net present value of all cash flows . .............. . . ............. $ (10,940)
The net present value and the internal rate of return models both consider the time value of money
and project profitability. They almost always provide the same evaluation of individual projects whose
acceptance or rejection will not affect other projects. (An exception can occur when periods of net cash
outflows are mixed with periods of net cash inflows. Under these circumstances, an investment pro
posal could have multiple internal rates of return.) The net present value and the internal rate of return
models, however, have two basic differences that often lead to differences in the evaluation of competing
investment proposals:
I.The net present value model gives explicit consideration to investment size. The internal rate of return
model does not.
2.The net present value model assumes that all net cash inflows are reinvested at the discount rate; the
internal rate of return model assumes that all net cash inflows are reinvested at the project's internal
rate of return.
These differences are considered later when we discuss mutually exclusive investments.
ADDITIONAL ASPECTS OF CAP TAL

BUDGETING
The capital budgeting models discussed do not make investment decisions. Rather, they help managers LOS Discuss
separate capital expenditure proposals that meet certain criteria from those that do not. Managers then the importance
focus on those proposals that pass the initial screening. of judgment,
attitudes toward
u gM Ie I es men risk, and relevant

cash flow
In performing this initial screening, management can use a single capital budgeting model or multiple information for
models, including some we have not discussed. Management might specify that proposals must be in line capital budgeting
with the organization's long-range goals and business strategy, have a maximum payback period of three decisions.
years, have a positive net present value when discounted at 14 percent, and have an initial investment of
less than $500,000. The maximum payback period might be intended to reduce risk, the present value cri
terion might be to ensure an adequate return to investors, and the maximum investment size might reflect
the resources available for investment.
Nonquantitative factors such as market position, operational performance improvement, and strategy
implementation often playa decisive role in management's final decision to accept or reject a capital ex
penditure proposal that has passed the initial screening. Also important at this point are top management's
attitudes toward risk and financing alternatives, their confidence in the professional judgment of other
managers making investment proposals, their beliefs about the future direction of the economy, and their
evaluation of alternative investments. In the following sections, we will focus on evaluating risk, differ
ential analysis of project cash flows, predicting differential costs and revenues for high-tech investments,
and evaluating mutually exclusive investments.
E aluating Risk
All capital expenditure proposals involve risk, including risk related to
Cost of the initial investment.
Time required to complete the initial investment and begin operations.
Whether the new facilities will operate as planned.
Life of the facilities.
Customers' demand for the product or service.
Final selling price.
Operating costs.
Disposal values.
Projected cash flows (such as those summarized for the Mobile Yogurt Shoppe proposal in Exhibit 12.2)
are based on management's best predictions. Although these predictions are likely to reflect the professional
judgment of economists, marketing personnel, engineers, and accountants, they are far from certain.
Many techniques have been developed to assist in the analysis of the risks inherent in capital budget
ing. Suggested approaches include the following:
To adjust the discount rate for individual projects based on management's perception of the risks
associated with a project. A project perceived as being almost risk free might be evaluated using a
discount rate of 12 percent; a project perceived as having moderate risk may be evaluated using a
discount rate of 16 percent; and a project perceived as having high risk might be evaluated using a
discount rate of 20 percent.
To compute several internal rates of return and/or net present values for a project. For example,
a project's net present value might be computed three times: first assuming the most optimistic
projections of cash flows; second assuming the most likely projections of cash flows; and third
assuming the most pessimistic projections of cash flows. The final decision is then based on
management's attitudes toward risk. A project whose most likely outcome is highly profitable would
probably be rejected if its pessimistic outcome might lead to bankruptcy.
To subject a capital expenditure proposal to sensitivity analysis, a study of the responsiveness of a
model's dependent variable(s) to changes in one or more of its independent vallables. Management
might want to know, for example, the minimum annual net cash inflows that will provide an internal
rate of return of 12 percent with other cost and revenue projections being as expected.
Consider the situation presented in Exhibit 12.2 and analyzed using the net present value and the
internal rate of return models in Exhibits 12-3 and 12-4. This proposal has a positive net present value
when its cash flows are discounted at 12 percent and an expected IRR of 20 percent. Assuming that Mobile
Yogurt Shoppes has a 12 percent discount rate, management might wish to know the minimum annual net
cash inflow that will meet this criterion.
In Exhibit 12.3, disinvestment cash inflows have a net present value of $6,804. When this amount
is subtracted from the initial investment, $87,750 ($94,554 - $6,804) of the initial investment must be
recovered from operations. If this amount is to be recovered over a five-year period with equal annual net
cash inflows and a 12 percent discount rate, the factor 3.605 (see Exhibit 2 in the chapter Appendix A)
must equate the annual net cash inflows with the portion of the initial investment to be recovered from
operations. Hence, the minimum annual net cash inflows must be $24,341:
· . I h' n
M Inlmum annua net cas In ow = $87,750
3.605
= $24,341
If management could then predict the probability of annual net cash inflows being more than or equal
to $24,341, this would be the likelihood of the project meeting or exceeding a 12 percent discount rate.
Again, the ultimate decision to accept or reject the proposal rests with management and their attitudes
toward risk.
Notice the similarity of determining the minimum annual net cash inflows and that of determining the
break-even point in Chapter 3. In effect, $24,341 in annual net cash inflows is a time-adjusted break-even
point.
C ... _iect ~~::IC:~,h FIt"'_A'~
All previous examples assume that capital expenditure proposals produce additional net cash inflows, but
this is not always the case. Units of government and not-for-profit organizations might provide services that
do not produce any cash inflows. For-profit organizations might be required to make capital expenditures to
maintain product quality or to bring facilities up to environmental or safety standards. In these situations, it
is impossible to compute a project's payback pellod, accounting rate of return, or internal rate of return. It
is possible, however, to compute the present value of all life cycle costs associated with alternative ways of
providing the service or meeting the environmental or safety standard. Here, the alternative with the smallest
negative net present value is preferred.
Capital expenditure proposals to reduce operating costs by upgrading facilities might not provide any
incremental cash inflows. Again, we can use a total cost approach and calculate the present value of the
costs associated with each alternative, with the low-cost alternative being preferred. Alternatively, we can
perform a differential analysis of cash flows and, treating any reduced operating costs as if they were cash
inflows, compute the net present value or the internal rate of return of the cost reduction proposal. Recall
from Chapter 4 that a relevant cost analysis focuses on the costs that differ under alternative actions. Once
the differential amounts have been determined, they can be adjusted for the time value of money. To il
lustrate the differential approach, we consider an example introduced in Chapter 4.
Elektra, Inc. produces a variety of electronic components, including 10,000 units per year of a com
ponent used in wireless headsets. The machine currently used in manufacturing the headset components is
two years old and has a remaining useful life of four years. It cost $90,000 and has an estimated salvage
value of zero dollars at the end of its useful life. Its current book value (original cost less accumulated
depreciation) is $60,000, but its current disposal value is only $35,000.
Management is evaluating the desirability of replacing the machine with a new machine. The new
machine costs $80,000, has a useful life of four years, and a predicted salvage value of zero dollars at the
end of its useful life. Although the new machine has the same productive capacity as the old machine, its
predicted operating costs are lower because it requires less electricity. Furthermore, because of a computer
control system, the new machine will require less frequent and less expensive inspections and adjust
ments. Finally, the new machine requires less maintenance.
An analysis of the cash flows associated with this cost reduction proposal, separated into the three
phases of the project's life, are presented in Exhibit 12.6. Because the proposal does not have a disposal
value, this portion of the analysis could have been omitted. (A detailed explanation of the relevant costs
included in this analysis is in Exhibit 4.1 and the accompanying Chapter 4 discussion of relevant costs.)
Assuming that Elektra, Inc. has a discount rate of 12 percent, the proposal's net present value (computed
in Exhibit 12.7) is $2,681, and the proposal is acceptable.
EXHIBIT 12.6 Differential Analysis of Predicted Cash Flows
Differential Analysis
of Predicted Cash Flows
Difference
Keep Replace (income
Old with New effect of
Machine Machine replacement)
(A) (8) (A) - (8)
Initial investment
Cost of new machine . $80,000 $80,000
Disposal value of old machine . (35,000) (35,000)
Net initial investment . $45,000
Annual operating cash savings

Conversion
Old machine (10,000 units x $5) . $50,000
New machine (10,000 units x $4) . $40,000 $10,000
Inspection and adjustment
Old machine (10 setups x $500 per setup) . 5,000
New machine (5 setups x $300 per setup) . 1,500 3,500
Machine maintenance
Old machine ($200 per month x 12 months) . 2,400
New machine ($200 per year) . 200 2,200
Net annual cost savings . $15,700
Disinvestment at end of life

Old machine ......................•................. .............. $ 0
New machine . $ 0
EXHIBIT 12.7 Differential Analysis of Predicted Cash Flows

(A) (B) (C) (A) x (C)

Operation . 15,700 1-4 3.037 47,681
Disinvestment . o 4 0.636 o
Predicting Differential Costs and Revenues for

..... inh_ Tech Investment
Care must be taken when evaluating proposals for investments in the technological innovations such as
flexible manufacturing systems and computer integrated manufacturing. The three types of errors to con
sider are: (l) investing in unnecessary or overly complex equipment, (2) overestimating cost saving, and
(3) underestimating incremental sales.
Investing in Unnecessary or Overly Complex Equipment

A common error is to simply compare the cost associated with the current inefficient way of doing things
with the predicted cost of performing the identical operations with more modern equipment. Although
capital budgeting models might suggest that such investments are justifiable, the result could be the costly
and rapid completion of non-value-added activities. Consider the following examples.
A company invests in an automated system to speed the movement of work in process between
workstations without first evaluating the plant layout. The firm is still unable to compete with other
companies having better organized plants that allow lower cycle times, lower work-in-process
inventories, and lower manufacturing costs. Management should have evaluated the plant layout
before investing in new equipment. They may have found that rearranging the factory floor would
have reduced materials movement and eliminated the need for the investment.
A company invests in an automated warehouse to permit the rapid storage and retrieval of goods
while competitors work to eliminate excess inventory. The firm is left with large inventories and
a large investment in the automated warehouse while competitors, not having to earn a return on
similar investments, are able to charge lower prices. Management should have evaluated the need
for current inventory levels and perhaps shifted to a just-in-time approach to inventory management
before considering the investment in an automated warehouse.
A company hires staff to pedorm quality inspections while competitors implement total quality
management and seek to eliminate the need for quality inspections. While defective products
or services are now identified before they affect customers, they still exist. Furthermore, the
company has higher expenditures than competitors, resulting in a less competitive cost structure.
The inspections might not have been needed if management had shifted from inspecting for
conformance to an emphasis on "doing it right the first time."
A company invests in automated welding equipment to more efficiently produce printer casings
while competitors simplify the product design and shift from welded to molded plastic casings.
Although the cost of producing the welded casings might be lower, the company's cost structure is
still not competitive.
All of these examples illustrate the limitations of capital budgeting models and the need for good
judgment. In the final analysis, managers, not models, make decisions. Management must carefully evalu
ate the situations and determine whether they have considered the proper alternatives and all important
cash flows.
Overestimating Cost Savings

When a number of activities drive manufacturing overhead costs, estimates of overhead cost savings
based on a single activity cost driver can significantly overestimate cost savings. Assume, for example,
that a company containing both machine-intensive and labor-intensive operations develops a cost-estimat
ing equation for overhead with labor as the only independent variable. Because of this, all overhead costs
are associated with labor. The predicted cost savings can be computed as the sum of predicted reductions
in labor plus predicted reductions in overhead; the predicted reductions in overhead are computed as the
overhead per direct labor dollar or labor hour multiplied by the predicted reduction in direct labor dollars
or labor hours. Because a major portion of the overhead is driven by factors other than direct labor, reduc
ing direct labor will not provide the predicted savings. Capital budgeting models might suggest that the
investment is acceptable, but the models are based on inaccurate cost data.
Management should beware of overly simplistic computations of cost savings. This is an area in
which management needs the assistance of well-trained management accountants and engineers.
Underestimating Incremental Sales or Cost Savings

In evaluating proposals for investments in new equipment, management often assumes that the baseline
for comparison is the current sales level, but this might not be the case. If competitors are investing in
equipment to better meet customer needs and to reduce costs, a failure to make similar investments might
result in uncompetitive prices and declining, rather than steady, sales. Hence, the baseline for sales without
the investment is overstated, and the incremental sales of the investment is understated. Not considering
the likely decline in sales understates the incremental sales associated with the investment and biases the
results against the proposed investment.
Investments in manufacturing technologies, such as flexible manufacturing systems (FMS) and com
puter integrated manufacturing (CIM), do more than simply allow the efficient production of current
products. Such investments also make possible the rapid, low-cost switching to new products. The result
is expanded sales opportunities.
Such investments might also produce cost savings further down the value chain, either within or outside
the company. Elektra's decision to acquire a new machine might have the unanticipated consequence of
reducing customer warranty claims or increasing sales because customers are attracted to a higher-quality
product.
Unfortunately, because such opportunities are difficult to quantify, they are often ignored in the
evaluation of capital expenditure proposals. The solution to this dilemma involves the application of
management's professional judgment, a willingness to take risks based on this professional jUdgment, and
recognition that certain investments transcend capital budgeting models in that they involve strategic as
well as long-range planning. At this level of planning, qualitative decisions concerning the nature of the
organization are at least as important as quantified factors. The following Business Insight examines the
difficulty Aetna Life and Casualty Company encountered in evaluating strategic investments in infor
mation technology.
BUSINESS INSIGHT Investment Returns Are Not Always Quantifiable

-----------
After spending a year trying to determine how to measure the return from investments in information
technology, the senior vice president of information and technology at Aetna Life & Casualty Com~
pany gave up, calling it "an exercise in futility." He observed that while there appears to be a correla
tion between investments in information technology and reductions in cost, it is difficult to say that
one caused the other. Aetna has a complex computer system that links a collection of central data
bases with computer networks around the country. The system provides up-to-date information so
that agents can immediately respond to customer questions. The complexity of the system makes it
difficult to evaluate proposals for additional investments in the system. The vice president's frustra
tion came from the fact that "once a business unit implemented a new technology solution, the [busi
ness and technology) became so integrated that you couldn't tell them apart." Aetna managers now
make the case for additional investments in technology on the basis of business objectives such as
customer satisfaction and product improvements. 6
6 "Magic Formula," Wall S,reetJollmal. November 14. [994, p. R18.

Evaluating Mutuall ive Inves ents

Two or more capital expenditure proposals are mutually exclusive investments if the acceptance of one
automatically causes the rejection of the other(s). Perhaps a builder with a tract of land on the outskirts of
Paris is trying to detelmine the most profitable use of the land. Because of the size of the tract and zoning
requirements, the land can be used for only one of three purposes: a shopping center, a housing develop
ment, or an office park.
When faced with mutually exclusive investments, management must determine which one to accept.
The decision is relatively easy if only one of the proposals meets the organization's investment criteria.
If, however, two or more proposals pass the initial screening peIformed by the investment criteria, man
agement faces the task of selecting the best of the acceptable proposals. To help in this determination,
management could request that the proposals be ranked on the basis of some criterion such as net present
value or internal rate of return. Unfortunately, while these models almost always lead to identical deci
sions when used to evaluate individual investment proposals, they frequently produce different rankings
of acceptable proposals. Assume that management can select only one of three mutually exclusive invest
ment proposals. Relevant information is summarized in Exhibit 12.8.
($ thousands) Proposal A Proposal B Proposal C
Predicted cash flows

Initial investment . $(26,900) $(55,960) $(30,560)
Operation
Year 1 . 10,000 20,000 20,000
Year 2 . 10,000 20,000 20,000
Year 3 . 10,000 20,000 0
Year 4 . 10,000 20,000 0
Disinvestment . o 0 0
Investment criterion
Net present value at 12% . $ 3,470 $ 4,780 $ 3,240
Internal rate of return. . . . . . 18% 16% 20%
Present value index . 1.129 1.085 1.106
Ranking by investment criterion (read across)
Net present value. . . . . . . . . . . . . . . 2 1 3
Internal rate of return . . . . . . . . . . . . 2 3 1
Present value index . . . . . . . . . . . . . 1 3 2
Assuming that the organization has a 12 percent cost of capital, all projects have a positive net present
value and an internal rate of return in excess of 12 percent. Therefore, all are acceptable. The problem is to
determine which of these acceptable proposals is most desirable. Ranking the proposals by their net present
value indicates that Proposal B is best, while ranking by IRR indicates that Proposal C is best.
A frequent criticism of using net present value to rank investment proposals is that it fails to adjust for
the size of the proposed investment. To overcome this difficulty, managers can rank projects on the basis
of each project's present value index, which is computed as the present value of the project's subsequent
cash flows divided by the initial investment:
Present value index = Present value of subsequent cash flows

Initial investment
For Proposal A, the present value of the subsequent cash flows, discounted at 12 percent, is $30,370,000
($10,000,000 X 3.037), and the present value index is 1.129:
· d - $30,370,000
P resent va Iue In ex - $26,900,000
= 1.129
Chapter 12 I Capital BUdgeting Decisions 429
Using this criterion, projects that have a present value index of 1.0 or higher are acceptable, and the
project with the highest present value index is preferred. Ranking the proposals in Exhibit 12.8 on the
basis of their present value index results in Proposal A being ranked number 1.
We now have three acceptable proposals, three criteria, three different rankings, and the task of
selecting only one of the three proposals. Many managers would select Proposal C because it has the
highest IRR or Proposal A because it has the highest present value index. Either selection provides a sat-
isfactory, but not an optimal, solution to the dilemma. If the true cost of capital is 12 percent and other
investment opportunities return only 12 percent, the net present value criterion provides the proper
choice. This is illustrated in Exhibit 12.9 by evaluating the additional return earned on the differences
between Proposals B and A and on the differences between Proposals Band C.
EXHIBIT 12.9 Analysis of Incremental Investments
Difference
($ thousands) Proposal B Proposal A B-A
Initial investment. . $(55,960) $(26,900) $(29,060)
Operation
Year 1 . 20,000 10,000 10,000
Year 2 . 20,000 10,000 10,000
Year 3 . 20,000 10,000 10,000
Year 4 . 20,000 10,000 10,000
Disinvestment . 0 0 o
Net present value of difference (B - A)
12% Present

Operation . 10,000 1-4 3.037 30,370
Disinvestment . o 4 0.636 o
Net present value . $ 1,310
Difference
Proposal B Proposal C B-C
Initial investment. ...........•............ $(55,960) $(30,560) $(25,400)
Operation
Year 1 . 20,000 20,000 o
Year 2 . 20,000 20,000 o
Year 3 . 20,000 0 20,000
Year 4 . 20,000 0 20,000
Disinvestment . 0 0 o
Net present value of difference (B - C)
12% Present

Operation . 20,000 2-4 3.037 - 1.690 26,940
Disinvestment. . o 4 0.636 o
Net present value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,540
The difference in the net present value and internal rate of return rankings results from differences in
their reinvestment assumptions. The net present value model assumes that all net cash inflows from a proj-
ect are reinvested at the discount rate; the internal rate of return model assumes that all net cash inflows
from a project are reinvested at the project's internal rate of return. If unlimited funds are available at the
discount rate, marginal investments are made at this rate, and the assumption underlying the net present
value model is the correct one. Returning to Exhibit 12.9, if all funds not invested in the chosen project and
all funds recovered from the chosen project can earn only the discount rate, the firm is $1,540,000 better
off by selecting Proposal B rather than Proposal C.
The present value index eliminates the impact of size from net present value computations. How-
ever, size is an important consideration in evaluating investment proposals, especial1y if funds not
invested in a project can earn only the discount rate. In Exhibit 12.9, we see that if funds not invested
in the chosen project can be invested only at the discount rate, the firm is $1,310,000 better off by
selecting Proposal B rather than Proposal A.
TAXES IN CAPITAL BUDGETING DECISI NS

L06 Determine To focus on capital budgeting concepts, we deferred consideration of the impact of taxes. Because income
the net present taxes affect cash flows and income, their consideration is important in evaluating investment proposals in
value of for-profit organizations.
investment The cost of investments in plant and equipment is not deducted from taxable revenues in determining
proposals with taxable income and income taxes at the time of the initial investment. Instead, the amount of the initial
consideration of investment is deducted as depreciation over the operating life of an asset. To illustrate the impact of taxes
taxes. on cash flows, assume:
Revenues and operating cash receipts are the same each year.
Depreciation is the only noncash expense of an organization.
Deoreciatijon . Shi~1
Depreciation does not require the use of cash (the funds were spent at the initial investment), but deprecia-
tion is said to provide a "tax shield" because it reduces cash payments for income taxes. The deprecia-
tion tax shield (the reduction in taxes due to the deductibility of depreciation from taxable revenues) is
computed as fol1ows:
Depreciation tax shield = Depreciation X Tax rate
The value of the depreciation tax shield is illustrated using Mobile Yogurt Shoppe's capital expendi-
ture proposal summarized in Exhibit 12.2. Assuming a tax rate of 34 percent, the annual net income and
after-tax cash flows for this investment without depreciation and with straight-line depreciation are shown
in Exhibit 12.10. Examine this exhibit, paying particular attention to the lines for depreciation, income
taxes, and net annual cash flow.
Mobile Yogurt Shoppe's annual depreciation tax shield, using straight-line depreciation, is $6,158,
computed as annual depreciation of $18, III ($90,554 investment in depreciable assets -:- 5-year life) mul-
tiplied by an assumed tax rate of 34 percent. Without the depreciation tax shield, annual cash payments for
income taxes would be $6,158 more, and after-tax cash flows would be $6,158 less.
The U.S. Tax Code contains guidelines concerning the depreciation of various types of assets. (Analy-
sis of these guidelines is beyond the scope of this text.) Tax guidelines allow organizations a choice in
tax depreciation procedures between straight-line depreciation and an accelerated depreciation method
detailed in the Tax Code. Because of the time value of money, profitable businesses should usually select
the tax depreciation procedure that provides the earliest depreciation. To illustrate the effect of accelerated
depreciation on taxes and capital budgeting, we use double-declining balance depreciation rather than the
EXHIBIT 12.10 Effect of Depreciation on Taxes, Income, and Cash Flow
Annual Taxes and Income Annual Taxes and Income

without Depreciation with Depreciation
Sales . $175,000 Sales . $175,000

Operating expenses Operating expenses
(except depreciation) . (145,000) (except depreciation) . (145,000)
Depreciation . o ~-r---" Depreciation ($90,554 -;- 5 years) . (18,111)
---
Income before taxes Income before taxes
without depreciation . 30,000 with depreciation . 11,889
Income taxes (34%) . (1 0,200) ~-\---..Income taxes (34%) . (4,042)
Net income . $ 19,800 Net income . $ 7,847
Depreciation reduces income taxes by the amount of depreciation times the tax rate. The difference in taxes,
$6,158 ($10,200 - $4,042), is equal to the difference in depreciation multiplied by the tax rate, $6,158
($18,111 x 0.34).
Annual Taxes and Cash Flow Annual Taxes and Cash Flow
without Depreciation with Depreciation
Sales . $175,000 Sales . $175,000

Operating expenses Operating expenses
(except depreciation) . (145,000) (except depreciation) . (145,000)
Income taxes . (1 0,200) ~-----,---..Income taxes . (4,042)
Net annual cash inflow . $ 19,800 ~---1---" Net annual cash inflow . $ 25,958
The deductibility of depreciation for tax purposes reduces cash payments for taxes, thus increasing the net cash
flow by the depreciation tax shield. The difference in cash flow, $6,158 ($25,958 - $19,800), is explained by the
depreciation multiplied by the tax rate, $6,158 ($18,111 x 0.34). This is the depreciation tax shield.
accelerated method detailed in the Code. When making capital expenditure decisions, managers should, of
course, refer to the most current version of the Tax Code to determine the specific depreciation guidelines
in effect at that time.
Exhibits 12.11 and 12.12 illustrate the effect of two alternative depreciation procedures, straight-line
and double-declining balance, on the net present value of Mobile Yogurt Shoppe's proposed investment.
We assume that the asset is fully depreciated for tax purposes during its five-year life and is sold for a
taxable gain equal to its predicted salvage value. The cash flows for this investment were presented in Ex-
hibit 12.2, and the effect of taxes on the investment's annual cash flows were examined in Exhibit 12.10.
Ignoring taxes, the investment was shown (in Exhibit 12.3) to have a positive net present value of $20,400
at a discount rate of 12 percent. With taxes, the investment has a positive net present value of $4,287 using
straight-line depreciation and $6,084 using double-declining balance depreciation. Although taxes and
cash flows are identical over the entire life of the project, the use of double-declining balance depreciation
for taxes results in a higher net present value because it results in lower cash expenditures for taxes in the
earlier years of an asset's life.
es e t re it
From time to time, for the purpose of stimulating investment and economic growth, the U.S. federal gov-
ernment has implemented an investment tax credit. An investment tax credit reduces taxes in the year a
new asset is placed in service by some stated percentage of the cost of the asset. In recent years tax credits,
EXHIBIT 12.11 Analysis of Capital Expenditures Including Tax Effects: Straight-Line Depreciation
Predicted
Cash Inflows Year(s) of 12% Present Present Value
(outflows) Cash Flows Value Factor of Cash Flows
(A) (8) (C) (A) x (C)
Initial investment
Vehicle and equipment . $(90,554) o 1.000 $ (90,554)
Inventory and other
working capital . (4,000) o 1.000 (4,000)
Op~rations
Annual taxable income
without depreciation ...........•.....•..•.... .. 30,000 1-5 3.605 108,150
Taxes on income
($30,000 x 0.34) ............................. • (10,200) 1-5 3.605 (36,771)
Depreciation tax shield' . 6,158 1-5 3.605 22,200
Disinvestment
Sale of vehicle and equipment . 8,000 5 0.567 4,536
Taxes on gain on sale
($8,000 x 0.34) . (2,720) 5 0.567 (1,542)
Inventory and other
working capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 5 0.567 2,268
'Computation of depreciation tax shield:
Annual straight-line depreciation ($90,554 -;- 5) . . . . . . . . . .. $18,111
Tax rate. . . . ............................. x 0.34
Depreciation tax shield . $ 6,158
such as the credits for purchasing hybrid automobiles, have been used to stimulate investments that reduce
the emission of greenhouses gases. Typically, this is done without reducing the depreciation base of the
asset for tax purposes. An investment tax credit reduces cash payments for taxes and, hence, is treated as
a cash inflow for capital budgeting purposes. This additional cash inflow increases the probability that a
new asset will meet a taxpayer's capital expenditure criteria.
EXHIBIT 12.12 Analysis of Capital Expenditures Including Tax Effects: DDB Depreciation

(A) (B) (C) (A) x (C)
Initial investment
Vehicle and equipment . $(90,554) 0 1.000 $ (90,554)
Inventory and other
working capital . 4,000 0 1.000 (4,000)
Operations
without depreciation . 30,000 1-5 3.605 108,150
Taxes on income
($30,000 x 0.34) . (10,200) 1-5 3.605 (36,771)
Depreciation tax shield·
Year 1 . 12,315 1 0.893 10,997
Year 2 . 7,389 2 0.797 5,889
Year 3 , , . 4,434 3 0.712 3,157
Year 4 . 2,660 4 0.636 1,692
Year 5 , . 3,990 5 0.567 2,262
Disinvestment
Sale of vehicle and equipment . 8,000 5 0.567 4,536
Taxes on gain on sale
($8,000 x 0.34) . (2,720) 5 0.567 (1,542)
Inventory and other
working capital . 4,000 5 0.567 2,268
Net present value of all cash flows . . ......................... $ 6,084
·Computation of depreciation tax shield:
Depreciation Annual Annual Tax Tax

Basel Rate Depreciation Rate Shield
Year (A) (B) (C) = (A) x (B) (D) (E) = (C) x (D)
1 $90,554 2/5 $36,222 0.34 $12,315

2 54,332 2/5 21,733 0.34 7,389
3 32,599 2/5 13,040 0.34 4,434
4 19,559 2/5 7,824 0.34 2,660
5 11,735 balance 11,735 0.34 3,990
'The depreciation base is reduced by the amount of all previous depreciation. The annual rate is twice the straight-line rate. For simplicity,
we depreciated the remaining balance in the fifth year and did not switch to straight-line depreciation when the straight-line amount
exceeds the double-declining balance amount. This would happen in the fourth year, when $19,559 -<- 2 = $9,780.
CHAPTER-END REVIEW
Consider the following investment proposal:
Initial investment
Operations (per year for 4 years)
Cash receipts . 25,000
Cash expenditures . 15,000
Disinvestment
Salvage value of plant and equipment . 2,000
Recovery of working capital. . . . . . . . . . . . . 3,000
Required
Determine each of the following:
a. Payback period.
b. Accounting rate of return on initial investment and on average investment.
Solution
Basic computations:
Initial investment
Working capital ......•...................................... 3,000
Total . $30,740
Operation
Cash receipts . . . . $25,000
Cash expenditures . (15,000)
Net cash inflow . $10,000
Disinvestment
Sale of depreciable assets . $ 2,000
Total ..... $ 5,000
a. Payback period = $30,740 -7- $10,000

= 3.074 years
b. Accounting rate of return on initial and average investments:
Annual net cash inflow from operations . $10,000

Less average annual depreciation
[($27,740 - $2,000) -7- 4] . (6,435)
Average annual increase in net income . $ 3,565
Average investment = ($30,740 + $5,000) -7- 2

= $17,870
Accounting rate of return = $3,565
on initial investment $30,740
= 0.1160, or 11.6%
Accounting rate of return = $3,565
on average investment $17,870
= 0.1995, or 19.95%
A P PEN 0 I X 1 2 A : Time Value of Money

When asked to choose between $500 today or an IOU for $500 to be paid one year later, rational decision makers
choose the $500 today. Two reasons for this involve the time value qfmoney and the risk. A dollar today is worth more
than a dollar tomorrow or at some future time. Having a dollar provides flexibility. It can be spent, buried, or invested
in a number of projects. If invested in a savings account, it will amount to more than one dollar at some future time
because of the effect of interest. The interest paid by a bank (or borrower) for the use of money is analogous to the
rent paid for the use of land, buildings, or equipment. Furthermore, we live in an uncertain world, and, for a variety of
reasons, the possibility exists that an IOU might not be paid.
Future Value
Future value is the amount that a current sum of money earning a stated rate of interest will accumulate to at the end
of a future period. Suppose we deposit $500 in a savings account at a financial institution that pays interest at the rate
of 10 percent per year. At the end of the first year, the original deposit of $500 will total $550 ($500 X 1.10). If we
leave the $550 for another year, the amount will increase to $605 ($550 X 1.10). It can be stated that $500 today has
a future value in one year of $550, or conversely, that $550 one year from today has a present value of $500. Interest
of $55 ($605 - $550) was earned in the second year, whereas interest of only $50 was earned in the first year. This
happened because interest during the second year was earned on the principal plus interest from the first year ($550).
When periodic interest is computed on principal plus prior periods' accumulated interest, the interest is said to be
compounded. Compound interest is used throughout this text.
To determine future values at the end of one period (usually a year), multiply the beginning amount (present
value) by I plus the interest rate. When multiple periods are involved, the future value is determined by repeatedly
multiplying the beginning amount by I plus the interest rate for each period. When $500 is invested for two years at
an interest rate of 10 percent per year, its future value is computed as $500 X 1.10 X 1.10. The following equation is
used to figure future value:
fv = pv(l + i)n
where:
fv = future value amount

pv = present value amount
i = interest rate per period
n = number of periods
For our $500 deposit, the equation becomes:
fv of $500 = pv(l + i)n

= $500(1 + O.lW
= $605
In a similar manner, once the interest rate and number of periods are known, the future value amount of any present
value amount is easily determined.
Present Value
Present value is the current worth of a specified amount of money to be received at some future date at some interest
rate. Solving for pv in the future value equation, the new present value equation is determined as follows:
v - fv
P - (1 + i)n
Using this equation, the present value of $8,800 to be received in one year, discounted at 10 percent, is computed as
follows:
v of $8 800 = $8,800
p , (1 + 0.10)1
$8,800
(1.10)
= $8,000
Thus, when the discount rate is 10 percent, the present value of $8,800 to be received in one year is $8,000.
The present value equation is often expressed as the future value amount times the present value of $1:
- x $1
pv - fv (1 + on
Using the equation for the present value of $1, the present value of $8,800 to be received inone year, discounted at
10 percent, is computed as follows:
pv of $8,800 = $8,800 x -----.1!
(1 + 0.10)"
= $8,800 x 0.909
= $8,000
The present value of $8,800 two periods from now is $7,273, computed as [$8,800 -;- (1.10)2] or [$8,800 X $1
(l.lOn
If a calculator or computer with spreadsheet software is not available, present value computations can be done
by hand. Tables, such as Table 12A.1 for the present value of $1 at various interest rates and time periods, can be
used to simplify hand computations. Using the factors in Table 12A. 1, the present value of any future amount can
be determined. For example, with an interest rate of 10 percent, the present value of the following future amounts to
be received in one period are as follows:
Present Value Factor

Future Value Amount of $1 Present Value
$ 100 x 0.909 $ 90.90

628 x 0.909 570.85
4,285 x 0.909 3,895.07
9,900 x 0.909 8,999.10
To further illustrate the use of Table 12A.l, consider the following application. Alert Company wants to invest its
surplus cash at 12 percent to have $10,000 to payoff a long-term note due at the end of five years. Table 12A.1 shows
that the present value factor of $1, discounted at 12 percent per year for five years, is 0.567. Multiplying $10,000 by
0.567, the present value is determined to be $5,670:
pv of $10,000 = $10,000 x Present value factor for $1

= $10,000 x 0.567
= $5,670
Therefore, if Alert invests $5,670 today, it will have $10,000 available to payoff its note in five years.
Managers also use present value tables to make investment decisions. Assume that Monroe Company can make
an investment that will provide a cash flow of $12,000 at the end of eight years. If the company demands a rate of
return of 14 percent per year, what is the most it will be willing to pay for this investment? From Table 12A.I, we find
that the present value factor for $\, discounted at 14 percent per year for eight years, is 0.351:
pv of $12,000 = $12,000 x Present value factor for $1

= $12,000 x 0.351
= $4,212
If the company demands an annual return of 14 percent, the most it would be willing to invest today is $4,212.
Annuities
Not all investments provide a single sum of money. Many investments provide periodic cash flows called annuities.
An annuity is a series of equal cash flows received or paid over equal intervals of time. Suppose that $100 will be
received at the end of each of the next three years. If the discount rate is 10 percent, the present value of this annuity
can be determined by summing the present value of each receipt:
Year 1 $100 x $1 -;- (1 + 0.10)1 = $ 90.90
Year 2 $100 x $1 -;- (1 + 0.10)2 = 82.65
Year 3 $100 x $1 -;- (1 + 0.10)3 = 75.13
Total. . . . . . . . . . . . . . . . . . . . .. $248.68
Alternatively, the following equation can be used to compute the present value of an annuity with cash flows at the
end of each period:
TABLE 12A.1 Present Value of $1
- --
Present value of $1 = (1 1r)0
Discount rate (r)
Periods (n) 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30%
0.943 0.926 0.909 0.893 0.877 0.862 0.847 0.833 0.820 0.806 0.794 0.781 0.769
2 0.890 0.857 0.826 0.797 0.769 0.743 0.718 0.694 0.672 0.650 0.630 0.610 0.592
3 0.840 0.794 0.751 0.712 0.675 0.641 0.609 0.579 0.551 0.524 0.500 0.477 0.455
4 0.792 0.735 0.683 0.636 0.592 0.552 0.516 0.482 0.451 0.423 0.397 0.373 0.350
5 0.747 0.681 0.621 0.567 0.519 0.476 0.437 0.402 0.370 0.341 0.315 0.291 0.269
6 0.705 0.630 0.564 0.507 0.456 0.410 0.370 0.335 0.303 0.275 0.250 0.227 0.207
7 0.665 0.583 0.513 0.452 0.400 0.354 0.314 0.279 0.249 0.222 0.198 0.178 0.159
8 0.627 0.540 0.467 0.404 0.351 0.305 0.266 0.233 0.204 0.179 0.157 0.139 0.123
9 0.592 0.500 0.424 0.361 0.308 0.263 0.225 0.194 0.167 0.144 0.125 0.108 0.094
10 0.558 0.463 0.386 0322 0.270 0.227 0.191 0.162 0.137 0.116 0.099 0.085 0.073
11 0.527 0.429 0.350 0.287 0.237 0.195 0.162 0.135 0.112 0.094 0.079 0.066 0.056
12 0.497 0.397 0.319 0.257 0.208 0.168 0.137 0.112 0.092 0.076 0.062 0.052 0.043
()
13 0.469 0.368 0.290 0.229 0.182 0.145 0.116 0.093 0.075 0.061 0.050 0.040 0.033 ::r
~
14 0.442 0.340 0.263 0.205 0.160 0.125 0.099 0.078 0.062 0.049 0.039 0.032 0.025 ,...
'0
..,CD
15 0.417 0.315 0.239 0.183 0.140 0.108 0.084 0.065 0.051 0.040 0.031 0.025 0.020 ....
lI.l
-
16 0.394 0.292 0.218 0.163 0123 0.093 0.071 0.054 0.042 0.032 0.025 0.019 0.015 0
(ll
17 0.371 0.270 0.198 0.146 0.108 0.080 0.060 0.045 0.034 0.026 0.020 0.015 0.012 '0
~
18 0.350 0.250 0.180 0.130 0.095 0.069 0.051 0.038 0.028 0.021 0.016 0.012 0.009 m
cQ.
19 0.331 0.232 0.164 0.116 0.083 0.060 0.043 0.031 0.023 0.017 0.012 0.009 0.007 (Q
~
20 0.312 0.215 0.149 0.104 0.073 0.051 0.037 0.026 0.019 0.014 0.010 0.007 0.005 5'
(Q
0
(!)
()
iiJ
ci':::J
(J)
.c.
Co)
.....
pya = Tx [1 - (1 + ~.10)n ]
where:
pva = present value of an annuity (also called the annuity factor)
i = prevailing rate per period
n = number of periods
a = annuity amount
This equation was used to compute the factors presented in Table 12A.2 for an annuity amount of $1. The present
value of an annuity of $1 per period for three periods discounted at 10 percent per period is as follows:
PVaOf$I=_I~x[l-
0.10
1
(1 + 0.10)3
]
= 2.4868
Using this factor, the present value of a $100 annuity can be computed as $100 X 2.4868, which yields $248.68.
To determine the present value of an annuity of any amount, the annuity factor for $1 can be multiplied by the annuity
amount.
To further illustrate the use of Table 12A.2, assume that Red Kite Company is considering an investment in a
piece of equipment that will produce net cash inflows of $2,000 at the end of each year for five years. If the company's
desired rate of return is 12 percent, an investment of $7,210 will provide such a return:
pya of $2,000 = $2,000 x Present value factor for an annuity of

$1 for five periods discounted at 12%
= $2,000 x 3.605
= $7,210
Here, the $2,000 annuity is multiplied by 3.605, the factor for an annuity of $1 for five periods found in Table
12A.2, discounted at 12 percent per period.
Another use of Table 12A.2 is to determine the amount that must be received annually to provide a desired rate
of return on an investment. Assume that Bumsville Company invests $33,550 and desires a return of the investment
plus interest of 8 percent in equal year-end payments for ten years. The minimum amount that must be received each
year is determined by solving the equation for the present value of an annuity:
pya = a x (pva of $1)
a = pya
pya of$1
From Table 12A.2, we see that the 8 percent factor for ten periods is 6.710. Dividing the $33,550 investment by
6.710, the required annuity is computed to be $5,000:
_ $33,550
a - 6.710
= $5,000
Unequal Cash Flows

Many investment situations do not produce equal periodic cash flows. When this occurs, the present value for each
cash flow must be detennined independently because the annuity table can be used only for equal periodic cash
flows. Table 12A.I is used to determine the present value of each future amount separately. To illustrate, assume that
the Atlanta Braves wish to acquire the contract of a popular baseball player who is known to attract large crowds.
Management believes this player will return incremental cash Hows to the team at the end of each of the next three
years in the amounts of $2,500,000, $4,000,000, and $1,500,000. After three years, the player anticipates retiring. If
the team's owners require a minimum return of 14 percent on their investment, how much would they be willing to
pay for the player's contract?
To solve this problem, it is necessary to detelmine the present value of the expected future cash flows. Here we
use Table 12A.I to find the $1 present value factors at 14 percent for Periods 1, 2, and 3. The cash flows are then
multiplied by these factors:
TABLE 12A.2 Present Value of an Annuity of $1
~ _.-- --- -- -- -
Present value of an annuity of $1 = t ~ - (1 1r)n ]

Discount rate (r)
Periods (n) 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 25% 26% 28% 30%
0.943 0.926 0.909 0.893 0.877 0.862 0.847 0.833 0.820 0.806 0.800 0.794 0.781 0.769
2 1.833 1.783 1.736 1.690 1.647 1.605 1.566 1.528 1.492 1.457 1.440 1.424 1.392 1.361
3 2.673 2.577 2.487 2.402 2.322 2.246 2.174 2.106 2.042 1.981 1.952 1.923 1.868 1.816
4 3.465 3.312 3.170 3.037 2.914 2.798 2.690 2.589 2.494 2.404 2.362 2.320 2.241 2.166
5 4.212 3.993 3.791 3.605 3.433 3.274 3.127 2.991 2.864 2.745 2.689 2.635 2.532 2.436
6 4.917 4.623 4.355 4.111 3.889 3.685 3.498 3.326 3.167 3.020 2.951 2.885 2.759 2.643
7 5.582 5.206 4.868 4.564 4.288 4.039 3.812 3.605 3.416 3.242 3.161 3.083 2.937 2.802
8 6.210 5.747 5.335 4.968 4.639 4.344 4.078 3.837 3.619 3.421 3.329 3.241 3.076 2.925
9 6.802 6.247 5.759 5.328 4.946 4.607 4.303 4.031 3.786 3.566 3.463 3.366 3.184 3.019
10 7.360 6.710 6.145 5.650 5.216 4.833 4.494 4.192 3.923 3.682 3.571 3.465 3.269 3.092
11 7.887 7.139 6.495 5.938 5.453 5.029 4.656 4.327 4.035 3.776 3.656 3.544 3.335 3.147
12 8.384 7.536 6.814 6.194 5.660 5.197 4.793 4.439 4.127 3.851 3.725 3.606 3.387 3.190 ()
:r
13 8.853 7.904 5.842 5.342 4.910 4.533 4.203 3.427 3.223 Pl
7.103 6.424 3.912 3.780 3.656
...
'0
14 9.295 8.244 7.367 6.628 6.002 5.468 5.008 4.611 4.265 3.962 3.824 3.695 3.459 3.249 .......CD
I\)
15 9.712 8.559 7.606 6.811 6.142 5.575 5.092 4.675 4.315 4.001 3.859 3.726 3.483 3.268 -
0
16 10.106 8.851 7.824 6.974 6.265 5.669 5.162 4.730 4.357 4.033 3.887 3.751 3.503 3.283 III
'0
17 10.477 9.122 8.022 7.120 6.373 5.749 5.222 4.775 4.391 4.059 3.910 3.771 3.518 3.295 ~
rn
c
18 10.828 9.372 8.201 7.250 6.467 5.818 5.273 4.812 4.419 4.080 3.928 3.786 3.529 3.304 Q.
co
19 11.158 9.604 8.365 7.366 6.550 5.877 5.316 4.844 4.442 4.097 3.942 3.799 3.539 3.311 ~
S'
co
20 11.470 9.818 8.514 7.469 6.623 5.929 5.353 4.870 4.460 4.110 3.954 3.808 3.546 3.316 0
CD
0
(ii'
0
:J
(j)
A
Co)
CD
Annual Present Value of Present Value

Year Cash Flow $1 at 14 Percent Amount
1 $2,500,000 x 0.877 $2,192,500

2 . . . . . . . . . . . . . . . . .. 4,000,000 x 0.769 3,076,000
3 . . . . . . . . . . . . . . . . .. 1,500,000 x 0.675 1,012,500
Total . $6,281,000
The total present value of the cash flows for the three years, $6,281,000, represents the maximum amount the
team would be willing to pay for the player's contract.
Deferred Returns
Many times, organizations make investments for which they receive no cash until several periods have passed. The
present value of an investment discounted at 12 percent per year, which has a $2,000 return only at the end of Years
4, 5, and 6, can be determined as follows:
Present Value of Present Value

Year Amount $1 at 12 Percent Amount
1 . $ 0 x 0.893 $ 0
2 . ox 0.797 o
3 . o x 0.712 o
4 . 2,000 x 0.636 1,272
5 . 2,000 x 0.567 1,134
6 . 2,000 x 0.507 1,014
Total . $3,420
Computation of the present value of the deferred annuity can also be perfonned using the annuity tables if the
cash flow amounts are equal for each period. The present value of an annuity for six years minus the present value of
an annuity for three years yields the present value of an annuity for Years 4 through 6.
Present value of an annuity for 6 years at 12 percent: $2,000 x 4.111 = $8,222

Present value of an annuity for 3 years at 12 percent: 2,000 x 2.402 = (4,804)
Present value of the deferred annuity . $3,418*
"The difference between the $3,420 above and the $3,418 here is due to rounding.
A P PEN 0 I X 1 2 B: Table Approach to Determining

Internal Rate of Return
We consider the use of present value tables to determine the internal rate of return of a series of cash flows with (I)
equal net cash flows after the initial investment and (2) unequal net cash flows after the initial investment.
Equal Cash Inflows

An investment proposal's internal rate of return is easily detennined when a single investment is followed by a series
of equal annual net cash flows. The general relationship between the initial investment and the equal annual cash
inflows is expressed as follows:
Initial = Present value factor x Annual net

investment for an annuity of $1 cash inflow
Solve for the appropriate present value factor as follows:
Present value factor _ Initial investment

for an annuity of $1 - Annual net cash inflows
Once the present value factor is calculated, use Table 12A.2 and go across the row corresponding to the expected
life of the project until a table factor equal to or closest to the project's computed present value factor is found. The
corresponding percentage for the present value factor is the proposal's internal rate of return. If a table factor does not
exactly equal the proposal's present value factor, a more accurate answer can be obtained by interpolation (which is
not discussed in this text).
To illustrate, assume that Mobile Yogurt Shoppe's proposed investment has a zero disinvestment value. Using all
information in Exhibit 12-2 (except that for disinvestment), the proposal's present value factor is 3.152:
Present value factor _ Initial investment

for an annuity of $1 Annual net cash inflows
_ $94,554
- $30,000
= 3.152
Using Table l2A.2, go across the row for five periods; the closest table factor is 3.127, which corresponds to an
internal rate of return of 18 percent.
Unequal Cash Inflows

If periodic cash flows subsequent to the initial investment are unequal, the simple procedure of determining a present
value factor and looking up the closest corresponding factor in Table 12A.2 cannot be used. Instead, a trial-and-error
approach must be used to determine the internal rate of return.
EXHIBIT 12B.1 Internal Rate of Return with Unequal Cash Flows

---_.....
First trial with a 24 percent discount rate

(A) (B) (C) (A) x (C)

Operation . 30,000 1-5 2.745 82,350
Disinvestment . 12,000 5 0.341 4,092
Net present value of all cash flows . $ (8,112)
Second trial with a 16 percent discount rate

(A) (B) (C) (A) x (C)

Operation . 30,000 1-5 3.274 98,220
Disinvestment. . 12,000 5 0.476 5,712
Third trial with a 20 percent discount rate

(A) (B) (C) (A) x (C)

Operation . 30,000 1-5 2.991 89,730
Disinvestment. . 12,000 5 0.402 4,824
Net present value of all cash flows . . . .. . . . . . . . . . . . . $ 0
The first step is to select a discount rate estimated to be close to the proposal's IRR and to compute the proposal's
net present value. If the resulting net present value is zero, the selected discount rate is the actual rate of return.
However, it is unlikely that the first rate selected will be the proposal's IRR. If the computation results in a positive
net present value, the actual IRR is higher than the initially selected rate. In this case, the next step is to compute the
proposal's net present value using a higher rate. If the second computation produces a negative net present value, the
actual IRR is less than the selected rate. Therefore, the actual IRR is between the first and the second rates. This trial-
and-error approach continues until a discount rate is found that equates the proposal's cash inflows and outflows. For
Mobile Yogurt Shoppe's investment proposal outlined in Exhibit 12-2, the details of the trial-and-error approach are
presented in Exhibit 12B.1.
In Exhibit 12B.1 the first rate produced a negative net present value, indicating that the proposal's 1RR is less
than 24 percent. To produce a positive net present value, a smaller rate was selected for the second trial. Since the
second rate produced a positive net present value, the proposal's true IRR must be between 16 and 24 percent. The 20
percent rate selected for the third trial produced a net present value of zero, indicating that this is the proposal's IRR.
GUIDANCE ANSWER
·J·~lLII
• You Are the Vice President of Finance
There is no single correct response to this question. It is useful to start by learning how other companies in
similar circumstances handle capital expenditure decisions. This might be done through personal contacts or
through professional organizations, such as the Financial Executives Institute. Another starting point might be
the formation of a small capital budgeting committee, which could be expanded as necessary once formal
procedures were in place. Early tasks of the committee might include developing guidelines for the size of
expenditures at various organizational levels subject to committee review and developing guidelines for the
criteria used in formal reviews. You would want to ensure that the CEO is in agreement with these proposals.
If the company has a board of directors, you would also want some mutual understanding of the board's role
in the approval of capital expenditures. Finally, you would want to make clear the importance of a post-audit
review.
Superscript A denotes assignments based on Appendix.
Q12-l. What is the relationship between long-range planning and capital budgeting?
Q12-2. What tasks are often assigned to the capital budgeting committee?
Q12-3. What purposes are served by a post-audit of approved capital expenditure proposals?
Q12-4. Into what three phases are a project's cash flows organized?
Q12-S. State three alternative definitions or descriptions of the internal rate of return.
Q12-6. Why is the cost of capital an important concept when discounting models are used for capital budgeting?
Q12-7. What weakness is inherent in the payback period when it is used as the sole investment criterion?
Q12-8. What weakness is inherent in the accounting rate of return when it is used as an investment criterion?
Q12-9. Why are the net present value and the internal rate of return models superior to the payback period and
the accounting rate of return models?
Q12-1O. State two basic differences between the net present value and the internal rate of return models that
often lead to differences in the evaluation of competing investment proposals.
Q12-11. Identify several nonquantitative factors that are apt to playa decisive role in the final selection of
projects for capital expenditures.
Q12-12. In what way does depreciation affect the analysis of cash flows for a proposed capital expenditure?
Chapter 12 [ Capital Budgeting Decisions 443
MINI EXERCISES
M12-13. A Time Value of Money: Basics (L02t
Using the equations and tables in Appendix J2A of this chapter, determine the answers to each of the
following independent situations:
a. The future value in two years of $1 ,000 deposited today in a savings account with interest
compounded annually at 6 percent.
b. The present value of $9,000 to be received in four years, discounted at 12 percent.
c. The present value of an annuity of $2,000 per year for five years discounted at 14 percent.
d. An initial investment of $32,010 is to be returned in eight equal annual payments. Determine the
amount of each payment if the interest rate is 10 percent.
e. A proposed investment will provide cash flows of $20,000, $8,000, and $6,000 at the end of Years I,
2, and 3, respectively. Using a discount rate of 20 percent, determine the present value of these cash
flows.
/. Find the present value of an investment that will pay $4,000 at the end of Years 10, 11, and 12. Use a
M12-I4. A Time Value of Money: Basics (L02)
Using the equations and tables in Appendix 12A of this chapter, determine the answers to each of the
following independent situations:
a. The future value in two years of $4,000 invested today in a certificate of deposit with interest
compounded annually at 10 percent.
b. The present value of $6,000 to be received in five years, discounted at 8 percent.
c. The present value of an annuity of $20,000 per year for four years discounted at 12 percent.
d. An initial investment of $29,480 is to be returned in six equal annual payments. Determine the
amount of each payment if the interest rate is 16 percent.
e. A proposed investment will provide cash flows of $6,000, $8,000, and $20,000 at the end of Years I,
2, and 3, respectively. Using a discount rate of 18 percent, determine the present value of these cash
flows.
f Find the present value of an investment that will pay $6,000 at the end of Years 8, 9, and 10. Use a
MI2-IS. NPV and IRR: Equal Annual Net Cash Inflows (L021
Apache Junction Company is evaluating a capital expenditure proposal that requires an initial investment of
$9,350, has predicted cash inflows of $2,000 per year for IS years, and has no salvage value.
Required
a. Using a discount rate of 16 percent, determine the net present value of the investment proposal.
b. Detelmine the proposal's internal rate of retum. (Refer to Appendix 12B if you use the table approach.)
c. What discount rate would produce a net present value of zero?
M12-I6. NPV and IRR: Equal Annual Net Cash Inflows (L02t
Sun Devil Company is evaluating a capital expenditure proposal that requires an initial investment of
$32,160, has predicted cash inflows of $7,500 per year for seven years, and has no salvage value.
Required
b. Determine the proposal's internal rate of return. (Refer to Appendix 12B if you use the table approach.)
c. What discount rate would produce a net present value of zero?
MI2-I7. Payback Period and Accounting Rate of Return: Equal Annual Operating Cash Flows without
Disinvestment (L03)
Adams is considering an investment proposal with the following cash flows:
Initial investment-depreciable assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $70,000

Net cash inflows from operations (per year for 4 years). . . . . . . . . . . . . . . . . . . . . . . . 20,000
Disinvestment. . . . . . . . . ........................................ 0
Required
a. Determine the payback period
b. Determine the accounting rate of return on initial investment
c. Determine the accounting rate of return on average investment
MI2-IS. Payback Period and Accounting Rate of Return: Equal Annual Operating Cash Flows with
Disinvestment (L03)
Baker is considering an investment proposal with the following cash flows:
Initial investment-depreciable assets . $120,000

Net cash inflows from operations (per year for 4 years) . 40,000
Disinvestment-depreciable assets . 20,000
Required
MI2-19. Payback Period and Accounting Rate of Return: Equal Annual Operating Cash Flows with
Disinvestment (L03)
Charlie is considering an investment proposal with the following cash flows:
Initial investment-depreciable assets . $90,000

Initial investment-working capital. . 10,000
Net cash inflows from operations (per year for 4 years) . 25,000
Disinvestment-depreciable assets . 10,000
Disinvestment-working capital . 10,000
Required
EXERCISES
EI2-20. NPV and IRR: Unequal Annual Net Cash Inflows (L02)
Assume that Goodrich CorpOl'ulion is evaluating a capital expenditure proposal that has the following
predicted cash flows:
Initial investment. . $(85,160)

Operation
Year 1 . 36,000
Year 2 . 50,000
Year 3 . 40,000
Salvage . o
Required
b. Determine the proposal's internal rate of return. (Refer to Appendix 12B if you use the table approach.)
EI2-21. NPV and IRR: Unequal Annual Net Cash Inflows (L02)
Salt River Company is evaluating a capital expenditure proposal that has the following predicted cash flows:
Initial investment. . $(43,270)

Operation
Year 1 . 20,000
Year 2 . 30,000
Year 3 . 10,000
Salvage . o
Required
h. Detem1ine the proposal's internal rate of return. (Refer to Appendix 12B if you use the table approach.)
E12-22. Payback Period, IRR, and Minimum Cash Flows (L02, 3)

The management of Mesquite Limited is currently evaluating the following investment proposal:
TimeD Year 1 Year 2 Year 3 Year 4
Initial investment. . . . . . . . $240,000

Net operating
cash inflows . $100,000 $100,000 $100,000 $100,000
Required
a. Determine the proposal's payback period.
b. Determine the proposal's internal rate of return. (Refer to Appendix 12B if you use the table
approach.)
c. Given the amount of the initial investment, determine the minimum annual net cash inflows required
to obtain an internal rate of return of 14 percent. Round the answer to the nearest dollar.
E12-23. TimecAdjusted Cost-Volume-Profit Analysis (L02,3)

Mill Avenue Treat Shop is considering the desirability of producing a new chocolate candy called Pleasure
Bombs, Before purchasing the new equipment required to manufacture Pleasure Bombs, Zita Pei'ia, the
shop's proprietor performed the following analysis:
Unit selling price . $1.45

Variable manufacturing and selling costs . (1.15)
Unit contribution margin . $0.30
Annual fixed costs
Depreciation (straight line for 3 years) . $ 20,000
Other (all cash) . 25,000
Total . $45,000
Annual break-even sales volume = $45,000 + $0.30 = 150,000 units
Because the expected annual sales volume is 150,000 units, Zita decided to undertake the production of
Pleasure Bombs. This required an immediate investment of $60,000 in equipment that has a life of three
years and no salvage value. After three years, the production of Pleasure Bombs will be discontinued.
Required
a. Evaluate the analysis performed by Zita Pefia
b. If Mill Avenue Treat Shop has a time value of money of 14 percent, should it make the investment
with projected annual sales of J60,000 units?
c. Considering the time value of money, what annual unit sales volume is required to break even?
E12-24. Time-Adjusted Cost-Volume-Profit Analysis with Income Taxes (LOG)

Assume the same facts as given in Exercise E-23.
Required
With a 40 percent tax rate and a 14 percent time value of money, determine the annual unit sales required to
break even on a time-adjusted basis.
E12-25. Payback Period and IRR of a Cost Reduction Proposal-Differential Analysis IL02, L03)
A light-emitting diode (LED) is a semiconductor diode that emits narrow-spectrum light. Although relatively
expensive when compared to incandescent bulbs, they use significantly less energy and last six to ten times
longer, with a slow decline in performance rather than an abrupt failure.
New York City currently has 80,000 incandescent bulbs in traffic lights at approximately 12,000
intersections. It is estimated that replacing all the incandescent bulbs with LED will cost $28 million.
However, the investment is also estimated to save the City $6.3 million per year in energy costs. 7
Required:
a. Determine the payback period of converting New York City traffic lights to LEDs.
b. If the average life of an incandescent streetlight is one year and the average life of an LED street-
light is seven years, should the City finance the investment in LED's at an interest rate of five percent
per year? Justify your answer.
E12-26. Payback Period and NPV of a Cost Reduction Proposal-Differential Analysis IL02, L03)
Mary Zimmerman decided to purchase a new Saturn VUE automobile. Being concerned about environmental
issues, she is leaning toward the hybrid VUE Green rather than the completely gasoline four-cylinder model.
Nevertheless, as a new business school graduate, she wants to detennine if there is an economic justification
for purchasing the VUE Green, which costs $1,300 more than the regular VUE. She has determined that city/
highway combined gas mileage of the Green VUE and regular VUE models are 27 and 23 miles per gallon
respectively. Mary anticipates she will u'avel an average of 12,000 miles per year for the next several years. s
Required:
a. Determine the payback period of the incremental investment if gasoline costs $3.50 per gallon.
b. Assuming that Mary plans to keep the care five years and does not believe there will be a trade-
in premium associated with the hybrid model, detennine the net present value of the incremental
investment at an eight percent time value of money.
c. Determine the cost of gasoline required for a payback period of three years.
d. At $3.50 per gallon, determine the VUE Green combined gas mileage required for a payback period
of three years
e. Identify other factors Mary should consider before making her decision.
PROBLEMS
P12-27. Ranking Investment Proposals: Payback Period, Accounting Rate of Return, and Net Present
Value (L02, 3, 41
Presented is information pertaining to the cash flows of three mutually exclusive investment proposals:
Proposal X Proposal Y Proposal Z
Initial investment . $45,000 $45,000 $45,000

Cash flow from operations
Year 1 . 40,000 22,500 45,000
Year 2 ,., , . 5,000 22,500
Year 3 . . . . . . , 22,500 22,500
Disinvestment . 0 0 0
Life (years) . 3 years 3 years 1 year
Required
a. Rank these investment proposals using the payback period, the accounting rate of return on initial
investment, and the net present value criteria. Assume that the organization's cost of capital is 14
percent. Round calculations to four decimal places.
b. Explain the difference in rankings. Which investment would you recommend?
P12-28. Ranking Investment Proposals: Net Present Value and Present Value Index IL02,41
Assume that Nestle Purina is considering the replacement of its traditional canned dog food with dog food
packaged in either resealable plastic containers or in disposable foil-lined pouches. Although either altemative
will produce significant cost savings and marketing benefits, limitations on available shelf space in stores
require management to select only one altemative. Cash flow infonnation on each altemative follows.
Plastic Lined
Containers Pouches
Initial investment in necessary equipment . $50,000 $150,000

Increase in annual net cash flows . $20,000 $56,000
Life of equipment (years) . 5 years 5 years
Salvage value of equipment . $10,000 $12,000
Nestle Purina has a 12 percent cost of capital.
Required
a. Evaluate the investment alternatives using the net present value and the present value index criteria.
b. Explain the difference in rankings. Which investment would you recommend?
7 Based on "Mayors Take the Lead," Newsweek, April 16,2007, pp. 68-73.
8 Based on Mike Spector, The Economics of Hybrids," Wall SO'eel Jot/mal, October 29,2007, p. RS
P12-29. Ranking Investment Proposals: Net Present Value and Present Value Index (L02,4)
Ocean Breeze Cat Sand Company is considering the replacement of its traditional bag packaging of cat sand
with either reusable plastic or aluminum pails. Customers would make a refundable deposit on the container
each time they purchased cat sand. Because the pails would be reusable, the net cost of cat sand to customers
who returned the pail for a refund would be lower than the cost of cat sand sold in bags. Ocean Breeze has
a 16 percent cost of capital. Cash flow information on each alternative follows.
Plastic Aluminum
Initial investment. . $120,000 $68,000

Increase in annual net cash flows . $ 52,500 $30,000
Life of equipment (years) . 4 years 4 years
Disposal value of equipment . $ 12,000 $9,000
Required
a. Evaluate the investment alternatives using the net present value and the present value index criteria.
b. Explain the difference in rankings. Which investment would you recommend if unlimited funds were
available at Ocean Breeze's cost of capital?
P12-30. Cost Reduction Proposal: IRR, NPV, and Payback Period (L02, 3)
JB Chemical currently discharges liquid waste into Calgary's municipal sewer system. However, the
Calgary municipal government has informed JB that a surcharge of $4 per thousand cubic liters will soon
be imposed for the discharge of this waste. This has prompted management to evaluate the desirability of
treating its own liquid waste.
A proposed system consists of three elements. The first is a retention basin, which would permit unusual
discharges to be held and treated before entering the downstream system. The second is a continuous self-
cleaning rotary filter required where solids are removed. The third is an automated neutralization process
required where materials are added to control the alkalinity-acid it)' range.
The system is designed to process 500,000 liters a day. However, management anticipates that only about
200,000 liters of liquid waste would be processed in a nonnal workday. The company operates 300 days per
year. The initial investment in the system would be $450,000, and annual operating costs are predicted to be
$150,000. The system has a predicted useful life of ten years and a salvage value of $50,000.
Required
a. Determine the project's net present value at a discount rate of 14 percent.
b. Determine the project's approximate internal rate of return. (Refer to Appendix 12B if you use the
table approach.)
c. Determine the project's payback period.
P12-31. NPV with Income Taxes: Straight-Line versus Accelerated Depreciation (L02, 6)
John Paul Jones Inc. is a conservatively managed boat company whose motto is, "The old ways are the good
ways." Management has always used straight-line depreciation for tax and external reporting purposes.
Although they are reluctant to change, they are aware of the impact of taxes on a project's profitability.
Required
For a typical $100,000 investment in equipment with a five-year life and no salvage value, determine the present
value of the advantage resulting from the use of double-declining balance depreciation as opposed to straight-line
depreciation. Assume an income tax rate of 40 percent and a discount rate of 16 percent. Also assume that there
will be a switch from double-declining balance to straight-line depreciation in the fourth year.
P12-32. Payback Period, NPV, and PVI: Taxes and Straight-Line Depreciation (L02, 3, 6)
Assume that United Technulogies is evaluating a proposal to change the company's manual design system
to a computer-aided design (CAD) system. The proposed system is expected to save 10,000 design hours per
year; an operating cost savings of $40 per hour. The annual cash expenditures of operating the CAD system
are estimated to be $200,000. The CAD system requires an initial investment of $500,000. The estimated
life of this system is five years with no salvage value. The tax rate is 40 percent, and United Technologies
uses straight-line depreciation for tax purposes. United Technologies has a cost of capital of 16 percent.
Required
a. Compute the annual after-tax cash flows related to the CAD project.
b. Compute each of the following for the project:
I. Payback period.
2. Net present value.
3. Present value index.
P12-33. NPV: Taxes and Accelerated Depreciation (L06)

Assume the same facts as given in P 12-32, except that management intends to use double-declining balance
depreciation with a switch to straight-line depreciation (applied to any undepreciated balance) starting in
Year 4.
Required
Determine the project's net present value.
P12-34. NPV Total and Differential Analysis of Replacement Decision (L02)

Gusher Petro is evaluating a proposal to purchase a new processor that would cost $120,000 and have
a salvage value of $12,000 in five years. Gusher's cost of capital is 16 percent. It would provide annual
operating cash savings of $15,000, as follows:
Old New
Processor Processor
Salaries . $34,000 $44,000

Supplies . 6,000 5,000
Utilities . 13,000 6,000
Cleaning and maintenance . 22,000 5,000
Total cash expenditures . $75,000 $60,000
If the new processor is purchased, Gusher will sell the old processor for its current salvage value of $30,000.
If the new processor is not purchased, the old processor will be disposed of in fi ve years at a predicted scrap
value of $2,000. The old processor's present book value is $50,000. If kept, the old processor will require
repairs predicted to cost $40,000 in one year.
Required
a. Use the total cost approach to evaluate the alternatives of keeping the old processor and purchasing
the new processor. Indicate which alternative is preferred.
b. Use the differential cost approach to evaluate the desirability of purchasing the new processor.
P12-35. NPV Total and Differential Analysis of Replacement Decision (L02)

White Snow Automatic Laundry must either have a complete overhaul of its current dry-cleaning system or
purchase a new one. Its cost of capital is 20 percent. White Snow's accountant has developed the following
cost projections:
Present New
System System
Purchase cost (new) . $40,000 $50,000

Remaining book value . 15,000
Overhaul needed . 20,000
Annual cash operating costs . 35,000 20,000
Current salvage value . 10,000
Salvage value in 5 years . 2,500 10,000
If White Snow keeps the old system, it will have to be overhauled immediately. With the overhaul, the old
system will have a useful life of five more years.
Required
a. Use the total cost approach to evaluate the alternatives of keeping the old system and purchasing the
new system. Indicate which alternative is preferred.
h. Use the differential cost approach to evaluate the desirability of purchasing the new system.
P12-36. NPV Differential Analysis of Replacement Decision (L02, 5)

The management of Essen Manufacturing Company is currently evaluating a proposal to purchase a new,
innovative drill press as a replacement for a less efficient piece of similar equipment, which would then
be sold. The cost of the equipment, including delivery and installation, is $175,000. If the equipment is
purchased, Essen will incur a $5,000 cost in removing the present equipment and revamping service facilities.
The present equipment has a book value of $100,000 and a remaining useful life of ten years. Because of
new technical improvements that have made the present equipment obsolete, it now has a disposal value of
only $40,000. Management has provided the following comparison of manufacturing costs:
Present New
Equipment Equipment
Annual production (units) . 400,000 400,000

Annual costs
Direct labor (per unit) .................................• $0.075 $0.05
Overhead
Depreciation (10% of asset's book value) $10,000 $17,500
Other . $48,000 $20,000

Management believes that if the current equipment is not replaced now, it will have to wait ten years
before replacement is justifiable.
Both pieces of equipment are expected to have a negligible salvage value at the end of ten years.
Management expects to sell the entire annual production of 400,000 units.
Essen's cost of capital is 14 percent.
Required
Evaluate the desirability of purchasing the new equipment
ASES
C12-37. Payback Period (L03,5)
In response to a significant increase in energy costs in the fall of 2000, American Energy Systems of
Hutchinson, Minnesota, introduced a stove that uses dry-shelled field corn as fuel. Depending on the size of
the house and weather conditions, tests indicated that heating an average house requires 15 to 30 bushels of
com per month. The stove sold for $2,170 and, with corn then at a historical low cost of $2 a bushel, heating
with corn was ten times cheaper than gas or heating oil and seven times cheaper than electricity.9
Required
a. Based on fall 2000 fuel costs determine the range of possible payback periods in months.
b. What other factors should be considered before purchasing a stove that uses corn?
c. Assuming the corn stove has a life of ten years, do you feel comfortable making this decision using
only the payback capital budgeting model? Why or why not?
C12-38. Determining Terms of Automobile Leases (Requires Spreadsheet) (L02, 5)
Avant-Garde Motor Company has asked you to develop lease terms for the firm's popular Avant-Garde
Challenger, which has an average selling price (new) of $25,noo. You know that leasing is attractive because it
assists consumers in obtaining new vehicles with a small down payment and "reasonable" monthly payments.
Market analysts have told you that to attract the widest number of young professionals, the Challenger must
have an initial down payment of no more than $1,000, monthly payments of no more than $450, and lease
terms of no more than three years. When the lease expires, Avant-Garde will sell the used Challengers at the
automobile's resale market price at that time. It is difficult to predict the future price of the increasingly popular
Challenger, but you have obtained the following information on the average resale prices of used Challengers:
Age Resale Price
1 year . $20,000
2 years . 18,500
3 years . 16,000
4 years . 13,500
5 years . 12,500
Avant-Garde's cost of capital is 18 percent per year, or 1.5 percent per month.
Required
a. With the aid of spreadsheet software, develop a competitive and profitable lease payment program.
Assume the down payment and the first lease payment are made immediately and that all subsequent
lease payments are made at the start of the month. [Hint: Most software packages include a function
such as the following: PMT (rate,nper,pv,fv,type), where rate = the time value of money; nper = the
number of periods; pv = the present value; fv = the future value; and type = 0 (when the payment is at
9 Based on Laurie Freeman, "Oil Shock: Throw Another Cob on the Fire," Business Week, March12, 2001, p, 16.
450 Chapter 12 I CapITal Budgeting Decisions
the end of the period) or I (when the payment is at the beginning of the period). For monthly payments,
rate should be set at the annual rate divided by 12, and npr should be set at the number of months in
the lease. Here, fv is the residual value. Consider the residual value as a future value and enter it as a
negative number, indicating the lessor has not paid the full cost of the car.]
h. Reevaluate the lease program assuming a down payment of $2,000.
c. Reevaluate the lease program assuming a down payment of $1 ,000 and a $2,000 increase in residual
values.
d. Reevaluate the lease program assuming a down payment of $2,000 and a $2,000 increase in residual
values.
e. What is your final recommendation? What risks are associated with your recommendation? Are there
any other actions to consider?
C12-39. Evaluating Data and Using Payback Period for an Investment Proposal (L03, 5)
To determine the desirability of investing in a 21-inch monitor (as opposed to the typical 17-inch monitor
that comes with a new personal computer), researchers developed an experiment testing the time required
to perform a set of tasks. The tasks included the following:
Setting up a meeting using electronic mail.
Reviewing meeting requests.
Checking an on-line schedule.
Embedding a video file into a document.
Searching a customer database to find a specific set of contracts.
Copying a database into a spreadsheet.
Modifying a slide presentation.
The researchers assumed this was a typical set of tasks performed by a manager. They determined that
there was a 9 percent productivity gain using the 21-inch monitor. One test manager commented that the
largest productivity gain came from being able to have multiple applications open at the same time and from
being able to view several files at once.
ReqUired
Accepting the 9 percent productivity gain as accurate, what additional infom1ation is needed to determine
the payback period of an investment in one 21-inch monitor that is to be used by a manager? Make any
necessary assumptions and obtain whatever data you can (perhaps from computer component advertisements)
to determine the payback period for the proposed investment.
C12-40. IRR and NPV with Performance Evaluation Conflict (L02, 4, 5)

Pepperoni Pizza Company owns and operates fast-service pizza parlors throughout North America. The
firm operates on a regional basis and provides almost complete autonomy to the manager of each region.
Regional managers are responsible for long-range planning, capital expenditures, personnel policies, pricing,
and so forth. Each year the performance of regional managers is evaluated by detennining the accounting
return on fixed assets in their regions; a return of 14 percent is expected. To determine this return, regional
net income is divided by the book value of fixed assets at the start of the year. Managers of regions earning a
return of more than 16 percent are identified for possible promotion, and managers of regions with a return
of less than 12 percent are subject to replacement.
Mr. Light, with a degree in hotel and restaurant management, is the manager of the NOItheast region.
He is regarded as a "rising star" and will be considered for promotion during the next two years. Light has
been with Pepperoni for a total of three years. During that period, the return on fixed assets in his region
(the oldest in the firm) has increased dramatically. He is currently considering a proposal to open five new
parlors in the Boston area. The total project involves an investment of $640,000 and will double the number
of Pepperoni pizzas sold in the Northeast region to a total of 600,000 per year. At an average price of $6
each, total sales revenue will be $3,600,000.
The expenses of operating each of the new parlors include variable costs of $4 per pizza and fixed costs
(excluding depreciation) of $80,904 per year. Because each of the new parlors has only a five-year life and
no salvage value, yearly straight-line depreciation will be $25,600 [($640,000 -;- 5 parlors) -;- 5 years].
Required
a. Evaluate the desirability of the $640,000 investment in new pizza parlors by computing the internal
rate of return and the net present value. Assume a time value of money of 14 percent. (Refer to
Appendix 12B if you use the table approach.)
b. If Light is shrewd, will he approve the expansion? Why or why not? (Additional computations are
suggested.)
C12-41. NPV and Project Reevaluation with Taxes, Straight-Line Depreciation (L02, 5, 6)
In 2007, the Bayside Chemical Company prepared the following analysis of an investment proposal for a
new manufacturing facility:
Because the proposal had a positive net present value when discounted at Bayside's cost of capital of
12 percent, the project was approved; all investments were made at the end of 2008. Shortly after production
began in January 2009, a government agency notified Bayside of required additional expenditures totaling
$200,000 to bring the plant into compliance with new federal emission regulations. Bayside has the option
either to comply with the regulations by December 31,2009, or to sell the entire operation (fixed assets
and working capital) for $250,000 on December 31,2009. The improvements will be depreciated over the
remaining four-year life of the plant using straight-line depreciation. The cost of site restoration will not be
affected by the improvements. If Bayside elects to sell the plant, any book loss can be treated as an offset
against taxable income on other operations. This tax reduction is an additional cash benefit of selling.

(A) (B) (C) (A) x (C)
Initial investment
Fixed assets .......... .............. . $(800,000) 0 1.000 $ (800,000)
Working capital ............. .......... (100,000) 0 1.000 (100,000)
Operations
without depreciation ................. 300,000 1-5 3.605 1,081,500
Taxes on income
($300,000 x 0.34) ................... (102,000) 1-5 3.605 (367,710)
Depreciation tax shield ................. 54,400' 1-5 3.605 196,112
Disinvestment
Site restoration ....................... 80,000 5 0.567 (45,360)
Tax shield of restoration
($80,000 x 0.34) .................... 27,200 5 0.567 15,422
Working capital ...................... 100,000 5 0.567 56,700
Net present value of all cash flows..... $ 36,664
'Computation of depreciation tax shield:

Annual straight-line depreciation ($800,000 -'- 5) . $160,000
Tax rate. x 0.34
Depreciation tax shield .. $ 54,400
Required
a. Should Bayside sell the plant or comply with the new federal regulations? To simplify calculations,
assume that any additional improvements are paid for on December 3 J, 2009.
b. Would Bayside have accepted the proposal in 2008 if it had been aware of the forthcoming federal
regulations?
c. Do you have any suggestions that might increase the project's net present value? (No calculations are
required.)
C12-42. NPV Analysis of Labor-Saving Investment: Cross-Subsidization (L02,5)

Heavy Loading Company's plant has three production departments. Presented are the actual cost functions
for each department (DLH = direct labor hour; MH = machine hour):
DI-Total annual overhead = $150,000 + $5DLH + $12MH

D2-Total annual overhead = $185,000 + $2DLH + $10MH
D3-Total annual overhead = $50,000 + $10DLH
The direct labor rate is $12 per hour in all departments. Departments 1 and 2 are machine intensive;
Department 3 is labor intensive. The fixed overhead in Departments I and 2 is related to building occupancy,
machine depreciation, and machine maintenance. The fixed overhead in Department 3 is related to building
occupancy.
Required
(The requirements are interrelated and concern a decision to introduce labor-saving equipment into
Department 3.)
452 Chapter 12 [ Capital Budgeting Decisions
a. Management is not aware of the actual overhead cost functions. A plantwide overhead rate (based on
the historic relationship between the plant's total annual overhead and total direct labor hours) is used
to assign overhead to departments and products. Presented are the actual number of direct labor hours
and machine hours for a typical year:
Department 1 Department 2 Department 3
Direct labor hours . 2,000 5,000 10,000

Machine hours . 5,000 20,000 o
Determine the plantwide overhead rate per direct labor hour and the annual overhead assigned to
Department 3.
b. Management is concerned about the high cost of products subject to Department 3 manufacturing
operations. It is evaluating a proposal to invest in a machine that would substantially reduce the
labor content of Department 3 operations. The machine would require an initial investment of
$500,000. In addition to fixed maintenance costs of $35,000 per year, the machine would have
operating costs of $15 per machine hour. It is predicted to operate 4,000 hours during a typical
year. Direct labor savings would amount to 7,000 hours per year. The machine is estimated to
have a life of five years with no salvage value. Heavy Loading's cost of capital is 16 percent. In
evaluating the investment proposal, management included overhead cost savings at the plantwide
rate per direct labor hour as determined in requirement (a). Following management's procedures,
determine the investment proposal's net present value. Based on this analysis, indicate whether
management should accept the proposal.
c. Assuming no change in costs (except in Department 3), determine the plantwide overhead rate
per direct labor hour if the proposal is accepted. Why does the rate change from that computed in
requirement (a)? Also determine the annual overhead now assigned to Department 3.
d. Evaluate the decision to invest in the new machine. Was this the correct decision? Why or why not?
(Provide additional analysis as appropriate.)
e. Assume that Heavy Loading did invest in the machine. Because the machine is a special purpose one,
it does not have any resale value, and its scrap value is exactly equal to removal costs. Based on your
analysis in requirement (d), what should management do now?
C12-43. Project Screening and Evaluation with Risk: Multiple Criteria (L01, 2, 3, 4, 5)
Transhemisphere uses a capital budgeting committee to evaluate and approve capital expenditure proposals.
Because the committee is composed of busy executives, a staff has been assigned to assist the committee
in the mechanical aspects of proposal evaluation. As a member of this staff, you have been requested to
evaluate five mutually exclusive capital expenditure proposals.
Transhemisphere uses multiple criteria in evaluating capital expenditure proposals. The criteria are
designed to consider the time period for which monies invested in a project are unavailable for other
purposes, the maximum possible time-adjusted loss on a project, and the time-adjusted relative profitability
of a project. To assist in monitoring accepted proposals, the committee also requests infonnation regarding
the minimum annual cash flows required for a time-adjusted break-even point. The criteria are applied
on a sequential basis, with only proposals that meet the earlier criteria receiving further evaluation. The
following specific procedures are to be followed in the evaluation:
1. Only proposals having an expected bailout and/or payback period of three years or less are subject to
fWiher evaluation. The bailout period is the time it takes to recover the investment in a project from
any source, including disposal.
2. Evaluate the net present value of the pessimistic cash flows associated with each project using
Transhemisphere's cost of capital of 16 percent. Projects whose pessimistic cash flows have a
negative net present value of $50,000 or more are eliminated from further consideration.
3. Rank the remaining projects on the basis of the internal rate of return of their expected cash flows.
(Refer to Appendix 12B if you use the table approach.)
4. For the highest-ranked project, detennine the minimum annual net cash inflows needed to provide an
internal rate of return equal to the company's cost of capital.
Information pertaining to the five capital expenditure proposals you have been asked to evaluate follows in
thousands of dollars (000):
Disposal Value
at End of Year Pessimistic Expected
Initial Annual Net Annual Net
Proposal Investment 2 3 Cash Inflow Life Cash Inflow Life
A $196 $150 $100 $ 0 $ 40 7 years $ 50 10 years

B 500 400 350 0 75 10 years 110 12 years
C 400 300 100 0 40 8 years 50 10 years
0 420 250 200 150 100 7 years 100 10 years
E 250 150 75 0 15 9 years 75 12 years
The nature of the investments is such that none of them has a disposal value after the end of its third year.
Required
a. Following Transhemisphere's capital budgeting procedures, evaluate the five proposals. (Round
calculations to the nearest dollar; do not interpolate.)
b. Regardless of Transhemisphere's procedures, which proposal do you recommend and why?
C12-44. Post-Audit and Reevaluation of Investment Proposal: NPV (L01, 2, 5)

Anthony Company's capital budgeting committee is evaluating a capital expenditure proposal for the
production of a high definition television receiver to be sold as an add-on feature for personal computers.
The proposal calls for an independent contractor to construct the necessary facilities by December 31,
20 I 0, at a total cost of $250,000. Payment for all construction costs will be made on that date. An additional
$50,000 in cash will also be made available on December 31,2010, for working capital to support sales and
production activities.
Management anticipates that the receiver has a limited market life; there is a high probability that
by 2017 all new PCs will have built-in high definition receivers. Accordingly, the proposal specifies that
production will cease on December 31,2016. The investment in working capital will be recovered on that
date, and the production facilities will be sold for $30,000. Predicted net cash inflows from operations for
20 II through 2016 are as follows:
2011 . $100,000
2012 . 100,000
2013 . 100,000
2014 . 40,000
2015 . 40,000
2016 . 40,000
Anthony Company has a time value of money of 16 percent. For capital budgeting purposes, all cash flows
are assumed to occur at the end of each year.
Required
a. Evaluate the capital expenditure proposal using the net present value method. Should Anthony accept
the proposal?
h. Assume that the capital expenditure proposal is accepted, but construction delays caused by labor
problems and difficulties in obtaining the necessary construction permits delay the completion of
the project. Payments totaling $200,000 were made to the construction company on December 31,
2010, for that year's construction. However, completion is now scheduled for December 31, 2011,
and an additional $100,000 will be required to complete construction. If the project is continued, the
additional $100,000 will be paid at the end of 2011, and the plant will begin operations on January I,
2012.
Because of the cost overruns, the capital budgeting committee requests a reevaluation of the
project in early 2011, before agreeing to any additional expenditures. After much effort, the following
revised predictions of net operating cash inflows are developed:
2012 . $120,000
2013 . 100,000
2014 . 40,000
2015 . 40,000
2016 . 40,000
The working capital investment and disinvestment and the plant salvage values have not changed,
except that the cash for working capital would now be made available on December 31, 2011.
Use the net present value method to reevaluate the initial decision to accept the proposal. Given
the information currently available about the project, should it have been accepted in 20 10? (Hint:
Determine the net present value as of December 31,2010, assuming management has not committed
Anthony to the proposal.)
c. Given the situation that exists in early 2011, should management continue or cancel the project?
Assume that the facilities have a cun'ent salvage value of $50,000. (Hint: Assume that the decision is
being made on January I, 2011.)
C12-4S. Post-Audit and Reevaluation of Investment Proposal: IRR (LOi, 2,5)

Throughout his four years in college, Ronald King worked at the local Beef Burger Restaurant in College
City. Although the working conditions were good and the pay was not bad, Ron believed he could do a much
better job of managing the restaurant than the current owner-manager. In particular, Ron believed that the
proper use of marketing campaigns and sales incentives, such as selling a second burger for a 25 percent
discount, could increase annual sales by 50 percent.
Just before graduation in 2009, Ron inherited $500,000 from his great uncle. He seriously considered
buying the restaurant. It seemed like a good idea because he liked the town and its college atmosphere,
knew the business, and always wanted to work for himself. He also knew that the current owner wanted to
sell the restaurant and retire to Florida. As part of a small business management course, Ron developed the
following income statement for the restaurant's 2008 operations:
Beef Burger Restaurant: College City

Income Statement
Sales . $450,000
Expenses
Cost of food . $150,000
Supplies . 20,000
Employee expenses . 140,000
Utilities . 28,000
Property taxes . 20,000
Insurance . 10,000
Advertising . 8,000
Depreciation . 60,000 436,000
Ron believed that the cost of food and supplies were all variable, the employee expenses and utilities
were one-half variable and one-half fixed in 2008, and all other expenses were fixed. If Ron purchased the
restaurant and followed through on his plans, he believed there would be a 50 percent increase in unit sales
volume and all variable costs. Of the fixed costs, only advellising would increase by $12,000. The use of
discounts and special promotions would, however, limit the increase in sales revenue to only 40 percent even
though sales volume increased 50 percent.
Required
Cl. Determine
I. The current annual net cash inflow.
2. The predicted annual net cash inflow if Ron executes his plans and his assumptions are correct.
b. Ron believes his plan would produce equal net cash inflows during each of the next 15 years, the
period remaining on a long-term lease for the land on which the restaurant is built. At the end of that
time, the restaurant would have to be demolished at a predicted net cost of $80,000. Assuming Ron
would otherwise invest the money in stock expected to yield 12 percent, determine the maximum
amount he should pay for the restaurant.
c. Assume that Ron accepts an offer from the current owner to buy the restaurant for $400,000.
Unfortunately, although the expected increase in sales volume does occur, customers make much
more extensive use of the promotions than Ron had anticipated. As a result, total sales revenues are
8 percent below projections. Furthermore, to improve employee attitudes, Ron gave a 10 percent
raise immediately after purchasing the restaurant. Reevaluate the initial decision using the actual
sales revenue and the increase in labor costs, assuming conditions will remain unchanged over the
remaining life of the project. Was the investment decision a wise one? (Round calculations to the
nearest dollar.)
d. Ron can sell the restaurant to a large franchise operator for $300,000. Alternatively, he believes that
additional annual marketing expenditures and changes in promotions costing $20,000 per year could
bring the sales revenues up to their original projections, with no other changes in costs. Should Ron
sell the restaurant or keep it and make the additional expenditures? (Round calculations to the nearest
dollar.) (Hint: Ron has just bought the restaurant.)

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7

L01 Differentiate between product and

PRODUCTION AND SERVICE DEPARTMENT

Department Service Functions Allocation Base

Support Services Receiving and inventory Total amount of department

Amount Total Amount of

'Direct department overhead

BUSINESS INSIGHT Computer Software Aids Telephone service Cost Allocation

EXHIBIT 7.1 low of Costs-Direct Method

Service Support Engineering Building

Product Product Product

service Department Cost Allocations-Direct Method

Total Mixing Bottling

Support Services Department

Cost Allocation Summary

Support Engineering Building and

BUSINESS INSIGHT Cost Allocations for College Services

Provider of Services .•.... S1 S2 P1 P2

Direct allocation of S2 to P1 and P2 .... $0 $(100,000) $50,000 $50,000

The step method is illustrated graphi-

EXHIBIT 7.4 Service Department Cost A1locations-Step Method

Support Building and

Engineering Resources Department

Cost Allocation Summary

Engineering Support Building and

Linear Algebra eciprocal) Metho

EXHIBIT 7.5 Flow of Costs-Unear Algebra Method

Product Product Product

Women's Apparel . $ 60,000 15 15,000

Total Women's Men's

Administrative Services Department

Cost Allocation Summary

Administrative Facilities Women's Men's Total

Allocation base . Number of Amount of

Total Administrative Women's Men's

Facilities Services Department

Cost Allocation Summary

Facilities Administrative Women's Men's Total

LEAN PRODUCTION AND JUST-IN-TIME

BUSINESS INSIGHT The History of Lean Production

RESEARCH INSIGHT Survey Documents Benefits of Lean Production Strategy

1. Developing long-teon relationships with a limited number of vendors.

Re u 9 rk-in- Procpss ·...,·..''''''''n T ' ... I'''1.'

educ' Fin' hed Good Invent

Mercedes Benz Produces Smart Car Using Just-in-Sequence

PERFORMANCE EVALUATION AND

Dysfunctional Effects of Traditional Performance Measures

Performance Measures Under Lean Production and JIT

Inventory turnover = Annual ,demand i~ unit~

Cost of goods sold

GMROI = Gross ~argin

Cycle Setup + Processing + Movement + Waiting + Inspection

" - Processing time

EXHIBIT 7.6 TraditionaJ Perfonnance Report with Standard Costs

Current Period Prior Period

Net sales.......................................... $1,400 100% $1,000 100%

EXHIBIT 7.7 Lean Production Performance Report

Current Prior Percent

Net Sales . $1,400 $1,000 40%

Wages . 140 120 16.7%