MANAGEMENT ACCOUNTING - Solutions Manual

TABLE OF CONTENTS

Chapter 1 1-1 – 1-19

MANAGEMENT ACCOUNTING: AN OVERVIEW
2 Management Accounting and the Business Environment 2-1 – 2-5
3 Understanding of Financial Statements 3-1 – 3-10

4 Financial Statements Analysis – I 4-1 – 4-9

5 Financial Statements Analysis – II 5-1 – 5-38
6 Cash Flow Analysis 6-1 – 6-18
7 Gross Profit Valuation Analysis and Earnings Per Share
Determination 7-1 – 7-7
8 Cost Concepts and Classifications 8-1 – 8-17
9 Cost Behavior: Analysis and Use 9-1 – 9-30
10 Systems Design: Job-Order Costing and Process Costing 10-1 – 10-16
11 Systems Design: Activity-Based Costing and Management 11-1 – 11-15
12 Variable Costing 12-1 – 12-21
13 Cost-Volume-Profit Relationships 13-1 – 13-37

14 Responsibility Accounting and Transfer Pricing 14-1 – 14-26

15 Functional and Activity-Based Budgeting 15-1 – 15-22
16 Standard Costs and Operating Performance Measures 16-1 – 16-17
17 Application of Quantitative Techniques in Planning, Control
and Decision Making - I 17-1 – 17-2
18 Application of Quantitative Techniques in Planning, Control
and Decision Making – II 18-1 – 18-7
19 Relevant Costs for Decision Making 19-1 – 19-33
20 Capital Budgeting Decisions 20-1 – 20-16
21 Decentralized Operations and Segment Reporting 21-1 – 21-4
22 Business Planning 22-1 – 22-6

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23 Strategic Cost Management; Balanced Scorecard 23-1 – 23-4

24 Advanced Analysis and Appraisal of Performance: Financial
and Nonfinancial 24-1 – 24-12
25 Managing Productivity and Marketing Effectiveness 25-1 – 25-19
26 Executive Performance Measures and Compensation 26-1 – 26-3
27 Managing Accounting in a Changing Environment 27-1 – 27-22

CHAPTER 1

MANAGEMENT ACCOUNTING: AN OVERVIEW

I. Questions

1. Use of the word “need” in the quoted passage is pejorative. It implies an

unlimited level of demand for information. However, rational managers
apply a cost-benefit criterion to information and will only want accounting
information if its benefits exceed its costs. Accounting information
provides benefits by improving decision making and controlling behavior
in organizations. In most organizations, accounting information is very
prevalent which implies that its benefits exceed its costs. Hence,
successful managers will find it in their self-interest to learn how to use
accounting information in these organizations.
Clearly, this statement is incurred in those firms where accounting
information has very limited usefulness (e.g., if the accounting
information is often wrong or is not produced in a timely fashion). In these
organizations, managers do not find the accounting information to have
benefits in excess of its costs, will not use it, do not need to know how to
use it, and definitely do not need it.

2. a. Historical costs are of limited use in making planning decisions in a

rapidly changing environment. With changing products, processes

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and prices, the historical costs are inadequate approximations of the

opportunity costs of using resources.
Historical costs may, however, be useful for control purposes, as they
provide information about the activities of managers and can be used
as performance measures to evaluate managers.
b. The purpose of accounting systems is to provide information for
planning purposes and control. Although historical costs are not
generally appropriate for planning purposes, additional measures are
costly to make. An accounting system should include additional
measures if the benefits of improved decision making are greater than
the costs of the additional information.
3. Finance and economics textbooks traditionally state that the goal of a
profit organization is to maximize shareholder wealth. Managers are
frequently presumed to act in the best interest of the shareholder, although
recent finance literature recognizes that appropriate incentives are
necessary to align manager interests with shareholder interests. The goal,
however, are not very clear as to how this is achieved. Most finance
textbooks focus on financing decisions and not on the use of assets and
dealing with customers.
Marketing’s goal of satisfying customers recognizes that customers are the
source of revenues for the organization, and therefore the means through
which shareholder value is increased. However, customer satisfaction is
only valuable insofar as it creates shareholder wealth. The further goal of
marketing is to ensure that customer satisfaction is maximized without
compromising the organization’s profitability.

4. Yes. Planning is really much more vital than control; that is, superior
control is fruitless if faulty plans are being implemented. However,
planning and control are so intertwined that it seems artificial to draw rigid
lines of separation between them.

5. Yes. The controller has line authority over the personnel in his own
department but is a staff executive with respect to the other departments.

6. Line authority is exerted downward over subordinates. Staff authority is

the authority to advise but not command others; it is exercised laterally or
upward. Functional authority is the right to command action laterally and
downward with regard to a specific function or specialty.

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7. Cost accounting is the controller’s primary means of implementing the 7-

point concept of modern controllership. Cost accounting is intertwined
with all seven duties to some extent, but its major focus is on the first three.

8. Bettina Company

President

VP, Production VP, Finance VP, Sales

Controller Treasurer

Assistant Assistant
Controller Treasurer

Special Cost Tax Internal General System &

Studies Accounting Manager Audit Accounting EDP
Manager Manager Manager Manager Manager

Cost Budget & Performance

Systems Standard Analyst
Analyst Cost Analyst

Cost Payroll Accounts Accounts Billing General

Clerk Clerk Receivable Payable Clerk Ledger
Clerk Clerk Bookkeeper

9. Management accountants contribute to strategic decisions by providing

information about the sources of competitive advantage and by helping
managers identify and build a company’s resources and capabilities.

10. In most organizations, management accountants perform multiple roles:

problem solving (comparative analyses for decision making),
scorekeeping (accumulating data and reporting reliable results), and
attention directing (helping managers properly focus their attention).

11. Three guidelines that help management accountants increase their value to
managers are (a) employ a cost-benefit approach, (b) recognize behavioral

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as well as technical considerations, and (c) identify different costs for

different purposes.

12. Management accounting is an integral part of the controller’s function in

an organization. In most organizations, the controller reports to the chief
financial officer, who is a key member of the top management team.

13. Management accountants have ethical responsibilities that are related to

competence, confidentiality, integrity, and objectivity.

14. By reporting and interpreting relevant data, the controller exerts a force or
influence that impels management toward making better-informed
decisions.

The controller of one company described the job as “a business advisor

to…help the team develop strategy and focus the team all the way through
recommendations and implementation.”

15.
Financial Accounting
Audience: External: shareholders, creditors, tax
authorities
Purpose: Report on past performance to external
parties; basis of contracts with owners and
lenders
Timeliness: Delayed; historical
Restrictions: Regulated; rules driven by generally accepted
accounting principles and government
authorities
Type of Information: Financial measurements only
Nature of Information: Objective, auditable, reliable, consistent,
precise
Scope: Highly aggregate; report on entire
organization

Managerial Accounting
Audience: Internal: Workers, managers, executives

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Purpose: Inform internal decisions made by employees

and managers; feedback and control on
operating performance
Timeliness: Current, future oriented
Restrictions: No regulations; systems and information
determined by management to meet strategic
and operational needs
Type of Information: Financial, plus operational and physical
measurements on processes, technologies,
suppliers customers, and competitors
Nature of Information: More subjective and judgmental; valid,
relevant, accurate
Scope: Disaggregate; inform local decisions and
actions

16. The competitive environment has changed dramatically. Companies

encountered severe competition from overseas companies that offered
high-quality products at low prices. Activity-based costing systems are
introduced in many manufacturing and service organizations to overcome
the inability of traditional cost systems to accurately assign overhead costs.
Activity-based management is a viable approach for managers to make
decisions based on ABC information. There has been improvement of
operational control systems such that information is more current and
provided more frequently. The nature of work has changed from
controlling to informing. Firms are concerned about continuous
improvement, employee empowerment and total quality. Nonfinancial
information has become a critical feedback measure. Finally, the focus of
many firms is on measuring and managing activities.

17. As measurements are made on operations and, especially, on individuals

and groups, the behavior of the individuals and groups are affected.
People will react to the measurements being made by focusing on the
variables or behavior being measured. In addition, if managers attempt to
introduce or redesign cost and performance measurement systems, people
familiar with the previous system will resist. Management accountants
must understand and anticipate the reactions of individuals to information
and measurements. The design and introduction of new measurements
and systems must be accompanied with an analysis of the likely reactions
to the innovations.

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II. Exercises

Exercise 1

a. (1) Problem solving

b. (3) Attention-directing
c. (1) Problem solving
d. (2) Scorekeeping

Exercise 2

a. (4) Marketing
b. (3) Production
c. (6) Customer service
d. (5) Distribution

Exercise 3

a. (4) Marketing
b. (3) Production
c. (5) Distribution
d. (4) Marketing
e. (5) Distribution
f. (3) Production
g. (1) Research and development
h. (2) Design

III. Problems

Problem 1 (Problem Solving, Scorekeeping, and Attention Directing)

Because the accountant’s duties are often not sharply defined, some of these
answers might be challenged:
1. Scorekeeping
2. Attention directing
3. Scorekeeping
4. Problem solving
5. Attention directing
6. Attention directing
7. Problem solving

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8. Scorekeeping (depending on the extent of the report) or attention

getting
9. This question is intentionally vague. The give-and-take of the
budgetary process usually encompasses all three functions, but it
emphasizes scorekeeping the least. The main function is attention
directing, but problem solving is also involved.
10. Problem solving

Problem 2 (Management Accounting Information System)

1. Inputs: b, g, i, m
2. Processes: a, d, f, j
3. Outputs: e, k, n
4. System objectives: c, h, l

Problem 3 (Role of Management Accountants)

Planning. The management accountant gains an understanding of the impact

on the organization of planned transactions (i.e., analyzing strengths and
weaknesses) and economic events, both strategic and tactical, and sets
obtainable goals for the organization. The development of budgets is an
example of planning.

Controlling. The management accountant ensures the integrity of financial

information, monitors performance against budgets and goals, and provides
information internally for decision making. Comparing actual performance
against budgeted performance and taking corrective action where necessary is
an example of controlling. Internal auditing is another example.

Evaluating Performance. The management accountant judges and analyzes

the implication of various past and expected events, and then chooses the
optimum course of action. The management accountant also translates data
and communicates the conclusions. Graphical analysis (such as trend, bar
charts, or regression) and reports comparing actual costs with budgeted costs
are examples of evaluating performance.

Ensuring Accountability of Resources. The management accountant

implements a reporting system closely aligned to organizational goals that
contribute to the measurement of the effective use of resources and
safeguarding of assets. Internal reporting such as comparison of actual to
budget is an example of accountability.

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External Reporting. The management accountant prepares reports in

accordance with generally accepted accounting principles and then
disseminates this information to shareholders, creditors, and regulatory tax
agencies. An annual report or a credit application are examples of external
reporting.

Problem 4 (Line Versus Staff)

Jamie Reyes is staff. She is in a support role – she prepares reports and helps
explain and interpret them. Her role is to help the line managers more
effectively carry out their responsibilities.

Stephen Santos is a line manager. He has direct responsibility for producing a

garden hose. Clearly, one of the basic objectives for the existence of a
manufacturing firm is to make a product. Thus, Stephen has direct
responsibility for a basic objective and therefore holds a line position.

Problem 5 (Professional Ethics and End-of-Year Games)

Requirement 1
The possible motivations for the snack foods division wanting to play end-of-
year games include:
(a) Management incentives. Yummy Foods may have a division bonus
scheme based on one-year reported division earnings. Efforts to front-end
revenue into the current year or transfer costs into the next year can
increase this bonus.
(b) Promotion opportunities and job security. Top management of Yummy
Foods likely will view those division managers that deliver high reported
earnings growth rates as being the best prospects for promotion. Division
managers who deliver “unwelcome surprises” may be viewed as less
capable.
(c) Retain division autonomy. If top management of Yummy Foods adopts a
“management by exception” approach, divisions that report sharp
reductions in their earnings growth rates may attract a sizable increase in
top management supervision.

Requirement 2
The “Standards of Ethical Conduct…” require management accountants to:

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 Refrain from either actively or passively subverting the attainment of

the organization’s legitimate and ethical objectives, and
 Communicate unfavorable as well as favorable information and
professional judgment or opinions.

Several of the “end-of-year games” clearly are in conflict with these

requirements and should be viewed as unacceptable by Tan:
(a) The fiscal year-end should be closed on midnight of December 31.
“Extending” the close falsely reports next year’s sales as this year’s sales.
(b) Altering shipping dates is falsification of the accounting reports.
(c) Advertisements run in December should be charged to the current year.
The advertising agency is facilitating falsification of the accounting
records.

The other “end-of-year games” occur in many organizations and may fall into
the “gray” to “acceptable” area. However, much depends on the circumstances
surrounding each one:
(a) If the independent contractor does not do maintenance work in December,
there is no transaction regarding maintenance to record. The responsibility
for ensuring that packaging equipment is well maintained is that of the
plant manager. The division controller probably can do little more than
observe the absence of a December maintenance charge.
(d) In many organizations, sales are heavily concentrated in the final weeks of
the fiscal year-end. If the double bonus is approved by the division
marketing manager, the division controller can do little more than observe
the extra bonus paid in December.
(e) If TV spots are reduced in December, the advertising cost in December
will be reduced. There is no record falsification here.
(g) Much depends on the means of “persuading” carriers to accept the
merchandise. For example, if an under-the-table payment is involved, it
is clearly unethical. If, however, the carrier receives no extra
consideration and willingly agrees to accept the assignment, the
transaction appears ethical.

Each of the (a), (d), (e) and (g) “end-of-year games” may well disadvantage
Yummy Foods in the long run. For example, lack of routine maintenance may
lead to subsequent equipment failure. The divisional controller is well advised
to raise such issues in meetings with the division president. However, if
Yummy Foods has a rigid set of line/staff distinctions, the division president

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is the one who bears primary responsibility for justifying division actions to
senior corporate officers.

Requirement 3

If Tan believes that Ryan wants her to engage in unethical behavior, she should
first directly raise her concerns with Ryan. If Ryan is unwilling to change his
request, Tan should discuss her concerns with the Corporate Controller of
Yummy Foods. Tan also may well ask for a transfer from the snack foods
division if she perceives Ryan is unwilling to listen to pressure brought by the
Corporate Controller, CFO, or even President of Yummy Foods. In the
extreme, she may want to resign if the corporate culture of Yummy Foods is
to reward division managers who play “end-of-year games” that Tan views as
unethical and possibly illegal.

Problem 6
James Torres has come up with a scheme that involves a combination of data
falsification and smoothing! Not only has he made up the revenue numbers,
but also he has had the gall to defer some of them to the next period. Making
up such numbers is clearly illegal. Smoothing, in this example is also illegal
because the numbers are fictitious.

Problem 7
Clearly the vice-president will lose his or her job if you turn him or her in.
Given that this is a major violation of the code of ethics and a violation patent
law, the vice-president could go to jail. Your best course of action is to check
your information and if the vice-president is definitely involved, go
immediately to the VP’s superior (who is probably a senior VP or the company
president). The organization’s attorneys will take over from there.

Problem 8

One option is to do nothing and ignore what you saw, however, this may
violate your own code of ethics and your ethical responsibilities under the
organization’s code of ethics. Given that you want to do something, it is
probably best to start by talking to employees in your organization whose job
it is to deal with ethical issues. If no such employees exist or are available,
you might start by using a decision model. This model incorporated the
following steps:
1. Determine the Facts – What, Who, Where, How
2. Define the Ethical Issue

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3. Identify Major Principles, Rule, Values

4. Specify the Alternatives.
5. Compare Values and Alternatives, See if Clear Decision
6. Assess the Consequences.
7. Make Your Decision.

IV. Cases

Case 1 (Financial vs. Managerial Accounting)

Requirement (a)
Other forward looking information desired in addition to the income statement
information are
1. Disclosure of the components of financial performance, i.e., nature
and source of revenues, various activities, transactions, and other
relevant events affecting the company.
2. Nature and function of the components of income and expenses

Requirement (b)
No. GAAP does not allow capitalization of employee training and advertising
costs even if management feels that they increase the value of the company’s
brand name. The reasons are uncertainty of the future benefits that may be
derived therefrom and difficulty and reliability of their measurement.

Requirement (c)
Detailed information that managers would likely request are analysis of the
significant increases in
1. Sales
2. Cost of sales
3. Payroll
4. Stock and option based compensation
5. Advertising and promotion.

Requirement (d)
Nonmonetary measures:
1. Change in number and profile of customers

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2. Share in the market

3. Who, what and how many are the competitors
4. Product lines offered by the entity vs. Product lines of competitors
5. Sales promotion and advertising activities

Requirement (e)
1. Competitors
2. Employees
3. Prospective creditors

Case 2 (You get what you measure!)

Requirement (a)
Increase in sales to new customers to sales
Too much emphasis on this ratio may lead the sales manager to spend more
time developing business with new customers and disregard the needs of
existing customers. It is therefore possible to lose the business of several key
accounts.

Requirement (b)
Decrease in cost of goods sold to sales
This performance measure could create the following problems:
1. Purchasing goods with poor quality at lower cost and selling them for
the same price.
2. Indiscriminately increasing selling price to widen the profit margin
without regard to competitor’s current prices.
3. If the entity is manufacturing its own goods, managers could try to
economize on costs, i.e., buying poorer quality of materials,
employing unskilled workers, etc. thereby causing deterioration of the
quality of the finished products.

In all of the above situations, customer patronage could eventually be

adversely affected.

Requirement (c)
Decrease in selling and administrative expense to sales

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Cost-cutting is generally advisable for as long as the quality of goods and

services are not compromised. Likewise, certain cost-saving measures could
demotivate sales people and other employees and could lead to counter-
productive activities.

Case 3 (The Roles of Managers and Management Accountants)

1. Managerial accounting, Financial accounting

2. Planning
3. Directing and motivating
4. Feedback
5. Decentralization
6. Line
7. Staff
8. Controller
9. Budgets
10. Performance report
11. Chief Financial Officer
12. Precision; Nonmonetary data

Case 4 (Ethics in Business)

If cashiers routinely short-changed customers whenever the opportunity

presented itself, most of us would be careful to count our change before leaving
the counter. Imagine what effect this would have on the line at your favorite
fast-food restaurant. How would you like to wait in line while each and every
customer laboriously counts out his or her change? Additionally, if you can’t
trust the cashiers to give honest change, can you trust the cooks to take the
time to follow health precautions such as washing their hands? If you can’t
trust anyone at the restaurant would you even want to eat out?

Generally, when we buy goods and services in the free market, we assume we
are buying from people who have a certain level of ethical standards. If we
could not trust people to maintain those standards, we would be reluctant to
buy. The net result of widespread dishonesty would be a shrunken economy
with a lower growth rate and fewer goods and services for sale at a lower
overall level of quality.

Case 5 (Ethics and the Manager)

Requirement 1

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Failure to report the obsolete nature of the inventory would violate the
Standards of Ethical Conduct as follows:

Competence
 Perform duties in accordance with relevant technical standards.
 Prepare complete reports using reliable information.
By failing to write down the value of the obsolete inventory, Perez would not
be preparing a complete report using reliable information. In addition,
generally accepted accounting principles (GAAP) require the write-down of
obsolete inventory.

Integrity
 Avoid conflicts of interest.
 Refrain from activities that prejudice the ability to perform duties
ethically.
 Refrain from subverting the legitimate goals of the organization.
 Refrain from discrediting the profession.
Members of the management team, of which Perez is a part, are responsible
for both operations and recording the results of operations. Since the team will
benefit from a bonus, increasing earnings by ignoring the obsolete inventory
is clearly a conflict of interest. Perez would also be concealing unfavorable
information and subverting the goals of the organization. Furthermore, such
behavior is a discredit to the profession.

Objectivity
 Communicate information fairly and objectively.
 Disclose all relevant information.
Hiding the obsolete inventory impairs the objectivity and relevance of
financial statements.

Requirement 2
As discussed above, the ethical course of action would be for Perez to insist
on writing down the obsolete inventory. This would not, however, be an easy
thing to do. Apart from adversely affecting her own compensation, the ethical
action may anger her colleagues and make her very unpopular. Taking the
ethical action would require considerable courage and self-assurance.

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Case 6 (Preparing an Organization Chart)

Requirement 1
See the organization chart on page 17.

Requirement 2
Line positions would include the university president, academic vice-
president, the deans of the four colleges, and the dean of the law school. In
addition, the department heads (as well as the faculty) would be in line
positions. The reason is that their positions are directly related to the basic
purpose of the university, which is education. (Line positions are shaded on
the organization chart.)

All other positions on the organization chart are staff positions. The reason is
that these positions are indirectly related to the educational process, and exist
only to provide service or support to the line positions.

Requirement 3
All positions would have need for accounting information of some type. For
example, the manager of central purchasing would need to know the level of
current inventories and budgeted allowances in various areas before doing any
purchasing; the vice president for admissions and records would need to know
the status of scholarship funds as students are admitted to the university; the
dean of the business college would need to know his/her budget allowances in
various areas, as well as information on cost per student credit hour; and so
forth.

Case 7 (Ethics in Business)

Requirement 1
No, Santos did not act in an ethical manner. In complying with the president’s
instructions to omit liabilities from the company’s financial statements he was
in direct violation of the IMA’s Standards of Ethical Conduct for Management
Accountants. He violated both the “Integrity” and “Objectivity” guidelines on
this code of ethical conduct. The fact that the president ordered the omission
of the liabilities is immaterial.

Requirement 2
No, Santos’ actions can’t be justified. In dealing with similar situations, the

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Securities and Exchange Commission (SEC) has consistently ruled that

“…corporate officers…cannot escape culpability by asserting that they acted
as ‘good soldiers’ and cannot rely upon the fact that the violative conduct may
have been condoned or ordered by their corporate superiors.” (Quoted from:
Gerald H. Lander, Michael T. Cronin, and Alan Reinstein, “In Defense of the
Management Accountant,” Management Accounting, May, 1990, p. 55) Thus,
Santos not only acted unethically, but he could be held legally liable if
insolvency occurs and litigation is brought against the company by creditors
or others. It is important that students understand this point early in the course,
since it is widely assumed that “good soldiers” are justified by the fact that
they are just following orders. In the case at hand, Santos should have resigned
rather than become a party to the fraudulent misrepresentation of the
company’s financial statements.

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Case 6
Requirement 1

President

Vice
Vice Vice Vice
Academic Vice President,
President, President, President,
President Financial
Auxiliary Admissions & Physical
Services
Services Records Plant
(Controller)

Manager, Manager, Manager,

Manager, Manager, Manager, Manager, Plant
Central University Grounds &
University Computer Accounting & Maintenance
Purchasing Bookstore Custodial
Press Services & Finance
Services

Dean,
Dean, Business Dean, Dean, Dean,
Engineering &
Humanities Fine Arts Law School
Quantitative

(Departments) (Departments) (Departments) (Departments)

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Case 8 (Ethics in Business)

Requirement 1
Andres Romero has an ethical responsibility to take some action in the matter
of PhilChem, Inc. and the dumping of toxic wastes. The Standards of Ethical
Conduct for Management Accountants specifies that management accountants
should not condone the commission of acts by their organization that violate
the standards of ethical conduct. The specific standards that apply are as
follows.
• Competence. Management accountants have a responsibility to
perform their professional duties in accordance with relevant laws and
regulations.
• Confidentiality. Management accountants must refrain from
disclosing confidential information unless legally obligated to do so.
However, Andres Romero may have a legal responsibility to take
some action.
• Integrity. Management accountants have a responsibility to:
- refrain from either actively or passively subverting the attainment
of the organization’s legitimate and ethical objectives.
- communicate favorable as well as unfavorable information and
professional judgments or opinions.
• Objectivity. Management accountants must fully disclose all relevant
information that could reasonably be expected to influence an
intended user’s understanding of the reports, comments, and
recommendations.

Requirement 2
The Standards of Ethical Conduct for Management Accountants indicates that
the first alternative being considered by Andres Romero, seeking the advice of
his boss, is appropriate. To resolve an ethical conflict, the first step is to
discuss the problem with the immediate superior, unless it appears that this
individual is involved in the conflict. In this case, it does not appear that
Romero’s boss is involved.

Communication of confidential information to anyone outside the company is

inappropriate unless there is a legal obligation to do so, in which case Romero
should contact the proper authorities.
Contacting a member of the Board of Directors would be an inappropriate
action at this time. Romero should report the conflict to successively higher
levels within the organization and turn only to the Board of Directors if the

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problem is not resolved at lower levels.

Requirement 3
Andres Romero should follow the established policies of the organization
bearing on the resolution of such conflict. If these policies do not resolve the
ethical conflict, Romero should report the problem to successively higher
levels of management up to the Board of Directors until it is satisfactorily
resolved. There is no requirement for Romero to inform his immediate
superior of this action because the superior is involved in the conflict. If the
conflict is not resolved after exhausting all courses of internal review, Romero
may have no other recourse than to resign from the organization and submit
an informative memorandum to an appropriate member of the organization.
(CMA Unofficial Solution, adapted)

V. Multiple Choice Questions

1. D 11. D 21. B 31. D 41. A 51. B

2. D 12. D 22. B 32. C 42. C 52. B
3. D 13. D 23. A 33. D 43. D 53. A
4. B 14. A 24. A 34. B 44. B 54. C
5. D 15. A 25. B 35. D 45. C 55. D
6. A 16. A 26. C 36. B 46. B 56. C
7. B 17. D 27. B 37. C 47. A 57. C
8. D 18. A 28. D 38. B 48. B 58. C
9. D 19. D 29. B 39. A 49. C 59. A
10. A 20. D 30. C 40. A 50. D 60. B

CHAPTER 2

MANAGEMENT ACCOUNTING
AND THE BUSINESS ENVIRONMENT

I. Questions

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1. Managerial accounting information often brings to the attention of

managers important issues that need their managerial experience and
skills. In many cases, managerial-accounting information will not answer
the question or solve the problem, but rather make management aware that
the issue or problem exists. In this sense, managerial accounting
sometimes is said to serve an attention-directing role.

2. Non-value-added costs are the costs of activities that can be eliminated

with no deterioration of product quality, performance, or perceived value.

3. Managers rely on many information systems in addition to managerial-

accounting information. Examples of other information systems include
economic analysis and forecasting, marketing research, legal research and
analysis, and technical information provided by engineers and production
specialists.

4. Becoming the low-cost producer in an industry requires a clear

understanding by management of the costs incurred in its production
process. Reports and analysis of these costs are a primary function of
managerial accounting.

5. Some activities in the value chain of a manufacturer of cotton shirts are as

follows:
(a) Growing and harvesting cotton
(b) Transporting raw materials
(c) Designing shirts
(d) Weaving cotton material
(e) Manufacturing shirts
(f) Transporting shirts to retailers
(g) Advertising cotton shirts
Some activities in the value chain of an airline are as follows:
(a) Making reservations and ticketing
(b) Designing the route network
(c) Scheduling
(d) Purchasing aircraft
(e) Maintaining aircraft
(f) Running airport operations, including handling baggage
(g) Serving food and beverages in flight
(h) Flying passengers and cargo

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Chapter 8 Cost Concepts and Classifications

6. Strategic cost management is the process of understanding and managing,

to the organization’s advantage, the cost relationships among the activities
in an organization’s value chain.

7. If customers who provide a company with the most profits are attracted,
satisfied, and retained, profits will increase as a result.

8. A value chain is a sequence of business functions whose objective is to

provide a product to a customer or provide an intermediate good or service
in a larger value chain. These business functions include R&D, design,
production, marketing, distribution, and customer service.

An organization can become more effective by focusing on whether each

link in the chain adds value from the customer’s perspective and furthers
the organization’s objectives.

9. Cost: Organizations are under continuous pressure to reduce the

cost of the products or services they sell to their customers.

Quality: Customers are expecting higher levels of quality and are less
tolerant of low quality than in the past.

Time: Time has many components: the time taken to develop and
bring new products to market; the speed at which an
organization responds to customer requests; and the reliability
with which promised delivery dates are met. Organizations
are under pressure to complete activities faster and to meet
promised delivery dates more reliably than in the past in order
to increase customer satisfaction.
Innovation: There is now heightened recognition that a continuing flow of
innovative products or services is a prerequisite for the
ongoing success of most organizations.

10. Managers make planning decisions and control decisions. Planning

decisions include deciding on organization goals, predicting results under
various alternative ways of achieving those goals, and then deciding how
to attain the desired goals. Control decisions include taking actions to
implement the planning decisions and deciding on performance evaluation
and feedback that will help future decision making.

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 Cost Concepts and Classifications Chapter 8

11. Four themes for managers to attain success are customer focus, value-
chain and supply-chain analysis, key success factors, and continuous
improvement and benchmarking.

12. Companies add value through R&D; design of products, services, or

processes; production; marketing; distribution; and customer service.
Managers in all business functions of the value chain are customers of
management accounting information.

13. This phrase means that people will direct their attention to work primarily
on those tasks that management monitors and measures. Employees may
not pay as much attention (or no attention) to tasks that are not measured.
Often management will reward people based on how well they perform
relative to a specific measure. As an example, in a manufacturing
organization, if people are measured and rewarded based on the number
of outputs per hour, regardless of quality, employees will focus their
attention on producing as many units of output as possible. A negative
consequence is that the quality of output may suffer.

14. Some of these new measures are quality, speed to market, cycle time,
flexibility, complexity and productivity.

15. Customer satisfaction is often thought to be a qualitative measure of

performance as one cannot directly observe “satisfaction.” However,
using attitude surveys and psychological measurements, customer
satisfaction can be measured in quantitative terms. For instance, people
who design surveys often employ attitude scales that ask questions in
which customers respond on a 1 to 5 scale. These values can be summed
and averaged to determine satisfaction scores.

16.
Stakeholders Contribution Requirements
Employees Effort, skills, Rewards, interesting
information jobs, economic
security, proper
treatment

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Chapter 8 Cost Concepts and Classifications

Partners Goods, services, Financial rewards

information commensurate with
the risk taken
Owners Capital Financial rewards
Community Allows the Conformance to laws,
organization to good corporate
operate and does not citizenship and,
oppose its operation perhaps, leadership

17. Competitive benchmarking is an organization’s search for, and

implementation of, the best way to do something as practiced in other
organizations.

Continuous improvement is the relentless search to (1) document,

understand, and improve the activities that the organization undertakes to
meet its customers’ requirement, (2) eliminate processing activities that do
not add product features that customers value, and (3) improve the
performance of activities that increase customer value or satisfaction.

18. A value-added activity is an activity that, if eliminated, would reduce the

product’s service to the customer in the long run.

An activity that cannot be classified as value-added is a nonvalue-added

activity:
a. Value-added
b. Nonvalue-added
c. Nonvalue-added
d. Value-added
e. Nonvalue-added
f. Nonvalue-added
g. Value-added
h. Value-added
i. Nonvalue-added
j. Value-added

19. Just-in-time means making a good or service only when the customer,
internal or external, requires it. Just-in-time requires a product layout with
a continuous flow (no delays) once production starts. It means that setup
costs must be reduced substantially to eliminate the need to produce in

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 Cost Concepts and Classifications Chapter 8

batches, and it means that processing systems must be reliable. Just-in-

time production is based on the elimination of all nonvalue-added
activities to reduce cost and time. It is an approach to improvement that
is continuous and involves employee empowerment and involvement.

20. Managerial accounting is concerned with providing information to

managers for use within the organization. Financial accounting is con-
cerned with providing information to stockholders, creditors, and others
outside of the organization.

21. A strategy is a game plan that enables a company to attract customers by

distinguishing itself from competitors. The focal point of a company’s
strategy should be its target customers.

II. Multiple Choice Questions

11. B 21. A 31. B

12. A 22. B 32. C
13. D 23. C 33. C
14. A 24. D
15. D 25. A
16. A 26. A
17. C 27. B
18. B 28. C
19. D 29. B
20. B 30. A

CHAPTER 3

UNDERSTANDING FINANCIAL STATEMENTS

I. Questions

1. A financial statement is a means of communicating information about an

enterprise in financial (i.e., peso) terms. It represents information that the
accountant believes is a true and fair representation of the financial activity
of the enterprise.

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Chapter 8 Cost Concepts and Classifications

2. Every financial statement relates to time in one way or another. A

statement of financial position, or balance sheet, represent a “picture” of
the enterprise at a point in time (e.g., the end of a month or year). An
income statement and a statement of cash flows, on the other hand, cover
activity that took place over a period of time (e.g., a month or year).

3. a. Creditors are interested in financial statements to assist them in

evaluating the ability of a business to repay its debts. No one wants
to extend credit to a company that is unable to meet its obligations as
they come due.
b. Potential investors use financial statements in selecting among
alternative investment opportunities. They are interested in investing
in companies in which the value of their investment will increase as a
result of future profitable operations.
c. Labor unions are interested in financial statements because the
financial position of a company and its profits are important factors in
the company’s ability to pay higher wages and to employ more people.

4. Business transactions affect a company’s financial position, and as a result

they change the statement of financial position or balance sheet. The other
financial statements – the income statement and the statement of cash
flows – are detailed expansions of certain aspects of the statement of
financial position and help explain how the company’s position changed
over time.
5. The cost principle indicates that many assets are included in the financial
records, and therefore, in the statement of financial position, at their
original cost to the reporting enterprise. This principle affects accounting
for assets in several ways, one of which is that the amount of most assets
is not adjusted periodically for changes in the market value of the assets.
Instead, cost is retained as the basic method of accounting, regardless of
changes in the market value of those assets.

6. The going concern assumption states that in the absence of evidence to the
contrary (i.e., bankruptcy proceedings), an enterprise is expected to
continue to operate in the foreseeable future. This means, for example,
that it will continue to use the assets it has in its financial statements for
the purpose for which they were acquired.

7. The three categories and the information included in each are:

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 Cost Concepts and Classifications Chapter 8

Operating activities – Cash provided by and used in revenue and expense

transactions.
Investing activities – Cash provided by and used as a result of investments
in assets, such as machinery, equipment, land, and buildings.
Financial activities – Cash provided by and used in debt and equity
financing, such as borrowing and repaying loans, and investments from
and dividends paid to the enterprise’s owners.

8. Adequate disclosure refers to the requirement that financial statements,

including accompanying notes, must include information necessary for
reasonably informed users of financial statements to understand the
company’s financial activities. This requirement is often met, in part, by
the addition of notes to the financial statements. Financial statement notes
include both quantitative and qualitative information that is not included
in the body of the financial statements.

9. A strong income statement is one that has significantly more pesos of

revenue than expenses, resulting in net income that is a relatively high
percentage of the revenue figure. A trend of relatively high income
numbers over time signals a particularly strong income situation.

10. A strong statement of cash flows is one that shows significant amounts of
cash generated from operating activities. This means that the enterprise is
generating cash from its ongoing activities and is not required to rely on
continuous debt and equity financing, or the sale of its major assets.

11. The purpose of classifications in financial statements is to develop useful

subtotals, which help users analyze the statements. The most commonly
used classifications are:
In a balance sheet: current assets, plant and equipment, other assets,
current liabilities, long-term liabilities and equity.
In a multiple-step income statement: revenue, cost of goods sold,
operating expenses, and nonoperating items. The operating expense
section often includes subclassifications for selling expenses and for
general and administrative expenses.
In a statement of cash flows: operating activities, investing activities, and
financing activities.

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Chapter 8 Cost Concepts and Classifications

12. In classified financial statements, similar items are grouped together to

produce subtotals which may assist users in their analyses. Comparative
financial statements show financial statements for two or more time
periods in side-by-side columns. Consolidated statements include not
only the financial statement amounts for the company itself but also for
any subsidiary companies that it owns. The financial statements of large
corporations often possess all three of these characteristics.

13. In a multiple-step income statement, different categories of expenses are

deducted from revenue in a series of steps, thus resulting in various
subtotals, such as gross profit and operating income. In a single-step
income statement, all expenses are combined and deducted from total
revenue in a single step. Both formats result in the same amount of net
income.

II. Matching Type

1.
1. d 3. a 5. e 7. f 9. c
2. g 4. j 6. h 8. b 10. i

2.
1. d 3. i 5. m 7. h 9. f 11. b 13. e
2. a 4. g 6. c 8. n 10. k 12. j 14. l

3.
a. F c. F e. I g. F I. I k. F
b. I d. I f. F h. F j. F l. I

III. Problems

Problem 1 (Preparing a Balance Sheet – A Second Problem)

Requirement (a)
SM Farms
Balance Sheet
September 30, 2005

Assets Liabilities and Equity

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 Cost Concepts and Classifications Chapter 8

Cash Liabilities:

P 16,710
Accounts Notes
receivable 22,365 payable P530,000

Land Accounts
payable 77,095
550,000
Barns and sheds 78,300 Property taxes
payable 9,135
Citrus trees 76,650 Wages
payable 1,820
Livestock 120,780
Total
liabilities P618,050
Irrigation system 20,125 Equity:
Farm machinery 42,970 Share
capital 250,000
Fences & gates 33,570 Retained
earnings* 93,420
Total Total
P961,470
P961,470

* Total assets, P961,470, minus total liabilities, P618,050, less share capital,
P250,000.

Requirement (b)
The loss of an asset, Barns and Sheds, from a typhoon would cause a decrease
in total assets. When total assets are decreased, the balance sheet total of
liabilities and equity must also decrease. Since there is no change in liabilities
as a result of the destruction of an asset, the decrease on the right-hand side of
the balance sheet must be in the retained earnings account. The amount of the
decrease in Barns and Sheds, in the equity, and in both balance sheet totals, is
P23,800.
Problem 2 (Preparing a Balance Sheet and Cash Flow Statement; Effects
of Business Transactions)

Requirement (a)

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Chapter 8 Cost Concepts and Classifications

The Tasty Bakery

Balance Sheet
August 1, 2005

Assets Liabilities and Equity

Cash Liabilities:

P 6,940
Accounts Notes
receivable 11,260 payable P
74,900
Supplies 7,000 Accounts
payable 16,200
Land Salaries
payable 8,900
67,000
Building 84,000
Total
liabilities P100,000
Equipment and fixtures Equity:
44,500
Share
capital 80,000
Retained
earnings 40,700
Total Total
P220,700
P220,700

Requirement (b)
The Tasty Bakery
Balance Sheet
August 3, 2005

Assets Liabilities and Equity

Cash Liabilities:

P 14,490
Accounts Notes
receivable 11,260 payable P
74,900

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 Cost Concepts and Classifications Chapter 8

Supplies 8,250 Accounts

payable 7,200
Land Salaries
payable 8,900
67,000
Building 84,000
Total
liabilities P 91,000
Equipment and fixtures Equity:
51,700
Share
capital 105,000
Retained
earnings 40,700
Total Total
P236,700
P236,700

The Tasty Bakery

Statement of Cash Flows
For the Period August 1 - 3, 2005

Cash flows from

operating activities:
Cash payment of P(16,200)
accounts payable
Cash purchase of (1,250)
supplies
Cash used in P(17,450)
operating activities

Cash flows from

investing activities:
None

Cash flows from

financing activities:

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Chapter 8 Cost Concepts and Classifications

Sale of share capital P25,000

Increase in cash P 7,550

Cash balance, August 1, 6,940
2005
Cash balance, August 3, P14,490
2005

Requirement (c)
The Tasty Bakery is in a stronger financial position on August 3 than it was on
August 1.

On August 1, the highly liquid assets (cash and accounts receivable) total only
P18,200, but the company has P25,100 in debts due in the near future (accounts
payable plus salaries payable).

On August 3, after additional infusion of cash from the sale of stock, the liquid
assets total P25,750, and debts due in the near future amount to P16,100.

Note to Instructor: The analysis of financial position strength in requirement

(c) is based solely upon the balance sheets at August 1 and August 3.
Hopefully, students will raise many legitimate issues regarding necessity of
information about operations, rate at which cash flows into the business, etc.
In this problem, the improvement in financial position results solely from the
sale of share capital.

Problem 3 (Preparing Financial Statements; Effects of Business

Transactions)

Requirement (a)
The First Malt Shop
Balance Sheet
September 30, 2005

Assets Liabilities and Equity

Cash Liabilities:

P 7,400

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 Cost Concepts and Classifications Chapter 8

Accounts receivable 1,250 Notes

payable* P
70,000
Supplies 3,440 Accounts
payable 8,500
Land
Total
55,000 liabilities P 78,500
Building 45,500 Equity:
Share
capital 50,000
Furniture & fixtures Retained
20,000 earnings 4,090
Total Total
P132,590
P132,590

* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500, equals
notes payable.

Requirement (b)
The First Malt Shop
Balance Sheet
October 6, 2005

Assets Liabilities and Equity

Cash Liabilities:

P 29,400
Accounts receivable 1,250 Notes
payable P
70,000
Supplies 4,440 Accounts
payable 18,000
Land
Total
55,000 liabilities P 88,000
Building 45,500 Equity:
Share
capital 80,000

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Chapter 8 Cost Concepts and Classifications

Furniture & fixtures Retained

38,000 earnings 5,590
Total Total
P173,590
P173,590

The First Malt Shop

Income Statement
For the Period October 1-6, 2005

Revenues P 5,500
Expenses (4,000)
Net income P 1,500

The First Malt Shop

Statement of Cash Flows
For the Period October 1-6, 2005

Cash flows from operating

activities:
Cash received from P5,500
revenues
Cash paid for expenses (4,000)
Cash paid for accounts (8,500)
payable
Cash paid for supplies
(1,000)
Cash used in P(8,000)
operating activities
Cash flows from investing
activities:
None
Cash flows from financing
activities:

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 Cost Concepts and Classifications Chapter 8

Cash received from sale P30,000

of share capital
Increase in cash P
22,000
Cash balance, October 1, 7,400
2005
Cash balance, October 6, P29,400
2005

Requirement (c)
The First Malt Shop is in a stronger financial position on October 6 than on
September 30. On September 30, the company had highly liquid assets (cash
and accounts receivable) of P8,650, which barely exceeded the P8,500 in
liabilities (accounts payable) due in the near future. On October 6, after the
additional investment of cash by shareholders, the company’s cash alone
exceeded its short-term obligations.

Problem 4 (Preparing a Balance Sheet; Discussion of Accounting

Principles)

Requirement (1)
Fil-Cinema Scripts
Balance Sheet
November 30, 2005

Assets Liabilities and Equity

Cash Liabilities:

P 3,940
Notes receivable 2,200 Notes
payable P
73,500
Accounts receivable 2,450 Accounts
payable 32,700

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Chapter 8 Cost Concepts and Classifications

Land
Total
39,000 liabilities P106,200
Building 54,320 Equity:
Share
capital 5,000
Office furniture* 12,825 Retained
earnings 3,535
Total Total
P114,735
P114,735

* P8,850 + P6,500 –
P2,525.

Requirement (2)
(1) The cash in Cruz’s personal savings account is not an asset of the business
entity Fil-Cinema Scripts and should not appear in the balance sheet of the
business. The money on deposit in the business bank account (P3,400)
and in the company safe (P540) constitute cash owned by the business.
Thus, the cash owned by the business at November 30 totals P3,940.

(2) The years-old IOU does not qualify as a business asset for two reasons.
First, it does not belong to the business entity. Second, it appears to be
uncollectible. A receivable that cannot be collected is not viewed as an
asset, as it represents no future economic benefit.

(3) The total amount to be included in “Office furniture” for the rug is P9,400,
the total cost, regardless of whether this amount was paid in cash.
Consequently, “Office furniture” should be increased by P6,500. The
P6,500 liability arising from the purchase of the rug came into existence
prior to the balance sheet date and must be added to the “Notes payable”
amount.
(4) The computer is no longer owned by Hollywood Scripts and therefore
cannot be included in the assets. To do so would cause an overstatement
of both assets and equity. The “Office furniture” amount must be reduced
by P2,525.

(5) The P22,400 described as “Other assets” is not an asset, because there is
no valid legal claim or any reasonable expectation of recovering the
income taxes paid. Also, the payment of income taxes by Cruz was not a

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 Cost Concepts and Classifications Chapter 8

business transaction by Fil-Cinema Scripts. If a refund were obtained

from the government, it would come to Cruz personally, not to the
business entity.

(6) The proper valuation for the land is its historical cost of P39,000, the
amount established by the transaction in which the land was purchased.
Although the land may have a current fair value in excess of its cost, the
offer by the friend to buy the land if Cruz would move the building appears
to be mere conversation rather than solid, verifiable evidence of the fair
value of the land. The “cost principle,” although less than perfect,
produces far more reliable financial statements than would result if owners
could “pull figures out of the air” in recording asset values.

(7) The accounts payable should be limited to the debts of the business,
P32,700, and should not include Cruz’s personal liabilities.

IV. Multiple Choice Questions

21. D 31. B 21. B 31. B

22. D 32. C 22. C 32. D
23. D 33. D 23. A 33. D
24. B 34. A 24. B 34. D
25. A 35. D 25. A 35. C
26. B a. A 26. D 36. A
27. D 17. A 27. B 37. A
28. C 18. B 28. B 38. C
29. B 19. C 29. D
30. C 20. C 30. C
CHAPTER 4

FINANCIAL STATEMENTS ANALYSIS - I

I. Questions

1. The objective of financial statements analysis is to determine the extent of

a firm’s success in attaining its financial goals, namely:
a. To earn maximum profit

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Chapter 8 Cost Concepts and Classifications

b. To maintain solvency
c. To attain stability

2. Some of the indications of satisfactory short-term solvency or working

capital position of a business firm are:
1. Favorable credit position
2. Satisfactory proportion of cash to the requirements of the current
volume
3. Ability to pay current debts in the regular course of business
4. Ability to extend more credit to customers
5. Ability to replenish inventory promptly

3. These tests are:

1. Improvement in the financial position
2. Well-balanced financial structure between borrowed funds and
equity
3. Effective employment of borrowed funds and equity
4. Ability to declare satisfactory amount of dividends to shareholders
5. Ability to withstand adverse business conditions
6. Ability to engage in research and development in an attempt to
provide new products or improve old products, methods or
processes

4. Some indicators of managerial efficiency are:

1. Ability to earn a reasonable return on its investment of borrowed
funds and equity
2. Ability to control operating costs within reasonable limits
3. No overinvestment in fixed assets, receivables and inventories

5. The techniques used in Financial Statement Analysis are:

I. Vertical analysis which shows the relationships of the items in the
same year: also referred to as “static measure.”
a. Financial ratios
b. Common-size statements

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 Cost Concepts and Classifications Chapter 8

II. Horizontal analysis which shows the changes or tendencies of an

item for 2 or more years; also referred to as “dynamic measure.”
a. Comparative statements - showing changes in absolute
amount and percentages
b. Trend percentages

III. Use of special reports or statements

a. Statements of Changes in Financial Position
b. Gross Profit / Net Income Variation Analysis

6. Refer to page 133 of the textbook.

7. Horizontal analysis involves the comparison of items on financial

statements between years. Analysis of comparative financial statements
or the increase/decrease method of analysis and trend percentages are the
two techniques that may be applied under horizontal analysis.

Vertical analysis involves the study of items on a single statement for a

single year, such as the analysis of an income statement for some given
year. Common-size statement and financial ratios are techniques used in
vertical analysis.

8. Trends can indicate whether a situation is improving, remaining the same

or deteriorating. They can also give insight to the probable future course
of events in a firm.

9. Trend percentages represent the expression of several years’ financial data

in percentage form in terms of a base year.

10. Refer to page 133 of the textbook.

11. Observation of trends is useful primarily in determining whether a

situation is improving, worsening, or remaining constant. By comparing
current data with similar data of prior periods we gain insight into the
direction in which future results are likely to move.

Some other standards of comparison include comparison with other

similar companies, comparison with industry standards, and comparison
with previous years’ information. By comparing analytical data for one
company with some independent yardstick, the analyst hopes to determine

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Chapter 8 Cost Concepts and Classifications

how the position of the company in question compares with some standard
of performance.

12. Trend percentages are used to show the increase or decrease in a financial
statement amount over a period of years by comparing the amount in each
year with the base-year amount. A component percentage is the
percentage relationship between some financial amount and a total of
which it is a part.

Measuring the change in sales over a period of several years would call
for use of trend percentages. The sales in the base year are assigned a
weight of 100%. The percentage for each later year is computed by
dividing that year’s sales by the sales in the base year.

13. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Premiere is apparently having
difficulty in effectively controlling its expenses.

14. A corporate net income of P1 million would be unreasonably low for a

large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by investing
in insured bank savings accounts or in government bonds which would be
virtually risk-free and would pay a higher return.

On the other hand, a profit of P1 million would be unreasonably high for

a corporation which had sales of only P5 million, assets of, say, P3 million,
and equity of perhaps one-half million pesos. In other words, the net
income of a corporation must be judged in relation to the scale of
operations and the amount invested.

II. True or False

1. True 3. True 5. False 7. True 9. True

2. False 4. True 6. False 8. False 10. True

III. Problems

Problem 1 (Percentage Changes)

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 Cost Concepts and Classifications Chapter 8

a. Accounts receivable decreased 16% (P24,000 decrease  P150,000 = 16%

decrease).
b. Marketable securities decreased 100% (P250,000 decrease  P250,000 =
100% decrease).
c. A percentage change cannot be calculated because retained earnings
showed a negative amount (a deficit) in the base year and a positive
amount in the following year.
d. A percentage change cannot be calculated because of the zero amount of
notes receivable in 2005, the base year.
e. Notes payable increased 7 ½% (P60,000 increase  P800,000 = 7 ½%
increase).
f. Cash increased 3% (P2,400 increase  P80,000 = 3% increase).
g. Sales increased 10% (P90,000 increase  P900,000 = 10% increase).

Problem 2 (Computing and Interpreting Rates of Change)

Requirement (a)
Computation of percentage changes:
1. Net sales increased 10% (P200,000 increase  P2,000,000 = 10%
increase).
2. Total expenses increased 11% (P198,000 increase  P1,800,000 = 11%
increase).

Requirement (b)
1. Total expenses grew faster than net sales. Net income cannot also have
grown faster than net sales, or the sum of the parts would exceed the size
of the whole.
2. Net income must represent a smaller percentage of net sales in 2006 than
it did in 2005. Again, the reason is that the expenses have grown at a faster
rate than net sales. Thus, total expenses represent a larger percentage of
total sales in 2006 than in 2005, and net income must represent a smaller
percentage.

Problem 3 (Financial Statement Analysis using Comparative Statements

or Increase-Decrease Method)

Requirement 1

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Chapter 8 Cost Concepts and Classifications

XYZ Corporation
Balance Sheet
As of December 31
Change
Peso %
2005 2006
Assets
Cash and equivalents 14,000 16,000 2,000 14.29%
Receivables 28,800 55,600 26,800 93.06%
Inventories 54,000 85,600 31,600 58.52%
Prepayments and others 4,800 7,400 2,600 54.17%
Total current assets 101,600 164,600 63,000 62.01%
Property, plant & equipment - net
of dep. 30,200 73,400 43,200 143.05%
Total assets 131,800 238,000 106,200 80.58%

Liabilities and Equity

Notes payable to banks 10,000 54,000 44,000 440.00%
Accounts payable 31,600 55,400 23,800 73.32%
Accrued liabilities 4,200 6,800 2,600 61.90%
Income taxes payable 5,800 7,000 1,200 20.69%
Total current liabilities 51,600 123,200 71,600 138.76%
Share capital 44,600 44,600 0 0.00%
Retained earnings 35,600 70,200 34,600 97.19%
Total equity 80,200 114,800 34,600 43.14%
Total liabilities and equity 131,800 238,000 106,200 80.58%

XYZ Corporation
Income Statement
Years ended December 31
(P thousands)
Change
Peso %
2005 2006
Net sales 266,400 424,000 157,600 59.16%
Cost of goods sold 191,400 314,600 123,200 64.37%
Gross profit 75,000 109,400 34,400 45.87%
Selling, general and administrative
expenses 35,500 58,400 22,900 64.51%
Income before income taxes 39,500 51,000 11,500 29.11%
Income taxes 12,300 16,400 4,100 33.33%
Net income 27,200 34,600 7,400 27.21%

Requirement 2

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Short-term financial position

1. Current Current
increased by 62.01% while increased by 138.76%
Assets Liabilities
 Unfavorable
2. Quick Current
increased by 62.40% while increased by 138.76%
Assets Liabilities
 Unfavorable
3. Net Accounts
increased by 59.16% while increased by 93.06%
Sales Receivable
 Unfavorable
4. Cost of Inventories
increased by 64.37% while increased by 58.52%
Goods Sold
 Favorable
Leverage
5. Total Total
increased by 80.58% while increased by 138.76%
Assets Liabilities
 Unfavorable
6. Total Total
increased by 138.76% while increased by 43.14%
Liabilities Equity
 Unfavorable
Profitability
7. Net Cost of
increased by 59.16% while increased by 64.37%
Sales Goods Sold
 Unfavorable

8. Net Selling,
Sales increased by 59.16% while General & increased by 64.51%
Administrative
Expenses
 Unfavorable
9. Net Net
increased by 59.16% while increased by 27.21%
Sales Income
 Unfavorable
10. Net Total
increased by 27.21% while increased by 80.58%
Income Assets
 Unfavorable

Problem 4 (Trend Percentages)

Requirement (1)
The trend percentages are:
Year 5 Year 4 Year 3 Year 2 Year 1
Sales 125.0 120.0 110.0 105.0 100.0

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Cash 80.0 90.0 105.0 110.0 100.0

Accounts receivable 140.0 124.0 108.0 104.0 100.0
Inventory 112.0 110.0 102.0 108.0 100.0
Total current assets 118.8 113.1 104.1 106.9 100.0

Current liabilities 130.0 106.0 108.0 110.0 100.0

Requirement (2)
Sales: The sales are increasing at a steady rate, with a particularly
strong gain in Year 4.

Assets: Cash declined from Year 3 through Year 5. This may have been
due to the growth in both inventories and accounts receivable.
In particular, the accounts receivable grew far faster than sales
in Year 5. The decline in cash may reflect delays in collecting
receivables. This is a matter for management to investigate
further.

Liabilities: The current liabilities jumped up in Year 5. This was probably

due to the buildup in accounts receivable in that the company
doesn’t have the cash needed to pay bills as they come due.

Problem 5 (Use of Trend Percentages)

a. 1. An unfavorable tendency could be observed in Receivables in relation

to Net Sales from 2003 – 2005 because receivables had been
increasing at a much faster rate than Net Sales. This could indicate
inefficiency in the collection of receivables or simply poor company
credit policy. The situation however, improved in 2006 and 2007
when sales started to move up at a faster rate than accounts receivable.
This would indicate improvement in the credit and collection policy
or more cash sales were being generated.
2. Unfavorable tendency in inventory persisted from 2003 to 2007
because it had been going up at a much faster rate than Net Sales. If
this continues, the company will end up with over-investment in
inventory because the buying rate is faster than the selling price.

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3. Favorable tendencies could be noted in Fixed Assets in relation to Net

Sales because inspite of the minimal additions to fixed assets made by
the company from 2003 through 2007, sales had been increasing at a
very encouraging rate.
4. Net Income had likewise been increasing at a much faster rate than net
sales. This is favorable because this would indicate that the company
had been successfully controlling the increases in Cost of Sales and
Operating Expenses.
b. Review computations of the Trend Percentages. It will be noted that the
Trend Percentages in Total Noncurrent Liabilities and Equity from 2005
to 2007 were interchanged. Correction should be made first before
interpretation is done.
1. The upward tendency in current assets had been accompanied by an
upward trend in current liabilities. It could be noted that current assets
had been moving up at a much faster rate than current liabilities. This
is favorable because the margin of safety of the short-term creditors is
widened.
2. Favorable tendencies could also be observed in noncurrent assets
which had been increasing and which increases had been accompanied
by downward trend in noncurrent liabilities. This would mean better
security on the part of creditors and stronger financial position.
3. There is an unfavorable tendency in Net Sales in relation to non-
current assets. Sales had not been increasing at the same rate as the
increases in fixed assets. This could indicate that more investments
are made in noncurrent assets without considering whether or not they
could sell the additional units of product they are producing.
c. The unfavorable trend in net income could be attributed to the following
tendencies:
1. Higher rates of increases in cost of sales as compared to sales.
2. Higher rates of increases in selling, general and administrative
expenses in relation to net sales.
3. Higher rates of increases in other financial expenses than the rates of
increases in net sales

IV. Multiple Choice Questions

31. D 36. A, C, D

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Chapter 8 Cost Concepts and Classifications

32. A 37. B*
33. A 38. D
34. B
35. D
36. C
37. C
38. A
39. D
40. C

* (P400,000 – P160,000)  P160,000 = 150%

CHAPTER 5

FINANCIAL STATEMENTS ANALYSIS - II

I. Questions

1. By looking at trends, an analyst hopes to get some idea of whether a

situation is improving, remaining the same, or deteriorating. Such
analyses can provide insight into what is likely to happen in the future.
Rather than looking at trends, an analyst may compare one company to
another or to industry averages using common-size financial statements.

2. Ratios highlight relationships, movements, and trends that are very

difficult to perceive looking at the raw underlying data standing alone.
Also, ratios make financial data easier to grasp by putting the data into
perspective. As to the limitation in the use of ratios, refer to page 129.

3. Price-earnings ratios are determined by how investors see a firm’s future

prospects. Current reported earnings are generally considered to be useful
only so far as they can assist investors in judging what will happen in the
future. For this reason, two firms might have the same current earnings,
but one might have a much higher price-earnings ratio if investors view it

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 Cost Concepts and Classifications Chapter 8

to have superior future prospects. In some cases, firms with very small
current earnings enjoy very high price-earnings ratios. This is simply
because investors view these firms as having very favorable prospects for
earnings in future years. By definition, a stock with current earnings of P4
and a price-earnings ratio of 20 would be selling for P80 per share.

4. A manager’s financing responsibilities relate to the acquisition of assets

for use in his or her company. The acquisition of assets can be financed
in a number of ways, including through issue of ordinary shares, through
issue of preference shares, through issue of long-term debt, through
leasing, etc. A manager’s operating responsibilities relate to how these
assets are used once they have been acquired. The return on total assets
ratio is designed to measure how well a manager is discharging his or her
operating responsibilities. It does this by looking at a company’s income
before any consideration is given as to how the income will be distributed
among capital resources, i.e., before interest deductions.

5. Financial leverage, as the term is used in business practice, means

obtaining funds from investment sources that require a fixed annual rate
of return, in the hope of enhancing the well-being of the ordinary
shareholders. If the assets in which these funds are invested earn at a rate
greater that the return required by the suppliers of the funds, then leverage
is positive in the sense that the excess accrues to the benefit of the ordinary
shareholders. If the return on assets is less than the return required by the
suppliers of the funds, then leverage is negative in the sense that part of
the earnings from the assets provided by the ordinary shareholders will
have to go to make up the deficiency.

6. How a shareholder would feel would depend in large part on the stability
of the firm and its industry. If the firm is in an industry that experiences
wide fluctuations in earnings, then shareholders might be very pleased that
no interest-paying debt exists in the firm’s capital structure. In hard times,
interest payments might be very difficult to meet, or earnings might be so
poor that negative leverage would result.

7. No, the stock is not necessarily overpriced. Book value represents the
cumulative effects on the balance sheet of past activities evaluated using
historical prices. The market value of the stock reflects investors’ beliefs
about the company’s future earning prospects. For most companies
market value exceeds book value because investors anticipate future
growth in earnings.

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8. A company in a rapidly growing technological industry probably would

have many opportunities to invest its earnings at a high rate of return; thus,
one would expect it to have a low dividend payout ratio.

9. It is more difficult to obtain positive financial leverage from preference

shares than from long-term debt due to the fact that interest on long-term
debt is tax deductible, whereas dividends paid on preference shares are not
tax deductible.

10. The current ratio would probably be highest during January, when both
current assets and current liabilities are at a minimum. During peak
operating periods, current liabilities generally include short-term
borrowings that are used to temporarily finance inventories and
receivables. As the peak periods end, these short-term borrowings are paid
off, thereby enhancing the current ratio.

11. A 2-to-1 current ratio might not be adequate for several reasons. First, the
composition of the current assets may be heavily weighted toward slow-
turning inventory, or the inventory may consist of large amounts of
obsolete goods. Second, the receivables may be large and of doubtful
collectibility, or the receivables may be turning very slowly due to poor
collection procedures.

12. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Sunday is apparently having difficulty
in effectively controlling its expenses.

13. If the company’s earnings are very low, they may become almost
insignificant in relation to stock price. While this means that the p/e ratio
becomes very high, it does not necessarily mean that investors are
optimistic. In fact, they may be valuing the company at its liquidation
value rather than a value based upon expected future earnings.

14. From the viewpoint of the company’s shareholders, this situation

represents a favorable use of leverage. It is probable that little interest, if
any, is paid for the use of funds supplied by current creditors, and only
11% interest is being paid to long-term bondholders. Together these two
sources supply 40% of the total assets. Since the firm earns an average
return of 16% on all assets, the amount by which the return on 40% of the
assets exceeds the fixed-interest requirements on liabilities will accrue to
the residual equity holders – the ordinary shareholders – raising the return
on equity.

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15. The length of operating cycle of the two companies cannot be determined
from the fact the one company’s current ratio is higher. The operating
cycle depends on the relationships between receivables and sales, and
between inventories and cost of goods sold. The company with the higher
current ratio might have either small amounts of receivables and
inventories, or large sales and cost of sales, either of which would tend to
produce a relatively short operating cycle.

16. The investor is calculating the rate of return by dividing the dividend by
the purchase price of the investment (P5  P50 = 10%). A more
meaningful figure for rate of return on investment is determined by
relating dividends to current market price, since the investor at the present
time is faced with the alternative of selling the stock for P100 and investing
the proceeds elsewhere or keeping the investment. A decision to retain the
stock constitutes, in effect, a decision to continue to invest P100 in it, at a
return of 5%. It is true that in a historical sense the investor is earning
10% on the original investment, but this is interesting history rather than
useful decision-making information.
17. A corporate net income of P1 million would be unreasonably low for a
large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by investing
in insured bank savings accounts or in government bonds which would be
virtually risk-free and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for
a corporation which had sales of only P5 million, assets of, say, P3 million,
and equity of perhaps one-half million pesos. In other words, the net
income of a corporation must be judged in relation to the scale of
operations and the amount invested.

II. True or False

1. True 3. True 5. True 7. True 9. False

2. True 4. False 6. True 8. True 10. False

III. Problems

Problem 1 (Common Size Income Statements)

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Common size income statements for 2005 and 2006:

2006 2005
Sales 100% 100%
........................................................
Cost of goods 66 67
sold
........................................................
Gross 34% 33%
profit
........................................................
Operating 28 29
expenses
........................................................
Net 6% 4%
income
........................................................

The changes from 2005 to 2006 are all favorable. Sales increased and the gross
profit per peso of sales also increased. These two factors led to a substantial
increase in gross profit. Although operating expenses increased in peso
amount, the operating expenses per peso of sales decreased from 29 cents to
28 cents. The combination of these three favorable factors caused net income
to rise from 4 cents to 6 cents out of each peso of sales.

Problem 2 (Measures of Liquidity)

Requirement (a)

Current assets:
Cash P 47,600
Marketable securities 175,040
Accounts receivable 230,540
Inventory 179,600
Unexpired insurance 4,500
Total current assets P637,280
Current liabilities:
Notes payable P 70,000
Accounts payable 125,430
Salaries payable 7,570
Income taxes payable 14,600
Unearned revenue 10,000

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Total current liabilities P227,600

Requirement (b)

The current ratio is 2.8 to 1. It is computed by dividing the current assets of

P637,280 by the current liabilities of P227,600. The amount of working
capital is P409,680, computed by subtracting the current liabilities of P227,600
from the current assets of P637,280.

The company appears to be in a strong position as to short-run debt-paying

ability. It has almost three pesos of current assets for each peso of current
liabilities. Even if some losses should be sustained in the sale of the
merchandise on hand or in the collection of the accounts receivable, it appears
probable that the company would still be able to pay its debts as they fall due
in the near future. Of course, additional information, such as the credit terms
on the accounts receivable, would be helpful in a careful evaluation of the
company’s current position.

Problem 3 (Common-Size Income Statement)

Requirement 1
2006 2005
Sales 100.0 % 100.0 %
Less cost of goods sold ............................................... 63.2 60.0
Gross margin .............................................................. 36.8 40.0
Selling expenses ......................................................... 18.0 17.5
Administrative expenses ............................................. 13.6 14.6
Total expenses ............................................................ 31.6 32.1
Net operating income ................................................. 5.2 7.9
Interest expense .......................................................... 1.4 1.0
Net income before taxes ............................................. 3.8 % 6.9 %

Requirement 2
The company’s major problem seems to be the increase in cost of goods sold,
which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006. This
suggests that the company is not passing the increases in costs of its products
on to its customers. As a result, cost of goods sold as a percentage of sales has
increased and gross margin has decreased. Selling expenses and interest
expense have both increased slightly during the year, which suggests that costs
generally are going up in the company. The only exception is the
administrative expenses, which have decreased from 14.6% of sales in 2005

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Chapter 8 Cost Concepts and Classifications

to 13.6% of sales in 2006. This probably is a result of the company’s efforts

to reduce administrative expenses during the year.

Problem 4 (Comparing Operating Results with Average Performance in

the Industry)

Requirement (a)
Ms. Freeze,Inc. Industry Average
Sales (net) 100% 100%
Cost of goods sold 49 57
Gross profit on sales 51% 43%
Operating expenses:
Selling 21% 16%
General and administrative 17 20
Total operating expenses 38% 36%
Operating income 13% 7%
Income taxes 6 3
Net income 7% 4%
Requirement (b)

Ms. Freeze’s operating results are significantly better than the average
performance within the industry. As a percentage of sales revenue, Ms.
Freeze’s operating income and net income after nearly twice the average for
the industry. As a percentage of total assets, Ms. Freeze’s profits amount to
an impressive 23% as compared to 14% for the industry.
The key to Ms. Freeze’s success seems to be its ability to earn a relatively high
rate of gross profit. Ms. Freeze’s exceptional gross profit rate (51%) probably
results from a combination of factors, such as an ability to command a
premium price for the company’s products and production efficiencies which
lead to lower manufacturing costs.
As a percentage of sales, Ms. Freeze’s selling expenses are five points higher
than the industry average (21% compared to 16%). However, these higher
expenses may explain Ms. Freeze’s ability to command a premium price for
its products. Since the company’s gross profit rate exceeds the industry
average by 8 percentage points, the higher-than-average selling costs may be
part of a successful marketing strategy. The company’s general and
administrative expenses are significantly lower than the industry average,
which indicates that Ms. Freeze’s management is able to control expenses
effectively.

Problem 5 (Common-Size Statements)

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 Cost Concepts and Classifications Chapter 8

Requirement 1

The income statement in common-size form would be:

2006 2005
Sales 100.0% 100.0%
.............................................................
Less cost of goods 65.0 60.0
sold
.............................................................
Gross 35.0 40.0
margin
.............................................................
Less operating 26.3 30.4
expenses
.............................................................
Net operating 8.7 9.6
income
.............................................................
Less interest 1.2 1.6
expense
.............................................................
Net income before 7.5 8.0
taxes
.............................................................
Less income taxes 2.3 2.4
(30%)
.............................................................
Net 5.3% 5.6%
income
.............................................................

The balance sheet in common-size form would be:

2006 2005
Current assets:
Cash 2.0% 5.1%
...........................................................

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Chapter 8 Cost Concepts and Classifications

Accounts receivable, 15.0 10.1

net
...........................................................
Inventory 30.1 15.2
...........................................................
Prepaid 1.0 1.3
expenses
...........................................................
Total current 48.1 31.6
assets

Plant and 51.9 68.4

equipment

Total 100.0% 100.0%

assets
Liabilities:
Current 25.1% 12.7%
liabilities

Bonds payable, 20.1 25.3

12%
Total 45.1 38.0
liabilities

Equity:
Preference shares, 8%, P10 15.0 19.0
par
Ordinary shares, P5 10.0 12.7
par
Retained 29.8 30.4
earnings

Total 54.9 62.0

equity

Total liabilities and 100.0% 100.0%

equity

Note: Columns do not total down in all cases due to rounding differences.

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 Cost Concepts and Classifications Chapter 8

Requirement 2

The company’s cost of goods sold has increased from 60 percent of sales in
2005 to 65 percent of sales in 2006. This appears to be the major reason the
company’s profits showed so little increase between the two years. Some
benefits were realized from the company’s cost-cutting efforts, as evidenced
by the fact that operating expenses were only 26.3 percent of sales in 2006 as
compared to 30.4 percent in 2005. Unfortunately, this reduction in operating
expenses was not enough to offset the increase in cost of goods sold. As a
result, the company’s net income declined from 5.6 percent of sales in 2005 to
5.3 percent of sales in 2006.

Problem 6 (Solvency of Alabang Supermarket)

Requirement (a)
(Pesos in
Millions)
Current assets:
Cash P 74.8
Receivables 152.7
Merchandise inventories 1,191.8
Prepaid expenses 95.5
Total current assets P1,514.8
Quick assets:
Cash P 74.8
Receivables 152.7
Total quick assets P 227.5

Requirement (b)
(1) Current ratio:
Current assets (Req. a) P1,514.8
Current liabilities P1,939.0
Current ratio (P1,514.8  P1,939.0) 0.8 to 1

(2) Quick ratio:

Quick assets (Req. a) P 227.5
Current liabilities P1,939.0
Quick ratio (P227.5  P1,939.0) 0.1 to 1

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(3) Working capital:

Current assets (Req. a) P1,514.8
Less: Current liabilities P1,939.0
Working capital P(424.2)

Requirement (c)

No. It is difficult to draw conclusions from the above ratios. Alabang

Supermarket’s current ratio and quick ratio are well below “safe” levels,
according to traditional rules of thumb. On the other hand, some large
companies with steady ash flows are able to operate successfully with current
ratios lower than Alabang Supermarket’s.
Requirement (d)

Due to characteristics of the industry, supermarkets tend to have smaller

amounts of current assets and quick assets than other types of merchandising
companies. An inventory of food has a short shelf life. Therefore, the
inventory of a supermarket usually represents only a few weeks’ sales. Other
merchandising companies may stock inventories representing several months’
sales. Also, supermarkets sell primarily for cash. Thus, they have relatively
few receivables. Although supermarkets may generate large amounts of cash,
it is not profitable for them to hold assets in this form. Therefore, they are
likely to reinvest their cash flows in business operations as quickly as possible.

Requirement (e)

In evaluating Alabang Supermarket’s liquidity, it would be useful to review

the company’s financial position in prior years, statements of cash flows, and
the financial ratios of other supermarket chains. One might also ascertain the
company’s credit rating from an agency such as Dun & Bradstreet.

Note to Instructor: Prior to the year in which the data for this problem was
collected, Alabang Supermarket had reported a negative retained earnings
balance in its balance sheet for several consecutive periods. The fact that
Alabang Supermarket has only recently removed the deficit from its financial
statements is also worrisome.

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)

Requirement (a)

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 Cost Concepts and Classifications Chapter 8

(1) Quick assets:

Cash P 47,524
Marketable securities (short-term) 55,926
Accounts receivable 23,553
Total quick assets P127,003

(2) Current assets:

Cash P 47,524
Marketable securities (short-term) 55,926
Accounts receivable 23,553
Inventories 32,210
Prepaid expenses 5,736
Total current assets P164,949

(3) Current liabilities:

Notes payable to banks (due within one year) P 20,000
Accounts payable 5,912
Dividends payable 1,424
Accrued liabilities (short-term) 21,532
Income taxes payable 6,438
Total current liabilities P 55,306

Requirement (b)

(1) Quick ratio:

Quick assets (Req. a) P127,003
Current liabilities (Req. a) P 55,306
Quick ratio (P127,003  P55,306) 2.3 to 1

(2) Current ratio:

Current assets (Req. a) P164,949
Current liabilities (Req. a) P 55,306
Current ratio (P164,949  P55,306) 3.0 to 1

(3) Working capital:

Current assets (Req. a) P164,949
Less: Current liabilities (Req. a) 55,306

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Chapter 8 Cost Concepts and Classifications

Working capital P109,643

(4) Debt ratio:

Total liabilities (given) P 81,630
Total assets (given) P353,816
Debt ratio (P81,630  P353,816) 23.1%

Requirement (c)

(1) From the viewpoint of short-term creditors, Bonbon Sweets’ appear highly
liquid. Its quick and current ratios are well above normal rules of thumb,
and the company’s cash and marketable securities alone are almost twice
its current liabilities.

(2) Long-term creditors also have little to worry about. Not only is the
company highly liquid, but creditors’ claims amount to only 23.1% of total
assets. If Bonbon Sweets’ were to go out of business and liquidate its
assets, it would have to raise only 23 cents from every peso of assets for
creditors to emerge intact.

(3) From the viewpoint of shareholders, Bonbon Sweets’ appears overly

liquid. Current assets generally do not generate high rates of return. Thus,
the company’s relatively large holdings of current assets dilutes its return
on total assets. This should be of concern to shareholders. If Bonbon
Sweets is unable to invest its highly liquid assets more productively in its
business, shareholders probably would like to see the money distributed
as dividends.

Problem 8 (Selected Financial Measures for Short-term Creditors)

Requirement 1

Current assets (P80,000 + P460,000 + P750,000 +

P10,000)............................................................................ P1,300,000
Current liabilities (P1,300,000 ÷ 2.5) ................................... 520,000
Working capital..................................................................... P 780,000

Requirement 2
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P80,000 + P0 + P460,000
Acid-test ratio = 8-58 = 1.04 to 1 (rounded)
P520,000
 Cost Concepts and Classifications Chapter 8

Requirement 3

a. Working capital would not be affected:

Current assets (P1,300,000 – P100,000) ........................... P1,200,000

Current liabilities (P520,000 – P100,000)......................... 420,000
Working capital ................................................................. P 780,000

b. The current ratio would rise:

Current assets
Current ratio =
Current liabilities
P1,200,000
Current rate = = 2.9 to 1 (rounded)
P420,000

Problem 9 (Selected Financial Ratios)

1. Gross margin percentage:

Gross margin P840,000
= = 40%
Sales P2,100,000

2. Current ratio:
Current assets P490,000
= = 2.45 to 1
Current liabilities P200,000

3. Acid-test ratio:
Quick assets P181,000
= = 0.91 to 1 (rounded)
Current liabilities P200,000

4. Accounts receivable turnover:

Sales P2,100,000
= = 14 times
Average accounts receivables P150,000

365 days
= 26.1 days (rounded)
14 times

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5. Inventory turnover:
Cost of goods sold P1,260,000
= = 4.5 times
Average inventory P280,000
365 days
= 81.1 days to turn (rounded)
4.5 times
6. Debt-to-equity ratio:
Total liabilities P500,000
= = 0.63 to 1 (rounded)
Total equity P800,000

7. Times interest earned:

Earnings before interest
and income taxes P180,000
Interest expense = = 6.0 times
P30,000

8. Book value per share:

Equity P800,000
= = P40 per share
Ordinary shares outstanding 20,000 shares*
* P100,000 total par value ÷ P5 par value per share = 20,000 shares

Problem 10 (Selected Financial Ratios for Ordinary Shareholders)

1. Earnings per share:

Net income to ordinary shares P105,000
= = P5.25 per share
Average ordinary shares 20,000 shares
outstanding

2. Dividend payout ratio:

Dividends paid per share P3.15
= = 60%
Earnings per share P5.25

3. Dividend yield ratio:

Dividends paid per share P3.15
= = 5%
Market price per share P63.00
4. Price-earnings ratio:

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 Cost Concepts and Classifications Chapter 8

Market price per share P63.00

= = 12.0
Earnings per share P5.25

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)

1. Return on total assets:

Return on Net income + [Interest expense x (1 – Tax rate)]

=
total assets Average total assets

P105,000 + [P30,000 x (1 – 0.30)]

=
½ (P1,100,000 + P1,300,000)
P126,000
= = 10.5%
P1,200,000

2. Return on ordinary shareholders’ equity:

Return on ordinary Net income – preference dividends

shareholders’ equity =
Average ordinary shareholders’ equity
P105,000
=
½ (P725,000 + P800,000)
P105,000
= = 13.8% (rounded)
P762,500

3. Financial leverage was positive, since the rate of return to the ordinary
shareholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the company’s
current liabilities, which may carry no interest cost, and to the bonds
payable, which have an after-tax interest cost of only 7%.

10% interest rate × (1 – 0.30) = 7% after-tax cost.

Problem 12 (Selected Financial Measures for Short-Term Creditors)

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Chapter 8 Cost Concepts and Classifications

Requirement (1)

Current assets
(P80,000 + P460,000 + P750,000 + P10,000) ...................... P1,300,000
Current liabilities (P1,300,000 ÷ 2.5) ....................................... 520,000
Working capital ........................................................................ P 780,000

Requirement (2)

Cash + Marketable securities

Acid-test + Accounts receivable + Short-term notes
=
ratio Current liabilities

P80,000 + P0 + P460,000 + P0
= = 1.04 (rounded)
P520,000

Requirement (3)

a. Working capital would not be affected by a P100,000 payment on accounts

payable:

Current assets (P1,300,000 – P100,000) ....................... P1,200,000

Current liabilities (P520,000 – P100,000)..................... 420,000
Working capital ............................................................. P 780,000

b. The current ratio would increase if the company makes a P100,000

payment on accounts payable:
Current assets
Current ratio =
Current liabilities
P1,200,000
= = 2.9 (rounded)
P420,000

Problem 13 (Effects of Transactions on Various Financial Ratios)

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 Cost Concepts and Classifications Chapter 8

1. Decrease Sale of inventory at a profit will be reflected in an increase

in retained earnings, which is part of shareholders’ equity.
An increase in shareholders’ equity will result in a decrease
in the ratio of assets provided by creditors as compared to
assets provided by owners.
2. No effect Purchasing land for cash has no effect on earnings or on the
number of ordinary shares outstanding. One asset is
exchanged for another.
3. Increase A sale of inventory on account will increase the quick assets
(cash, accounts receivable, marketable securities) but have
no effect on the current liabilities. For this reason, the acid-
test ratio will increase.
4. No effect Payments on account reduce cash and accounts payable by
equal amounts; thus, the net amount of working capital is
not affected.
5. Decrease When a customer pays a bill, the accounts receivable
balance is reduced. This increases the accounts receivable
turnover, which in turn decreases the average collection
period.
6. Decrease Declaring a cash dividend will increase current liabilities,
but have no effect on current assets. Therefore, the current
ratio will decrease.
7. Increase Payment of a previously declared cash dividend will reduce
both current assets and current liabilities by the same
amount. An equal reduction in both current assets and
current liabilities will always result in an increase in the
current ratio, so long as the current assets exceed the current
liabilities.
8. No effect Book value per share is not affected by the current market
price of the company’s stock.

9. Decrease The dividend yield ratio is obtained by dividing the

dividend per share by the market price per share. If the

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Chapter 8 Cost Concepts and Classifications

dividend per share remains unchanged and the market

price goes up, then the yield will decrease.
10. Increase Selling property for a profit would increase net income and
therefore the return on total assets would increase.
11. Increase A write-off of inventory will reduce the inventory balance,
thereby increasing the turnover in relation to a given level
of cost of goods sold.
12. Increase Since the company’s assets earn at a rate that is higher than
the rate paid on the bonds, leverage is positive, increasing
the return to the ordinary shareholders.
13. No effect Changes in the market price of a stock have no direct effect
on the dividends paid or on the earnings per share and
therefore have no effect on this ratio.
14. Decrease A decrease in net income would mean less income
available to cover interest payments. Therefore, the times-
interest-earned ratio would decrease.
15. No effect Write-off of an uncollectible account against the
Allowance for Bad Debts will have no effect on total
current assets. For this reason, the current ratio will remain
unchanged.
16. Decrease A purchase of inventory on account will increase current
liabilities, but will not increase the quick assets (cash,
accounts receivable, marketable securities). Therefore, the
ratio of quick assets to current liabilities will decrease.
17. Increase The price-earnings ratio is obtained by dividing the market
price per share by the earnings per share. If the earnings
per share remains unchanged, and the market price goes
up, then the price-earnings ratio will increase.
18. Decrease Payments to creditors will reduce the total liabilities of a
company, thereby decreasing the ratio of total debt to total
equity.

Problem 14 (Interpretation of Financial Ratios)

a. The market price is going down. The dividends paid per share over the
three-year period are unchanged, but the dividend yield is going up.

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Therefore, the market price per share of stock must be decreasing.

b. The earnings per share is increasing. Again, the dividends paid per share
have remained constant. However, the dividend payout ratio is decreasing.
In order for the dividend payout ratio to be decreasing, the earnings per
share must be increasing.

c. The price-earnings ratio is going down. If the market price of the stock is
going down [see part (a) above], and the earnings per share are going up
[see part (b) above], then the price-earnings ratio must be decreasing.

d. In Year 1, leverage was negative because in that year the return on total
assets exceeded the return on ordinary equity. In Year 2 and in Year 3,
leverage was positive because in those years the return on ordinary equity
exceeded the return on total assets employed.

e. It is becoming more difficult for the company to pay its bills as they come
due. Although the current ratio has improved over the three years, the acid-
test ratio is down. Also note that the accounts receivable and inventory are
both turning more slowly, indicating that an increasing portion of the
current assets is being made up of those items, from which bills cannot be
paid.

f. Customers are paying their bills more slowly in Year 3 than in Year 1. This
is evidenced by the decline in accounts receivable turnover.

g. Accounts receivable is increasing. This is evidenced both by a slowdown

in turnover and in an increase in total sales.

h. The level of inventory undoubtedly is increasing. Notice that the inventory

turnover is decreasing. Even if sales (and cost of goods sold) just remained
constant, this would be evidence of a larger average inventory on hand.
However, sales are not constant but rather are increasing. With sales
increasing (and undoubtedly cost of goods sold also increasing), the
average level of inventory must be increasing as well in order to service
the larger volume of sales.

IV. Cases

Case 1 (Common-Size Statements and Financial Ratios for Creditors)

Requirement 1

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This Year Last Year

a. Current assets .......................................... P2,060,000 P1,470,000
Current liabilities ..................................... 1,100,000 600,000
Working capital ....................................... P 960,000 P 870,000

b. Current assets (a) ..................................... P2,060,000 P1,470,000

Current liabilities (b) ............................... P1,100,000 P600,000
Current ratio (a) ÷ (b) .............................. 1.87 to 1 2.45 to 1

c. Quick assets (a) ....................................... P740,000 P650,000

Current liabilities (b) ............................... P1,100,000 P600,000
Acid-test ratio (a) ÷ (b) ............................ 0.67 to 1 1.08 to 1

d. Sales on account (a) ................................. P7,000,000 P6,000,000

Average receivables (b) ........................... P525,000 P375,000
Turnover of receivables (a) ÷ (b) ............. 13.3 times 16.0 times

Average age of receivables:

365 ÷ turnover ......................................... 27.4 days 22.8 days

e. Cost of goods sold (a) .............................. P5,400,000 P4,800,000

Average inventory (b) .............................. P1,050,000 P760,000
Inventory turnover (a) ÷ (b)..................... 5.1 times 6.3 times

Turnover in days: 365 ÷ turnover ............ 71.6 days 57.9 days

f. Total liabilities (a) ................................... P1,850,000 P1,350,000
Equity (b)................................................. P2,150,000 P1,950,000
Debt-to-equity ratio (a) ÷ (b) ................... 0.86 to 1 0.69 to 1

g. Net income before interest and taxes (a) . P630,000 P490,000

Interest expense (b) ................................. P90,000 P90,000
Times interest earned (a) ÷ (b) ................ 7.0 times 5.4 times
Requirement 2

a. METRO BUILDING SUPPLY

Common-Size Balance Sheets

This Year Last Year

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Current assets:
Cash.................................................... 2.3 % 6.1 %
Marketable securities ......................... 0.0 1.5
Accounts receivable, net .................... 16.3 12.1
Inventory ............................................ 32.5 24.2
Prepaid expenses ................................ 0.5 0.6
Total current assets ................................. 51.5 44.5
Plant and equipment, net ........................ 48.5 55.5
Total assets ............................................. 100.0 % 100.0 %

Liabilities:
Current liabilities................................ 27.5 % 18.2 %
Bonds payable, 12%........................... 18.8 22.7
Total liabilities ....................................... 46.3 40.9
Equity:
Preference shares, P50 par, 8% .......... 5.0 6.1
Ordinary shares, P10 par .................... 12.5 15.2
Retained earnings ............................... 36.3 37.9
Total equity ............................................ 53.8 59.1
Total liabilities and equity ...................... 100.0 % 100.0 %

Note: Columns do not total down in all cases due to rounding.

b. METRO BUILDING SUPPLY

Common-Size Income Statements

This Year Last Year

Sales ........................................................ 100.0 % 100.0 %
Less cost of goods sold ........................... 77.1 80.0
Gross margin ........................................... 22.9 20.0
Less operating expenses .......................... 13.9 11.8
Net operating income .............................. 9.0 8.2
Less interest expense ............................... 1.3 1.5
Net income before taxes .......................... 7.7 6.7
Less income taxes ................................... 3.1 2.7
Net income .............................................. 4.6 % 4.0 %

Requirement 3

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The following points can be made from the analytical work in parts (1) and (2)
above:

The company has improved its profit margin from last year. This is attributable
to an increase in gross margin, which is offset somewhat by an increase in
operating expenses. In both years the company’s net income as a percentage
of sales equals or exceeds the industry average of 4%.

Although the company’s working capital has increased, its current position
actually has deteriorated significantly since last year. Both the current ratio
and the acid-test ratio are well below the industry average, and both are
trending downward. (This shows the importance of not just looking at the
working capital in assessing the financial strength of a company.) Given the
present trend, it soon will be impossible for the company to pay its bills as they
come due.

The drain on the cash account seems to be a result mostly of a large buildup in
accounts receivable and inventory. This is evident both from the common-size
balance sheet and from the financial ratios. Notice that the average age of the
receivables has increased by 5 days since last year, and that it is now 9 days
over the industry average. Many of the company’s customers are not taking
their discounts, since the average collection period is 27 days and collection
terms are 2/10, n/30. This suggests financial weakness on the part of these
customers, or sales to customers who are poor credit risks. Perhaps the
company has been too aggressive in expanding its sales.

The inventory turned only 5 times this year as compared to over 6 times last
year. It takes three weeks longer for the company to turn its inventory than the
average for the industry (71 days as compared to 50 days for the industry).
This suggests that inventory stocks are higher than they need to be.

In the authors’ opinion, the loan should be approved on the condition that the
company take immediate steps to get its accounts receivable and inventory
back under control. This would mean more rigorous checks of
creditworthiness before sales are made and perhaps paring out of slow paying
customers. It would also mean a sharp reduction of inventory levels to a more
manageable size. If these steps are taken, it appears that sufficient funds could
be generated to repay the loan in a reasonable period of time.

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Case 2 (Financial Ratios for Ordinary Shareholders)

Requirement 1

a. This Year Last Year

Net income............................................. P324,000 P240,000
Less preference dividends ..................... 16,000 16,000
Net income remaining for ordinary (a) .. P308,000 P224,000
Average number of ordinary shares (b) . 50,000 50,000
Earnings per share (a) ÷ (b) ................... P6.16 P4.48

b. Ordinary dividend per share (a)* ........... P2.16 P1.20

Market price per share (b) ..................... P45.00 P36.00
Dividend yield ratio (a) ÷ (b) ................. 4.8% 3.33%
*P108,000 ÷ 50,000 shares = P2.16;
P60,000 ÷ 50,000 shares = P1.20

c. Ordinary dividend per share (a) ............... P2.16 P1.20

Earnings per share (b) .............................. P6.16 P4.48
Dividend payout ratio (a) ÷ (b) ................ 35.1% 26.8%

d. Market price per share (a) ........................ P45.00 P36.00

Earnings per share (b) .............................. P6.16 P4.48
Price-earnings ratio (a) ÷ (b) .................... 7.3 8.0

Investors regard Metro Building Supply less favorably than other firms in
the industry. This is evidenced by the fact that they are willing to pay only
7.3 times current earnings for a share of the company’s stock, as compared
to 9 times current earnings for the average of all stocks in the industry. If
investors were willing to pay 9 times current earnings for Metro Building
Supply’s stock, then it would be selling for about P55 per share (9 × P6.16),
rather than for only P45 per share.
e. This Year Last Year
Equity....................................................... P2,150,000 P1,950,000
Less preference shares ............................. 200,000 200,000
Ordinary equity (a) .................................. P1,950,000 P1,750,000

Number of ordinary shares (b) ................. 50,000 50,000

Book value per share (a) ÷ (b) ................. P39.00 P35.00

A market price in excess of book value does not mean that the price of a
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stock is too high. Market value is an indication of investors’ perceptions

of future earnings and/or dividends, whereas book value is a result of
already completed transactions and is geared to the past.

Requirement 2

a. This Year Last Year

Net income ............................................... P 324,000 P 240,000
Add after-tax cost of interest paid:
[P90,000 × (1 – 0.40)] .......................... 54,000 54,000
Total (a) .................................................... P 378,000 P 294,000

Average total assets (b) ............................ P3,650,000 P3,000,000

Return on total assets (a) ÷ (b) ................. 10.4% 9.8%

b. This Year Last Year

Net income ............................................... P 324,000 P 240,000
Less preference dividends ........................ 16,000 16,000
Net income remaining for ordinary
shareholders (a) .................................... P 308,000 P 224,000

Average total equity* ............................... P2,050,000 P1,868,000

Less average preference shares ................ 200,000 200,000
Average ordinary equity (b) ..................... P1,850,000 P1,668,000
*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000).

Return on ordinary equity (a) ÷ (b) ....... 16.6% 13.4%

c. Financial leverage is positive in both years, since the return on ordinary

equity is greater than the return on total assets. This positive financial
leverage is due to three factors: the preference shares, which has a dividend
of only 8%; the bonds, which have an after-tax interest cost of only 7.2%
[12% interest rate × (1 – 0.40) = 7.2%]; and the accounts payable, which
may bear no interest cost.

Requirement 3

We would recommend keeping the stock. The stock’s downside risk seems
small, since it is selling for only 7.3 times current earnings as compared to 9

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times earnings for the average firm in the industry. In addition, its earnings
are strong and trending upward, and its return on ordinary equity (16.6%) is
extremely good. Its return on total assets (10.4%) compares favorably with
that of the industry.

The risk, of course, is whether the company can get its cash problem under
control. Conceivably, the cash problem could worsen, leading to an eventual
reduction in profits through inability to operate, a reduction in dividends, and
a precipitous drop in the market price of the company’s stock. This does not
seem likely, however, since the company can easily control its cash problem
through more careful management of accounts receivable and inventory. If
this problem is brought under control, the price of the stock could rise sharply
over the next few years, making it an excellent investment.

Case 3 (Comprehensive Ratio Analysis)

Requirement 1
This Year Last Year
a. Net income ............................................... P 280,000 P 168,000
Add after-tax cost of interest:
P120,000 × (1 – 0.30) .......................... 84,000
P100,000 × (1 – 0.30) .......................... 70,000
Total (a) .................................................... P 364,000 P 238,000

Average total assets (b) ............................ P5,330,000 P4,640,000

Return on total assets (a) ÷ (b) ................. 6.8% 5.1%

b. Net income ............................................... P 280,000 P 168,000

Less preference dividends ........................ 48,000 48,000
Net income remaining for ordinary (a) .... P 232,000 P 120,000

Average total equity ................................. P3,120,000 P3,028,000

Less average preference shares ................ 600,000 600,000
Average ordinary equity (b) ..................... P2,520,000 P2,428,000

Return on ordinary equity (a) ÷ (b) .......... 9.2% 4.9%

c. Leverage is positive for this year, since the return on ordinary equity (9.2%)
is greater than the return on total assets (6.8%). For last year, leverage is

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negative since the return on the ordinary equity (4.9%) is less than the
return on total assets (5.1%).

Requirement 2

This Year Last Year

a. Net income remaining for ordinary (a) ... P 232,000 P 120,000
Average number of ordinary shares (b) ... 50,000 50,000
Earnings per share (a) ÷ (b)..................... P4.64 P2.40

b. Ordinary dividend per share (a) .............. P1.44 P0.72

Market price per share (b) ....................... P36.00 P20.00
Dividend yield ratio (a) ÷ (b) .................. 4.0% 3.6%

c. Ordinary dividend per share (a) .............. P1.44 P0.72

Earnings per share (b) ............................. P4.64 P2.40
Dividend payout ratio (a) ÷ (b) ............... 31.0% 30.0%

d. Market price per share (a) .......................... P36.00 P20.00

Earnings per share (b) ................................ P4.64 P2.40
Price-earnings ratio (a) ÷ (b) ...................... 7.8 8.3

Notice from the data given in the problem that the average P/E ratio for
companies in Helix’s industry is 10. Since Helix Company presently has
a P/E ratio of only 7.8, investors appear to regard it less well than they do
other companies in the industry. That is, investors are willing to pay only
7.8 times current earnings for a share of Helix Company’s stock, as
compared to 10 times current earnings for a share of stock for the average
company in the industry.

e. Equity ...................................................... P3,200,000 P3,040,000

Less preference shares ............................ 600,000 600,000
Ordinary equity (a).................................. P2,600,000 P2,440,000

Number of ordinary shares (b) ................ 50,000 50,000

Book value per share (a) ÷ (b) ................ P52.00 P48.80

Note that the book value of Helix Company’s stock is greater than the
market value for both years. This does not necessarily indicate that the
stock is selling at a bargain price. Market value is an indication of

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 Cost Concepts and Classifications Chapter 8

investors’ perceptions of future earnings and/or dividends, whereas book

value is a result of already completed transactions and is geared to the past.

f. Gross margin (a) ..................................... P1,050,000 P860,000

Sales (b) .................................................. P5,250,000 P4,160,000
Gross margin percentage (a) ÷ (b) .......... 20.0% 20.7%

Requirement 3
This Year Last Year
a. Current assets .......................................... P2,600,000 P1,980,000
Current liabilities .................................... 1,300,000 920,000
Working capital ....................................... P1,300,000 P1,060,000

b. Current assets (a) .................................... P2,600,000 P1,980,000

Current liabilities (b) ............................... P1,300,000 P920,000
Current ratio (a) ÷ (b).............................. 2.0 to 1 2.15 to 1

c. Quick assets (a) ....................................... P1,220,000 P1,120,000

Current liabilities (b) ............................... P1,300,000 P920,000
Acid-test ratio (a) ÷ (b) ........................... 0.94 to 1 1.22 to 1

d. Sales on account (a) ................................ P5,250,000 P4,160,000

Average receivables (b)........................... P750,000 P560,000
Accounts receivable turnover (a) ÷ (b) ... 7.0 times 7.4 times
Average age of receivables,
365 ÷ turnover ..................................... 52 days 49 days
e. Cost of goods sold (a) ............................. P4,200,000 P3,300,000
Average inventory (b) ............................. P1,050,000 P720,000
Inventory turnover (a) ÷ (b) .................... 4.0 times 4.6 times
Number of days to turn inventory,
365 days ÷ turnover (rounded) ............ 91 days 79 days

f. Total liabilities (a) ................................... P2,500,000 P1,920,000

Equity (b) ................................................ P3,200,000 P3,040,000
Debt-to-equity ratio (a) ÷ (b) .................. 0.78 to 1 0.63 to 1

g. Net income before interest and taxes (a). P520,000 P340,000

Interest expense (b) ................................. P120,000 P100,000
Times interest earned (a) ÷ (b) ................ 4.3 times 3.4 times

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Requirement 4

As stated by Meri Ramos, both net income and sales are up from last year. The
return on total assets has improved from 5.1% last year to 6.8% this year, and
the return on ordinary equity is up to 9.2% from 4.9% the year before. But this
appears to be the only bright spot in the company’s operating picture. Virtually
all other ratios are below the industry average, and, more important, they are
trending downward. The deterioration in the gross margin percentage, while
not large, is worrisome. Sales and inventories have increased substantially,
which should ordinarily result in an improvement in the gross margin
percentage as fixed costs are spread over more units. However, the gross
margin percentage has declined.

Notice particularly that the average age of receivables has lengthened to 52

days—about three weeks over the industry average—and that the inventory
turnover is 50% longer than the industry average. One wonders if the increase
in sales was obtained at least in part by extending credit to high-risk customers.
Also notice that the debt-to-equity ratio is rising rapidly. If the P1,000,000
loan is granted, the ratio will rise further to 1.09 to 1.

In the author’s opinion, what the company needs is more equity—not more
debt. Therefore, the loan should not be approved. The company should be
encouraged to make another issue of ordinary stock in order to provide a
broader equity base on which to operate.

Case 4 (Statement Reconstruction Using Ratios)

Bulacan Company
Income Statement
For the Year Ended December 31, 2005

Sales P140,800
Less: Cost of Sales (4) 84,480
Gross Profit P 56,320
Less: Expenses 46,320
Net Income (1) P 10,000

Bulacan Company
Balance Sheet
December 31, 2005

Assets
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 Cost Concepts and Classifications Chapter 8

Current Assets:
Cash P 27,720
Accounts Receivable (5) 28,160
Merchandise Inventory (3) 21,120
Total Current Assets (2) P 77,000
Fixed Assets (8) 55,000
Total Assets P132,000

Liabilities and Equity

Current Liabilities:
Accounts Payable (2) P 44,000
Equity:
Share Capital (issued 20,000 shares) (6) P40,000
Retained Earnings 48,000 88,000
Total Liabilities and Equity P132,000

Supporting Computations:
Net Income
(1) Earnings Per Share =
Ordinary Shares Outstanding
X
P0.50 =
20,000
X (Net Income) = P10,000

(2) Current Assets Pxx 1.75

Current Liabilities xx 1
Working Capital P33,000 0.75

Current Liabilities = P33,000  0.75

= P44,000

Current Assets
(3) Current Ratio =
Current Liabilities
X
1.27 =
44,000

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Chapter 8 Cost Concepts and Classifications

X (Current Assets) = P77,000

Quick Assets
Quick Ratio =
Current Liabilities

X
1.27 =
44,000
X (Current Assets) = P55,880

Current Assets P77,000

Quick Assets 55,800
Inventory P21,120

Cost of Sales
(4) Inventory turnover = Ave. Inventory
X
4 =
P21,120
X (Cost of Sales) = P84,480

Quick Assets
(5) Average age of outstanding =
Accounts Receivable Current Liabilities

365
= 73 days (Average age of
5
receivables)
Net Sales
Average Receivables = 5

P140,800
= 5
X
X (Receivables) = P28,160

Another Method:

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 Cost Concepts and Classifications Chapter 8

P140,800
= 73 days = P28,160 Accounts receivable
365

(6) Earnings for the year as a percentage of Share Capital

P10,000
= 25%
Share Capital
Share Capital = P40,000

(7) Current Fixed Current Liabilities +

Assets + Assets = Equity

P77,000 + 0.625X = P44,000 + X

0.375X = P33,000

X = P88,000 Equity
(8) Fixed Assets to Equity
Fixed Assets
= 0.625
Equity
X
= 0.625
P140,800
X (Fixed Assets) = P55,000

Case 5 (Ethics and the Manager)

Requirement 1

The loan officer stipulated that the current ratio prior to obtaining the loan must
be higher than 2.0, the acid-test ratio must be higher than 1.0, and the interest
on the loan must be no more than four times net operating income. These ratios
are computed below:
Current assets
Current ratio =
Current liabilities
P290,000
Current rate = = 1.8 (rounded)
P164,000
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P70,000 +8-77
P0 + P50,000
Acid-test ratio = = 0.70 (rounded)
P164,000
Chapter 8 Cost Concepts and Classifications

Net operating income P20,000

= = 5.0
Interest on the loan P80,000 x 0.10 x (6/12)

The company would fail to qualify for the loan because both its current ratio
and its acid-test ratio are too low.

Requirement 2

By reclassifying the P45 thousand net book value of the old machine as
inventory, the current ratio would improve, but there would be no effect on the
acid-test ratio. This happens because inventory is considered to be a current
asset but is not included in the numerator when computing the acid-test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
Current rate = = 2.0 (rounded)
P164,000

Cash + Marketable securities + Current receivables

Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000
Acid-test ratio = = 0.70 (rounded)
P164,000
Even if this tactic had succeeded in qualifying the company for the loan, we
strongly advise against it. Inventories are assets the company has acquired for
the sole purpose of selling them to outsiders in the normal course of business.
Used production equipment is not considered to be inventory—even if there is
a clear intention to sell it in the near future. Since the loan officer would not
expect used equipment to be included in inventories, doing so would be
intentionally misleading.

Nevertheless, the old equipment is an asset that could be turned into cash. If
this were done, the company would immediately qualify for the loan since the
P45 thousand in cash would be included in the numerator in both the current
ratio and in the acid-test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
P164,000
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Current rate = = 2.0 (rounded)

Cash + Marketable securities + Current receivables

Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000 + P45,000
Acid-test ratio = = 1.00 (rounded)
P164,000
However, other options may be available. After all, the old machine is being
used to relieve bottlenecks in the plastic injection molding process and it would
be desirable to keep this standby capacity. We would advise Rome to fully
and honestly explain the situation to the loan officer. The loan officer might
insist that the machine be sold before any loan is approved, but he might
instead grant a waiver of the current ratio and acid-test ratio requirements on
the basis that they could be satisfied by selling the old machine. Or he may
approve the loan on the condition that the equipment is pledged as collateral.
In that case, Rome would only have to sell the machine if he would otherwise
be unable to pay back the loan.

Case 6 (Financial Ratios for Ordinary Shareholders)

[pesos in thousands]
Requirement (1)

Calculation of the gross margin percentage:

Gross margin
Gross margin percentage =
Sales
P23,000
= = 34.8%
P66,000
Requirement (2)

Calculation of the earnings per share:

Net income – Preference dividends
Earnings per share =
Average number of ordinary shares outstanding
P1,980 – P60
= = P3.20 per share
600 shares
Requirement (3)

Calculation of the price-earnings ratio:

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Market price per share

Price-earnings ratio =
Earnings per share
P26
= = 8.1
P3.20
Requirement (4)

Calculation of the dividend payout ratio:

Dividends per share
Dividend payout ratio =
Earnings per share
P0.75
= = 23.4%
P3.20

Requirement (5)

Calculation of the dividend yield ratio:

Dividends per share
Dividend yield ratio =
Market price per share
P0.75
= = 2.9%
P26.00
Requirement (6)

Calculation of the return on total assets:

Net income + [Interest expense x (1 – Tax rate)]
Return on total assets =
Average total assets
P1,980 + [P800 x (1 – 0.40)]
= = 3.7%
(P65,810 + P68,480) / 2
Requirement (7)

Calculation of the return on ordinary shareholders’ equity:

Beginning balance, shareholders’ equity (a) P39,610

Ending balance, shareholders’ equity (b) 41,080
Average shareholders’ equity [(a) + (b)]/2 40,345
Average preference shares 1,000

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Average ordinary shareholders’ equity P39,345

Return on ordinary Net income – Preference dividends
=
shareholders’ equity Average ordinary shareholders’ equity
P1,980 – P60
= = 4.9%
P39,345
Requirement (8)

Calculation of the book value per share:

Book value Total shareholders’ equity – Preference shares
=
per share Number of ordinary shares outstanding
P41,080 – P1,000
= = P66.80 per share
Case 7 (Financial Ratios for Short-Term
600 shares Creditors)

Requirement (1)

Calculation of working capital:

Working capital = Current assets – Current liabilities

= P22,680 – P19,400 = P3,280
Requirement (2)

Calculation of the current ratio:

Current assets
Current ratio =
Current liabilities
P22,680
= = 1.17
P19,400

Requirement (3)

Calculation of the acid-test ratio:

Cash + Marketable securities
+ Accounts receivable + Short-term notes
Acid-test ratio =
Current liabilities
P1,080 + P0 + P9,000 + P0
Acid-test ratio = = 0.52
P19,400

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Requirement (4)

Calculation of accounts receivable turnover:

Accounts receivable Sales on account

= Average accounts receivable balance
turnover
P66,000
Acid-test ratio = = 8.5
(P6,500 + P9,000) / 2

Requirement (5)

Calculation of the average collection period:

Average collection 365 days

= Accounts receivable turnover
period
365 days = 42.9 days
Acid-test ratio =
8.5
Requirement (6)

Calculation of inventory turnover:

Inventory Cost of goods sold

= Average inventory balance
turnover
P43,000
Acid-test ratio = = 3.8
(P10,600 + P12,000) / 2
Requirement (7)

Calculation of the average sale period:

Average sale 365 days

= Inventory turnover
period
365 days
Acid-test ratio = = 96.1 days
3.8

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Case 8 (Financial Ratios for Long-Term Creditors)

Requirement (1)

Calculation of the times interest earned ratio:

Times interest Earnings before interest expense

= and income taxes
earned ratio
Inventory expense
P4,100
Acid-test ratio = = 5.1
P800

Requirement (2)

Calculation of the debt-to-equity ratio:

Debt-to-equity Total liabilities

= Shareholders’ equity
ratio
P27,400
Acid-test ratio = = 0.67
P41,080

V. Multiple Choice Questions

41. A 39. C 34. B 41. C 41. C

42. C 40. A 35. D 42. D
43. D 41. C 36. A 43. C
44. B 42. B 37. C 44. A
45. A 43. D 38. A 45. A
46. D 44. B 39. C 46. C
47. C 45. A 40. D 47. A
48. D 46. C 41. A 48. A
49. A 47. A 42. D 49. C
50. B 48. C 43. A 50. C

CHAPTER 6

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CASH FLOW ANALYSIS

I. Questions

1. Purposes of the Statement of Cash Flows

a. To predict future cash flows
b. To evaluate management decisions
c. To determine the ability to pay dividends to shareholders and
interest and principal to creditors
d. To show the relationship of net income to changes in the
business’s cash.

2. Comparative balance sheets present the financial position of the enterprise

at two points in time. The income statement for the period between the
two balance sheets describes how the income-producing activities affected
the financial position. Because cash flows from operating activities may
differ substantially from net income, and because numerous other
financing and investing activities have an impact on financial position, the
statement of cash flows is necessary. The statement emphasizes changes
in the cash balances that result from changes in assets, liabilities and equity
accounts caused by operating, investing and financing activities.

3. The most important source of cash for many successful companies is from
operating activities. A large positive operating cash flow is a good sign
because it means funds have been internally generated with no fixed
obligations or commitment to return such to anybody.

4. It is possible for cash to decrease during a year when income is high

because cash may be used not only for operating activities but also for
investing and financing activities.

5. Transactions involving accounts payable are not considered to be

financing activities because such transactions are used to obtain goods and
services rather than to obtain cash. Furthermore, purchases of goods and
services relate to a company’s day-to-day operating activities.

6. The loss is added back to net income to avoid double counting since the
entire proceeds from the sale (net book value minus loss on sale) will
appear as a cash inflow from investing activities.

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7. Three categories of transactions that may result in increases in cash are

a. Operating activities
b. Investing activities (e.g., sale of investments or other assets).
c. Financing activities (e.g., borrowing or sale of shares).

These activities are sources of cash when cash is increased as a result of

the particular activity.

8. Three categories of transactions that may result in decreases in cash are

a. Operating activities
b. Investing activities (e.g., purchase of investments or other assets).
c. Financing activities (e.g., repayment of debt or retirement of shares).

These activities are uses of cash when cash is decreased as a result of the
particular activity.

9. Noncash transactions do not provide or consume cash even though they

may result in significant changes in financial position. Examples are the
issuance of share capital for plant assets and the conversion of debt or
preference shares into ordinary shares. Such transactions are not presented
in the body of the statement of cash flows but rather disclosed in a separate
schedule as financing or investing activities.

10. While net loss is usually associated with a decrease in cash, it may be a
source of cash if noncash expenses are greater than the amount of the net
loss. For example, if a net loss of P100,000 included amortization and
depreciation of P125,000 and no noncash revenues existed, cash provided
by operating activities would be P25,000, computed as follows:

Net loss P(100,000)

Add: Expenses not requiring cash – depreciation
and amortization 125,000
Net cash provided by operating activities P 25,000

11. The change in cash is the difference between cash at the beginning and
end of the accounting period. The net amount of cash provided by or used
in operating, investing and financing activities must equal this change in
cash. For example, if cash increased by P150,000 during the year, total
sources from operating, investing, and financing activities must exceed

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total uses by P150,000. Also, if cash decreased by P25,000 during the

year, total uses of cash must exceed total sources by P25,000.

12. (a) The use of cash does not occur until the cash dividend is actually paid
in the next period. The declaration of the dividend does affect
financial position, however, and should be disclosed as a noncash
financing activity in a separate schedule accompanying the statement
of cash flows.
(b) Because the dividend was declared and paid in the same accounting
period, it appears in the statement of cash flows as a cash decrease in
the financing activities category.

13. Disagree. The refunding of 10% debt by the 8% debt represents a

significant financing activity, even though the net impact of the exchange
on the balance sheet or on the amount of cash is not material. The issuance
of 8% bonds and the retirement of 10% bonds should be reported as
noncash financing transactions in a schedule accompanying the statement
of cash flows.

14. The net income figure includes P150,000 as an expense. Only P112,500
of this amount resulted in a decrease in cash, because P37,500 represents
an increase in the deferred income tax liability account. In determining
cash provided by operating activities, the amount of income tax paid is
P112,500 (direct method). Alternatively, under the indirect method,
P37,500 must be added to net income to determine cash flows from
operating activities.

15. The loss is omitted when listing expenses requiring cash payment (direct
approach) or added back to net income (indirect approach) in determining
cash provided by operating activities. This eliminates the impact of the
transaction from cash provided by operating activities. Then, the proceeds
from the sale are included as a source of cash in the investing activities
category of the statement of cash flows. Any tax effects of the transaction
are included in the tax expense figure and remain a part of cash flows from
operating activities.

16. (1) Operating activities: Transactions that affect current assets, current
liabilities, or net income.
(2) Investing activities: Transactions that involve the acquisition or
disposition of noncurrent assets.

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(3) Financing activities: Transactions (other than the payment of interest)

involving borrowing from creditors, and any transactions (involving
the owners of a company.

17. Interest is included as an operating activity since it is part of net income.

Financing activities are narrowly defined to include only the principal
amount borrowed or repaid.

18. Since the entire proceeds from a sale of an asset (including any gain)
appear as a cash inflow from investing activities, the gain must be
deducted from net income to avoid double counting.

19. The direct method reconstructs the income statement on a cash basis by
restating revenues and expenses in terms of cash inflows and outflows.
The indirect method starts with net income and adjusts it to a cash basis to
determine the cash provided by operating activities.

20. An increase in the Accounts Receivable account must be deducted from

net income under the indirect method because this is an increase in a
noncash asset.

21. A decrease in the Accounts Payable account must be added to cost of

goods sold under the direct method. The cost of goods sold is increased by
the amount of the decrease in accounts payable. Because the cost of goods
sold is increased, the net cash flow provided by operating activities is
decreased. The effect of a decrease in a liability is a decrease in cash.

22. A sale of equipment for cash would be classified as an investing activity.

Any transaction involving the acquisition or disposition of noncurrent
assets is classified as an investing activity.

II. Exercises

Exercise 1

Net income ................................................................. P84,000

Adjustments to convert net income to a cash basis:
Depreciation charges for the year ........................... P50,000
Increase in accounts receivable .............................. (60,000)
Increase in inventory .............................................. (77,000)
Decrease in prepaid expenses ................................. 2,000
Increase in accounts payable .................................. 30,000

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Decrease in accrued liabilities ................................ (4,000)

Increase in deferred income taxes .......................... 6,000 (53,000)
Net cash provided by operating activities ................... P31,000

Exercise 2

Sales .................................................................... P1,000,000

Adjustments to a cash basis:
Less increase in accounts receivable ........... – 60,000 P940,000
Cost of goods sold ............................................... 580,000
Adjustments to a cash basis:
Plus increase in inventory ............................ + 77,000
Less increase in accounts payable ............... – 30,000 627,000
Selling and administrative expenses.................... 300,000
Adjustments to a cash basis:
Less decrease in prepaid expenses............... – 2,000
Plus decrease in accrued liabilities .............. + 4,000
Less depreciation charges ............................ – 50,000 252,000
Income taxes ........................................................ 36,000
Adjustments to a cash basis:
Less increase in deferred income taxes ....... – 6,000 30,000
Net cash provided by operating activities ........... P 31,000

Note that the P31,000 agrees with the cash provided by operating activities
figure under the indirect method in the previous exercise.

Exercise 3

Item Amount Add Deduct

Accounts Receivable..................... P70,000 decrease X
Accrued Interest Receivable ......... P6,000 increase X
Inventory ....................................... P110,000 increase X
Prepaid Expenses .......................... P3,000 decrease X
Accounts Payable .......................... P40,000 decrease X
Accrued Liabilities ........................ P9,000 increase X
Deferred Income Taxes Liability .. P15,000 increase X
Sale of equipment ......................... P8,000 gain X
Sale of long-term investments ...... P12,000 loss X

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Exercise 4

Requirement (1)

Net income ................................................................................... P75

Adjustments to convert net income to a cash basis:
Depreciation charges ................................................................ P40
Decrease in accounts receivable ............................................... 10
Increase in inventory ................................................................ (30)
Decrease in prepaid expenses ................................................... 5
Increase in accounts payable .................................................... 20
Decrease in accrued liabilities .................................................. (10)
Increase in taxes payable .......................................................... 10
Increase in deferred taxes ......................................................... 5
Loss on sale of long-term investments ..................................... 5
Gain on sale of land.................................................................. (40) 15
Net cash provided by operating activities .................................... P90

Requirement (2)

Swan Company
Statement of Cash Flows

Operating activities:
Net cash provided by operating activities (see above) .................... P 90

Investing activities:
Proceeds from sale of long-term investments..................................P 45
Proceeds from sale of land .............................................................. 70
Additions to long-term investments ................................................ (20)
Additions to plant & equipment ...................................................... (150)
Net cash used for investing activities .............................................. (55)

Financing activities:
Decrease in bonds payable .............................................................. (20)
Increase in ordinary shares .............................................................. 40
Cash dividends ................................................................................ (35)

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Net cash used by financing activities .............................................. (15)

Net increase in cash (net cash flow) ................................................ 20

Cash balance, beginning .................................................................. 100
Cash balance, ending ....................................................................... P120

While not a requirement, a worksheet may be helpful.

Source Cash
or Flow Adjust- Adjusted
Change Use? Effect ments Effect Classification
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable .................................................. –10 Source +10 +10 Operating
Inventory ................................................................... +30 Use –30 –30 Operating
Prepaid expenses ..................................................... –5 Source +5 +5 Operating
Noncurrent assets:
Long-term investments ............................................. –30 Source +30 –50 –20 Investing
–
Plant and equipment ................................................. +150 Use 150 –150 Investing
Land .......................................................................... –30 Source +30 –30 0 Investing

Liabilities, Contra assets, and Shareholders’ Equity

Contra assets:
Accumulated depreciation ........................................ +40 Source +40 +40 Operating
Current liabilities:
Accounts payable...................................................... +20 Source +20 +20 Operating
Accrued liabilities ...................................................... –10 Use –10 –10 Operating
Taxes payable ........................................................... +10 Source +10 +10 Operating
Noncurrent liabilities:
Bonds payable .......................................................... –20 Use –20 –20 Financing
Deferred income taxes .............................................. +5 Source +5 +5 Operating
Shareholders’ equity:
Ordinary shares ........................................................ +40 Source +40 +40 Financing
Retained earnings:
Net income........................................................... +75 Source +75 +75 Operating
Dividends ............................................................. –35 Use –35 –35 Financing

Additional entries
Proceeds from sale of investments ................................ +45 +45 Investing
Loss on sale of investments ........................................... +5 +5 Operating
Proceeds from sale of land ............................................ +70 +70 Investing
Gain on sale of land ....................................................... –40 –40 Operating
Total +20 0 +20

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Exercise 5

Sales .............................................................................. P600

Adjustments to a cash basis:
Decrease in accounts receivable ............................ +10 P610
Cost of goods sold ......................................................... 250
Adjustments to a cash basis:
Increase in inventory ............................................. +30
Increase in accounts payable ................................. –20 260
Selling and administrative expenses.............................. 280
Adjustments to a cash basis:
Decrease in prepaid expenses ................................ –5
Decrease in accrued liabilities ............................... +10
Depreciation charges ............................................. –40 245
Income taxes .................................................................. 30
Adjustments to a cash basis:
Increase in taxes payable ....................................... –10
Increase in deferred taxes ...................................... –5 15
Net cash provided by operating activities ..................... P 90
Exercise 6

Requirements (1) and (2)

Stephenie Company
Statement of Cash Flows
For the Year Ended December 31, 2008

Operating activities:
Net income .......................................................................... P 56
Adjustments to convert net income to cash basis:
Depreciation charges ................................................... 25
Increase in accounts receivable ................................... (80)
Decrease in inventory .................................................. 35
Increase in prepaid expenses ....................................... (2)
Increase in accounts payable ....................................... 75
Decrease in accrued liabilities ..................................... (10)
Gain on sale of investments ......................................... (5)
Loss on sale of equipment ........................................... 2
Increase in deferred income taxes ............................... 8 48

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Net cash provided by operating activities ........................... 104

Investing activities:
Proceeds from sale of long-term investments ..................... 12
Proceeds from sale of equipment ........................................ 18
Additions to plant and equipment ....................................... (110)
Net cash used for investing activities .................................. (80)

Financing activities:
Increase in bonds payable.................................................... 25
Decrease in ordinary shares................................................. (40)
Cash dividends .................................................................... (16)
Net cash used for financing activities.................................. (31)

Net decrease in cash ............................................................ (7)

Cash balance, January 1, 2008 ............................................ 11
Cash balance, December 31, 2008 ...................................... P 4

While not a requirement, a worksheet may be helpful.

Source Cash
or Flow Adjust- Adjusted Classi-
Change Use? Effect ments Effect fication
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable ........................................ +80 Use –80 –80 Operating
Inventory ......................................................... –35 Source +35 +35 Operating
Prepaid expenses ........................................... +2 Use –2 –2 Operating
Noncurrent assets:
Plant and equipment ....................................... +80 Use –80 –30 –110 Investing
Long-term investments ................................... –7 Source +7 –7 0 Investing

Liabilities, Contra assets, and Shareholders’ Equity

Contra assets:
Accumulated depreciation .............................. +15 Source +15 +10 +25 Operating
Current liabilities:
Accounts payable............................................ +75 Source +75 +75 Operating
Accrued liabilities ............................................ –10 Use –10 –10 Operating
Noncurrent liabilities:
Bonds payable ................................................ +25 Source +25 +25 Financing
Deferred income taxes .................................... +8 Source +8 +8 Operating
Shareholders’ equity:
Ordinary shares .............................................. –40 Use –40 –40 Financing

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Retained earnings:
Net income................................................. +56 Source +56 +56 Operating
Dividends ................................................... –16 Use –16 –16 Financing

Additional entries
Proceeds from sale of equipment ........................ +18 +18 Investing
Loss on sale of equipment ................................... +2 +2 Operating
Proceeds from sale of long-term investments ...... +12 +12 Investing
Gain on sale of long-term investments ................ –5 –5 Operating

Total –7 0 –7

II. Problems

Problem 1

Transaction Operating Investing Financing Source Use

1. Short-term investment
securities were
purchased .................... X X
2. Equipment was
purchased .................... X X
3. Accounts payable
increased ..................... X X
4. Deferred taxes
decreased .................... X X
5. Long-term bonds were
issued .......................... X X
6. Ordinary shares were
sold ............................. X X
7. Interest was paid to
long-term creditors ...... X X
8. A long-term mortgage
was entirely paid off ... X X
9. A cash dividend was
declared and paid ........ X X
10. Inventories decreased ... X X
11. Accounts receivable
increased....................... X X
12. Depreciation charges
totaled P200,000 for the
year ............................... X X

Problem 2 (Analysis of Cash Flow Transactions)

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Requirement (a)

The eight items should be presented in the statement of cash flows as follows:
1. Net income is the basis for the calculation of cash flows from operating
activities by starting with that number and adjusting for noncash revenue
and expense transactions (indirect method) or by computing by the direct
method the positive cash flows from revenues, less the negative cash flows
from expenses. The cash flows from the transaction giving rise to the
extraordinary loss is reclassified as an investing activity.
2. The acquisition of intangibles is a negative cash flow from investing
activities. The amortization is a noncash expense in determining cash
flows from operating activities.
3. The payment of a cash dividend is a negative cash flow that is presented
in the financing activities section of the statement.
4. The purchase of treasury share is a negative cash flow in the financing
activities section of the statement.
5. The depreciation expense recognized during the year is a noncash expense
in determining cash flows from operating activities.
6. The conversion of convertible bonds into ordinary shares is a noncash
financing activity that requires disclosure in a separate schedule.
7. The changes in plant asset accounts – land, equipment, and building –
represent activities whose cash flow effects are presented in the investing
activities section of the statement.
8. The increase in working capital also represents the change in cash because
all other current assets and current liabilities remained constant. The net
of all cash flows from operating, investing and financing activities must
reconcile with the change in cash in the statement of cash flows.

Requirement (b)

1. Net cash provided by operating activities

Net income P145,000
Noncash expense adjustments:
Depreciation expense 46,250
Amortization expense 6,000
Reclassification of extraordinary loss 15,000
P212,250
2. Net cash used in investing activities

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Purchase of intangible assets P (34,000)

Purchase of land (130,000)
Purchase of equipment (60,000)
Purchase of building (100,000)
Sale of land 165,000
P(159,000)
3. Net cash used in financing activities
Purchase of treasury shares P(31,000)
Payment of dividends (12,500)
P(43,500)
Computations:
Depreciation expense
Change in accumulated depreciation account P35,000
Accumulated depreciation on fully depreciated
assets disposed 11,250
P46,250
Purchase of land
Change in land account P (50,000)
Cost of land sold in condemnation proceedings 180,000
P130,000

Problem 3 (Cash Flow from Operating Activities)

Cash received from customers:

Total revenues P185,000
Less: Note receivable (15,000) P170,000
Cash disbursed for expenses:
Total expenses (P173,000 + P4,200) P177,200
Less: Income taxes deferred (1,260)
Depreciation (25,000)
Amortization (7,000) (143,940)
Net cash provided by operating activities P 26,060

Problem 4 (Cash Flow from Operating Activities)

Cash received from customers (1) P5,237,000

Cash paid for expenses:
Cost of goods sold P3,150,000
Selling 246,000

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Salaries and wages (2) 394,400

Interest (3) 65,200
Miscellaneous operating 5,000
Incomes taxes (4) 335,000 4,195,600
Net cash provided by operating activities P1,041,400
Computations:
1. Revenue from sales P5,432,000
Less: Note receivable (120,000)
Land (75,000)
P5,237,000

2. Salaries and wages expense P 400,000

Less: Increase in accrued salaries and wages
(P45,600 – P40,000) (5,600)
P 394,400

3. Interest expense P 72,000

Less: Discount amortization (6,800)
P 65,200

4. Income tax expense P 445,000

Less: Deferred portion (110,000)
P 335,000

Problem 5 (Statement of Cash Flows Preparation – Indirect)

Green Tea Company

Statement of Cash Flows
For the Year Ended December 31, 2005

Cash flows from operating

activities
Net income* P8,500
Adjustments to reconcile net
income to net cash flows
provided by operating activities:
Depreciation 1,000

*
Increase in retained earnings (P20,000 – P13,000) P7,000
Dividends declared 1,500
Net income P8,500

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Amortization of intangibles 1,000

Increase in current assets
(6,000)
Increase in current liabilities 3,000
Net cash provided by P7,500
operating activities

Cash flows from financing activities

Dividends paid (1,500)
Retirement of long-term liabilities (1,000)
Net cash used in financing (2,500)
activities
Net increase in cash P 5,000
Cash, January 1, 2005 10,000
Cash, December 31, 2005 P15,000

Problem 6 (Cash Flow Statement Preparation – Direct)

Requirement (a)

Hundred Acre Company

Statement of Cash Flows
For the Year Ended December 31, 2005

Cash flows from operating

activities
Cash received from customers P74,000
Cash paid for expense 67,000
Net cash provided by P7,000
operating activities
Cash flow from investing activities
Sale of equipment 9,500
Sale of investments 15,000
Acquisition of equipment (53,000)
Net cash used in investing (28,500)
activities
Cash flows from financing activities
Sale of ordinary shares 40,000
Payment of cash dividends (8,500)
Net cash used in financing 31,500
activities

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Net increase in cash P10,000

Cash, January 1, 2005 20,000
Cash, December 31, 2005 P30,000

Reconciliation of net income to net cash

provided by operating activities:
Net income P15,000
Adjustments to reconcile net income to
net cash provided by operating
activities:
Depreciation expense 24,500*
Amortization expense 1,000
Increase in accounts receivable (33,000)
Decrease in accrued expenses (500)
Net cash provided by operating activities P 7,000

Computations:
Cash received from customers:
Revenues P107,000
Deduct: Increase in accounts receivable
(P78,000 – P45,000) 33,000
P 74,000
Cash paid for expenses:
Expenses P 92,000
Add: Decrease in accrued expenses
(P7,500 – P7,000) 500
Deduct: Depreciation expense
(P33,600 – P27,100 + P18,000) (24,500)
Amortization (1,000)
P 67,000
Cash from sale of equipment:
Cost P 27,500
Deduct: Accumulated depreciation (18,000)
Cash received on sale at book value P 9,500
Cash paid to acquire equipment:
Increase in property, plant and equipment

*
Net increase during 2005 (P33,600 – P27,100) P 6,500
Accumulated depreciation on assets sold 18,000
Depreciation expense for 2005 P24,500

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 Cost Concepts and Classifications Chapter 8

(P118,100 – P92,600) P 25,500

Cost of machinery sold 27,500
P 53,000
Cash received on sale of shares:
Increase in ordinary shares amount
(P100,000 – P75,000) P 25,000
Increase in additional paid-in capital account
(P55,000 – P40,000) 15,000
P 40,000
Cash dividends:
Increase in retained earnings (P21,000 – P14,500) P 6,500
Net income (P107,000 – P92,000) (15,000)
P 8,500

Requirement (b)

The reconciliation of net income to net cash provided by or used in operating

activities is required to be disclosed in order to show more clearly the
relationship and emphasize the differences between the two. Users of financial
statements are often not as aware of the accrual concepts, which determine net
income, as are preparers of those statements. The reconciliation of net income
to net cash flows from operating activities clearly demonstrates that the two
are different and details those events and transactions that account for the
difference.

Problem 7 (Interpretation of Cash Flow Statement)

Requirement (a)

The two companies are similar in the following respects:

1. Overall size.
2. Industry in which they operate.
3. Current ratio (2.4 to 1).
4. Overall peso amounts of cash provided and used:

Range, 2002-2005
Cash Cash Used
Provided
Ebony P125,000 – P115,000 –
Company P168,000 P170,000

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Chapter 8 Cost Concepts and Classifications

Ivory P135,000 – P125,000 –

Company P160,000 P165,000

5. Net increase in working capital is identical for each year, 2002 – 2005.

Requirement (b)

The two companies are dissimilar in the makeup of the sources of cash, as
indicated in the following analysis:

Sources of Cash in Percentages

2002 2003 2004 2005
E I E I E I E I
b v b v b v b v
o o o o o o o o
n r n r n r n r
y y y y y y y y
C
a
s
h
p
r
o
v
i
d
e
d
:
Opera 80 37 77 21 70 (38) 76 7
tions

Long- 8 56 -- 10 -- 44 9 --
term
debt
Share -- -- 16 52 -- 63 -- 56
capita
l
Asset 12 7 7 17 30 31 15 37
dispos
ition
100 100 100 100 100 100 100 100

Ebony Company has relied much more heavily on operations to provide cash
and to a very limited extent on debt and equity financing and asset disposition.

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 Cost Concepts and Classifications Chapter 8

On the other hand, Ivory Company has not been able to provide cash from
operations and has been required to rely on the alternatives of debt and equity
financing and asset disposition.

Requirement (c)

Ebony Company is in a considerably stronger position (as determined by the

data given) and thus should be considered the better investment and credit risk.
The following points are significant:
1. Ebony Company has provided 70%-80% of its cash via operating
activities, supplementing with other means to maintain a current ratio
at the industry average. Ebony has not had to rely consistently on any
alternative source of funding.
2. Ivory Company has apparently been forced to rely continuously on
debt financing except in 2005, perhaps because of the inability to
obtain such financing. The year 2004 is particularly weak for Ivory,
with operations resulting in a P60,000 reduction in cash. The ability
of Ivory to sustain its present financial position (i.e., current ratio, etc.)
is questionable in light of its history.

III. Multiple Choice Questions

1. D 4. D 7. C 10. B
2. C 5. B 8. B 11. A
3. D 6. D 9. A 12. D

CHAPTER 7

GROSS PROFIT VARIATION ANALYSIS AND

EARNINGS PER SHARE DETERMINATION

I. Problems

Problem I

The Dawn Mining Company

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Chapter 8 Cost Concepts and Classifications

Gross Profit Variation Analysis

For 2006

Increase in Sales:
Quantity Factor [(24,000) x P8] P(192,000)
Price Factor (105,000 x P3) 315,000
Quantity/Price Factor [(24,000) x P3] (72,000) P 51,000
Less: Increase (decrease) in Cost of Sales:
Quantity Factor [(24,000) x P9] P(216,000)
Cost Factor [105,000 x (P.50)] (52,500)
Quantity/Cost Factor [(24,000) x (P.50)] 12,000 (256,500)
Increase in Gross Profit P 307,500

Problem II

1. Selling Price Factor

Sales in 2006 P210,000
Less: Sales in 2006 at 2005 prices
(P210,000  105%) 200,000
Favorable P 10,000

2. Cost Factor
Cost of Sales in 2006 P164,000
Less: Cost of Sales in 2006 at 2005 costs 176,000
Favorable P(12,000)

3. Quantity Factor
Increase in Sales
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Favorable P 50,000
Less: Increase in Cost of Sales
Cost of Sales in 2006 at 2005 costs
(P132,000 x 133-1/3%) P176,000
Less: Cost of Sales in 2005 132,000
Unfavorable P 44,000
Net favorable quantity factor 6,000*
Increase in Gross Profit P 28,000

* This may also be obtained using the following presentation:

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Quantity Factor:
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Increase in Sales P 50,000
Multiplied by: Ave. Gross Profit rate in 2005 12%
Net favorable variance P 6,000

Problem III
Requirement A:
Tony Corporation
Statement Accounting for Gross Profit Variation
For 2006

Increase (Decrease) in Sales accounted for as follows:

Price Factor
Sales this year P210,210
Less: Sales this year at last year’s prices 269,500
Favorable (Unfavorable) P(59,290)
Quantity Factor
Sales this year at last year’s
prices (P210,210  78%) P269,500
Less: Sales last year 192,500
Favorable (Unfavorable) P 77,000
Net Increase (decrease) in sales P 17,710
Increase (decrease) in Cost of Sales accounted for as follows:

Cost Factor
Cost of Sales this year P 165,400
Less: Cost of Sales this year at last
year’s costs 161,700
(Favorable) Unfavorable P 3,700

Quantity Factor
Cost of Sales this year at last year’s
costs (115,500 x 140%) P 161,700
Less: Cost of Sales last year 115,500
(Favorable) Unfavorable P 46,200

Net increase (decrease) in Cost of Sales P 49,900

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Net increase (decrease) in Gross Profit P (32,190)

Gross Profit, this year P 44,810

Gross Profit, last year 77,000
Increase (Decrease) in Gross Profit P(32,190)

Requirement B:

(1) Change in Quantity = P 77,000 = 40% increase

P192,500

(2) Change in Unit Costs = P 3,700 = 2.38% increase

P161,700

Problem IV

Quantity Factor
1. Decrease in Sales due to decrease in the number
of customers [(1,000) x 18 MCF x P2.50)] P(45,000)
2. Increase in Sales due to increase in consumption
rate per customer (26,000 x 2 MCF x P2.50) 130,000
Net Increase P 85,000

Price Factor
3. Decrease in Sales due to the decrease in rate per
MCF [P(.05) x 520,000] (26,000)
Increase in operating revenues P 59,000

Supporting Computations:
Average Consumption:
(a) 2006 = 520,000  26,000 = 20 MCF/customer
2005 = 486,000  27,000 = 18 MCF/customer
Increase in Consumption
per customer 2 MCF/customer

(b) 27,000 - 26,000 = 1,000 decrease in number of customers

(c) Price 2006 P2.45

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 Cost Concepts and Classifications Chapter 8

2005 2.50
Decrease in rate or
price per MCF sold P(.05)

Problem V

XYZ Corporation
Gross Profit Variation Analysis
For 2006

Price Factor
Sales in 2006 P 1,750
Less: Sales in 2006 at 2005 prices
A (25 x P10) P 250
B (75 x P20) 1,500 1,750
Increase (decrease) in gross profit P -

Cost Factor:
Cost of sales in 2006 P 875
Less: Cost of sales in 2006 at 2005 costs:
A (25 X P5) P 125
B (75 x P10) 750 875
Increase (decrease) in gross profit P -

Quantity Factor:
Increase (decrease) in total quantity
Multiplied by: Average gross profit
per unit in 2005 (P750  100) P 7.50
Increase (decrease) in gross profit P -

Sales Mix Factor:

Average gross profit per unit in 2006 at
2005 prices P8.75 *
Less: Average gross profit per unit in 2005 7.50
Increase (decrease) P1.25
Multiplied by: Total quantity in 2006 100
Increase (decrease) in gross profit P125.00
Increase in Gross Profit P125.00

* Sales in 2006 at 2005 prices P1,750

Less: Cost of sales in 2006 at 2005 prices 875

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Gross profit in 2006 at 2005 prices P 875

Average Gross Profit on 2006 at 2005 prices:

P875 = P8.75
100 (volume in 2006)

Problem VI (Computation of Weighted Average Number of Ordinary

Shares)

Number of Shares
Adjustment
for 25%
stock As Weighted
Date Unadjusted dividend Adjusted Multiplier Shares
1/1/2006 16,000 4,000 20,000 12/12 20,000
2/15/2006 3,200 800 4,000 10.5/12 3,500
4/1/2006 (3,000) (750) (3,750) 9/12 (2,812)
6/1/2006 1,400 350 1,750 7/12 1,020
9/1/2006 6,400 1,600 8,000 4/12 2,667
12/1/2006 6,000 (6,000) - - -
Total 30,000 - 30,000 24,375

Problem VII (Computation of Basic EPS and Diluted EPS)

1. Basic EPS = P 90,000

100,000

= P0.90

2. Diluted EPS = P90,000 + (10% x P500,000 x 65%)

P500,000
100,000 + x 100
P1,000
P90,000 + P32,500
= 150,000
= P0.82 (rounded off)

Problem VIII

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 Cost Concepts and Classifications Chapter 8

Requirements (1) and (2)

Explanation Earnings  Shares = Per Share

Basic earnings and shares P122,000 a
 33,333 b
= P3.66 Basic
Stock option share increment 293c
Tentative DEPS1 amounts P122,000  33,626 = P3.63 DEPS1
10% bond interest expense savingse 13,300d
Increment in shares 4,400d
Tentative DEPS2 amounts P135,300  38,026 = P3.56 DEPS2
7.5% preference dividend savingse 28,500d
Increment in shares 9,310d
P163,800  47,336 = P3.46 DEPS3
5.8% bonds 21,924 6,264
Diluted earnings and shares P185,724  53,600 = P3.465 Diluted

a
P122,000 = P150,500 (net income) - P28,500 (preference dividends)
b
Weighted average shares: 25,000 x 1.20 = 30,000 x 7/12 = 17,500
32,000 x 1.20 = 38,400 x 4/12 = 12,800
38,400 - 2,000 = 36,400 x 1/12 = 3,033
Weighted average shares 33,333

c
Increment due to stock options:

Issued 4,000
4,000 x ( P33 + P5 )
Reacquired = (3,707)
P41
Increment in shares 293
d
Impact on diluted earnings per share and ranking:
Impact Ranking

[(0.10 x P200,000) – P1,000] x 0.7 P13,300

10% bonds: = 4,400 P3.02 5
200 x 22

5.8% bonds: (0.058 x P540,000) x 0.7 P21,924 P3.50 3

540 x 11.6 = 6,264

7.5% preference: (0.075 x P380,000) P3.06 2

P28,500
3,800 x 2.45 =
e
Dilutive effect on diluted earnings per share: 9,310
10% bonds: P3.02 impact < P3.63 (DEPS1), therefore dilutive
7.5% preference: P3.06 impact < P3.56 (DEPS2), therefore dilutive

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5.8% bonds: P3.50 impact > P3.46 (DEPS3), therefore exclude from EPS

Requirement 3

Fuego Company would report basic earnings per share of P3.66 and diluted
earnings per share of P3.46 on its 2005 income statement.

II. Multiple Choice Questions

1. B 5. A 9. A 13. A 17. A 21. C

2. B 6. B 10. A 14. D 18. B 22. A
3. C 7. B 11. D* 15. C 19. C 23. B
4. D 8. B 12. C 16. A 20. D

* Supporting computation for no. 11:

P3,500,000 + (P800,000 x 65%)
Diluted EPS for 12/31/2006 =
400,000 + 25,000 + 225,000
P4,020,000
= or P6.18
650,000
CHAPTER 8

COST CONCEPTS AND CLASSIFICATIONS

I. Questions

1. The phrase “different costs for different purposes” refers to the fact that
the word “cost” can have different meanings depending on the context in
which it is used. Cost data that are classified and recorded in a particular
way for one purpose may be inappropriate for another use.

2. Fixed costs remain constant in total across changes in activity, whereas

variable costs change in proportion to the level of activity.

3. Examples of direct costs of the food and beverage department in a hotel

include the money spent on the food and beverages served, the wages of
table service personnel, and the costs of entertainment in the dining room
and lounge. Examples of indirect costs of the food and beverage

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 Cost Concepts and Classifications Chapter 8

department include allocations of the costs of advertising for the entire

hotel, of the costs of the grounds and maintenance department, and of the
hotel general manager’s salary.

4. The cost of idle time is treated as manufacturing overhead because it is a

normal cost of the manufacturing operation that should be spread out
among all of the manufactured products. The alternative to this treatment
would be to charge the cost of idle time to a particular job that happens to
be in process when the idle time occurs. Idle time often results from a
random event, such as a power outage. Charging the cost of the idle time
resulting from such a random event to only the job that happened to be in
process at the time would overstate the cost of that job.

5. a. Uncontrollable cost
b. Controllable cost
c. Uncontrollable cost

6. Product costs are costs that are associated with manufactured goods until
the time period during which the products are sold, when the product costs
become expenses. Period costs are expensed during the time period in
which they are incurred.

7. The most important difference between a manufacturing firm and a service

industry firm, with regard to the classification of costs, is that the goods
produced by a manufacturing firm are inventoried, whereas the services
produced by a service industry firm are consumed as they are produced.
Thus, the costs incurred in manufacturing products are treated as product
costs until the period during which the goods are sold. Most of the costs
incurred in a service industry firm to produce services are operating
expenses that are treated as period costs.

8. Product costs are also called inventoriable costs because they are assigned
to manufactured goods that are inventoried until a later period, when the
products are sold. The product costs remain in the finished goods
inventory account until the time period when the goods are sold.

9. A sunk cost is a cost that was incurred in the past and cannot be altered by
any current or future decision. A differential cost is the difference in a
cost item under two decision alternatives.

10. a. Direct cost

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b. Direct cost
c. Indirect cost
d. Indirect cost

11. The two properties of a relevant cost are:

1. it differs between the decision options
2. it will be incurred in the future

12. The three types of product costs are:

1. direct materials – the materials used in manufacturing the product,
which become a physical part of the finished product.
2. direct labor – the labor used in manufacturing the product.
3. factory overhead – the indirect costs for materials, labor, and facilities
used to support the manufacturing process, but not used directly in
manufacturing the product.

13. The three types of manufacturing inventories are:

1. materials inventory – the store of materials used in the manufacturing
process or in providing the service.
2. work in process inventory – accounts for all costs put into the
manufacturing of products that are started but not complete at the
financial statement date.
3. finished goods inventory – the cost of goods that are ready for sale.

14. Direct materials include the materials in the product and a reasonable
allowance for scrap and defective units, while indirect materials are
materials used in manufacturing that are not physically part of the finished
product.

15. The income statement of a manufacturing company differs from the

income statement of a merchandising company in the cost of goods sold
section. A merchandising company sells finished goods that it has
purchased from a supplier. These goods are listed as “purchases” in the
cost of goods sold section. Since a manufacturing company produces its
goods rather than buying them from a supplier, it lists “cost of goods
manufactured” in place of “purchases.” Also, the manufacturing company
identifies its inventory in this section as Finished Goods inventory, rather
than as Merchandise Inventory.

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 Cost Concepts and Classifications Chapter 8

16. Yes, costs such as salaries and depreciation can end up as part of assets on
the balance sheet if these are manufacturing costs. Manufacturing costs are
inventoried until the associated finished goods are sold. Thus, if some units
are still in inventory, such costs may be part of either Work in Process
inventory or Finished Goods inventory at the end of a period.

17. No. A variable cost is a cost that varies, in total, in direct proportion to
changes in the level of activity. A variable cost is constant per unit of
product. A fixed cost is fixed in total, but the average cost per unit changes
with the level of activity.

18. Manufacturing overhead is an indirect cost since these costs cannot be

easily and conveniently traced to particular units of products.

19.
Direct labor cost (34 hours  P15 per hour) .......................... P510
Manufacturing overhead cost (6 hours  P15 per hour) ........ 90
Total wages earned ................................................................ P600

20.
Direct labor cost (45 hours  P14 per hour) ......................... P630
Manufacturing overhead cost (5 hours  P7 per hour) ......... 35
Total wages earned .............................. P665

II. Exercises

Exercise 1 (Schedule of Cost of Goods Manufactured and Sold; Income

Statement)

Requirement 1

Amazing Aluminum Company

Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2005

Direct material:
Raw-material inventory, January P 60,000
1
Add: Purchases of raw 250,000
material

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Raw material available for P310,000

use
Deduct: Raw-material inventory, December 70,000
31
Raw material P240,000
used

Direct 400,000
labor

Manufacturing overhead:
Indirect P 10,000
material

Indirect 25,000
labor

Depreciation on plant and 100,000

equipment

Utilities 25,000
................................................................
................................................................
Other 30,000
................................................................
................................................................
Total manufacturing 190,000
overhead

Total manufacturing P830,000

costs
Add: Work-in-process inventory, January 120,000
1
Subtotal P950,000
.......................................................................
.......................................................................
Deduct: Work-in-process inventory, December 1 115,000
.......................................................................

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 Cost Concepts and Classifications Chapter 8

Cost of goods P835,000

manufactured
.......................................................................

Requirement 2

Amazing Aluminum Company

Schedule of Cost of Goods Sold
For the Year Ended December 31, 2005

Finished goods inventory, January P150,000

1
Add: Cost of goods 835,000
manufactured

Cost of goods available for P985,000

sale
Deduct: Finished goods inventory, December 165,000
31
Cost of goods P820,000
sold

Requirement 3

Amazing Aluminum Company

Income Statement
For the Year Ended December 31, 2005

Sales P1,105,00
revenue 0
Less: Cost of goods
sold 820,000
Gross P
margin 285,000
Selling and administrative
expenses 110,000

Income before P
taxes 175,000
Income tax
expense 70,000

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Chapter 8 Cost Concepts and Classifications

Net P
income 105,000

Exercise 2

Fixed (F) Period (P)

Cost Item Variable (V) Product (R)
a. Transportation-in costs on materials
purchased V R
b. Assembly-line workers’ wages V R
c. Property taxes on work in process
inventories V R
d. Salaries of top executives in the F P
company
e. Overtime premium for assembly workers V R
f. Sales commissions V P
g. Sales personnel office rental F P
h. Production supervisory salaries F R
i. Controller’s office supplies F P
Fixed (F) Period (P)
Cost Item Variable (V) Product (R)
j. Executive office heat and air F P
conditioning
k. Executive office security personnel F P
l. Supplies used in assembly work V R
m. Factory heat and air conditioning F R
n. Power to operate factory equipment V R
o. Depreciation on furniture for sales staff F P
p. Varnish used for finishing product V R
q. Marketing personnel health insurance F P
r. Packaging materials for finished product V R
s. Salary of the quality control manager
who checks work on the assembly line F R
t. Assembly-line workers’ dental insurance F R

Exercise 3 (Cost Classifications; Manufacturer)

1. a, d, g, i
2. a, d, g, j
3. b, f

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 Cost Concepts and Classifications Chapter 8

4. b, d, g, k
5. a, d, g, k
6. a, d, g, j
7. b, c, f
8. b, d, g, k
9. b, c and d*, e and f and g*, k*
* The building is used for several purposes.
10. b, c, f
11. b, c, h
12. b, c, f
13. b, c, e
14. b, c and d†, e and f and g†, k†
†
The building that the furnace heats is used for several purposes.
15. b, d, g, k

Exercise 4 (Economic Characteristics of Costs)

1. marginal cost
2. sunk cost
3. average cost
4. opportunity cost
5. differential cost
6. out-of-pocket cost

Exercise 5 (Cost Classifications; Hotel)

1. a, c, e, k
2. b, d, e, k
3. d, e, i
4. d, e, i
5. a, d, e, k
6. a, d, e, k
7. d, e, k
8. b, d†, e, k

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Chapter 8 Cost Concepts and Classifications
†
Unless the dishwasher has been used improperly.
9. h
10. a, d, e*, j
* The hotel general manager may have some control over the total space allocated
to the kitchen.
11. i
12. j
13. a, c, e
14. e, k

Exercise 6

Pickup Truck Output

3,000 trucks 6,000 trucks 9,000 trucks

Variable production costs P 29,640,000 P 59,280,000 P 88,920,000
Fixed production costs 39,200,000 39,200,000 39,200,000
Variable selling costs 4,500,000 9,000,000 13,500,000
Fixed selling costs 13,660,000 13,660,000 13,660,000
Total costs P 87,000,000 P121,140,000 P155,280,000

Selling price per truck 46,000 40,100 35,900

Unit cost 29,000 20,190 17,253

Profit per truck 17,000 19,910 18,647

Exercise 7

(see next page)

Exercise 8

1. The wages of employees who build the sailboats: direct labor cost.
2. The cost of advertising in the local newspapers: marketing and selling cost.
3. The cost of an aluminum mast installed in a sailboat: direct materials cost.
4. The wages of the assembly shop’s supervisor: manufacturing overhead
cost.
5. Rent on the boathouse: a combination of manufacturing overhead,

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 Cost Concepts and Classifications Chapter 8

administrative, and marketing and selling cost. The rent would most likely
be prorated on the basis of the amount of space occupied by
manufacturing, administrative, and marketing operations.
6. The wages of the company’s bookkeeper: administrative cost.
7. Sales commissions paid to the company’s salespeople: marketing and
selling cost.
8. Depreciation on power tools: manufacturing overhead cost.

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 Cost Concepts and Classifications Chapter 8

Exercise 7

P Product Cost
er
io
d
Var F (Selling and Dire D Manufa S Oppor
iab i Administrative) ct ir cturing u tunity
le x Cost Mat e Overhe n Cost
Co e eria c ad k
st d ls t C
C L o
o a s
s b t
t o
r
1. Wood used
in a table
X X
(P200 per
table)
2. Labor cost
to assemble
X X
a table (P80
per table)
3. Salary of
the factory
supervisor X X
(P76,000
per year)
4. Cost of
electricity to
produce
tables (P4 X X
per
machine-
hour)

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 Cost Concepts and Classifications Chapter 8
5.
Depr
eciation of
machines
X
used to X X *
produce
tables
(P20,000
per year)
6. Salary of
the
company
X X
president
(P200,000
per year)
7. Advertising
expense
X X
(P500,000
per year)
8.
Com
missions
paid to X X
salesperso
ns (P60 per
table sold)
9. Rental
income
forgone on X1
factory
space
*
This is a sunk cost because the outlay for the equipment was made in a previous period.
1
This is an opportunity cost because it represents the potential benefit that is lost or sacrificed as a result of using the factory space to produce tables. Opportunity
cost is a special category of cost that is not ordinarily recorded in an organization’s accounting books. To avoid possible confusion with other costs, we will not
attempt to classify this cost in any other way except as an opportunity cost.

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Exercise 9

Direct Indirect
Cost Cost Object Cost Cost
1. The salary of the head chef The hotel’s restaurant X
2. The salary of the head chef A particular restaurant X
customer
3. Room cleaning supplies A particular hotel guest X
4. Flowers for the reception A particular hotel guest X
desk
5. The wages of the doorman A particular hotel guest X
6. Room cleaning supplies The housecleaning X
department
7. Fire insurance on the hotel The hotel’s gym X
building
8. Towels used in the gym The hotel’s gym X

Note: The room cleaning supplies would most likely be considered an indirect
cost of a particular hotel guest because it would not be practical to keep track
of exactly how much of each cleaning supply was used in the guest’s room.

III. Problems

Problem 1

The relevant costs for this decision are the differential costs. These are:

Opportunity cost or lost wages (take home)

[P1,500 x 70% x 12 months] ........ P12,600
Tuition..................................................... 2,200
Books and supplies ................................. 300
Total differential costs ...................... P15,100

Room and board, clothing, car, and incidentals are not relevant because these
are presumed to be the same whether or not Francis goes to school. The
possibility of part-time work, summer jobs, or scholarship assistance could be
considered as reductions to the cost of school. If students are familiar with the
time value of money, then they should recognize that the analysis calls for a
comparison of the present value of the differential after-tax cash inflows with
the present value of differential costs of getting the education (including the
opportunity costs of lost income).
Problem 2

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 Cost Concepts and Classifications Chapter 8

Requirement (a)

Only the differential outlay costs need be considered. The travel and other
variable expenses of P22 per hour would be the relevant costs. Any amount
received in excess would be a differential, positive return to Pat.

Requirement (b)

The opportunity cost of the hours given up would be considered in this

situation. Unless Pat receives more than the P100 normal consulting rate, the
contract would not be beneficial.

Requirement (c)

In this situation Pat would have to consider the present value of the contract
and compare that to the present value of the existing consulting business. The
final rate may be more or less than the normal P100 rate depending on the
outcome of Pat’s analysis.

Problem 3

Utilities for the bakery 2,100

Paper used in packaging product 90
Salaries and wages in the bakery 19,500
Cookie ingredients 35,000
Bakery labor and fringe benefits 1,300
Bakery equipment maintenance 800
Depreciation of bakery plant and equipment 2,000
Uniforms 400
Insurance for the bakery 900
Boxes, bags, and cups used in the bakery 1,100
Bakery overtime premiums 2,600
Bakery idle time 500
Total product costs in pesos 66,290

Problem 4

Administrative costs 1,000

Rent for administration offices 17,200
Advertising 1,900

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Office manager’s salary 13,000

Total period costs in pesos 33,100

Problem 5

Requirement (a)

Sunk costs not shown could include lost book value on traded assets,
depreciation estimates for new investment, and interest costs on capital needed
during facilities construction.

Requirement (b)

The client might be used to differential cost as a decision tool, and believes
(correctly) that use of differential analyses has several advantages --- it is
quicker, requires less data, and tends to give a better focus to the decision. The
banker might suspect the client of hiding some material data in order to make
the proposal more acceptable to the financing agency.

Problem 6

Requirement (1)

EH Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31

Direct materials:
Raw materials, inventory, January 1 P
45,000
Add: Purchases of raw materials
375,000
Raw materials available for use 420,000
Deduct: Raw materials inventory,
December 31 30,000
Raw materials used in production P
390,000
Direct labor 75,000
Manufacturing overhead:
Utilities, factory 18,000
Depreciation, factory 81,000

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 Cost Concepts and Classifications Chapter 8

Insurance, factory 20,000

Supplies, factory 7,500
Indirect labor 150,000
Maintenance, factory
43,500
Total manufacturing overhead cost
320,000
Total manufacturing cost 785,000
Add: Work in process inventory,
January 1 90,000
875,000
Deduct: Work in process inventory,
December 31 50,000
Cost of goods manufactured P825,000

Requirement (2)

The cost of goods sold would be computed as follows:

Finished goods inventory, January 1 P130,000

Add: Cost of goods manufactured
825,000
Goods available for sale 955,000
Deduct: Finished goods inventory, December
31 105,000
Cost of goods sold P850,000

Requirement (3)

EH Corporation
Income Statement
For the Year Ended December 31

Sales P1,250,000
Cost of goods sold (above) 850,000
Gross margin 400,000
Selling and administrative expenses:
Selling expenses P
70,000
Administrative expenses
135,000 205,000

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Net operating income P

195,000

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 Cost Concepts and Classifications Chapter 8

Problem 7

Note to the Instructor: Some of the answers below are debatable.

Adminis- Manufacturing
Variable or Selling trative (Product) Cost
Cost Item Fixed Cost Cost Direct Indirect
1. Depreciation, executive jet ...................................................................... F X
2. Costs of shipping finished goods to customers ....................................... V X
3. Wood used in manufacturing furniture .................................................... V X
4. Sales manager’s salary ............................................................................ F X
5. Electricity used in manufacturing furniture ............................................. V X
6. Secretary to the company president ......................................................... F X
7. Aerosol attachment placed on a spray can produced by the company .... V X
8. Billing costs ............................................................................................. V X*
9. Packing supplies for shipping products overseas .................................... V X
10. Sand used in manufacturing concrete ...................................................... V X
11. Supervisor’s salary, factory ..................................................................... F X
12. Executive life insurance .......................................................................... F X
13. Sales commissions ................................................................................... V X
14. Fringe benefits, assembly line workers ................................................... V X**
15. Advertising costs ..................................................................................... F X
16. Property taxes on finished goods warehouses ......................................... F X
17. Lubricants for production equipment ...................................................... V X
*Could be an administrative cost.
**Could be an indirect cost.

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 Cost Concepts and Classifications Chapter 8
Problem 8
Requirement (1)
Period
(Selling
Product Cost and
Variable Fixed Direct Direct Mfg. Admin.) Opportunity Sunk
Name of the Cost Cost Cost Materials Labor Overhead Cost Cost Cost
Ling’s present salary of P400,000 per
month ...................................................... X
Rent on the garage, P15,000 per month ....... X X
Rent of production equipment, P50,000 per
month ...................................................... X X
Materials for producing flyswatters, at
P30.00 each ............................................. X X
Labor cost of producing flyswatters, at
P50.00 each ............................................. X X
Rent of room for a sales office, P7,500 per
month ...................................................... X X
Answering device attachment, P2,000 per
month ...................................................... X X
Interest lost on savings account, P100,000
per year ................................................... X
Advertising cost, P40,000 per month ........... X X
Sales commission, at P10.00 per flyswatter . X X
Legal and filing fees, P60,000 ..................... X

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Requirement (2)

The P60,000 legal and filing fees are not a differential cost. These legal and
filing fees have already been paid and are a sunk cost. Thus, the cost will not
differ depending on whether Ling decides to produce flyswatters or to stay
with the consulting firm. All other costs listed above are differential costs since
they will be incurred only if Ling leaves the consulting firm and produces the
flyswatters.

Problem 9

Requirement (1)

Ms. Rio’s first action was to direct that discretionary expenditures be delayed
until the first of the new year. Providing that these “discretionary
expenditures” can be delayed without hampering operations, this is a good
business decision. By delaying expenditures, the company can keep its cash a
bit longer and thereby earn a bit more interest. There is nothing unethical about
such an action. The second action was to ask that the order for the parts be
cancelled. Since the clerk’s order was a mistake, there is nothing unethical
about this action either.

The third action was to ask the accounting department to delay recognition of
the delivery until the bill is paid in January. This action is dubious. Asking the
accounting department to ignore transactions strikes at the heart of the integrity
of the accounting system. If the accounting system cannot be trusted, it is very
difficult to run a business or obtain funds from outsiders. However, in Ms.
Rio’s defense, the purchase of the raw materials really shouldn’t be recorded
as an expense. He has been placed in an extremely awkward position because
the company’s accounting policy is flawed.

Requirement (2)

The company’s accounting policy with respect to raw materials is incorrect.

Raw materials should be recorded as an asset when delivered rather than as an
expense. If the correct accounting policy were followed, there would be no
reason for Ms. Rio to ask the accounting department to delay recognition of
the delivery of the raw materials. This flawed accounting policy creates
incentives for managers to delay deliveries of raw materials until after the end
of the fiscal year. This could lead to raw materials shortages and poor relations
with suppliers who would like to record their sales before the end of the year.

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The company’s “manage-by-the-numbers” approach does not foster ethical

behavior—particularly when managers are told to “do anything so long as you
hit the target profits for the year.” Such “no excuses” pressure from the top too
often leads to unethical behavior when managers have difficulty meeting target
profits.

IV. Multiple Choice Questions

1. B 7. C 13. D 19. A 25. C

2. D 8. D 14. D† 20. A* 26. B
3. B 9. C 15. B† 21. B 27. B
4. A 10. C 16. A† 22. B 28. A **
5. C 11. A 17. C† 23. C 29. A
6. D 12. C 18. C 24. C 30. B

* Controllable costs are those costs that can be influenced by a specified

manager within a given time period.
** The answer assumes absorption costing method is used.
†
Supporting Computations
14. P60 + P10 + P18 + P4 = P92 16. P60 + P10 + P18 + P32 = P120
15. P32 + P16 = P48 17. P4 + P16 = P20

CHAPTER 9

COST BEHAVIOR: ANALYSIS AND USE

I. Questions

1. a. Variable cost: A variable cost is one that remains constant on a per

unit basis, but which changes in total in direct relationship to changes
in volume.
b. Fixed cost: A fixed cost is one that remains constant in total amount,
but which changes, if expressed on a per unit basis, inversely with
changes in volume.

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c. Mixed cost: A mixed cost is a cost that contains both variable and
fixed cost elements.

2. a. Unit fixed costs will decrease as volume increases.

b. Unit variable costs will remain constant as volume increases.
c. Total fixed costs will remain constant as volume increases.
d. Total variable costs will increase as volume increases.

3. a. Cost behavior: Cost behavior can be defined as the way in which

costs change or respond to changes in some underlying activity, such
as sales volume, production volume, or orders processed.
b. Relevant range: The relevant range can be defined as that range of
activity within which assumptions relative to variable and fixed cost
behavior are valid.

4. Although the accountant recognizes that many costs are not linear in
relationship to volume at some points, he concentrates on their behavior
within narrow bands of activity known as the relevant range. The relevant
range can be defined as that range of activity within which assumptions as
relative to variable and fixed cost behavior are valid. Generally, within
this range an assumption of strict linearity can be used with insignificant
loss of accuracy.
5. The high-low method, the scattergraph method, and the least-squares
regression method are used to analyze mixed costs. The least-squares
regression method is generally considered to be most accurate, since it
derives the fixed and variable elements of a mixed cost by means of
statistical analysis. The scattergraph method derives these elements by
visual inspection only, and the high-low method utilizes only two points
in doing a cost analysis, making it the least accurate of the three methods.

6. The fixed cost element is represented by the point where the regression
line intersects the vertical axis on the graph. The variable cost per unit is
represented by the slope of the line.

7. The two assumptions are:

1. A linear cost function usually approximates cost behavior within the
relevant range of the cost driver.

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2. Changes in the total costs of a cost object are traceable to variations or

changes in a single cost driver.

8. No. High correlation merely implies that the two variables move together
in the data examined. Without economic plausibility for a relationship, it
is less likely that a high level of correlation observed in one set of data will
be found similarly in another set of data.

9. Refer to page 312 of the textbook.

10. The relevant range is the range of the cost driver in which a specific
relationship between cost and cost driver is valid. This concept enables
the use of linear cost functions when examining CVP relationships as long
as the volume levels are within that relevant range.

11. A unit cost is computed by dividing some amount of total costs (the
numerator) by the related number of units (the denominator). In many
cases, the numerator will include a fixed cost that will not change despite
changes in the denominator. It is erroneous in those cases to multiply the
unit cost by activity or volume change to predict changes in total costs at
different activity or volume levels.

12. Cost estimation is the process of developing a well-defined relationship

between a cost object and its cost driver for the purpose of predicting the
cost. The cost predictions are used in each of the management functions:
Strategic Management: Cost estimation is used to predict costs of
alternative activities, predict financial impacts of alternative strategic
choices, and to predict the costs of alternative implementation strategies.
Planning and Decision Making: Cost estimation is used to predict costs
so that management can determine the desirability of alternative options
and to budget expenditures, profits, and cash flows.
Management and Operational Control: Cost estimation is used to develop
cost standards, as a basis for evaluating performance.
Product and Service Costing: Cost estimation is used to allocate costs to
products and services or to charge users for jointly incurred costs.

13. The five methods of cost estimation are:

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a. Account Classification. Advantages: simplicity and ease of use.

Disadvantages: subjectivity of method and some costs are a mix of
both variable and fixed.
b. Visual fit. The visual fit method is easy to use, and requires only that
the data is graphed. Disadvantages are that the scale of the graph may
limit ability to estimate costs accurately and in both graphical and
tabular form, significant perceptual errors are common.
c. High-Low. Because of the precision in the development of the
equation, it provides a more consistent estimate than the visual fit and
is not difficult to use. Disadvantages: uses only two selected data
points and is, therefore, subjective.
d. Work Measurement. The advantage is accurate estimates through
detailed study of the different operations in the product process, but
like regression, it is more complex.
e. Regression. Quantitative, objective measures of the precision and
accuracy and reliability of the model are the advantages of this model;
disadvantages are its complexity: the effort, expense, and expertise
necessary to utilize this method.

14. Implementation problems with cost estimation include:

a. cost estimates outside of the relevant range may not be reliable.
b. sufficient and reliable data may not be available.
c. cost drivers may not be matched to dependent variables properly in
each observation.
d. the length of the time period for each observation may be too long, so
that the underlying relationship between the cost driver and the
variable to be estimated is difficult to isolate from the numerous
variables and events occurring in that period of time; alternatively the
period may be too short, so that the data is likely to be affected by
accounting errors in which transactions are not properly posted in the
period in which they occurred.
e. dependent variables and cost drivers may be affected by trend or
seasonality.
f. when extreme observations (outliers) are used the reliability of the
results will be diminished.
g. when there is a shift in the data, as, for example, a new product is
introduced or when there is a work stoppage, the data will be
unreliable for future estimates.

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15. The dependent variable is the cost object of interest in the cost estimation.
An important issue in selecting a dependent variable is the level of
aggregation in the variable. For example, the company, plant, or
department may all be possible levels of data for the cost object. The
choice of aggregation level depends on the objectives for the cost
estimation, data availability, reliability, and cost/benefit considerations. If
a key objective is accuracy, then a detailed level of analysis is often
preferred. The detail cost estimates can then be aggregated if desired.

16. Nonlinear cost relationships are cost relationships that are not adequately
explained by a single linear relationship for the cost driver(s). In
accounting data, a common type of nonlinear relationship is trend and
seasonality. For a trend example, if sales increase by 8% each year, the
plot of the data for sales with not be linear with the driver, the number of
years. Similarly, sales which fluctuate according to a seasonal pattern will
have a nonlinear behavior. A different type of nonlinearity is where the
cost driver and the dependent variable have an inherently nonlinear
relationship. For example, payroll costs as a dependent variable estimated
by hours worked and wage rates is nonlinear, since the relationship is
multiplicative and therefore not the additive linear model assumed in
regression analysis.

17. The advantages of using regression analysis include that it:

a. provides an estimation model with best fit (least squared error) to the
data
b. provides measures of goodness of fit and of the reliability of the model
which can be used to assess the usefulness of the specific model, in
contrast to the other estimation methods which provide no means of
self-evaluation
c. can incorporate multiple independent variables
d. can be adapted to handle non-linear relationships in the data, including
trends, shifts and other discontinuities, seasonality, etc.
e. results in a model that is unique for a given set of data

18. High correlation exists when the changes in two variables occur together.
It is a measure of the degree of association between the two variables.
Because correlation is determined from a sample of values, there is no
assurance that it measures or describes a cause and effect relationship
between the variables.

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19. An activity base is a measure of whatever causes the incurrence of a

variable cost. Examples of activity bases include units produced, units
sold, letters typed, beds in a hospital, meals served in a cafe, service calls
made, etc.

20. (a) Variable cost: A variable cost remains constant on a per unit basis, but
increases or decreases in total in direct relation to changes in activity.
(b) Mixed cost: A mixed cost is a cost that contains both variable and fixed
cost elements.
(c) Step-variable cost: A step-variable cost is a cost that is incurred in
large chunks, and which increases or decreases only in response to
fairly wide changes in activity.

Mixed Cost

Variable Cost

Cost

Step-Variable Cost

Activity

21. The linear assumption is reasonably valid providing that the cost formula
is used only within the relevant range.

22. A discretionary fixed cost has a fairly short planning horizon—usually a

year. Such costs arise from annual decisions by management to spend on
certain fixed cost items, such as advertising, research, and management
development. A committed fixed cost has a long planning horizon—
generally many years. Such costs relate to a company’s investment in

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facilities, equipment, and basic organization. Once such costs have been
incurred, they are “locked in” for many years.

23. a. Committed d. Committed

b. Discretionary e. Committed
c. Discretionary f. Discretionary

24. The high-low method uses only two points to determine a cost formula.
These two points are likely to be less than typical since they represent
extremes of activity.

25. The term “least-squares regression” means that the sum of the squares of
the deviations from the plotted points on a graph to the regression line is
smaller than could be obtained from any other line that could be fitted to
the data.

26. Ordinary single least-squares regression analysis is used when a variable

cost is a function of only a single factor. If a cost is a function of more than
one factor, multiple regression analysis should be used to analyze the
behavior of the cost.

II. Exercises

Exercise 1 (Cost Classification)

1. b
2. f
3. e
4. i
5. e
6. h
7. l
8. a
9. j
10. k
11. c or d
12. g

Exercise 2 (Cost Estimation; High-Low Method)

Requirement (1)

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Cost equation using square fee as the cost driver:

Variable costs:

P4,700 – P2,800
= P1.134
4,050 – 2,375

Fixed costs:

P4,700 = Fixed Cost + P1.134 x 4,050

Fixed Cost = P107

Equation One: Total Cost = P107 + P1.134 x square feet

There are two choices for the High-Low points when using openings for the
cost driver. At 11 openings there is a cost of P2,800 and at 10 openings there
is a cost of P2,875.

Cost equation using 11 openings as the cost driver:

Variable costs:

P4,700 – P2,800
= P237.50
19 – 11

Fixed costs:

P4,700 = Fixed Cost + P237.50 x 19

Fixed Cost = P187.50

Equation Two: Total Cost = P187.50 + P237.50 x openings

Cost equation using 10 openings as the cost driver:

Variable costs:

P4,700 – P2,875
= P202.78
19 – 10

Fixed costs:

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P4,700 = Fixed Cost + P202.78 x 19

Fixed Cost = P847.18

Equation Three: Total Cost = P847.18 + P202.78 x openings

Predicted total cost for a 3,200 square foot house with 14 openings using
equation one:

P107 + P1.134 x 3,200 = P3,735.80

Predicted total cost for a 3,200 square foot house with 14 openings using
equation two:

P187.50 + P237.50 x 14 = P3,512.50

Predicted total cost for a 3,200 square foot house with 14 openings using
equation three:

P847.18 + P202.78 x 14 = P3,686.10

There is no simple method to determine which prediction is best when using

the High-Low method. In contrast, regression provides quantitative measures
(R-squared, standard error, t-values,…) to help asses which regression
equation is best.

Predicted cost for a 2,400 square foot house with 8 openings, using equation
one:

P107 + P1.134 x 2,400 = P2,828.60

We cannot predict with equation 2 or equation 3 since 8 openings are outside

the relevant range, the range for which the high-low equation was developed.

Requirement 2

Figure 9-A shows that the relationship between costs and square feet is
relatively linear without outliers, while Figure 9-B shows a similar result for
the relationship between costs and number of openings. From this perspective,
both variables are good cost drivers.

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Figure 9-A

P5,000
P4,500
P4,000

P3,500
P3,000
Cost

P2,500

P2,000
P1,500
P1,000

P500

P0
2,375

2,450

2,600

2,600

2,650

2,700

2,800

2,850

3,010

3,550

3,700

4,050

Square Feet

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Figure 9-B

Cost versus No. of Openings

P5,000
P4,500
P4,000
P3,500
P3,000
Cost

P2,500
P2,000
P1,500
P1,000
P500
P0
10 11 11 12 12 13 13 13 15 16 16 19
Num ber of Openings

Exercise 3 (Cost Estimation; Account Classification)

Requirement 1

Fixed Costs:
Rent P10,250
Depreciation 400
Insurance 750

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Advertising 650
Utilities 1,250
Mr. Black’s salary 18,500
Total P31,800
Variable Costs:
Wages P17,800
CD Expense 66,750
Shopping Bags 180
Total P84,730

Variable Costs Per Unit = P84,730 / 8,900

= P95.20

Cost Function Equation: y = P31,800 + P95.20 x (CD’s sold)

Requirement 2

New Sales = 8,900 x 1.25

= 11,125 units
= round to 11,130

Total Costs = P31,800 + P95.20 x (11,130)

= P137,760

Per Unit Total Costs = P137,760 / 11,130

= P123.80

Add P1 profit per disc: P123.80 + P10 = P133.80

Requirement 3

Adjusted New Sales = 8,900 x 11.50

= 10,240 units

Revenue = P133.80 x (10,240)

= P137,010

Total Cost = P31,800 + P95.20 x (10,240)

= P129,280

Cost Per Disc = P129,280 / 10,240 = P126.30

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Profit Per Disk = P133.80 – P126.30

= P7.50

Exercise 4 (Cost Estimation Using Graphs; Service)

Requirement 1

Sales and Advertising Expense

P160,000
P140,000
P120,000
P100,000
Sales

P80,000
P60,000
P40,000
P20,000
P0
P2,500

P3,000

P3,500

P4,000

P4,500

P5,000

P5,500

Advertising Expense

Requirement 2
There seems to be a positive linear relationship for the data between P2,500
and P4,000 of advertising expense. Llanes’ analysis is correct within this
relevant range but not outside of it. Notice that the relationship between
advertising expense and sales changes at P4,000 of expense.

Exercise 5 (Fixed and Variable Cost Behavior)

Requirement (1)

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 Cost-Volume-Profit Relationships Chapter 13

Cups of Coffee Served

in a Week
1,800 1,900 2,000
Fixed cost ......................................... P11,000 P11,000 P11,000
Variable cost .................................... 4,680 4,940 5,200
Total cost.......................................... P15,680 P15,940 P16,200
Cost per cup of coffee served * ........ P8.71 P8.39 P8.10
* Total cost ÷ cups of coffee served in a week
Requirement (2)

The average cost of a cup of coffee declines as the number of cups of coffee
served increases because the fixed cost is spread over more cups of coffee.

Exercise 6 (Scattergraph Analysis)

Requirement (1)

The completed scattergraph is presented below:

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Chapter 13 Cost-Volume-Profit Relationships

16,000

14,000

12,000

10,000
Total Cost

8,000

6,000

4,000

2,000

0
0 2,000 4,000 6,000 8,000 10,000
Units Processed

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 Cost-Volume-Profit Relationships Chapter 13

Requirement (2)
(Students’ answers will vary considerably due to the inherent imprecision and
subjectivity of the quick-and-dirty scattergraph method of estimating variable
and fixed costs.)
The approximate monthly fixed cost is P6,000—the point where the straight
line intersects the cost axis.
The variable cost per unit processed can be estimated as follows using the
8,000-unit level of activity, which falls on the straight line:
Total cost at the 8,000-unit level of activity ................................. P14,000
Less fixed costs ............................................................................ 6,000
Variable costs at the 8,000-unit level of activity .......................... P 8,000
P8,000 ÷ 8,000 units = P1 per unit.
Observe from the scattergraph that if the company used the high-low method
to determine the slope of the line, the line would be too steep. This would result
in underestimating the fixed cost and overestimating the variable cost per unit.

Exercise 7 (High-Low Method)

Requirement (1)
Electrical
Month Occupancy-Days Costs
High activity level (August) ................... 3,608 P8,111
Low activity level (October) .................. 186 1,712
Change.................................................... 3,422 P6,399
Variable cost = Change in cost ÷ Change in activity
= P6,399 ÷ 3,422 occupancy-days
= P1.87 per occupancy-day
Total cost (August) ............................................................... P8,111
Variable cost element
(P1.87 per occupancy-day × 3,608 occupancy-days) ....... 6,747
Fixed cost element................................................................ P1,364

Requirement (2)

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Electrical costs may reflect seasonal factors other than just the variation in
occupancy days. For example, common areas such as the reception area must
be lighted for longer periods during the winter. This will result in seasonal
effects on the fixed electrical costs.

Additionally, fixed costs will be affected by how many days are in a month. In
other words, costs like the costs of lighting common areas are variable with
respect to the number of days in the month, but are fixed with respect to how
many rooms are occupied during the month.

Other, less systematic, factors may also affect electrical costs such as the
frugality of individual guests. Some guests will turn off lights when they leave
a room. Others will not.

Exercise 8 (Least-Squares Regression)

The least-squares regression estimates of fixed and variable costs can be

computed using any of a variety of statistical and mathematical software
packages or even by hand.

Month Rental Car Wash

Returns Costs
January 2,310 P10,11
............................. 3
February 2,453 P12,69
............................. 1
March 2,641 P10,90
............................. 5
April 2,874 P12,94
............................. 9
May 3,540 P15,33
............................. 4
June 4,861 P21,45
............................. 5
July 5,432 P21,27
............................. 0
August 5,268 P19,93
............................. 0
September 4,628 P21,86
............................. 0

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October 3,720 P18,38

............................. 3
November 2,106 P
............................. 9,830
December 2,495 P11,08
............................. 1

Intercept P2,29
6
Slope P3.74
RSQ 0.92
The intercept provides the estimate of the fixed cost element, P2,296 per
month, and the slope provides the estimate of the variable cost element, P3.74
per rental return. Expressed as an equation, the relation between car wash costs
and rental returns is
Y = P2,296 + P3.74X
where X is the number of rental returns.

Note that the R2 is 0.92, which is quite high, and indicates a strong linear
relationship between car wash costs and rental returns.

While not a requirement of the exercise, it is always a good to plot the data on
a scattergraph. The scattergraph can help spot nonlinearities or other problems
with the data. In this case, the regression line (shown below) is a reasonably
good approximation to the relationship between car wash costs and rental
returns.

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Php25,000

Car Wash Costs Php20,000

Php15,000

Php10,000

Php5,000

Php0
0 1,000 2,000 3,000 4,000 5,000 6,000
Rental Returns

III. Problems

Problem 1

Requirement (a) Miles Total Annual

Driven Cost*
High level of activity ......................... 120,000 P13,920
Low level of activity .......................... 80,000 10,880
Difference ..................................... 40,000 P 3,040

* 120,000 miles x P0.116 = P13,920.

80,000 miles x P0.136 = P10,880.
Variable cost per mile:
Change in cost, P3,040
Change in activity,40,000 = P0.076 per mile.
Fixed cost per year:

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Total cost at 120,000 miles ................................... P13,920

Less variable cost element: 120,000 x P0.076 ..... 9,120
Fixed cost per year ............................................. P 4,800
Requirement (b)
Y = P4,800 + P0.076X
Requirement (c)

Fixed cost ..................................................................... P 4,800

Variable cost: 100,000 miles x P0.076 ....................... 7,600
Total annual cost ................................................... P12,400

Problem 2

Requirement 1

Cost of goods sold ...................................................... Variable

Shipping expense ....................................................... Mixed
Advertising expense ................................................... Fixed
Salaries and commissions .......................................... Mixed
Insurance expense ...................................................... Fixed
Depreciation expense ................................................. Fixed

Requirement 2

Analysis of the mixed expenses:

Salaries
Shipping and Comm.
Units Expense Expense
High level of activity ............... 4,500 P56,000 P143,000
Low level of activity ................ 3,000 44,000 107,000
Difference .......................... 1,500 P12,000 P 36,000

Variable cost element:

Change in cost
= Variable rate
Change in activity
P12,000
Shipping expense:
1,500 units = P8 per unit.

P36,000
Salaries and comm. expense: 1,500 units = P24 per unit.

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Fixed cost element:

Shipping Salaries and
Expense Comm. Expense
Cost at high level of P56,000 P143,000
activity
Less variable cost element:
4,500 units x 36,000
P8
4,500 units x 108,000
P24

Fixed cost P20,000 P 35,000

element

The cost elements are:

Shipping expense: P20,000 per month plus P8 per unit or Y = P20,000
+ P8X.
Salaries and comm. expense: P35,000 per month plus P24 per unit or
Y = P35,000 + P24X.

Requirement 3
LILY COMPANY
Income Statement
For the Month Ended June 30

Sales in units................................................... 4,500

Sales revenues ................................................ P630,000
Less variable expenses:
Cost of goods sold (@P56) ........................ P252,000
Shipping expense (@P8) ........................... 36,000
Salaries and commission expense
(@P24) ................................................... 108,000 396,000
Contribution margin ....................................... 234,000

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Less fixed expense:

Shipping expense ....................................... 20,000
Advertising ................................................ 70,000
Salaries and commissions .......................... 35,000
Insurance.................................................... 9,000
Depreciation .............................................. 42,000 176,000
Net income ..................................................... P 58,000

Problem 3
Requirement 1

Number of Total Cost

Year Leagues (X) (Y) XY X2
2004 5 P13,000 P 65,000 25
2005 2 7,000 14,000 4
2006 4 10,500 42,000 16
2007 6 14,000 84,000 36
2008 3 10,000 30,000 9
20 P54,500 P235,000 90

n (XY) - (X) (Y)

b =
n (X2) - (X)2
5 (235,000) - (20) (54,500)
= 5 (90) - (20)2
= 1,700

a = (Y) - b(X)
n
(54,500) - 1,700 (20)
= 5
= P4,100

Therefore, the variable cost per league is P1,700 and the fixed cost is
P4,100 per year.

Requirement 2

Y = P4,100 + P1,700X

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Requirement 3

The expected value total would be:

Fixed cost .............................................................. P 4,100
Variable cost (7 leagues x P1,700) ........................ 11,900
Total cost .......................................................... P16,000

The problem with using the cost formula from (2) to derive this total cost figure
is that an activity level of 7 sections lies outside the relevant range from which
the cost formula was derived. [The relevant range is represented by a solid
line on the graph in requirement 4 below.]

Although an activity figure may lie outside the relevant range, managers will
often use the cost formula anyway to compute expected total cost as we have
done above. The reason is that the cost formula frequently is the only basis
that the manager has to go on. Using the cost formula as the starting point
should not present a problem so long as the manager is alert for any unusual
problems that the higher activity level might bring about.

Requirement 4
P16,000 Y

P14,000

P12,000

P10,000

P8,000

P6,000

P4,000

P2,000
X
P-
0 1 2 3 4 5 6 7 8

Problem 4 (Regression Analysis, Service Company)

Requirement 1

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Figure 9-C plots the relationship between labor-hours and overhead costs and
shows the regression line.

y = P48,271 + P3.93 X

Economic plausibility. Labor-hours appears to be an economically plausible

driver of overhead cost for a catering company. Overhead costs such as
scheduling, hiring and training of workers, and managing the workforce are
largely incurred to support labor.

Goodness of fit. The vertical differences between actual and predicted costs
are extremely small, indicating a very good fit. The good fit indicates a strong
relationship between the labor-hour cost driver and overhead costs.

Slope of regression line. The regression line has a reasonably steep slope from
left to right. The positive slope indicates that, on average, overhead costs
increase as labor-hours increase.

Requirement 2

The regression analysis indicates that, within the relevant range of 2,500 to
7,500 labor-hours, the variable cost per person for a cocktail party equals:
Food and beverages P15.00
Labor (0.5 hrs. x P10 per hour) 5.00
Variable overhead (0.5 hrs. x P3.93 per labor-hour) 1.97
Total variable cost per person P21.97

Requirement 3

To earn a positive contribution margin, the minimum bid for a 200-person

cocktail party would be any amount greater than P4,394. This amount is
calculated by multiplying the variable cost per person of P21.97 by the 200
people. At a price above the variable costs of P4,394, Bobby Gonzales will be
earning a contribution margin toward coverage of his fixed costs.

Of course, Bobby Gonzales will consider other factors in developing his bid
including (a) an analysis of the competition – vigorous competition will limit
Gonzales’ ability to obtain a higher price (b) a determination of whether or not
his bid will set a precedent for lower prices – overall, the prices Bobby
Gonzales charges should generate enough contribution to cover fixed costs and

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earn a reasonable profit, and (c) a judgment of how representative past

historical data (used in the regression analysis) is about future costs.

Figure 9-C
Regression Line of Labor-Hours on Overhead Costs for Bobby Gonzales’
Catering Company

P90,000

P80,000

P70,000
Overhead Costs

P60,000

P50,000

P40,000

P30,000

P20,000

P10,000

P0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Cost Driver: Labor-Hours

Problem 5 (Linear Cost Approximation)

Requirement 1
Difference in cost
Slope coefficient (b) =
Difference in labor-hours
P529,000 – P400,000
= = P43.00
7,000 – 4,000
Constant (a) = P529,000 – P43.00 (7,000)
= P228,000

Cost function = P228,000 + P43.00 (professional labor-hours)

The linear cost function is plotted in Figure 9-D.

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No, the constant component of the cost function does not represent the fixed
overhead cost of the ABS Group. The relevant range of professional labor-
hours is from 3,000 to 8,000. The constant component provides the best
available starting point for a straight line that approximates how a cost behaves
within the 3,000 to 8,000 relevant range.

Requirement 2

A comparison at various levels of professional labor-hours follows. The linear

cost function is based on formula of P228,000 per month plus P43.00 per
professional labor-hours.

Total overhead cost behavior:

M M M M M M
o o o o o o
n n n n n n
t t t t t t
h h h h h h
1 2 3 4 5 6
Actual
total P P P P P P
overhe 3 4 4 4 5 5
ad 4 0 3 7 2 8
costs 0 0 5 7 9 7
, , , , , ,
0 0 0 0 0 0
0 0 0 0 0 0
0 0 0 0 0 0
Linear
approx 3 4 4 4 5 5
imatio 5 0 4 8 2 7
n 7 0 3 6 9 2
, , , , , ,
0 0 0 0 0 0
0 0 0 0 0 0
0 0 0 0 0 0
Actual
minus P P P P P P
linear ( ( ( 1
approx 1 0 8 9 0 5
imatio 7 , , ,
n , 0 0 0
0 0 0 0
0 0 0 0
0 ) )
)
Professio 3 4 5 6 7 8
nal , , , , , ,
labor- 0 0 0 0 0 0
hours

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0 0 0 0 0 0
0 0 0 0 0 0

The data are shown in Figure 9-D. The linear cost function overstates costs
by P8,000 at the 5,000-hour level and understates costs by P15,000 at the
8,000-hour level.

Requirement 3
Based on
Linear
Based on Cost
Actual Function
Contribution before deducting
incremental overhead P38,000 P38,000
Incremental overhead 35,000 43,000
Contribution after incremental P 3,000 P
overhead (5,000)

The total contribution margin actually forgone is P3,000.

Figure 9-D
Linear Cost Function Plot of Professional Labor-Hours
on Total Overhead Costs for ABS Consulting Group

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P700,000

P600,000
Total Overhead Costs

P500,000

P400,000

P300,000

P200,000

P100,000

P0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Professional Labor-Hours Billed

Problem 6 (Cost Behavior)

The variable cost per hour can be computed as follows:

P20,000 / 5,000 hours = P4 per hour

Therefore, the missing amounts are as follows:

Hours of Operating Time

5,0 6,0 7,0 8,0
00 00 00 00
Total
costs:
Va
riable
costs
(@ P P P P
P4 per 20, 24, 28, 32,
hour) 000 000 000 000

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Fi 168 168 168 168

xed ,00 ,00 ,00 ,00
costs 0 0 0 0
Total P P P P
costs 188 192 196 200
,00 ,00 ,00 ,00
0 0 0 0

Hours of Operating Time

5,0 6,0 7,0 8,0
00 00 00 00
Cost
per
hour:
Va P P P P
riable 4.0 4.0 4.0 4.0
cost 0 0 0 0
Fi
xed 33. 28. 24. 21.
cost 60 00 00 00
Total
cost P P P P
per 37. 32. 28. 25.
hour 60 00 00 00

Observe that the total variable costs increase in proportion to the number of
hours of operating time, but that these costs remain constant at P4 if expressed
on a per hour basis.

In contrast, the total fixed costs do not change with changes in the level of
activity. They remain constant at P168,000 within the relevant range. With
increases in activity, however, the fixed cost per hour decreases, dropping from
P33.60 per hour when the boats are operated 5,000 hours a period to only
P21.00 per hour when the boats are operated 8,000 hours a period. Because of
this troublesome aspect of fixed costs, they are most easily (and most safely)
dealt with on a total basis, rather than on a unit basis, in cost analysis work.

Problem 7 (High-Low Method)

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Requirement (1)

The first step in the high-low method is to identify the periods of the lowest
and highest activity. Those periods are November (1,100 patients admitted)
and June (1,900 patients admitted).

The second step is to compute the variable cost per unit using those two data
points:

Number of Admitting
Month Patients Department
Admitted Costs
High activity level 1,900 P15,200
(June)
Low activity level 1,100 12,800
(November)
Change 800 P 2,400

Change in cost
Variable cost =
Change in activity
P240,000
=
800 patients admitted

= P3 per patient admitted

The third step is to compute the fixed cost element by deducting the variable
cost element from the total cost at either the high or low activity. In the
computation below, the high point of activity is used:
Fixed cost element = Total cost – Variable cost element
= P15,200 – (P3 per patient admitted
x 1,900 patients admitted)
= P9,500
Requirement (2)
The cost formula is Y = P9,500 + P3X.

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Problem 8 (Scattergraph Analysis; Selection of an Activity Base)

Requirement (1)
The completed scattergraph for the number of units produced as the activity
base is presented below:

5,000

4,500

4,000

3,500
Janitorial Labor Cost

3,000
2,500

2,000

1,500

1,000

500

0
0 20 40 60 80 100 120 140
Units Produced

Requirement (2)

The completed scattergraph for the number of workdays as the activity base is
presented below:

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5,000

4,500

4,000

3,500
Janitorial Labor Cost

3,000

2,500

2,000

1,500

1,000

500

0
0 2 4 6 8 10 12 14 16 18 20 22 24
Number of Janitorial Workdays

Requirement (3)

The number of workdays should be used as the activity base rather than the
number of units produced. There are several reasons for this. First, the
scattergraphs reveal that there is a much stronger relationship (i.e., higher
correlation) between janitorial costs and number of workdays than between
janitorial costs and number of units produced. Second, from the description of
the janitorial costs, one would expect that variations in those costs have little
to do with the number of units produced. Two janitors each work an eight-hour
shift—apparently irrespective of the number of units produced or how busy
the company is. Variations in the janitorial labor costs apparently occur
because of the number of workdays in the month and the number of days the
janitors call in sick. Third, for planning purposes, the company is likely to be
able to predict the number of working days in the month with much greater
accuracy than the number of units that will be produced.

Note that the scattergraph in part (1) seems to suggest that the janitorial labor
costs are variable with respect to the number of units produced. This is false.
Janitorial labor costs do vary, but the number of units produced isn’t the cause
of the variation. However, since the number of units produced tends to go up
and down with the number of workdays and since the janitorial labor costs are

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driven by the number of workdays, it appears on the scattergraph that the

number of units drives the janitorial labor costs to some extent. Analysts must
be careful not to fall into this trap of using the wrong measure of activity as
the activity base just because it appears there is some relationship between cost
and the measure of activity. Careful thought and analysis should go into the
selection of the activity base.

IV. Multiple Choice Questions

1. A 11. C* 21. C 31. D 41. B

2. D 12. C* 22. D 32. B 42. D
3. B 13. C 23. C 33. A 43. C
4. A 14. A 24. A 34. B
5. B 15. D 25. D 35. A
6. B 16. C 26. B 36. D
7. C 17. D 27. D 37. B
8. D 18. B 28. B 38. C
9. C 19. C 29. A 39. B
10. A 20. C 30. D 40. D

* Supporting Computations:
11. (10,000 x 2) – (P3,000 x 2) – P5,000 = P9,000
12. [(P20 + P3 + P6) x 2,000 units] + (P10 x 1,000 units) = P68,000

CHAPTER 10

SYSTEMS DESIGN: JOB-ORDER COSTING AND

PROCESS COSTING

I. Questions
1. Job-order costing is used in those manufacturing situations where there are
many different products produced each period. Each product or job is
different from all others and requires separate costing. Process costing is
used in those manufacturing situations where a single, homogeneous

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product, such as cement, bricks, or gasoline, is produced for long periods

at a time.
2. The job cost sheet is used in accumulating all costs assignable to a
particular job. These costs would include direct materials cost traceable
to the job, and manufacturing overhead cost allocable to the job. When a
job is completed, the job cost sheet is used to compute the cost per
completed unit. The job cost sheet is then used as a control document for:
(1) determining how many units have been sold and determining the cost
of these units; and (2) determining how many units are still in inventory at
the end of a period and determining the cost of these units on the balance
sheet.
3. Many production costs cannot be traced directly to a particular product or
job, but rather are incurred as a result of overall production activities.
Therefore, in order to be assigned to products, such costs must be allocated
to the products in some manner. Examples of such costs would include
utilities, maintenance on machines, and depreciation of the factory
building. These costs are indirect production costs.
4. A firm will not know its actual manufacturing overhead costs until after a
period is over. Thus, if actual costs were used to cost products, it would
be necessary either (1) to wait until the period was over to add overhead
costs to jobs, or (2) to simply add overhead cost to jobs as the overhead
cost was incurred day by day. If the manager waits until after the period
is over to add overhead cost to jobs, then cost data will not be available
during the period. If the manager simply adds overhead cost to jobs as the
overhead cost is incurred, then unit costs may fluctuate from month to
month. This is because overhead cost tends to be incurred somewhat
evenly from month to month (due to the presence of fixed costs), whereas
production activity often fluctuates. For these reasons, most firms use
predetermined overhead rates, based on estimates of overhead cost and
production activity, to apply overhead cost to jobs.
5. An allocation base should act as a cost driver in the incurrence of the
overhead cost; that is, the base should cause the overhead cost. If the
allocation base does not really cause the overhead, then costs will be
incorrectly attributed to products and jobs and their costs will be distorted.
6. A process costing system is appropriate in those situations where a
homogeneous product is produced on a continuous basis.
7. In a process costing system, costs are accumulated by department.

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8. First, the activity performed in a department must be performed uniformly

on all units moving through it. Second, the output of the department must
be homogeneous.
9. The reason cost accumulation is simpler is that costs only need to be
identified by department - not by separate job. Usually there will be only
a few departments in a company, whereas there can be hundreds or even
thousands of jobs in a job-order costing system.
10. A quantity schedule shows the physical flow of units through a department
during a period. It serves several purposes. First, it provides the manager
with information relative to activity in his or her department and also
shows the manager the stage of completion of any in-process units.
Second, it serves as an essential guide in computing the equivalent units
and in preparing the other parts of the production report.
11. By definition, manufacturing overhead consists of costs that cannot be
practically traced to products or jobs. Therefore, if these costs are to be
assigned to products or jobs, they must be allocated rather than traced.
12. Assigning manufacturing overhead costs to jobs does not ensure a profit.
The units produced may not be sold and if they are sold, they may not be
sold at prices sufficient to cover all costs. It is a myth that assigning costs
to products or jobs ensures that those costs will be recovered. Costs are
recovered only by selling to customers—not by allocating costs.
13. (a) Job-order costing and process costing have the same basic purposes—
to assign materials, labor, and overhead cost to products and to provide
a mechanism for computing unit product costs.
(b) Both systems use the same basic manufacturing accounts.
(c) Costs flow through the accounts in basically the same way in both
systems.
14. The company will want to distinguish between the costs of the metals used
to make the medallions, but the medals are otherwise identical and go
through the same production processes. Thus, operation costing is ideally
suited for the company’s needs.

II. Exercises

Exercise 1 (Process Costing and Job Order Costing)

a. Job-order costing f. Process costing

b. Process costing g. Process costing

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c. Process costing * h. Job-order costing

d. Job-order costing i. Job-order costing
e. Job-order costing j. Job-order costing
* Some of the listed companies might use either a process costing or a job-
order costing system, depending on how operations are carried out and how
homogeneous the final product is. For example, a plywood manufacturer
might use job-order costing if plywoods are constructed of different woods
or come in markedly different sizes.

Exercise 2 (Applying Overhead with Various Bases)

Requirement 1

Predetermined overhead rates:

Company X:

Predetermined Estimated total manufacturing overhead cost

=
overhead rate Estimated total amount of the allocation base
P432,000
= = P7.20 per DLH
60,000 DLHs
Company Y:

Predetermined Estimated total manufacturing overhead cost

=
overhead rate Estimated total amount of the allocation base
P270,000
= = P3.00 per MH
90,000 DLHs
Company Z:

Predetermined Estimated total manufacturing overhead cost

=
overhead rate Estimated total amount of the allocation base
P384,000
= = 160% of materials cost
P240,000 materials cost
Requirement 2

Actual overhead costs incurred ......................................... P420,000

Overhead cost applied to Work in Process: ......................
58,000* actual hours × P7.20 per hour ....................... 417,600
Underapplied overhead cost .............................................. P 2,400

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* 7,000 hours + 30,000 hours + 21,000 hours = 58,000 hours

Exercise 3 (Departmental Overhead Rates)

Requirement 1

Milling Department:

Predetermined Estimated total manufacturing overhead cost

=
overhead rate Estimated total amount of the allocation base
P510,000
= = P8.50 per machine-hour
60,000 machine-hours
Assembly Department:

Predetermined Estimated total manufacturing overhead cost

=
overhead rate Estimated total amount of the allocation base
P800,000
= = 125% of direct labor cost
P640,000 direct labor cost
Requirement 2
Overhead Applied
Milling Department: 90 MHs × P8.50 per MH P765
Assembly Department: P160 × 125% 200
Total overhead cost applied P965

Requirement 3

Yes; if some jobs required a large amount of machine time and little labor cost,
they would be charged substantially less overhead cost if a plantwide rate
based on direct labor cost were being used. It appears, for example, that this
would be true of job 123 which required considerable machine time to
complete, but required only a small amount of labor cost.

Exercise 4 (Process Costing Journal Entries)

Work in Process—Mixing ........................................ 330,000

Raw Materials Inventory .................................. 330,000

Work in Process—Mixing ........................................ 260,000

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Work in Process—Baking ........................................ 120,000

Wages Payable .................................................. 380,000

Work in Process—Mixing ........................................ 190,000

Work in Process—Baking ........................................ 90,000
Manufacturing Overhead .................................. 280,000

Work in Process—Baking ........................................ 760,000

Work in Process—Mixing ................................ 760,000

Finished Goods ......................................................... 980,000

Work in Process—Baking ................................ 980,000

Exercise 5 (Quantity Schedule, Equivalent Units, and Cost per Equivalent

Unit – Weighted Average Method)

Requirement 1

Weighted-Average Method
Quantity
Schedule
Gallons to be accounted for:
Work in process, May 1 (materials 80%
complete, labor and overhead 75%
complete) ............................................. 80,000
Started into production ............................. 760,000
Total gallons accounted for ........................... 840,000

Equivalent Units
Materials Labor Overhead
Gallons accounted for as follows:
Transferred to the next department ........... 790,000 790,000 790,000 790,000
Work in process, May 31 (materials 60%
complete, labor and overhead 20%
complete) ............................................. 50,000 30,000 10,000 10,000
Total gallons accounted for ............................ 840,000 820,000 800,000 800,000

Requirement 2

Total Costs Materials Labor Overhead Whole Unit

Cost to be accounted for:
Work in process, May 1 ................... P 146,600 P 68,600 P 30,000 P 48,000

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Cost added during the month ........... 1,869,200 907,200 370,000 592,000
Total cost to be accounted for (a) .......... P2,015,800 P975,800 P400,000 P640,000
Equivalent units (b) ............................... — 820,000 800,000 800,000
Cost per equivalent unit (a) ÷ (b) .......... P1.19 + P0.50 + P0.80 = P2.49

Exercise 6 (Quantity Schedule, Equivalent Units, and Cost per Equivalent

Unit – FIFO Method)

Requirement 1

FIFO Method
Quantity
Schedule
Gallons to be accounted for:
Work in process, May 1 (materials 80%
complete, labor and overhead 75%
complete) ............................................. 80,000
Started into production ............................. 760,000
Total gallons accounted for ........................... 840,000

Equivalent Units
Materials Labor Overhead
Gallons accounted for as follows:
Transferred to the next department:
From the beginning inventory ............... 80,000 16,000* 20,000* 20,000*
Started and completed this month** .... 710,000 710,000 710,000 710,000
Work in process, May 31 (materials 60%
complete, labor and overhead 20%
complete) ............................................. 50,000 30,000 10,000 10,000
Total gallons accounted for ........................... 840,000 756,000 740,000 740,000

* Work required to complete the beginning inventory.

** 760,000 gallons started – 50,000 gallons in ending work in process = 710,000 gallons started
and completed.

Requirement 2

Total Costs Materials Labor Overhead Whole Unit

Cost to be accounted for:
Work in process, May 31 ................. P 146,600
Cost added during the month (a)...... 1,869,200 P907,200 P370,000 P592,000
Total cost to be accounted for ............... P2,015,800
Equivalent units (b) ............................... 756,000 740,000 740,000
Cost per equivalent unit (a) ÷ (b) .......... P1.20 + P0.50 + P0.80 = P2.50

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Exercise 7

Requirement (1)

The direct materials and direct labor costs listed in the exercise would have
been recorded on four different documents: the materials requisition form for
Job KC123, the time ticket for Kristine, the time ticket for Clarisse, and the
job cost sheet for Job KC123.

Requirement (2)

The costs for Job KC123 would have been recorded as follows:

Materials requisition form:

Quantity Unit Cost Total Cost
Blanks 40 P80.00 P3,200
Nibs 960 P6.00 5,760
P8,960

Time ticket for Kristine

Time Job
Started Ended Completed Rate Amount Number
9:00 AM 12:15 PM 3.25 P120.00 P390.00 KC123

Time ticket for Clarisse

Time Job
Started Ended Completed Rate Amount Number
2:15 PM 4:30 PM 2.25 P140.00 P315.00 KC123

Job Cost Sheet for Job KC123

Direct materials ............... P8,960.00
Direct labor:
Kristine ..................... 390.00
Clarisse ..................... 315.00
P9,665.00

Exercise 8

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The predetermined overhead rate is computed as follows:

Estimated total manufacturing overhead.............................. P586,000

÷ Estimated total direct labor hours (DLHs) ........................ 40,000 DLHs
= Predetermined overhead rate ............................................ P14.65 per DLH

Exercise 9

Weighted-Average Method
Materials Labor Overhead Total
Work in process, May 1 ................... P 14,550 P23,620 P118,100
Cost added during May .................... 88,350 14,330 71,650
Total cost (a) .................................... P102,900 P37,950 P189,750

Equivalent units of
production (b) .............................. 1,200 1,100 1,100
Cost per equivalent unit
(a) ÷ (b)........................................ P85.75 P34.50 P172.50 P292.75

Exercise 10

FIFO Method
Materials Conversion
To complete beginning work in process:
Materials: 400 units x (100% – 75%) .................... 100
Conversion: 400 units x (100% – 25%) ................. 300
Units started and completed during the period (42,600
units started – 500 units in ending inventory) ........ 42,100 42,100
Ending work in process
Materials: 500 units x 80% complete .................... 400
Conversion: 500 units x 30% complete ................. 150
Equivalent units of production ...................................... 42,600 42,550

III. Problems

Problem 1

Requirement 1

a. Raw Materials Inventory ........................................... 210,000

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Accounts Payable .................................................. 210,000

b. Work in Process ........................................................ 178,000

Manufacturing Overhead .......................................... 12,000
Raw Materials Inventory ....................................... 190,000

c. Work in Process ........................................................ 90,000

Manufacturing Overhead .......................................... 110,000
Salaries and Wages Payable .................................. 200,000

d. Manufacturing Overhead .......................................... 40,000

Accumulated Depreciation .................................... 40,000

e. Manufacturing Overhead .......................................... 70,000

Accounts Payable .................................................. 70,000

f. Work in Process ........................................................ 240,000

Manufacturing Overhead....................................... 240,000
30,000 MH x P8 per MH = P240,000.

g. Finished Goods ......................................................... 520,000

Work in Process .................................................... 520,000

h. Cost of Goods Sold ................................................... 480,000

Finished Goods...................................................... 480,000

Accounts Receivable ................................................. 600,000

Sales ...................................................................... 600,000
P480,000 × 1.25 = P600,000

Requirement 2

Manufacturing Overhead Work in Process

(b) 12,000 240,000(f) Bal. 42,000 510,000
(g)
(c) 110,000 (b) 178,000
(d) 40,000 (c) 90,000

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(e) 70,000 (f) 240,000

8,000 Bal. 30,000
(Overapplied
overhead)

Problem 2

Requirement 1

The costing problem does, indeed, lie with manufacturing overhead cost, as
suggested. Since manufacturing overhead is mostly fixed, the cost per unit
increases as the level of production decreases. The problem can be solved by
use of predetermined overhead rates, which should be based on expected
activity for the entire year. Many students will use units of product in
computing the predetermined overhead rate, as follows:
Estimated manufacturing overhead cost, P840,000
= P4.20 per unit.
Estimated units to be produced, 200,000

The predetermined overhead rate could also be set on the basis of either direct
labor cost or direct materials cost. The computations are:
Estimated manufacturing overhead cost, P840,000
= 350% of direct
Estimated direct labor cost, P240,000 labor cost

Estimated manufacturing overhead cost, P840,000 140% of direct

Estimated direct materials cost, P600,000 = materials cost

Requirement 2

Using a predetermined overhead rate, the unit costs would be:

Quarter
First Second Third Fourth
Direct materials ................... P240,000 P120,000 P 60,000 P180,000
Direct labor ......................... 96,000 48,000 24,000 72,000
Manufacturing overhead:
Applied at P4.20 per
units; 350% of direct

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labor cost, or 140% of 336,000 168,000 84,000 252,000

direct materials cost .........
Total cost ...................... P672,000 P336,000 P168,000 P504,000
Number of units
produced........................... 80,000 40,000 20,000 60,000
Estimated cost per unit ........ P8.40 P8.40 P8.40 P8.40

Problem 3

Weighted-Average Method
Quantity
Schedule
Pounds to be accounted for:
Work in process, May 1
(all materials, 55% labor and
overhead added last 30,000
month)

Started into production during

May 480,000

Total 510,000
pounds

Equivalent Units
Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to Department 490,000* 490,000 490,000
2
Work in process, May 31
(all materials, 90% labor and
overhead added this 20,000 20,000 18,000
month)

Total 510,000 510,000 508,000

pounds
* 30,000 + 480,000 - 20,000 = 490,000.
Problem 4 (Weighted-Average Method; Interpreting a Production
Report)

Requirement 1

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Weighted-Average Method

The equivalent units for the month would be:

Quantity Equivalent Units

Schedule Materials Conversion
Units accounted for as follows:
Transferred to next 190,000 190,000 190,000
department

Work in process, April 30

(75% materials, 60%
conversion cost added this
month) 40,000 30,000 24,000

Total units and equivalent units

of 230,000 220,000 214,000
production

Requirement 2

Total Cost Materials Conversion Whole Unit

Work in P 98,000 P 67,800 P 30,200
process,
April 1
Cost added
during the 827,000 579,000 248,000
month
Total cost P925,000 P646,800 P278,200
(a)

Equivalent
units of – 220,000 214,000
productio
n (b)
Cost per EU – P2.94 + P1.30 = P4.24

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(a)  (b)

Requirement 3

Total units transferred ....................................................... 190,000

Less units in the beginning inventory................................ 30,000
Units started and completed during April ......................... 160,000

Requirement 4

No, the manager should not be rewarded for good cost control. The reason for
the Mixing Department’s low unit cost for April is traceable to the fact that
costs of the prior month have been averaged in with April’s costs in computing
the lower, P2.94 per unit figure. This is a major criticism of the weighted-
average method in that the figures computed for product costing purposes can’t
be used to evaluate cost control or measure performance for the current period.

Problem 5 (Preparation of Production Report from Analysis of Work in

Process T-account – Weighted-Average Method)

Requirement 1

Weighted-Average Method

Quantity Schedule and Equivalent Units

Quantity
Schedule
Pounds to be accounted for:
Work in process, May 1
(materials all complete, labor
and overhead 4/5 35,000
complete)

Started into 280,000

production

Total pounds to be accounted 315,000

for

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Equivalent Units (EU)

Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to 270,000 270,000 270,000
Blending*

Work in process, May 31

(materials all complete, labor
and overhead 2/3 45,000 45,000 30,000
complete)

Total pounds accounted 315,000 315,000 300,000

for
* 35,000 + 280,000 – 45,000 = 270,000.

Cost per Labor & Whole

Equivale Total Materials Overh Unit
nt Unit ead
Cost to be
account
ed for:
Work in P 63,700 P 43,400 P 20,300
process,
May 1
Cost
added 587,300 397,600 189,700
durin
g the
mont
h
Total cost
to be P651,000 P441,000 P210,000
account
ed for

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(a)

Equivalent 315,000 300,000

units
(b)
Cost per
equivale P1.40 + P0.70 = P2.10
nt unit
(a)  (b)

Cost Reconciliation

Total Equivalent Units (EU)

Cost Materials Conversion
Cost accounted for as follows:
Transferred to Blending:
270,000 pounds x P2.10
per P567,000 270,000 270,000
pound
Work in process, May 31:
Materials, at P1.40 per 63,000 45,000
EU
Labor and overhead, at P0.70
per 21,000 30,000
EU
Total work in process, May 84,000
31
Total costs accounted P651,000
for

Requirement 2

In computing unit costs, the weighted-average method mixes costs of the prior
period with current period costs. Thus, under the weighted-average method,
unit costs are influenced to some extent by what happened in a prior period.
This problem becomes particularly significant when attempting to measure
performance in the current period. Good (or bad) cost control in the current
period might be concealed to some degree by the costs that have been brought
forward in the beginning inventory.

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IV. Multiple Choice Questions

1. D 6. D 11. A 16. A
2. D 7. A 12. D 17. D
3. D 8. C 13. B 18. A
4. C 9. C 14. D 19. C
5. D 10. B 15. C 20. D

CHAPTER 11

SYSTEMS DESIGN: ACTIVITY-BASED COSTING

AND MANAGEMENT

I. Questions
1. The three levels available are: Level 1, in which a company uses a
plantwide overhead rate; Level 2, in which a company uses departmental
overhead rates; and Level 3, in which a company uses activity-based
costing.
2. New approaches to costing are needed because events of the last few
decades have made drastic changes in many organizations. Automation
has greatly decreased the amount of direct labor required to manufacture
products; product diversity has increased in that companies are
manufacturing a wider range of products and these products differ
substantially in volume, lot size, and complexity of design; and total
overhead cost has increased to the point in some companies that a
correlation no longer exists between it and direct labor.
3. The departmental approach to assigning overhead cost to products relies
solely on volume as an assignment base. Where diversity exists between
products (that is, where products differ in terms of number of units
produced, lot size, or complexity of production), volume alone is not
adequate for overhead costing. Overhead costing based on volume will
systematically overcost high-volume products and undercost low-volume
products.

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4. Process value analysis (PVA) is a systematic approach to gaining an

understanding of the steps associated with a product or service. It
identifies all resource-consuming activities involved in the production
process and labels these activities as being either value-added or non-
value-added. Thus, it is the beginning point in designing an activity-based
costing system since management must know what activities are involved
with each product before activity centers can be designated and cost
drivers established. Also, PVA helps management to eliminate any non-
value-added activities and thereby streamline operations and minimize
costs.
5. The four general levels of activities are:
1. Unit-level activities, which are performed each time a unit is
produced.
2. Batch-level activities, which are performed each time a batch of goods
is handled or processed.
3. Product-level activities, which are performed as needed to support
specific products.
4. Facility-level activities, which simply sustain a facility’s general
manufacturing process.
6. First, activity-based costing increases the number of cost pools used to
accumulate overhead costs. Second, it changes the base used to assign
overhead costs to products. And third, it changes a manager’s perception
of many overhead costs in that costs that were formerly thought to be
indirect (such as depreciation or machine setup) are identified with
specific activities and thereby are recognized as being traceable to
individual products.
7. The two chief limitations are: First, the portion of overhead costs that
relate to facility-level activities are still usually allocated to products on
some arbitrary basis, such as machine-hours or direct labor-hours. Critics
of activity-based costing argue that facility-level activities account for the
bulk of all overhead costs in some companies. Second, high measurement
costs are involved in operating an activity-based costing system. That is,
the system requires the tracking of large amounts of detail and the
completion of many separate computations in order to determine the cost
of a unit or product.
8. Yes, activity-based costing can be used in service organizations. It has
been successfully implemented, for example, in railroads, hospitals, banks
and data service companies.

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9. A resource driver is a measure of the quality of resources consumed by an

activity.
10. An activity driver is a measure of frequency and intensity of demands
placed on activities by cost objects.
11. Two-stage allocation is a procedure that first assigns a firm’s resource
costs, namely factory overhead cost, to cost pools, and then to cost objects.

12. Two major advantages of ABM are:

a. ABM measures the effectiveness of the key business processes and
activities, and identifies how they can be improved to reduce costs and
improve the customer value.
b. ABM improves the management focus by allocating resources to key
value-added activities, key customers, key products, and continuous
improvement methods to maintain the firm’s competitive advantage.
13. When direct labor is used as an allocation base for overhead, it is implicitly
assumed that overhead cost is directly proportional to direct labor. When
cost systems were originally developed in the 1800s, this assumption may
have been reasonably accurate. However, direct labor has declined in
importance over the years while overhead has been increasing. This
suggests that there is no longer a direct link between the level of direct
labor and overhead. Indeed, when a company automates, direct labor is
replaced by machines; a decrease in direct labor is accompanied by an
increase in overhead. This violates the assumption that overhead cost is
directly proportional to direct labor. Overhead cost appears to be driven
by factors such as product diversity and complexity as well as by volume,
for which direct labor has served as a convenient measure.
14. Employees may resist activity-based costing because it changes the “rules
of the game.” ABC changes some of the key measures, such as product
costs, used in making decisions and may affect how individuals are
evaluated. Without top management support, employees may have little
interest in making these changes. In addition, if top managers continue to
make decisions based on the numbers generated by the traditional costing
system, subordinates will quickly conclude that the activity-based costing
system can be ignored.
15. Unit-level activities are performed for each unit that is produced. Batch-
level activities are performed for each batch regardless of how many units
are in the batch. Product-level activities must be carried out to support a

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product regardless of how many batches are run or units produced.

Customer-level activities must be carried out to support customers
regardless of what products or services they buy. Organization-sustaining
activities are carried out regardless of the company’s precise product mix
or mix of customers.
16. Organization-sustaining costs, customer-level costs, and the costs of idle
capacity should not be assigned to products. These costs represent
resources that are not consumed by the products.

II. True or False

1. True 3. False 5. False 7. True

2. True 4. True 6. False 8. True

III. Exercises

Exercise 1
Examples of Examples of
Activity Traceable Cost
Activity Classification Costs Drivers
a. Materials are moved Batch-level Labor cost; Number of
from the receiving depreciation receipts;
dock to product pounds
of equipment;
flow lines by a handled
space cost
material-handling
crew
b. Direct labor workers Unit-level Direct labor Direct labor-
assemble various cost; indirect hours
products labor cost;
labor benefits
c. Ongoing training is Facility-level* Space cost; Hours of
provided to all training costs; training time;
employees in the administration number trained
company costs
d. A product is Product-level Space cost; Hours of
designed by a supplies used; design time;
specialized design depreciation of number of
team design engineering
equipment change orders

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e. Equipment setups Batch-level Labor cost; Number of

are performed on a supplies used; setups; hours
regular basis depreciation of or setup time
equipment
f. Numerical control Unit-level Power; Machine-
(NC) machines are supplies used; hours; number
used to cut and maintenance; of units
shape materials depreciation
* Personnel administration and training costs might be traceable in part to the
facility-level and in part to other activity centers at the unit-level, product-level,
and batch-level.

Exercise 2

1. plantwide overhead rate 6. Batch-level

2. volume 7. Product-level
3. two stage, stage, stage 8. Facility-level
4. Process value analysis 9. high-volume, low-volume, low-volume
5. Unit-level 10. activity centers

Exercise 3

a. Various individuals manage the parts

inventories. Product-level
b. A clerk in the factory issues purchase orders
for a job. Batch-level
c. The personnel department trains new Organization-
production workers. sustaining
d. The factory’s general manager meets with
other department heads such as marketing to Organization-
coordinate plans. sustaining
e. Direct labor workers assemble products. Unit-level
f. Engineers design new products. Product-level
g. The materials storekeeper issues raw materials
to be used in jobs. Batch-level
h. The maintenance department performs
periodic preventative maintenance on Organization-
general-use equipment. sustaining

Note: Some of these classifications are debatable and may depend on the

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specific circumstances found in particular companies.

Exercise 4

Sales (P1,650 per standard model glider × 10 standard

model gliders + P2,300 per custom designed glider ×
2 custom designed gliders) ........................................... P21,100
Costs:
Direct materials (P462 per standard model glider × 10
standard model gliders + P576 per custom
designed glider × 2 custom designed gliders) .......... P5,772
Direct labor (P19 per direct labor-hour × 28.5 direct
labor-hours per standard model glider × 10
standard model gliders + P19 per direct labor-hour
× 32 direct labor-hours per custom designed glider
× 2 custom designed gliders) .................................... 6,631
Supporting manufacturing (P18 per direct labor-hour
× 28.5 direct labor-hours per standard model glider
× 10 standard model gliders + P18 per direct labor-
hour × 32 direct labor-hours per custom designed
glider × 2 custom designed gliders) ......................... 6,282
Order processing (P192 per order × 3 orders) .............. 576
Custom designing (P261 per custom design × 2
custom designs) ........................................................ 522
Customer service (P426 per customer ×
1 customer) ............................................................... 426 20,209
Customer margin .............................................................. P 891

Exercise 5

Requirement 1

The predetermined overhead rate is computed as follows:

Predetermined P290,000
= = P5.80 per DLH
overhead rate 50,000 DLHs

The unit product costs under the company’s traditional costing system are
computed as follows:
Special Regular
Direct materials ................................................................... P60.00 P45.00
Direct labor ......................................................................... 9.60 7.20
Manufacturing overhead (0.8 DLH × P5.80 per DLH; 4.64 3.48

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0.6 DLH × P5.80 per DLH) ...........................................

Unit product cost ................................................................. P74.24 P55.68
Requirement 2

The activity rates are computed as follows:

(a)
Estimated (b)
Overhead Total (a) ÷ (b)
Activities Cost Expected Activity Activity Rate
Supporting direct labor ................. P150,000 50,000 DLHs P3 per DLH
Batch setups.................................. P60,000 250 setups P240 per setup
Safety testing ................................ P80,000 100 tests P800 per test

Manufacturing overhead is assigned to the two products as follows:

Special Product:
(a) (b) (a) × (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor .................................... P3 per DLH 8,000 DLHs P24,000
Batch setups .................................................... P240 per setup 200 setups 48,000
Safety testing................................................... P800 per test 80 tests 64,000
Total P136,000

Regular Product:
(a) (b) (a) × (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor .................................... P3 per DLH 42,000 DLHs P126,000
Batch setups .................................................... P240 per setup 50 setups 12,000
Safety testing................................................... P800 per test 20 tests 16,000
Total P154,000

Activity-based costing unit product costs are computed as follows:

Specia Regula
l r
Direct materials ................................................................................ P60.00 P45.00
Direct labor ...................................................................................... 9.60 7.20
Manufacturing overhead (P136,000 ÷ 10,000 units; P154,000 ÷
70,000 units) ............................................................................... 13.60 2.20
Unit product cost .............................................................................. P83.20 P54.40

IV. Problems

Problem 1

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Cost Pool Cost Driver Cost

Systems Rate Consumption Assignment
Traditional cost system 350% P10,000 P35,000
ABC system
Labor 10% P10,000 P 1,000
Machining P25/hour 800 hours 20,000
Setup P10/hour 100 hours 1,000
Production order P100/order 12 orders 1,200
Material handling P20/requisition 5 requisitions 100
Parts administration P40/part 18 parts 720
P24,020
Problem 2

Requirement 1

(a)
Total overhead = P200,000 + P32,000 + P100,000 + P120,000
= P452,000

Overhead rate = P452,000 / 50,000 direct labor hours

= P9.04 per direct labor hour

Overhead assigned to proposed job = P9.04 x 1,000 direct labor hours

= P9,040

(b) Total cost of proposed job:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 9,040
Total cost P25,040

(c) Company’s bid = Full manufacturing cost x 120% = P25,040 x 120%

= P30,048

Requirement 2

(a) Maintenance : P200,000 / 20,000 = P10 per machine hour

Materials handling: P32,000 / 1,600 = P20 per move
Setups: P100,000 / 2,500 = P40 per setup
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Inspection: P120,000 / 4,000 = P30 per inspection

Overhead assigned to proposed job:

Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspection (P30 x 10) 300
Total overhead assigned to job P5,620

(b) Total cost of proposed project:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 5,620
Total cost P21,620

(c) Company’s bid = Full manufacturing cost x 120% = P21,620 x 120%

= P25,944

The bid price of P25,944 was determined as follows:

Direct materials P6,000
Direct labor 10,000
Overhead assigned:
Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspections (P30 x 10) 300
Total overhead assigned to job 5,620
Total cost P21,620
Markup 120%
Bid price P25,944

Problem 3 (Activity-Based Costing)

Requirement 1

The first-stage allocation of costs to the activity cost pools appears below:

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Activity Cost Pools

Assembling Processing Supporting
Units Orders Customers Other Total
Manufacturing
overhead P250,000 P175,000 P25,000 P50,000 P500,000
Selling and
administrative
overhead 30,000 135,000 75,000 60,000 300,000
Total cost P280,000 P310,000 P100,000 P110,000 P800,000

Requirement 2

The activity rates for the cost pools are:

(a) (b) (a)  (b)

Total Cost Total Activity Activity Rate
Assembling units P280,000 1,000 units P280 per unit
Processing orders P310,000 250 orders P1,240 per order
Supporting customers P1,000 per
P100,000 100 customers customer

Requirement 3

The overhead cost attributable to Lucky Sale would be computed as follows:

(a) (b) (a) x (b)

Activity Cost Pools Activity Rate Activity ABC Cost
Assembling units P280 per unit 80 units P22,400
Processing orders P1,240 per order 4 orders P4,960
Supporting customers P1,000 per customer 1 customer P1,000

Requirement 4

The customer margin can be computed as follows:

Sales (P595 per unit x 80 units) P47,600

Costs:
Direct materials (P180 per unit x 80 units) P14,400
Direct labor (P50 per unit x 80 units) 4,000
Unit-related overhead (above) 22,400
Order-related overhead (above) 4,960
Customer-related overhead (above) 1,000 46,760
Customer margin P 840

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Problem 4 (Activity-Based Costing as an Alternative to Traditional

Product Costing)

Requirement 1

a. When direct labor-hours are used to apply overhead cost to products, the
company’s predetermined overhead rate would be:
Predetermined Manufacturing overhead cost
=
overhead rate Direct labor hours

P1,480,000
= = P74 per DLH
20,000 DLHs

b. Model
HY5 AS2
Direct materials ............................................ P35.00 P25.00
Direct labor:
P20 per hour × 0.2 DLH, 0.4 DLH .......... 4.00 8.00
Manufacturing overhead:
P74 per hour × 0.2 DLH, 0.4 DLH .......... 14.80 29.60
Total unit product cost ................................. P53.80 P62.60

Requirement 2

a. Predetermined overhead rates for the activity cost pools:

(a) (b)
Estimated Estimated (a) ÷ (b)
Activity Cost Pool Total Cost Total Activity Activity Rate
Machine setups....... P180,000 250 setups P720 per setup
Special milling ....... P300,000 1,000 MHs P300 per MH
General factory....... P1,000,000 20,000 DLHs P50 per DLH

The overhead applied to each product can be determined as follows:

Model HY5
(a) (a) × (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups ................................................ P720 per setup 150 setups P108,000
Special milling ................................................ P300 per MH 1,000 MHs 300,000

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General factory ............................................. P50 per DLH 4,000 DLHs 200,000

Total manufacturing overhead cost (a) ......... P608,000
Number of units produced (b) ...................... 20,000
Overhead cost per unit (a) ÷ (b).................... P30.40

Model AS2
(a) (a) × (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups ................................................ P720 per setup 100 setups P 72,000
Special milling ................................................ P300 per MH 0 MHs 0
General factory ............................................. P50 per DLH 16,000 DLHs 800,000
Total manufacturing overhead cost (a) ......... P872,000
Number of units produced (b) ...................... 40,000
Overhead cost per unit (a) ÷ (b) ................... P21.80

b. The unit product cost of each model under activity-based costing would be
computed as follows:
Model
HY5 AS2
Direct materials ..................................................................................... P35.00 P25.00
Direct labor (P20 per DLH × 0.2 DLH; P20 per DLH × 04.DLH) ....... 4.00 8.00
Manufacturing overhead (above) .......................................................... 30.40 21.80
Total unit product cost .......................................................................... P69.40 P54.80

Comparing these unit cost figures with the unit costs in Part 1(b), we find
that the unit product cost for Model HY5 has increased from P53.80 to
P69.40, and the unit product cost for Model AS2 has decreased from
P62.60 to P54.80.

Requirement 3

It is especially important to note that, even under activity-based costing, 68%

of the company’s overhead costs continue to be applied to products on the
basis of direct labor-hours:
Machine setups (number of setups) ............... P 180,000 12 %
Special milling (machine-hours) ................... 300,000 20
General factory (direct labor-hours) .............. 1,000,000 68

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Total overhead cost ....................................... P1,480,000 100 %

Thus, the shift in overhead cost from the high-volume product (Model AS2)
to the low-volume product (Model HY5) occurred as a result of reassigning
only 32% of the company’s overhead costs.

The increase in unit product cost for Model HY5 can be explained as follows:
First, where possible, overhead costs have been traced to the products rather
than being lumped together and spread uniformly over production. Therefore,
the special milling costs, which are traceable to Model HY5, have all been
assigned to Model HY5 and none assigned to Model AS2 under the activity-
based costing approach. It is common in industry to have some products that
require special handling or special milling of some type. This is especially true
in modern factories that produce a variety of products. Activity-based costing
provides a vehicle for assigning these costs to the appropriate products.

Second, the costs associated with the batch-level activity (machine setups)
have also been assigned to the specific products to which they relate. These
costs have been assigned according to the number of setups completed for each
product. However, since a batch-level activity is involved, another factor
affecting unit costs comes into play. That factor is batch size. Some products
are produced in large batches and some are produced in small batches. The
smaller the batch, the higher the cost per unit of the batch activity. In the case
at hand, the data can be analyzed as shown below.
Model HY5:
Cost to complete one setup [see 2(a)] ............................ P720 (a)
Number of units processed per setup
(20,000 units ÷ 150 setups)........................................ 133.33 (b)
Setup cost per unit (a) ÷ (b) ........................................... P5.40
Model AS2:
Cost to complete one setup (above) ............................... P720 (a)
Number of units processed per setup
(40,000 units ÷ 100 setups)........................................ 400 (b)
Setup cost per unit (a) ÷ (b) ........................................... P1.80

Thus, the cost per unit for setups is three times as great for Model HY5, the
low-volume product, as it is for Model AS2, the high-volume product. Such
differences in cost are obscured when direct labor-hours (or any other volume
measure) is used as the basis for applying overhead cost to products.

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In sum, overhead cost has shifted from the high-volume product to the low-
volume product as a result of more appropriately assigning some costs to the
products on the basis of the activities involved, rather than on the basis of
direct labor-hours.

V. Multiple Choice Questions

1. A 11. B 21. D
2. D 12. D 22. A
3. C 13. C 23. B
4. B 14. A 24. A
5. A 15. C 25. B
6. D 16. D 26. D
7. A 17. D 27. B
8. B 18. C 28. C
9. D 19. B 29. A
10. C 20. A 30. C

CHAPTER 12

VARIABLE COSTING

I. Questions
1. The variable costing technique does not consider fixed costs as
unimportant or irrelevant, but it maintains that the distinction between
behaviors of different costs is crucial for certain decisions.

2. The central issue in variable costing is what is the proper timing for release
of fixed manufacturing overhead as expense: at the time of incurrence, or
at the time the finished units to which the fixed overhead relates are sold.

3. Direct costing would be more accurately called variable or marginal

costing because in substance it is the inventory costing method which
applies only variable production costs to product; fixed factory overhead
is not assigned to product.

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4. Marketing and administrative costs are treated as period costs under both
variable costing and absorption costing methods of product costing.

5. Under absorption costing, as a company manufactures units of product,

the fixed manufacturing overhead costs of the period are added to the units,
along with direct materials, direct labor, and variable manufacturing
overhead. If some of these units are not sold by the end of the period, then
they are carried into the next period as inventory. The fixed manufacturing
overhead cost attached to the units in ending inventory follow the units
into the next period as part of their inventory cost. When the units carried
over as inventory are finally sold, the fixed manufacturing overhead cost
that has been carried over with the units is included as part of that period’s
cost of goods sold.

6. Many accountants and managers believe absorption costing does a better

job of matching costs with revenues than variable costing. They argue that
all manufacturing costs must be assigned to products to properly match the
costs of producing units of product with the revenues from the units when
they are sold. They believe that the fixed costs of depreciation, taxes,
insurance, supervisory salaries, and so on, are just as essential to
manufacturing products as are the variable costs.

7. If fixed manufacturing overhead cost is released from inventory, then

inventory levels must have decreased and therefore production must have
been less than sales.

8. Under absorption costing it is possible to increase net operating income

without increasing sales by increasing the level of production. If
production exceeds sales, units of product are added to inventory. These
units carry a portion of the current period’s fixed manufacturing overhead
costs into the inventory account, thereby reducing the current period’s
reported expenses and causing net operating income to rise.

9. Generally speaking, variable costing cannot be used externally for

financial reporting purposes nor can it be used for tax purposes.

10. If production exceeds sales, absorption costing will show higher net
operating income than variable costing. The reason is that inventories will
increase and therefore part of the fixed manufacturing overhead cost of the
current period will be deferred in inventory to the next period under
absorption costing. By contrast, all of the fixed manufacturing overhead

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cost of the current period will be charged immediately against revenues as

a period cost under variable costing.

11. Absorption and variable costing differ in how they handle fixed
manufacturing overhead. Under absorption costing, fixed manufacturing
overhead is treated as a product cost and hence is an asset until products
are sold. Under variable costing, fixed manufacturing overhead is treated
as a period cost and is expensed on the current period’s income statement.

12. Advocates of variable costing argue that fixed manufacturing costs are not
really the cost of any particular unit of product. If a unit is made or not,
the total fixed manufacturing costs will be exactly the same. Therefore,
how can one say that these costs are part of the costs of the products? These
costs are incurred to have the capacity to make products during a particular
period and should be charged against that period as period costs according
to the matching principle.

II. Exercises

Exercise 1 (Variable and Absorption Costing Unit Product Costs and

Income Statements)

Requirement 1

a. The unit product cost under absorption costing would be:

Direct materials ........................................................................... P18
Direct labor .................................................................................. 7
Variable manufacturing overhead ................................................ 2
Total variable manufacturing costs .............................................. 27
Fixed manufacturing overhead (P160,000 ÷ 20,000 units) ......... 8
Unit product cost ......................................................................... P35

b. The absorption costing income statement:

Sales (16,000 units × P50 per unit) ....................... P800,000
Less cost of goods sold:
Beginning inventory .......................................... P 0
Add cost of goods manufactured
(20,000 units × P35 per unit) ......................... 700,000

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Goods available for sale .................................... 700,000

Less ending inventory
(4,000 units × P35 per unit) ........................... 140,000 560,000
Gross margin ......................................................... 240,000
Less selling and administrative expenses .............. 190,000 *
Net operating income ............................................ P 50,000
*(16,000 units × P5 per unit) + P110,000 = P190,000.

Requirement 2

a. The unit product cost under variable costing would be:

Direct materials ............................................................................... P18
Direct labor ...................................................................................... 7
Variable manufacturing overhead .................................................... 2
Unit product cost ............................................................................. P27

b. The variable costing income statement:

Sales (16,000 units × P50 per unit) ...................... P800,000
Less variable expenses:
Variable cost of goods sold:
Beginning inventory ..................................... P 0
Add variable manufacturing costs
(20,000 units × P27 per unit) .................... 540,000
Goods available for sale ............................... 540,000
Less ending inventory
(4,000 units × P27 per unit) ...................... 108,000
Variable cost of goods sold ............................... 432,000 *
Variable selling expense
(16,000 units × P5 per unit) .......................... 80,000 512,000
Contribution margin ............................................. 288,000
Less fixed expenses:
Fixed manufacturing overhead ......................... 160,000
Fixed selling and administrative ....................... 110,000 270,000
Net operating income ........................................... P 18,000
* The variable cost of goods sold could be computed more simply as:
16,000 units × P27 per unit = P432,000.

Exercise 2 (Variable and Absorption Costing Unit Product Costs)

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Requirement 1

Sales (40,000 units × P33.75 per unit) ......... P1,350,000

Less variable expenses:
Variable cost of goods sold
(40,000 units × P16 per unit*) .............. P640,000
Variable selling and administrative expenses
(40,000 units × P3 per unit) .............................. 120,000 760,000
Contribution margin ..................................... 590,000
Less fixed expenses:
Fixed manufacturing overhead ................. 250,000
Fixed selling and administrative expenses 300,000 550,000
Net operating income ................................... P 40,000

* Direct materials ............................................................ P10

Direct labor .................................................................. 4
Variable manufacturing overhead ................................ 2
Total variable manufacturing cost ................................ P16

Requirement 2

The difference in net operating income can be explained by the P50,000 in

fixed manufacturing overhead deferred in inventory under the absorption
costing method:
Variable costing net operating income.......................................... P40,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing: 10,000 units × P5 per unit in
fixed manufacturing overhead cost ........................................... 50,000
Absorption costing net operating income ..................................... P90,000

Exercise 3 (Variable Costing Unit Product Cost and Income Statement;

Break-even)

Requirement 1

Under variable costing, only the variable manufacturing costs are included in
product costs.

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Direct materials............................................................................. P 600

Direct labor ................................................................................... 300
Variable manufacturing overhead ................................................. 100
Unit product cost .......................................................................... P1,000

Note that selling and administrative expenses are not treated as product costs;
that is, they are not included in the costs that are inventoried. These expenses
are always treated as period costs and are charged against the current period’s
revenue.

Requirement 2

The variable costing income statement appears below:

Sales........................................................................ P18,000,000
Less variable expenses:
Variable cost of goods sold:
Beginning inventory ..................................... P 0
Add variable manufacturing costs
(10,000 units × P1,000 per unit) ................ 10,000,000
Goods available for sale ................................ 10,000,000
Less ending inventory (1,000 units × P1,000
per unit) .................................................. 1,000,000
Variable cost of goods sold* ............................... 9,000,000
Variable selling and administrative (9,000 units
× P200 per unit) ................................................. 1,800,000 10,800,000
Contribution margin ............................................... 7,200,000
Less fixed expenses:
Fixed manufacturing overhead ............................... 3,000,000
Fixed selling and administrative ............................. 4,500,000 7,500,000
Net operating loss ................................................... P (300,000)

* The variable cost of goods sold could be computed more simply as: 9,000 units sold
× P1,000 per unit = P9,000,000.

Requirement 3

The break-even point in units sold can be computed using the contribution
margin per unit as follows:

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Selling price per unit........................................................................... P2,000

Variable cost per unit .......................................................................... 1,200
Contribution margin per unit .............................................................. P 800

Exercise 4 (Absorption
Fixed expenses
Break-even unitCosting
sales Unit
= Product Cost and Income Statement)
Unit contribution margin
P7,500,000
=
Requirement 1 P800 per unit
= 9,375 units
Under absorption costing, all manufacturing costs (variable and fixed) are
included in product costs.

Direct materials ................................................................. P 600

Direct labor ........................................................................ 300
Variable manufacturing overhead ...................................... 100
Fixed manufacturing overhead
(P3,000,000 ÷ 10,000 units) .......................................... 300
Unit product cost ............................................................... P1,300

Requirement 2

The absorption costing income statement appears below:

Sales (9,000 units × P2,000 per unit) ................... P18,000,000

Cost of goods sold:
Beginning inventory ......................................... P 0
Add cost of goods manufactured
(10,000 units × P1,300 per unit) ................... 13,000,000
Goods available for sale ................................... 13,000,000
Less ending inventory
(1,000 units × P1,300 per unit) ..................... 1,300,000 11,700,000
Gross margin ........................................................ 6,300,000
Selling and administrative expenses:
Variable selling and administrative (9,000
units × P200 per unit) ................................... 1,800,000
Fixed selling and administrative ...................... 4,500,000 6,300,000
Net operating income ........................................... P 0

Note: The company apparently has exactly zero net operating income even
though its sales are below the break-even point computed in Exercise 3. This

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occurs because P300,000 of fixed manufacturing overhead has been deferred

in inventory and does not appear on the income statement prepared using
absorption costing.
Exercise 5 (Variable Costing Income Statement; Explanation of Difference in Net

Operating Income)

Requirement 1

2,000 units × P60 per unit fixed manufacturing overhead = P120,000

Requirement 2

The variable costing income statement appears below:

Sales .......................................................................... P4,000,000

Variable expenses:
Variable cost of goods sold:
Beginning inventory .......................................... P 0
Add variable manufacturing costs
(10,000 units × P310 per unit) .................... 3,100,000
Goods available for sale .................................... 3,100,000
Less ending inventory
(2,000 units × P310 per unit) ......................... 620,000
Variable cost of goods sold* .................................. 2,480,000
Variable selling and administrative
(8,000 units × P20 per unit) ............................... 160,000 2,640,000
Contribution margin .................................................. 1,360,000
Fixed expenses:
Fixed manufacturing overhead .............................. 600,000
Fixed selling and administrative ............................ 400,000 1,000,000
Net operating income ................................................ P 360,000

* The variable cost of goods sold could be computed more simply as: 8,000
units sold × P310 per unit = P2,480,000.

The difference in net operating income between variable and absorption

costing can be explained by the deferral of fixed manufacturing overhead cost
in inventory that has taken place under the absorption costing approach. Note

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from part (1) that P120,000 of fixed manufacturing overhead cost has been
deferred in inventory to the next period. Thus, net operating income under the
absorption costing approach is P120,000 higher than it is under variable
costing.
Exercise 6 (Evaluating Absorption and Variable Costing as Alternative
Costing Methods)

Requirement 1

a. By assumption, the unit selling price, unit variable costs, and total fixed
costs are constant from year to year. Consequently, variable costing net
operating income will vary with sales. If sales increase, variable costing
net operating income will increase. If sales decrease, variable costing net
operating income will decrease. If sales are constant, variable costing net
operating income will be constant. Because variable costing net operating
income was P16,847 each year, unit sales must have been the same in each
year.

The same is not true of absorption costing net operating income. Sales and
absorption costing net operating income do not necessarily move in the
same direction because changes in inventories also affect absorption
costing net operating income.

b. When variable costing net operating income exceeds absorption costing

net operating income, sales exceeds production. Inventories shrink and
fixed manufacturing overhead costs are released from inventories. In
contrast, when variable costing net operating income is less than
absorption costing net operating income, production exceeds sales.
Inventories grow and fixed manufacturing overhead costs are deferred in
inventories. The year-by-year effects are shown below.

Year 1 Year 2 Year 3

Variable costing NOI Variable costing NOI Variable costing NOI
= Absorption costing < Absorption costing > Absorption costing
NOI NOI NOI
Production = Sales Production > Sales Production < Sales
Inventories remain the
same Inventories grow Inventories shrink

Requirement 2

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a. As discussed in part (1 a) above, unit sales and variable costing net

operating income move in the same direction when unit selling prices and
the cost structure are constant. Because variable costing net operating
income declined, unit sales must have also declined. This is true even
though the absorption costing net operating income increased. How can
that be? By manipulating production (and inventories) it may be possible
to maintain or increase the level of absorption costing net operating
income even though unit sales decline. However, eventually inventories
will grow to be so large that they cannot be ignored.

b. As stated in part (1 b) above, when variable costing net operating income

is less than absorption costing net operating income, production exceeds
sales. Inventories grow and fixed manufacturing overhead costs are
deferred in inventories. The year-by-year effects are shown below.

Year 1 Year 2 Year 3

Variable costing NOI = Variable costing NOI < Variable costing NOI
Absorption costing Absorption costing < Absorption costing
NOI NOI NOI
Production = Sales Production > Sales Production > Sales
Inventories remain the
same Inventories grow Inventories grow

Requirement 3

Variable costing appears to provide a much better picture of economic reality

than absorption costing in the examples above. In the first case, absorption
costing net operating income fluctuates wildly even though unit sales are the
same each year and unit selling prices, unit variable costs, and total fixed costs
remain the same. In the second case, absorption costing net operating income
increases from year to year even though unit sales decline. Absorption costing
is much more subject to manipulation than variable costing. Simply by
changing production levels (and thereby deferring or releasing costs from
inventory) absorption costing net operating income can be manipulated
upward or downward.

Note: This exercise is based on the following data:

Common data:
Annual fixed manufacturing costs ............................... P153,153
Contribution margin per unit ...................................... P35,000

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Annual fixed SGA costs ............................................... P180,000

Part 1:
Year 1 Year 2 Year 3
Beginning inventory ................................................... 1 1 2
Production.................................................................. 10 11 9
Sales ........................................................................... 10 10 10
Ending ........................................................................ 1 2 1

Variable costing net operating income ....................... P16,84 P16,84 P16,84

7 7 7

Fixed manufacturing overhead in beginning P15,31 P15,31 P27,84

inventory* ........................................................... 5 5 6
Fixed manufacturing overhead in ending inventory .. P15,31 P27,84 P17,01
5 6 7
Absorption costing net operating income .................. P16,84 P29,37
7 8 P6,018

* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2

for Year 1. A FIFO inventory flow assumption is used.

Part 2:
Year 1 Year 2 Year 3
Beginning inventory ............................................ 1 1 4
Production ........................................................... 10 12 20
Sales .................................................................... 10 9 8
Ending ................................................................. 1 4 16

Variable costing net operating income (loss) ...... P16,84 (P18,153 (P53,153
7 ) )

Fixed manufacturing overhead in beginning P15,31

inventory* .................................................... 5 P15,315 P51,051
Fixed manufacturing overhead in ending P15,31 P122,52
inventory ...................................................... 5 P51,051 2
Absorption costing net operating income............ P16,84
7 P17,583 P18,318

* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2

for Year 1. A FIFO inventory flow assumption is used.
III. Problems

Problem 1

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Requirement 1: Variable Costing Method

Romero Parts, Inc.

Income Statement - Manufacturing
For the Year Ended December 31, 2005

Sales P20,700,000
Less: Variable Cost of Sales
Inventory, Jan. 1 P1,155,000
Current Production 7,700,000
Total Available for Sale P8,855,000
Inventory, Dec. 31 805,000 8,050,000
Contribution Margin P12,650,000
Less Fixed Costs and Expenses 6,000,000
Net Income P 6,650,000

Requirement 2: Absorption Costing Method

Romero Parts, Inc.

Income Statement - Manufacturing
For the Year Ending December 31, 2006

Sales P26,100,000
Less Cost of goods sold:
Inventory, Jan. 1 P 1,380,000
Current Production 16,100,000
Total Available for Sale P17,480,000
Inventory, Dec. 31 747,500
Cost of Sales - Standard P16,732,500
Favorable Capacity Variance 900,000 15,832,500
Income from Manufacturing P10,267,500

Requirement 3: Variable Costing Method

Romero Parts, Inc.
Income Statement - Manufacturing

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For the Year Ending December 31, 2006

Sales P26,100,000
Less Variable Cost of Sales:
Inventory, Jan. 1 P 805,000
Production 9,800,000
Total Available for Sale P10,605,000
Inventory, Dec. 31 455,000 10,150,000
Contribution Margin - Manufacturing P15,950,000
Less Fixed Cost 5,400,000
Income from Manufacturing P10,550,000

Reconciliation
Net Income, absorption costing P10,267,500
Add Fixed Factory Overhead Inventory, 1/1 575,000
Total P10,842,500
Less Fixed Factory Overhead Inventory, 12/31 292,500
Net Income, direct costing P10,550,000

Problem 2

Requirement 1
Honey Company
Income Statement - Direct Costing
For the Year Ended December 31, 2005
Sales P280,000
Less Variable Cost of Sales:
Finished Goods Inventory, 1/1 P 4,000
Current Production 120,000
Total Available for Sale P124,000
Finished Goods Inventory, 12/31 12,000
Variable Cost of Sale - Standard P112,000
Unfavorable Variance 5,000 117,000

Contribution Margin - Manufacturing P163,000

Less Variable Marketing Expenses 28,000
Contribution Margin - Final P135,000
Less Fixed Costs and Expenses:
Fixed Factory Overhead P 54,000
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Fixed Marketing and

Administrative Expenses 20,000 74,000
Net Income P 61,000

Requirement 2

Honey Company
Income Statement - Absorption Costing
For the Year Ended December 31, 2005

Sales P280,000
Less: Cost of Sales
Finished goods inventory, Jan. 1 (1,000 x P5.50) P 5,500
Current production costs
Variable (30,000 x P4.00) P120,000
Fixed (30,000 x P1.50) 45,000 165,000
P170,500
Less: Finished goods inventory, Dec. 31
(3,000 x P5.50) 16,500
Cost of Sales - at Standard P154,000
Add (Deduct) Variance
Unfavorable variable manufacturing
costs variances 5,000
Underapplied fixed factory overhead
(6,000 x P1.50) 9,000
Cost of Sales - Actual P168,000
Gross Profit P112,000
Less: Selling and administrative expenses
Variable 28,000
Fixed 20,000
P 48,000
Net Income P 64,000

Problem 3 (Variable Costing Income Statement; Reconciliation)

Requirement 1

The unit product cost under the variable costing approach would be computed
as follows:
Direct materials .................................................................... P 8
Direct labor .......................................................................... 10

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Variable manufacturing overhead ........................................ 2

Unit product cost .................................................................. P20

With this figure, the variable costing income statements can be prepared:
Year 1 Year 2
Sales....................................................................... P1,000,000 P1,500,000
Less variable expenses:
Variable cost of goods sold @ P20 per unit ....... 400,000 600,000
Variable selling and administrative
@ P3 per unit ................................................. 60,000 90,000
Total variable expenses.......................................... 460,000 690,000
Contribution margin .............................................. 540,000 810,000
Less fixed expenses:
Fixed manufacturing overhead .......................... 350,000 350,000
Fixed selling and administrative ........................ 250,000 250,000
Total fixed expenses .............................................. 600,000 600,000
Net operating income (loss)................................... P (60,000) P 210,000

Requirement 2

Variable costing net operating income (loss)......... P (60,000) P 210,000

Add: Fixed manufacturing overhead cost
deferred in inventory under absorption costing
(5,000 units × P14 per unit) .............................. 70,000
Deduct: Fixed manufacturing overhead cost
released from inventory under absorption
costing (5,000 units × P14 per unit).................. (70,000)
Absorption costing net operating income .............. P 10,000 P 140,000

Problem 4 (Prepare and Interpret Statements; Changes in Both Sales and

Production; JIT)

Requirement 1

Year 1 Year 2 Year 3

Sales P1,000,000 P 800,000 P1,000,000
Less variable expenses:
Variable cost of goods sold
@ P4 per unit .................................. 200,000 160,000 200,000
Variable selling and administrative 100,000 80,000 100,000

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@ P2 per unit ..................................

Total variable expenses ............................ 300,000 240,000 300,000
Contribution margin ................................ 700,000 560,000 700,000
Less fixed expenses:
Fixed manufacturing overhead ......... 600,000 600,000 600,000
Fixed selling and administrative ....... 70,000 70,000 70,000
Total fixed expenses ................................ 670,000 670,000 670,000
Net operating income (loss) ..................... P 30,000 P(110,000) P 30,000

Requirement 2

a.
Year 1 Year 2 Year 3
Variable manufacturing cost .............. P 4 P 4 P 4
Fixed manufacturing cost:
P600,000 ÷ 50,000 units ................ 12
P600,000 ÷ 60,000 units ................ 10
P600,000 ÷ 40,000 units ................ 15
Unit product cost ............................... P16 P14 P19

b.
Variable costing net operating income
(loss) ................................................ P30,000 P(110,000) P 30,000
Add (Deduct): Fixed manufacturing
overhead cost deferred in inventory
from Year 2 to Year 3 under
absorption costing (20,000 units ×
P10 per unit) .................................... 200,000 (200,000)
Add: Fixed manufacturing overhead
cost deferred in inventory from Year
3 to the future under absorption
costing (10,000 units × P15 per
unit).................................................. 150,000
Absorption costing net operating
income (loss).................................... P30,000 P 90,000 P(20,000)

Requirement 3

Production went up sharply in Year 2 thereby reducing the unit product cost,
as shown in (2a). This reduction in cost, combined with the large amount of

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fixed manufacturing overhead cost deferred in inventory for the year, more
than offset the loss of revenue. The net result is that the company’s net
operating income rose even though sales were down.

Requirement 4

The fixed manufacturing overhead cost deferred in inventory from Year 2 was
charged against Year 3 operations, as shown in the reconciliation in (2b). This
added charge against Year 3 operations was offset somewhat by the fact that
part of Year 3’s fixed manufacturing overhead costs was deferred in inventory
to future years [again see (2b)]. Overall, the added costs charged against Year
3 were greater than the costs deferred to future years, so the company reported
less income for the year even though the same number of units was sold as in
Year 1.

Requirement 5

a. Several things would have been different if the company had been using
JIT inventory methods. First, in each year production would have been
geared to sales so that little or no inventory of finished goods would have
been built up in either Year 2 or Year 3. Second, unit product costs
probably would have been the same in all three years, since these costs
would have been established on the basis of expected sales (50,000 units)
for each year. Third, since only 40,000 units were sold in Year 2, the
company would have produced only that number of units and therefore
would have had some underapplied overhead cost for the year. (See the
discussion on underapplied overhead in the following paragraph.)

b. If JIT had been in use, the net operating income under absorption costing
would have been the same as under variable costing in all three years. The
reason is that with production geared to sales, there would have been no
ending inventory on hand, and therefore there would have been no fixed
manufacturing overhead costs deferred in inventory to other years.
Assuming that the company expected to sell 50,000 units in each year and
that unit product costs were set on the basis of that level of expected
activity, the income statements under absorption costing would have
appeared as follows:
Year 1 Year 2 Year 3
Sales ................................................................... P1,000,000 P 800,000 P1,000,000
Less cost of goods sold:
Cost of goods manufactured @ P16 per unit ..... 800,000 640,000 * 800,000

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Add underapplied overhead ............................... 120,000 **

Cost of goods sold ............................................. 800,000 760,000 800,000
Gross margin ...................................................... 200,000 40,000 200,000
Selling and administrative expenses .................. 170,000 150,000 170,000
Net operating income (loss) ............................... P 30,000 P(110,000) P 30,000

* 40,000 units × P16 per unit = P640,000.

** 10,000 units not produced × P12 per unit fixed manufacturing overhead cost =
P120,000 fixed manufacturing overhead cost not applied to products.

Problem 5 (Contrasting Variable and Absorption Costing)

Requirement 1 (a)

Under absorption costing, all manufacturing costs, variable and fixed, are
included in unit product costs:

Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6
Variable manufacturing overhead 3 3
Fixed manufacturing overhead
(P120,000  10,000 units) 12
(P120,000  6,000 units) 20

Unit product cost P32 P40

Requirement 1 (b)

The absorption costing income statements follow:

Year 1 Year 2
Sales (8,000
units x P50 P400,0 P400,0
per unit) 00 00
Cost of goods
sold:

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Beginning P P
inventory 0 64,000
Add cost of
goods
manufactur
ed (10,000
units x P32
per unit;
6,000 units
x P40 per 320,00 240,00
unit) 0 0
Goods
available for 320,00 304,00
sale 0 0
Less ending
inventory
(2,000 units
x P32 per
unit; 0 units
x P40 per 256,00 304,00
unit) 64,000 0 0 0
Gross margin 144,00
0 96,000
Selling and
administrativ
e expenses
(8,000 units
x P4 per unit 102,00 102,00
+ P70,000) 0 0
Net operating P P
income 42,000 (6,000)
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Requirement 2 (a)

Under variable costing, only the variable manufacturing costs are included in
unit product costs:

Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6
Variable manufacturing overhead 3 3
Unit product cost P20 P20

Requirement 2 (b)

The variable costing income statements follow. Notice that the variable cost
of goods sold is computed in a simpler, more direct manner than in the
examples provided earlier. On a variable costing income statement, this
simple approach or the more complex approach illustrated earlier is acceptable
for computing the cost of goods sold.

Year 1 Year 2
Sales (8,000
units x P50 P400,0 P400,0
per unit) 00 00
Variable
expenses:
Variable
cost of
goods sold
(8,000
units x P20 P160,0 P160,0
per unit) 00 00

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Variable
selling and
administra
tive (8,000
units x P4 192,00 192,00
per unit) 32,000 0 32,000 0
Contribution 208,00 208,00
margin 0 0
Fixed
expenses:
Fixed
manufacturi 120,00 120,00
ng overhead 0 0
Fixed selling
and
administra
tive 190,00 190,00
expenses 70,000 0 70,000 0
Net operating P P
income 18,000 18,000
Requirement 3

The reconciliation of the variable and absorption costing net operating incomes
follows:
Year 1 Year 2
Variable costing net operating income P18,000 P18,000
Add fixed manufacturing overhead costs
deferred in inventory under
absorption costing (2,000 units x P12
per unit) 24,000
Deduct fixed manufacturing overhead
costs released from inventory under (24,000)

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absorption costing (2,000 units x P12

per unit)
Absorption costing net operating income P42,000 P(6,000)

Problem 6 (Variable Costing Income Statement; Reconciliation)

Requirement 1

Sales (40,000 units × P33.75 per unit) ................... P1,350,000

Variable expenses:
Variable cost of goods sold
(40,000 units × P16 per unit*) ....................... P640,000
Variable selling and administrative expenses
(40,000 units × P3 per unit) ........................... 120,000 760,000
Contribution margin ............................................... 590,000

Fixed expenses:
Fixed manufacturing overhead .......................... 250,000
Fixed selling and administrative expenses ......... 300,000 550,000
Net operating income ............................................. P 40,000

* Direct materials ........................................................ P10

Direct labor ............................................................... 4
Variable manufacturing overhead ............................. 2
Total variable manufacturing cost ............................ P16

Requirement 2

The difference in net operating income can be explained by the P50,000 in

fixed manufacturing overhead deferred in inventory under the absorption
costing method:

Variable costing net operating income ...................................... P40,000

Add: Fixed manufacturing overhead cost deferred in
inventory under absorption costing: 10,000 units × P5 per
unit in fixed manufacturing overhead cost ............................ 50,000
Absorption costing net operating income .................................. P90,000

IV. Multiple Choice Questions

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1. D 11. B
2. B 12. A
3. B 13. C
4. B 14. D
5. B 15. B
6. C 16. A
7. A 17. C
8. B 18. C
9. A 19. B
10. A 20. C

CHAPTER 13

COST-VOLUME-PROFIT RELATIONSHIPS

I. Questions
1. The total “contribution margin” is the excess of total revenue over total
variable costs. The unit contribution margin is the excess of the unit price
over the unit variable costs.
2. Total contribution margin:
Selling price - manufacturing variable costs expensed - nonmanufacturing
variable costs expensed = Total contribution margin.
Gross margin:
Selling price - variable manufacturing costs expensed - fixed
manufacturing costs expensed = Gross margin.
3. A company operating at “break-even” is probably not covering costs
which are not recorded in the accounting records. An example of such a
cost is the opportunity cost of owner-invested capital. In some small
businesses, owner-managers may not take a salary as large as the
opportunity cost of forgone alternative employment. Hence, the
opportunity cost of owner labor may be excluded.

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4. In the short-run, without considering asset replacement, net operating cash

flows would be expected to exceed net income, because the latter includes
depreciation expense, while the former does not. Thus, the cash basis
break-even would be lower than the accrual break-even if asset
replacement is ignored. However, if asset replacement costs are taken into
account, (i.e., on a “cradle to grave” basis), the long-run net cash flows
equal long-run accrual net income, and the long-run break-even points are
the same.
5. Both unit price and unit variable costs are expressed on a per product basis,
as:
 = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n where:
 = operating profit,
P = average unit selling price,
V = average unit variable cost,
X = quantity of units,
F = total fixed costs for the period.
6. If the relative proportions of products (i.e., the product “mix”) is not held
constant, products may be substituted for each other. Thus, there may be
almost an infinite number of ways to achieve a target operating profit. As
shown from the multiple product profit equation, there are several
unknowns for one equation:
 = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n.
7. A constant product mix is assumed to simplify the analysis. Otherwise,
there may be no unique solution.
8. Operating leverage measures the impact on net operating income of a
given percentage change in sales. The degree of operating leverage at a
given level of sales is computed by dividing the contribution margin at that
level of sales by the net operating income.
9. Three approaches to break-even analysis are (a) the equation method, (b)
the contribution margin method, and (c) the graphical method. In the
equation method, the equation is: Sales = Variable expenses + Fixed
expenses + Profits, where profits are zero at the break-even point. The
equation is solved to determine the break-even point in units or peso sales.

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10. The margin of safety is the excess of budgeted (or actual) sales over the
break-even volume of sales. It states the amount by which sales can drop
before losses begin to be incurred.
11. The sales mix is the relative proportions in which a company’s products
are sold. The usual assumption in cost-volume-profit analysis is that the
sales mix will not change.
12. A higher break-even point and a lower net operating income could result
if the sales mix shifted from high contribution margin products to low
contribution margin products. Such a shift would cause the average
contribution margin ratio in the company to decline, resulting in less total
contribution margin for a given amount of sales. Thus, net operating
income would decline. With a lower contribution margin ratio, the break-
even point would be higher since it would require more sales to cover the
same amount of fixed costs.
13. The contribution margin (CM) ratio is the ratio of the total contribution
margin to total sales revenue. It can be used in a variety of ways. For
example, the change in total contribution margin from a given change in
total sales revenue can be estimated by multiplying the change in total
sales revenue by the CM ratio. If fixed costs do not change, then a peso
increase in contribution margin will result in a peso increase in net
operating income. The CM ratio can also be used in break-even analysis.
Therefore, knowledge of a product’s CM ratio is extremely helpful in
forecasting contribution margin and net operating income.
14. Incremental analysis focuses on the changes in revenues and costs that will
result from a particular action.
15. All other things equal, Company B, with its higher fixed costs and lower
variable costs, will have a higher contribution margin ratio than Company
A. Therefore, it will tend to realize a larger increase in contribution margin
and in profits when sales increase.
16. (a) If the selling price decreased, then the total revenue line would rise less
steeply, and the break-even point would occur at a higher unit volume. (b)
If the fixed cost increased, then both the fixed cost line and the total cost
line would shift upward and the break-even point would occur at a higher
unit volume. (c) If the variable cost increased, then the total cost line would
rise more steeply and the break-even point would occur at a higher unit
volume.

II. Exercises

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Exercise 1 (Using a Contribution Format Income Statement)

Requirement 1
Total Per Unit
Sales (30,000 units × 1.15 = 34,500 units) .................... P172,500 P5.00
Less variable expenses .................................................. 103,500 3.00
Contribution margin ...................................................... 69,000 P2.00
Less fixed expenses ....................................................... 50,000
Net operating income .................................................... P 19,000

Requirement 2

Sales (30,000 units × 1.20 = 36,000 units) .................... P162,000 P4.50

Less variable expenses .................................................. 108,000 3.00
Contribution margin ...................................................... 54,000 P1.50
Less fixed expenses ....................................................... 50,000
Net operating income .................................................... P 4,000

Requirement 3

Sales (30,000 units × 0.95 = 28,500 units) .................... P156,750 P5.50

Less variable expenses .................................................. 85,500 3.00
Contribution margin ...................................................... 71,250 P2.50
Less fixed expenses (P50,000 + P10,000) ..................... 60,000
Net operating income .................................................... P 11,250

Requirement 4

Sales (30,000 units × 0.90 = 27,000 units) .................... P151,200 P5.60

Less variable expenses .................................................. 86,400 3.20
Contribution margin ...................................................... 64,800 P2.40
Less fixed expenses ....................................................... 50,000
Net operating income .................................................... P 14,800

Exercise 2 (Break-even Analysis and CVP Graphing)

Requirement 1

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The contribution margin per person would be:

Price per ticket ........................................................................ P30

Less variable expenses:
Dinner ................................................................................. P7
Favors and program ............................................................ 3 10
Contribution margin per person ............................................. P20

The fixed expenses of the Extravaganza total P8,000; therefore, the break-even
point would be computed as follows:

Sales = Variable expenses + Fixed expense + Profits

P30Q = P10Q + P8,000 + P0

P20Q = P8,000
Q = P8,000 ÷ P20 per person
Q = 400 persons; or, at P30 per person, P12,000

Alternative solution:
Break-even Fixed expenses
point =
Unit contribution margin
in unit sales
P8,000
=
P20 per person

= 400 persons
or, at P30 per person, P12,000.

Requirement 2

Variable cost per person (P7 + P3) .................................................... P10

Fixed cost per person (P8,000 ÷ 250 persons) ................................... 32
Ticket price per person to break even ................................................ P42

Requirement 3

Cost-volume-profit graph:

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P22,000

P20,000

P18,000

P16,000 Total Sales

P14,000
Break-even point: 400 persons,
P12,000 or P12,000 in sales
Pesos

P10,000

P8,000 Total Expenses

P6,000 Fixed Expenses

P4,000

P2,000

P0
0 100 200 300 400 500 600
Number of Persons

Exercise 3 (Break-even and Target Profit Analysis)

Requirement 1

Sales = Variable expenses + Fixed expenses + Profits

P900Q = P630Q + P1,350,000 + P0
P270Q = P1,350,000
Q = P1,350,000 ÷ P270 per lantern
Q = 5,000 lanterns, or at P900 per lantern, P4,500,000 in sales

Alternative solution:
Break-even Fixed expenses
point =
Unit contribution margin
in unit sales
P1,350,000
=
P270 per lantern
= 5,000 lanterns
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or at P900 per lantern, P4,500,000 in sales

Requirement 2

An increase in the variable expenses as a percentage of the selling price would

result in a higher break-even point. The reason is that if variable expenses
increase as a percentage of sales, then the contribution margin will decrease as
a percentage of sales. A lower CM ratio would mean that more lanterns would
have to be sold to generate enough contribution margin to cover the fixed costs.

Requirement 3
Present: Proposed:
8,000 Lanterns 10,000 Lanterns*
Total Per Unit Total Per Unit
Sales .......................................... P7,200,000 P900 P8,100,000 P810 **
Less variable expenses .............. 5,040,000 630 6,300,000 630
Contribution margin .................. 2,160,000 P270 1,800,000 P180
Less fixed expenses................... 1,350,000 1,350,000
Net operating income ................ P 810,000 P 450,000

* 8,000 lanterns × 1.25 = 10,000 lanterns

** P900 per lantern × 0.9 = P810 per lantern

As shown above, a 25% increase in volume is not enough to offset a 10%

reduction in the selling price; thus, net operating income decreases.

Requirement 4

Sales = Variable expenses + Fixed expenses + Profits

P810Q = P630Q + P1,350,000 + P720,000
P180Q = P2,070,000
Q = P2,070,000 ÷ P180 per lantern
Q = 11,500 lanterns

Alternative solution:
Unit sales to Fixed expenses + Target profit
attain target profit =
Unit contribution margin
P1,350,000 + P720,000
=
P180 per lantern
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Chapter 13 Cost-Volume-Profit Relationships

Exercise 4 (Operating Leverage)

Requirement 1

Sales (30,000 doors) ....................................... P18,000,000 P600

Less variable expenses.................................... 12,600,000 420
Contribution margin ....................................... 5,400,000 P180
Less fixed expenses ........................................ 4,500,000
Net operating income...................................... P 900,000
Degree of Contribution margin
operating leverage =
Net operating income
P5,400,000
=
P900,000

= 6
Requirement 2

a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%, over

present sales of 30,000 doors. Since the degree of operating leverage is 6,
net operating income should increase by 6 times as much, or by 150% (6
× 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income ............................................. P 900,000
Expected increase in net operating income next year
(150% × P900,000)......................................................... 1,350,000
Total expected net operating income .................................. P2,250,000

Exercise 5 (Multiproduct Break-even Analysis)

Requirement 1
Model E700 Model J1500 Total Company
Amount % Amount % Amount %
Sales P700,000 100 P300,000 100 P1,000,000 100
Less variable expenses ... 280,000 40 90,000 30 370,000 37
Contribution margin ....... P420,000 60 P210,000 70 630,000 63 *
Less fixed expenses ........ 598,500
Net operating income ..... P 31,500

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* 630,000 ÷ P1,000,000 = 63%.

Requirement 2

The break-even point for the company as a whole would be:

Break-even point Fixed expenses
in total peso sales =
Overall CM ratio
P598,500
=
0.63

= P950,000 in sales
Requirement 3

The additional contribution margin from the additional sales can be computed
as follows:
P50,000 × 63% CM ratio = P31,500

Assuming no change in fixed expenses, all of this additional contribution

margin should drop to the bottom line as increased net operating income.

This answer assumes no change in selling prices, variable costs per unit, fixed
expenses, or sales mix.
Exercise 6 (Break-even Analysis; Target Profit; Margin of Safety)

Requirement 1

Sales = Variable expenses + Fixed expenses + Profits

P40Q = P28Q + P150,000 + P0
P12Q = P150,000
Q = P150,000 ÷ P12 per unit
Q = 12,500 units, or at P40 per unit, P500,000

Alternatively:

Break-even Fixed expenses

point =
Unit contribution margin
in unit sales
P150,000
=
P12 per unit

= 12,500 units
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or, at P40 per unit, P500,000.

Requirement 2

The contribution margin at the break-even point is P150,000 since at that point
it must equal the fixed expenses.

Requirement 3
Unit sales to Fixed expenses + Target profit
attain target profit =
Unit contribution margin
P150,000 + P18,000
=
P12 per unit

= 14,000 units

Total Unit
Sales (14,000 units × P40 per unit).................................. P560,000 P40
Less variable expenses
(14,000 units × P28 per unit) ....................................... 392,000 28
Contribution margin
(14,000 units × P12 per unit) ....................................... 168,000 P12
Less fixed expenses ......................................................... 150,000
Net operating income....................................................... P 18,000

Requirement 4

Margin of safety in peso terms:

Margin of safety in pesos = Total sales – Break-even sales

= P600,000 – P500,000 = P100,000

Margin of safety in percentage terms:

Margin of safety Margin of safety in pesos
percentage =
Total sales
P100,000
=
P600,000
= 16.7% (rounded)
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Requirement 5

The CM ratio is 30%.

Expected total contribution margin: P680,000 × 30% ............... P204,000

Present total contribution margin: P600,000 × 30%................... 180,000
Increased contribution margin .................................................... P 24,000

Alternative solution:

P80,000 incremental sales × 30% CM ratio = P24,000

Since in this case the company’s fixed expenses will not change, monthly net
operating income will increase by the amount of the increased contribution
margin, P24,000.

Exercise 7 (Changes in Variable Costs, Fixed Costs, Selling Price, and

Volume)

Requirement (1)

The following table shows the effect of the proposed change in monthly
advertising budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales ......................................... P225,000 P240,000 P15,000
Variable expenses ..................... 135,000 144,000 9,000
Contribution margin ................. 90,000 96,000 6,000
Fixed expenses ......................... 75,000 83,000 8,000
Net operating income ............... P 15,000 P 13,000 P(2,000)

Assuming that there are no other important factors to be considered, the

increase in the advertising budget should not be approved since it would lead
to a decrease in net operating income of P2,000.

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Alternative Solution 1

Expected total contribution margin:

P240,000 × 40% CM ratio............................................ P96,000
Present total contribution margin:
P225,000 × 40% CM ratio............................................ 90,000
Incremental contribution margin ...................................... 6,000
Change in fixed expenses:
Less incremental advertising expense .......................... 8,000
Change in net operating income ....................................... P(2,000)

Alternative Solution 2

Incremental contribution margin:

P15,000 × 40% CM ratio............................................. P 6,000
Less incremental advertising expense .............................. 8,000
Change in net operating income ....................................... P(2,000)

Requirement (2)

The P3 increase in variable costs will cause the unit contribution margin to
decrease from P30 to P27 with the following impact on net operating income:
Expected total contribution margin with the higher-quality
components:
3,450 units × P27 per unit .................................................... P93,150
Present total contribution margin:
3,000 units × P30 per unit .................................................... 90,000
Change in total contribution margin ........................................ P 3,150

Assuming no change in fixed costs and all other factors remain the same, the
higher-quality components should be used.

Exercise 8 (Compute the Margin of Safety)

Requirement (1)

To compute the margin of safety, we must first compute the break-even unit
sales.

Sales = Variable expenses + Fixed expenses + Profits

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P25Q = P15Q + P8,500 + P0

P10Q = P8,500
Q = P8,500 ÷ P10 per unit
Q = 850 units

Sales (at the budgeted volume of 1,000 units) ............................. P25,000

Break-even sales (at 850 units) .................................................... 21,250
Margin of safety (in pesos)........................................................... P 3,750

Requirement (2)

The margin of safety as a percentage of sales is as follows:

Margin of safety (in pesos)...................................................... P3,750

÷ Sales ..................................................................................... P25,000
Margin of safety as a percentage of sales ................................ 15.0%
Exercise 9 (Compute and Use the Degree of Operating Leverage)

Requirement (1)

The company’s degree of operating leverage would be computed as follows:

Contribution margin .................................. P36,000

÷ Net operating income ............................. P12,000
Degree of operating leverage .................... 3.0

Requirement (2)

A 10% increase in sales should result in a 30% increase in net operating

income, computed as follows:

Degree of operating leverage ....................................................... 3.0

× Percent increase in sales............................................................ 10%
Estimated percent increase in net operating income .................... 30%

Requirement (3)

The new income statement reflecting the change in sales would be:

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Percent of
Amount Sales
Sales ............................................. P132,000 100%
Variable expenses......................... 92,400 70%
Contribution margin ..................... 39,600 30%
Fixed expenses ............................. 24,000
Net operating income ................... P 15,600

Net operating income reflecting change in sales......................... P15,600

Original net operating income ..................................................... P12,000
Percent change in net operating income...................................... 30%

Exercise 10 (Compute the Break-Even Point for a Multiproduct

Company)

Requirement (1)

The overall contribution margin ratio can be computed as follows:

Total contribution margin
Overall CM ratio =
Total sales
P120,000
=
P150,000
= 80%
Requirement (2)

The overall break-even point in sales pesos can be computed as follows:

Total fixed expenses
Overall break-even =
Overall CM ratio
P90,000
=
80%

= P112,500
Requirement (3)

To construct the required income statement, we must first determine the

relative sales mix for the two products:

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Ping Pong Total

Original peso sales ................... P100,000 P50,000 P150,000
Percent of total ......................... 67% 33% 100%
Sales at break-even .................. P75,000 P37,500 P112,500

Ping Pong Total

Sales ......................................... P75,000 P37,500 P112,500
Variable expenses* .................. 18,750 3,750 22,500
Contribution margin ................. P56,250 P33,750 90,000
Fixed expenses ......................... 90,000
Net operating income ............... P 0

*Ping variable expenses: (P75,000/P100,000) × P25,000 = P18,750

Pong variable expenses: (P37,500/P50,000) × P5,000 = P3,750

Exercise 11 (Break-Even and Target Profit Analysis)

Requirement (1)

Variable expenses: P60 × (100% – 40%) = P36.

Requirement (2)

a. Selling price ............................................... P60 100%

Variable expenses ...................................... 36 60%
Contribution margin ................................... P24 40%
Let Q = Break-even point in units.
Sales = Variable expenses + Fixed expenses + Profits
P60Q = P36Q + P360,000 + P0
P24Q = P360,000
Q = P360,000 ÷ P24 per unit
Q = 15,000 units
In sales pesos: 15,000 units × P60 per unit = P900,000
Alternative solution:
Let X = Break-even point in sales pesos.
X = 0.60X + P360,000 + P0
0.40X = P360,000

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X = P360,000 ÷ 0.40
X = P900,000
In units: P900,000 ÷ P60 per unit = 15,000 units
b. P60Q = P36Q + P360,000 + P90,000
P24Q = P450,000
Q = P450,000 ÷ P24 per unit
Q = 18,750 units

In sales pesos: 18,750 units × P60 per unit = P1,125,000

Alternative solution:

X = 0.60X + P360,000 + P90,000

0.40X = P450,000
X = P450,000 ÷ 0.40
X = P1,125,000

In units: P1,125,000 ÷ P60 per unit = 18,750 units

c. The company’s new cost/revenue relationships will be:

Selling price .......................................................... P60 100%

Variable expenses (P36 – P3) ............................... 33 55%
Contribution margin .............................................. P27 45%

P60Q = P33Q + P360,000 + P0

P27Q = P360,000
Q = P360,000 ÷ P27 per unit
Q = 13,333 units (rounded).

In sales pesos: 13,333 units × P60 per unit = P800,000 (rounded)

Alternative solution:

X = 0.55X + P360,000 + P0
0.45X = P360,000
X = P360,000 ÷ 0.45
X = P800,000

In units: P800,000 ÷ P60 per unit = 13,333 units (rounded)

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Requirement (3)
Break-even point Fixed expenses
a. in unit sales =
Unit contribution margin
= P360,000  P24 per unit = 15,000 units

In sales pesos: 15,000 units × P60 per unit = P900,000

Alternative solution:
Break-even point Fixed expenses
in sales pesos =
CM ratio
= P360,000  0.40 = P900,000
In units: P900,000 ÷ P60 per unit = 15,000 units

Unit sales to Fixed expenses + Target profit

b. =
attain target profit Unit contribution margin
= (P360,000 + P90,000)  P24 per unit

= 18,750 units

In sales pesos: 18,750 units × P60 per unit = P1,125,000

Alternative solution:
Peso sales to Fixed expenses + Target profit
attain target profit =
CM ratio
= (P360,000 + P90,000)  0.40

= P1,125,000

In units: P1,125,000 ÷ P60 per unit = 18,750 units

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c. Break-even point Fixed expenses

in unit sales =
Unit contribution margin
= P360,000  P27 per unit

= 13,333 units (rounded)

In sales pesos: 13,333 units × P60 per unit = P800,000 (rounded)

Alternative solution:
Break-even point Fixed expenses
in sales pesos =
CM ratio
= P360,000  0.45

= P800,000
In units: P800,000 ÷ P60 per unit = 13,333 (rounded)

Exercise 12 (Operating Leverage)

Requirement (1)

Sales (30,000 doors) ............................... P1,800,000 P60

Variable expenses................................... 1,260,000 42
Contribution margin ............................... 540,000 P18
Fixed expenses ....................................... 450,000
Net operating income ............................. P 90,000
Degree of Contribution margin
operating leverage =
Net operating income
= P540,000  P90,000 = 6
Requirement (2)

a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%, over

present sales of 30,000 doors. Since the degree of operating leverage is 6,
net operating income should increase by 6 times as much, or by 150% (6
× 25%).
b. Expected total peso net operating income for the next year is:

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Present net operating income ................................................ P 90,000

Expected increase in net operating income next year
(150% × P90,000) ............................................................. 135,000
Total expected net operating income .................................... P225,000

III. Problems

Problem 1 (CVP Relationships)

Requirement 1
Contribution margin P15
CM ratio = = = 25%
Selling price P60
Variable expense P45
Variable expense ratio = = = 75%
Selling price P60

Requirement 2

Sales = Variable expenses + Fixed expenses + Profits

P60Q = P45Q + P240,000 + P0
P15Q = P240,000
Q = P240,000 ÷ P15 per unit
Q = 16,000 units, or at P60 per unit, P960,000

Alternative solution:

X = 0.75X + P240,000 + P0
0.25X = P240,000
X = P240,000 ÷ 0.25
X = P960,000; or at P60 per unit, 16,000 units

Requirement 3

Increase in sales ................................................... P400,000

Multiply by the CM ratio ..................................... x 25%
Expected increase in contribution margin............ P100,000

Since the fixed expenses are not expected to change, net operating income will
increase by the entire P100,000 increase in contribution margin computed
above.

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Requirement 4

Sales = Variable expenses + Fixed expenses + Profits

P60Q = P45Q + P240,000 + P90,000
P15Q = P330,000
Q = P330,000 ÷ P15 per unit
Q = 22,000 units

Contribution margin method:

Fixed expenses + Target profit P240,000 + P90,000
= = 22,000 units
Contribution margin per unit P15 per unit

Requirement 5

Margin of safety in pesos = Total sales – Break-even sales

= P1,200,000 – P960,000 = P240,000

Margin of safety Margin of safety in pesos P240,000

=
percentage =
Total sales P1,200,000 = 20%

Requirement 6
Contribution margin P300,000
a. Degree of operating leverage = = 5
Net operating P60,000
=
income
b. Expected increase in sales........................................... 8%
Degree of operating leverage ...................................... x 5
Expected increase in net operating income ................. 40%

c. If sales increase by 8%, then 21,600 units (20,000 x 1.08 = 21,600) will be
sold next year. The new income statement will be as follows:
Percent of
Total Per Unit Sales

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Sales (21,600 P1,296,000 P60 100%

units)
..........................................
Less variable 972,000 45 75%
expenses
..........................................
Contribution 324,000 P15 25%
margin
..........................................
Less fixed 240,000
expenses
..........................................
Net operating P 84,000
income
..........................................

Thus, the P84,000 expected net operating income for next year represents
a 40% increase over the P60,000 net operating income earned during the
current year:
P84,000 – P60,000 P24,000
= = 40% increase
P60,000 P60,000
Note from the income statement above that the increase in sales from
20,000 to 21,600 units has resulted in increases in both total sales and total
variable expenses. It is a common error to overlook the increase in
variable expense when preparing a projected income statement.

Requirement 7

a. A 20% increase in sales would result in 24,000 units being sold next year:
20,000 units x 1.20 = 24,000 units.
Percent of
Total Per Unit Sales
Sales (24,000 P1,440,000 P60 100%
units)
..........................................
Less variable 1,152,000 48* 80%
expenses
..........................................
Contribution 288,000 P12 20%
margin
..........................................

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Less fixed 210,000†

expenses
..........................................
Net operating P 78,000
income
..........................................

* P45 + P3 = P48; P48  P60 = 80%.

†
P240,000 – P30,000 = P210,000.

Note that the change in per unit variable expenses results in a change in
both the per unit contribution margin and the CM ratio.

b. Break-even point Fixed expenses

in unit sales =
Contribution margin per unit
P210,000
=
P12 per unit

Break-even
c. Yes, based point=
on these data
17,500
the changes
units
Fixedshould
expenses
be made. The changes will
=
increase the company’s net operatingCMincome
in peso sales ratio from the present P60,000 to
P78,000 per year. Although the changes
P210,000 also result in a higher break-
will
even point (17,500 units as=compared 0.20to the present 16,000 units), the
company’s margin of safety will actually be wider than before:
= P1,050,000
Margin of safety in pesos = Total sales – Break-even sales
= P1,440,000 – P1,050,000 = P390,000

As shown in requirement (5) above, the company’s present margin of

safety is only P240,000. Thus, several benefits will result from the
proposed changes.

Problem 2 (Basics of CVP Analysis; Cost Structure)

Requirement 1
The CM ratio is 30%.
Total Per Unit Percentage
Sales (13,500 units) ........................ P270,000 P20 100 %
Less variable expenses.................... 189,000 14 70

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Contribution margin ....................... P 81,000 P 6 30 %

The break-even point is:

Sales = Variable expenses + Fixed expenses + Profits
P20Q = P14Q + P90,000 + P0
P 6Q = P90,000
Q = P90,000 ÷ P6 per unit
Q = 15,000 units
15,000 units × P20 per unit = P300,000 in sales

Alternative solution:
Break-even point Fixed expenses
in unit sales =
Contribution margin per unit
P90,000
=
P6 per unit
= 15,000 units
Break-even point Fixed expenses
in sales pesos = CM ratio
P90,000
=
0.30
= P300,000 in sales
Requirement 2

Incremental contribution margin:

P70,000 increased sales × 30% CM ratio .................................. P21,000
Less increased fixed costs:
Increased advertising cost .......................................................... 8,000
Increase in monthly net operating income ..................................... P13,000

Since the company presently has a loss of P9,000 per month, if the changes are

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adopted, the loss will turn into a profit of P4,000 per month.

Requirement 3

Sales (27,000 units × P18 per unit*)......................................... P486,000

Less variable expenses
(27,000 units × P14 per unit) ................................................ 378,000
Contribution margin ................................................................. 108,000
Less fixed expenses (P90,000 + P35,000) ................................ 125,000
Net operating loss ..................................................................... P(17,000)

*P20 – (P20 × 0.10) = P18

Requirement 4

Sales = Variable expenses + Fixed expenses + Profits

P 20Q = P14.60Q* + P90,000 + P4,500
P5.40Q = P94,500
Q = P94,500 ÷ P5.40 per unit
Q = 17,500 units

* P14.00 + P0.60 = P14.60.

Alternative solution:

Unit sales to Fixed expenses + Target profit

attain target profit =
CM per unit
P90,000 + P4,500
=
P5.40 per unit**

= 17,500 units
** P6.00 – P0.60 = P5.40.

Requirement 5

a. The new CM ratio would be:

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Per Unit Percentage

Sales .................................................... P20 100 %
Less variable expenses ........................ 7 35
Contribution margin ............................ P13 65 %

The new break-even point would be:

Break-even point Fixed expenses
in unit sales =
Contribution margin per unit
P208,000
=
P13 per unit
= 16,000 units

Break-even point Fixed expenses

in sales pesos = CM ratio
P208,000
=
0.65
= P320,000 in sales
b. Comparative income statements follow:

Not Automated Automated

Total Per Unit % Total Per Unit %
Sales (20,000 units) ..... P400,000 P20 100 P400,000 P20 100
Less variable expenses 280,000 14 70 140,000 7 35
Contribution margin .... 120,000 P 6 30 260,000 P13 65
Less fixed expenses ..... 90,000 208,000
Net operating income .. P 30,000 P 52,000

c. Whether or not one would recommend that the company automate its
operations depends on how much risk he or she is willing to take, and
depends heavily on prospects for future sales. The proposed changes
would increase the company’s fixed costs and its break-even point.
However, the changes would also increase the company’s CM ratio (from
30% to 65%). The higher CM ratio means that once the break-even point
is reached, profits will increase more rapidly than at present. If 20,000
units are sold next month, for example, the higher CM ratio will generate

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P22,000 more in profits than if no changes are made.

The greatest risk of automating is that future sales may drop back down to
present levels (only 13,500 units per month), and as a result, losses will be
even larger than at present due to the company’s greater fixed costs. (Note
the problem states that sales are erratic from month to month.) In sum, the
proposed changes will help the company if sales continue to trend upward
in future months; the changes will hurt the company if sales drop back
down to or near present levels.

Note to the Instructor: Although it is not asked for in the problem, if time
permits you may want to compute the point of indifference between the
two alternatives in terms of units sold; i.e., the point where profits will be
the same under either alternative. At this point, total revenue will be the
same; hence, we include only costs in our equation:

Let Q = Point of indifference in units sold

P14Q + P90,000 = P7Q + P208,000
P7Q = P118,000
Q = P118,000 ÷ P7 per unit
Q = 16,857 units (rounded)

If more than 16,857 units are sold, the proposed plan will yield the greatest
profit; if less than 16,857 units are sold, the present plan will yield the greatest
profit (or the least loss).

Problem 3 (Sales Mix; Multiproduct Break-even Analysis)

Requirement 1

Products
Sinks Mirrors Vanities Total
Percentage of total sales ....... 32% 40% 28% 100%
Sales ................................... P160,000 100 % P200,000 100 % P140,000 100 % P500,000 100 %
Less variable expenses ......... 48,000 30 160,000 80 77,000 55 285,000 57
Contribution margin ............. P112,000 70 % P 40,000 20 % P 63,000 45 % 215,000 43 %*
Less fixed expenses ............. 223,600
Net operating income (loss) . P ( 8,600)
* P215,000 ÷ P500,000 = 43%.

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Requirement 2
Break-even sales:
Break-even point Fixed expenses
in total peso sales =
CM ratio
P223,600
Requirement 3 =
0.43

Memo to the president: = P520,000 in sales

Although the company met its sales budget of P500,000 for the month, the mix
of products sold changed substantially from that budgeted. This is the reason
the budgeted net operating income was not met, and the reason the break-even
sales were greater than budgeted. The company’s sales mix was planned at
48% Sinks, 20% Mirrors, and 32% Vanities. The actual sales mix was 32%
Sinks, 40% Mirrors, and 28% Vanities.

As shown by these data, sales shifted away from Sinks, which provides our
greatest contribution per peso of sales, and shifted strongly toward Mirrors,
which provides our least contribution per peso of sales. Consequently,
although the company met its budgeted level of sales, these sales provided
considerably less contribution margin than we had planned, with a resulting
decrease in net operating income. Notice from the attached statements that the
company’s overall CM ratio was only 43%, as compared to a planned CM ratio
of 52%. This also explains why the break-even point was higher than planned.
With less average contribution margin per peso of sales, a greater level of sales
had to be achieved to provide sufficient contribution margin to cover fixed
costs.

Problem 4 (Basic CVP Analysis)

Requirement 1

The CM ratio is 60%:

Selling price ......................................... P150 100 %
Less variable expenses......................... 60 40
Contribution margin ............................ P 90 60 %

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Requirement 2
Break-even point Fixed expenses
in total sales pesos = CM ratio
P1,800,000
=
0.60

= P3,000,000 in sales
Requirement 3

P450,000 increased sales × 60% CM ratio = P270,000 increased contribution

margin. Since fixed costs will not change, net operating income should also
increase by P270,000.

Requirement 4
Contribution margin P2,160,000
a. Degree of operating leverage = = 6
Net operating P360,000
=
income
b. 6 × 15% = 90% increase in net operating income.

Requirement 5
Last Year: Proposed:
28,000 units 42,000 units*
Total Per Unit Total Per Unit
Sales .............................. P4,200,000 P150.00 P5,670,000 P135.00 **
Less variable expenses .. 1,680,000 60.00 2,520,000 60.00
Contribution margin...... 2,520,000 P 90.00 3,150,000 P 75.00
Less fixed expenses ...... 1,800,000 2,500,000
Net operating income .... P 720,000 P 650,000

* 28,000 units × 1.5 = 42,000 units

** P150 per unit × 0.90 = P135.00 per unit

No, the changes should not be made.

Requirement 6

Expected total contribution margin:

28,000 units × 200% × P70 per unit* ................................ P3,920,000
Present total contribution margin:
28,000 units × P90 per unit ................................................ 2,520,000

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Incremental contribution margin, and the amount by which

advertising can be increased with net operating income
remaining unchanged ......................................................... P1,400,000

* P150 – (P60 + P20) = P70

Problem 5 (Break-Even and Target Profit Analysis)

Requirement 1

The contribution margin per patch would be:

Selling price ............................................................................. P30

Less variable expenses:
Purchase cost of the patches ................................................ P15
Commissions to the student salespersons ............................ 6 21
Contribution margin ................................................................ P 9

Since there are no fixed costs, the number of unit sales needed to yield the
desired P7,200 in profits can be obtained by dividing the target profit by the
unit contribution margin:
Target profit P7,200
= = 800 patches
Unit contribution margin P9 per patch
800 patches x P30 per patch = P24,000 in total sales

Requirement 2

Since an order has been placed, there is now a “fixed” cost associated with the
purchase price of the patches (i.e., the patches can’t be returned). For example,
an order of 200 patches requires a “fixed” cost (investment) of P3,000 (200
patches × P15 per patch = P3,000). The variable costs drop to only P6 per
patch, and the new contribution margin per patch becomes:

Selling price.......................................................................................... P30

Less variable expenses (commissions only) ......................................... 6
Contribution margin ............................................................................. P24

Since the “fixed” cost of P3,000 must be recovered before Ms. Morales shows
any profit, the break-even computation would be:

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Break-even Fixed expenses

point =
Unit contribution margin
in unit sales
P3,000
= = 125 patches
P24 per patch
125 patches x P30 per patch = P3,750 in total sales

If a quantity other than 200 patches were ordered, the answer would change
accordingly.

Problem 6

Requirement 1: Break-even chart

TR
600,000

500,000

TC
400,000
(P)
Break-even
300,000 point

200,000

FC
100,000

5,000 10,000 15,000 20,000 25,000 30,000

(units)

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Requirement 2: Profit-volume graph

250,000

P 200,000
R
O
F 150,000
I
T
100,000

Break-even
50,000
point

0
5,000 10,000 15,000 20,000 25,000 30,000

50,000

100,000
L
O
150,000
S
S
200,000

250,000

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Problem 7 (Sales Mix; Break-Even Analysis; Margin of Safety)

Requirement (1)
a. Hun Yun Total
Pesos % P % Euros %
Sales ......................................... P80,000 100 P48,000 100 P128,000 100
Variable expenses .................... 48,000 60 9,600 20 57,600 45
Contribution margin................. P32,000 40 P38,400 80 70,400 55
Fixed expenses ......................... 66,000
Net operating income ............... P 4,400

b. Break-even sales = Fixed expenses ÷ CM ratio

= P66,000 ÷ 0.55 = P120,000

Margin of safety
= Actual sales – Break-even sales
in pesos
= P128,000 – P120,000

= P8,000

Margin of safety
= Margin of safety in pesos  Actual sales
percentage
= P8,000  P128,000

= 6.25%
Requirement (2)

a. Hun Yun HY143 Total

Pesos % Pesos % Pesos % Pesos %
Sales P80,000 100 P48,000 100 P32,000 100 P160,000 100
Variable expenses 48,000 60 9,600 20 2,4000 75 81,600 51
Contribution margin P32,000 40 P38,400 80 P 8,000 25 78,400 49
Fixed expenses 66,000
Net operating income P 12,400

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b. Break-even sales = Fixed expenses ÷ CM ratio

= P66,000 ÷ 0.49 = P134,700 (rounded)

Margin of safety
= Actual sales – Break-even sales
in pesos
= P160,000 – P134,700

= P25,300

Margin of safety
= Margin of safety in pesos  Actual sales
percentage
= P25,300  P160,000

= 15.81%
Requirement (3)

The reason for the increase in the break-even point can be traced to the
decrease in the company’s average contribution margin ratio when the third
product is added. Note from the income statements above that this ratio drops
from 55% to 49% with the addition of the third product. This product, called
HY143, has a CM ratio of only 25%, which causes the average contribution
margin ratio to fall.

This problem shows the somewhat tenuous nature of break-even analysis when
more than one product is involved. The manager must be very careful of his or
her assumptions regarding sales mix when making decisions such as adding or
deleting products.

It should be pointed out to the president that even though the break-even point
is higher with the addition of the third product, the company’s margin of safety
is also greater. Notice that the margin of safety increases from P8,000 to
P25,300 or from 6.25% to 15.81%. Thus, the addition of the new product shifts
the company much further from its break-even point, even though the break-
even point is higher.

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Problem 8 (Break-Even Analysis with Step Fixed Costs)

Requirement (1)

The total annual fixed cost of the Pediatric Ward can be computed as follows:

Annual Supervising Total Other Fixed Total Fixed

Patient-Days Aides Nurses Nurses Personnel Cost Cost
@ P360,000 @ P580,000 @ P760,000
10,000-12,000 P2,520,000 P8,700,000 P2,280,000 P13,500,000 P27,400,000 P40,900,000
12,001-13,750 P2,880,000 P8,700,000 P2,280,000 P13,860,000 P27,400,000 P41,260,000
13,751-16,500 P3,240,000 P9,280,000 P3,040,000 P15,560,000 P27,400,000 P42,960,000
16,501-18,250 P3,600,000 P9,280,000 P3,040,000 P15,920,000 P27,400,000 P43,320,000
18,251-20,750 P3,600,000 P9,860,000 P3,800,000 P17,260,000 P27,400,000 P44,660,000
20,751-23,000 P3,960,000 P10,440,000 P3,800,000 P18,200,000 P27,400,000 P45,600,000

Requirement (2)

The “break-even” can be computed for each range of activity by dividing the total fixed cost for that range of activity by the contribution
margin per patient-day, which is P3,000 (=P4,800 revenue − P1,800 variable cost).

(a) (b)
Annual Total Fixed Contribution “Break-Even” Within Relevant
Patient-Days Cost Margin (a) ÷ (b) Range?
10,000-12,000 P40,900,000 P3,000 13,633 No
12,001-13,750 P41,260,000 P3,000 13,753 No
13,751-16,500 P42,960,000 P3,000 14,320 Yes
16,501-18,250 P43,320,000 P3,000 14,440 No
18,251-20,750 P44,660,000 P3,000 14,887 No
20,751-23,000 P45,600,000 P3,000 15,200 No

While a “break-even” can be computed for each range of activity (i.e., relevant range), all but one of these break-evens is bogus. For example,

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within the range of 10,000 to 12,000 patient-days, the computed break-even is 13,633 (rounded) patient-days. However, this level of activity is
outside this relevant range. To serve 13,633 patient-days, the fixed costs would have to be increased from P40,900,000 to P41,260,000 by adding
one more aide. The only “break-even” that occurs within its own relevant range is 14,320. This is the only legitimate break-even.

Requirement (3)

The level of activity required to earn a profit of P7,200,000 can be computed as follows:

Activity to
(a) (b) Attain Target
Annual Total Fixed Total Fixed Cost + Contribution Profit Within Relevant
Patient-Days Cost Target Profit Target Profit Margin (a) ÷ (b) Range?
10,000-12,000 P40,900,000 P7,200,000 P48,100,000 P3,000 16,033 No
12,001-13,750 P41,260,000 P7,200,000 P48,460,000 P3,000 16,153 No
13,751-16,500 P42,960,000 P7,200,000 P50,160,000 P3,000 16,720 No
16,501-18,250 P43,320,000 P7,200,000 P50,520,000 P3,000 16,840 Yes
18,251-20,750 P44,660,000 P7,200,000 P51,860,000 P3,000 17,287 No
20,751-23,000 P45,600,000 P7,200,000 P52,800,000 P3,000 17,600 No

In this case, the only solution that is within the appropriate relevant range is 16,840 patient-days.

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IV. Multiple Choice Questions

1. B 6. B 11. B 16. D 21. A 26. A

2. B 7. D 12. A 17. D 22. D 27. B
3. B 8. B 13. A 18. D 23. C 28. C
4. C 9. A 14. C 19. C 24. B 29. B
5. C 10. D 15. D 20. D 25. C 30. A

CHAPTER 14

RESPONSIBILITY ACCOUNTING AND

TRANSFER PRICING

I. Questions
1. Cost centers are evaluated by means of performance reports. Profit centers
are evaluated by means of contribution income statements (including cost
center performance reports), in terms of meeting sales and cost objectives.
Investment centers are evaluated by means of the rate of return which they
are able to generate on invested assets.
2. Overall profitability can be improved (1) by increasing sales, (2) by
reducing expenses, or (3) by reducing assets.
3. ROI may lead to dysfunctional decisions in that divisional managers may
reject otherwise profitable investment opportunities simply because they
would reduce the division’s overall ROI figure. The residual income
approach overcomes this problem by establishing a minimum rate of
return which the company wants to earn on its operating assets, thereby
motivating the manager to accept all investment opportunities promising
a return in excess of this minimum figure.
4. A cost center manager has control over cost, but not revenue or investment
funds. A profit center manager, by contrast, has control over both cost and
revenue. An investment center manager has control over cost and revenue
and investment funds.
5. The term transfer price means the price charged for a transfer of goods or
services between units of the same organization, such as two departments

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or divisions. Transfer prices are needed for performance evaluation

purposes.
6. The use of market price for transfer purposes will create the actual
conditions under which the transferring and receiving units would be
operating if they were completely separate, autonomous companies. It is
generally felt that the creation of such conditions provides managerial
incentive, and leads to greater overall efficiency in operations.
7. Negotiated transfer prices should be used (1) when the volume involved is
large enough to justify quantity discounts, (2) when selling and/or
administrative expenses are less on intracompany sales, (3) when idle
capacity exists, and (4) when no clear-cut market price exists (such as a
sister division being the only supplier of a good or service).
8. Suboptimization can result if transfer prices are set in a way that benefits
a particular division, but works to the disadvantage of the company as a
whole. An example would be a transfer between divisions when no
transfers should be made (e.g., where a better overall contribution margin
could be generated by selling at an intermediate stage, rather than
transferring to the next division). Suboptimization can also result if
transfer pricing is so inflexible that one division buys from the outside
when there is substantial idle capacity to produce the item internally. If
divisional managers are given full autonomy in setting, accepting, and
rejecting transfer prices, then either of these situations can be created,
through selfishness, desire to “look good”, pettiness, or bickering.

II. Exercises

Exercise 1 (Evaluation of a Profit Center)

No. Although Department 3 does not cover all of the cost allocated to it. It
contributes P21,000 to the total operations over and above its direct costs.
Without Department 3, the company would earn P21,000 less as compared
with the original over-all income of P47,000.

Department
1 2 4 Total
Revenue P132,000 P168,000 P98,000 P398,000
Direct cost of department 82,000 108,000 61,000 251,000
Contribution of the
department P 50,000 P 60,000 P37,000 P147,000
Allocated cost 121,000
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Net income P 26,000

With the discontinuance of Department 3, the revenue and direct cost of the
department are eliminated, but there is no reduction in the total allocated cost.

Exercise 2 (Evaluation of an Investment Center)

Requirement 1
ROI RI
Operating assets P400,000 P400,000
Operating income P100,000 P100,000
ROI (P100,000  P400,000) 25%
Minimum required income
(16% x P400,000) P64,000
RI (P100,000 - P64,000) P36,000

Requirement 2

The manager of the Cling Division would not accept this project under the ROI
approach since the division is already earning 25%. Accepting this project
would reduce the present divisional performance, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000* P112,000
ROI 25% 20% 24.35%
* P60,000 x 20% = P12,000

Under the RI approach, on the other hand, the manager would accept this
project since the new project provides a higher return than the minimum
required rate of return (20 percent vs. 16 percent). The new project would
increase the overall divisional residual income, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000 P112,000
Minimum required
return at 16% 64,000 9,600* 73,600
RI P 36,000 P 2,400 P 38,400

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* P60,000 x 16% = P9,600

Exercise 3 (ROI, Comparison of Three Divisions)

Requirement 1

Division X Division Y Division Z

ROI: P10,000 P12,600 P 28,800
= 25% = 18% = 16%
P40,000 P70,000 P180,000

Requirement 2

Division X would reject this investment opportunity since the addition would
lower the present divisional ROI. Divisions Y and Z would accept it because
they would look better in terms of their divisional ROI.

Exercise 4 (ROI, RI, Comparisons of Two Divisions)

Requirement 1

Net Operating income X Sales = ROI

Sales Average Operating Assets

P630,000 P9,000,000
Division A : X = ROI
P9,000,000 P3,000,000

7% X 3 = 21%

P1,800,000 P20,000,000
Division B : X = ROI
P20,000,000 P10,000,000

9% X 2 = 18%
Requirement 2

Division A Division B
Average operating assets (a) ........ P3,000,000 P10,000,000
Net operating income ................... P 630,000 P 1,800,000

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Minimum required return on average

operating assets - 16% x (a) .... 480,000 1,600,000
Residual income ........................... P 150,000 P 200,000

Requirement 3

No, Division B is simply larger than Division A and for this reason one would
expect that it would have a greater amount of residual income. As stated in
the text, residual income can’t be used to compare the performance of divisions
of different sizes. Larger divisions will almost always look better, not
necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Division B does not appear to be
as well managed as Division A. Note from Part (2) that Division B has only
an 18 percent ROI as compared to 21 percent for Division A.

Exercise 5 (Evaluation of a Cost Center)

(1) Controllable Costs by supervisor of Department 10 are as follows:

a. Supplies, Department 10
b. Repairs and Maintenance, Department 10
c. Labor Cost, Department 10

(2) Direct Costs of Department 10 are

a. Salary, supervisor of Department 10
b. Supplies, Department 10
c. Repairs and Maintenance, Department 10
d. Labor Cost, Department 10

(3) Costs allocated to Factory Department are:

a. Factory, heat and light
b. Depreciation, factory
c. Factory insurance
d. Salary of factory superintendent

(4) Costs which do not pertain to factory operations are:

a. Sales salaries and commissions
b. General office salaries

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Exercise 6 (Evaluating New Investments Using Return on Investment

(ROI) and Residual Income)

Requirement 1

Computation of ROI

Division A:
P300,000 P6,000,000
ROI = x = 5% x 4 = 20%
P6,000,000 P1,500,000

Division B:
P900,000 P10,000,000
ROI = x = 9% x 2 = 18%
P10,000,000 P5,000,000

Division C:

P180,000 P8,000,000
ROI = x = 2.25% x 4 = 9%
P8,000,000 P2,000,000

Requirement 2

Division A Division B Division C

Average operating assets .................... P1,500,000 P5,000,000 P2,000,000
Required rate of return ........................ × 15% × 18% × 12%
Required operating income ................. P 225,000 P 900,000 P 240,000
Actual operating income ..................... P 300,000 P 900,000 P 180,000
Required operating income (above) ... 225,000 900,000 240,000
Residual income ................................. P 75,000 P 0 P (60,000)

Requirement 3

a. and b. Division A Division B Division C

Return on investment (ROI) ......... 20% 18% 9%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ......................... Reject Reject Accept

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Minimum required return for

computing residual income....... 15% 18% 12%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ......................... Accept Reject Accept

If performance is being measured by ROI, both Division A and Division B

probably would reject the 17% investment opportunity. The reason is that
these companies are presently earning a return greater than 17%; thus, the new
investment would reduce the overall rate of return and place the divisional
managers in a less favorable light. Division C probably would accept the 17%
investment opportunity, since its acceptance would increase the Division’s
overall rate of return.

If performance is being measured by residual income, both Division A and

Division C probably would accept the 17% investment opportunity. The 17%
rate of return promised by the new investment is greater than their required
rates of return of 15% and 12%, respectively, and would therefore add to the
total amount of their residual income. Division B would reject the opportunity,
since the 17% return on the new investment is less than B’s 18% required rate
of return.

Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company)

Requirement 1
Division A Division B Total Company
1 2
Sales P3,500,000 P2,400,000 P5,200,000 3

Less expenses:
Added by the division ... 2,600,000 1,200,000 3,800,000
Transfer price paid ........ — 700,000 —
Total expenses ................... 2,600,000 1,900,000 3,800,000
Net operating income ........ P 900,000 P 500,000 P1,400,000
1
20,000 units × P175 per unit = P3,500,000.
2
4,000 units × P600 per unit = P2,400,000.
3
Division A outside sales (16,000 units × P175 per unit) .................. P2,800,000
Division B outside sales (4,000 units × P600 per unit) .................... 2,400,000
Total outside sales ............................................................................ P5,200,000

Observe that the P700,000 in intracompany sales has been eliminated.

Requirement 2

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Division A should transfer the 1,000 additional units to Division B. Note that
Division B’s processing adds P425 to each unit’s selling price (B’s P600
selling price, less A’s P175 selling price = P425 increase), but it adds only
P300 in cost. Therefore, each tube transferred to Division B ultimately yields
P125 more in contribution margin (P425 – P300 = P125) to the company than
can be obtained from selling to outside customers. Thus, the company as a
whole will be better off if Division A transfers the 1,000 additional tubes to
Division B.

Exercise 8 (Transfer Pricing Situations)

Requirement 1

The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable on lost sales
Transfer price  cost per unit
+
Number of units transferred
.
There is no idle capacity, so each of the 20,000 units transferred from Division
X to Division Y reduces sales to outsiders by one unit. The contribution
margin per unit on outside sales is P20 (= P50 – P30).
P20 x 20,000
Transfer price  (P30 – P2) +
20,000
Transfer price = P28 + P20 = P48

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P47. Therefore, Division Y would be unwilling to pay more than
P47 per unit.

Transfer price  Cost of buying from outside supplier = P47

The requirements of the two divisions are incompatible and no transfer will
take place.

Requirement 2

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In this case, Division X has enough idle capacity to satisfy Division Y’s
demand. Therefore, there are no lost sales and the lowest acceptable price as
far as the selling division is concerned is the variable cost of P20 per unit.
P0
Transfer price  P20 +
20,000
= P20

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P34. Therefore, Division Y would be unwilling to pay more than
P34 per unit.

Transfer price  Cost of buying from outside supplier = P34

In this case, the requirements of the two divisions are compatible and a transfer
will hopefully take place at a transfer price within the range:

P20  Transfer price  P34

Exercise 9 (Transfer Pricing: Decision Making)

Requirement 1

Division A’s purchase decision from the overall firm perspective:

Purchase costs from outside 10,000 x P150 = P1,500,000

Less: Savings of Divisions B’s variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P 100,000

Assuming Division B has no outside sales, Division A should buy inside from
Division B for the benefit of the entire firm.

Requirement 2

As above, but in addition, if Division A buys outside, Division B saves an

additional P200,000.

Purchase costs from outside 10,000 x P150 = P1,500,000

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Less: Savings of B material assignment 200,000

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Net Cost (Benefit) for A to buy outside P (100,000)

The additional savings in Division B means that now Division A should buy
outside.

Requirement 3

Assuming the outside price drops from P150 to P130:

Purchase costs from outside 10,000 x P130 = P1,300,000

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P (100,000)

Division A should buy outside.

Exercise 10 (Compute the Return on Investment (ROI))

Requirement (1)
Net operating income
Margin = Sales
P5,400,000
= P18,000,000 = 30%
Requirement (2)
Sales
Turnover = Average operating assets
P18,000,000
= P36,000,000 = 0.5
Requirement (3)

ROI = Margin x Turnover

= 30% x 0.5 = 15%

Exercise 11 (Residual Income)

Average operating assets (a)....................................... P2,200,000

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Net operating income ................................................. P400,000

Minimum required return: 16% × (a) ......................... 352,000
Residual income ......................................................... P 48,000

III. Problems

Problem 1 (Evaluation of Profit Centers)

Requirement (a)

Jadlow Manufacturing Corporation

Income Statement
For the Year Ended December 31, 2005

Total Product S Product T

Sales P5,100,000 P2,700,000 P2,400,000
Less: Variable Costs 3,330,000 1,890,000 1,440,000
Contribution Margin P1,770,000 P 810,000 P 960,000
Less: Controllable fixed
expenses 501,000 66,000 435,000
Contribution to the recovery
of non-controllable fixed
expenses P1,269,000 P 744,000 P 525,000

Requirement (b)

The complaint of the manager of Product T is justified on the ground that his
product line shows a positive contribution margin and therefore, contributes to
the recovery of non-controllable fixed expenses. This observation is, of
course, made under the assumption that the preceding year’s figures (which
are not given) were less favorable than the current year.

Problem 2 (Evaluation of Profit Centers)

Requirement 1
Product

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A B C
Incremental sales P71,000 P46,000 P117,000
Less: Incremental costs 42,000 15,000 96,000
Net income P29,000 P31,000 P 21,000

Product B seems to offer the best profit potential.

Requirement 2
The sunk costs are:
Depreciation of equipment P 6,400
Operating cost of the equipment 4,600
Total P11,000

Requirement 3
Opportunity cost of selling Product B is
From Product A P29,000
From Product C 21,000
Total P50,000

Problem 3 (Evaluation of Performance)

Ranjie Tool Company

Performance Report
For the Year 2005
Budgeted Labor Hours 4,000
Actual Labor Hours 4,200
Budget
Actual Based on
Cost-Volume 4,200 4,200 Variance
Formula Hours Hours U (F)
Variable Overhead Costs:
Utilities P0.80 per hour P 3,600 P 3,360 P240
Supplies 1.80 7,400 7,560 (160)
Indirect labor 1.20 5,300 5,040 260
Total P3.80 P16,300 P15,960 P340
Fixed Overhead Costs:
Utilities P 1,600 P 1,600 -
Supplies 2,200 2,200 -
Depreciation 6,000 6,000 -
Indirect labor 5,400 5,400 -
Insurance 1,200 1,200 -

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Total P16,400 P16,400 -

Total Factory Overhead Costs P32,700 P32,360 P340

Problem 4 (Evaluation of Performance)

Requirement 1

Performance Report for the Production Manager

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Direct material P24,000 P20,000 P4,000 (U)
Direct labor 48,000 50,000 2,000 (F)
Supplies 4,000 6,000 2,000 (F)
Maintenance 3,000 4,000 1,000 (F)
Total P79,000 P80,000 P1,000 (F)

The cost of raw materials rose significantly, possibly because of (1) deficient
machinery due to the cutback in maintenance expenditures and/or (2) to the
lower labor cost, possibly due to the use of less-skilled workers. Supplies
decreased, indicating possible inadequacies for next period’s production run.

Requirement 2

Performance Report for the Vice President

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Marketing division P104,000 P102,000 P2,000 (U)
Production division 79,000 80,000 1,000 (F)
Personnel division 72,000 76,000 4,000 (F)
Other costs 68,800 70,000 1,200 (F)
Total P323,800 P328,000 P4,200 (F)
The marketing division is behind its cost allotment. The personnel division
came in somewhat under its budgeted costs. Perhaps there has been a cutback
in hiring, indicating possible reduction in future production.

Problem 5 (Target Sales Price; Return on Investment)

Requirement 1

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Return on investment = Operating income / Investment

20% = X / P800,000
Target Operating Income = P160,000

Target revenues, calculated as follows:

Fixed overhead P200,000

Variable costs 1,500,000 x P300 450,000
Desired operating income 160,000
Revenues P810,000

The selling price per units is P540 = P810,000 / 1,500

Requirement 2

Data are in thousands.

Units 1,500 2,000 1,000

Revenues P810 P1,080 P540

Variable costs 450 600 300

Fixed costs 200 200 200
Total costs 650 800 500

Operating income P160 P280 P 40

Return on 20% 35% 5%
investment
= P160 / = P280 / = P40 /
P800 P800 P800

Note how the change in income follows the change in revenues, as predicted
by operating leverage. Operating leverage multiplied times the percentage
change in sales gives the percentage change in income. Thus, the greater the
operating leverage ratio, the larger the effect on income and ROI of a given
percentage change in sales. This exercise provides an opportunity to review
the relationship between volume and profit. See the illustration below:

Operating leverage = contribution margin / operating income

= (P810 – P450) / P160 = 2.25

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% change in income = operating leverage x % change in revenues

= 2.25 x 33.33% = 75%

% change in income
If volume goes to 2,000 units: (P280 – P160) / P160 = 75%
If volume goes to 1,000 units: (P160 – P40) / P160 = 75%

% change in ROI
If volume goes to 2,000 units: (35% - 20%) / 20% = 75%
If volume goes to 1,000 units: (20% - 5%) / 20% = 75%

Problem 6 (Contrasting Return on Investment (ROI) and Residual

Income)

Requirement 1

ROI computations:

Net operating income Sales

ROI = x
Sales Average operating assets

Pasig: P630,000 P9,000,000

x = 7% x 3 = 21%
P9,000,000 P3,000,000

P1,800,000 P20,000,000
Quezon: x = 9% x 2 = 18%
P20,000,000 P10,000,000

Requirement 2
Pasig Quezon
Average operating assets (a) ................... P3,000,000 P10,000,000
Net operating income.............................. P 630,000 P 1,800,000
Minimum required return on average
operating assets—16% × (a) ............... 480,000 P 1,600,000
Residual income ..................................... P 150,000 P 200,000

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Requirement 3

No, the Quezon Division is simply larger than the Pasig Division and for this
reason one would expect that it would have a greater amount of residual
income. Residual income can’t be used to compare the performance of
divisions of different sizes. Larger divisions will almost always look better,
not necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Quezon does not appear to be as
well managed as Pasig. Note from Part (1) that Quezon has only an 18% ROI
as compared to 21% for Pasig.

Problem 7 (Transfer Pricing)

Requirement 1

Since the Valve Division has idle capacity, it does not have to give up any
outside sales to take on the Pump Division’s business. Applying the formula
for the lowest acceptable transfer price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable on lost sales
Transfer price  cost per unit
+
Number of units transferred
P0
Transfer price  P16 +
10,000
= P16

The Pump Division would be unwilling to pay more than P29, the price it is
currently paying an outside supplier for its valves. Therefore, the transfer price
must fall within the range:

P16  Transfer price  P29

Requirement 2

Since the Valve Division is selling all of the valves that it can produce on the
outside market, it would have to give up some of these outside sales to take on
the Pump Division’s business. Thus, the Valve Division has an opportunity
cost, which is the total contribution margin on lost sales:
Total contribution margin
Variable on lost sales
Transfer price  cost per unit
+
Number of units transferred
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(P30 – P16) x 10,000

Transfer price  P16 +
10,000

= P16 + P14 = P30

Application of Quantitative Techniques in Planning, Control and Decision Making – II Chapter 18

Since the Pump Division can purchase valves from an outside supplier at only
P29 per unit, no transfers will be made between the two divisions.

Requirement 3

Applying the formula for the lowest acceptable price from the viewpoint of the
selling division, we get:
Total contribution margin
Variable on lost sales
Transfer price  cost per unit
+
Number of units transferred

(P30 – P16) x 10,000

Transfer price  (P16 – P3) +
10,000

= P13 + P14 = P27

In this case, the transfer price must fall within the range:

P27  Transfer price  P29

Problem 8 (Transfer Pricing)

To produce the 20,000 special valves, the Valve Division will have to give up
sales of 30,000 regular valves to outside customers. Applying the formula for
the lowest acceptable price from the viewpoint of the selling division, we get:
Total contribution margin
Variable on lost sales
Transfer price  cost per unit
+
Number of units transferred

18-263 (P30 – P16) x 30,000

Transfer price  P20 +
20,000

= P20 + P21 = P41

Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

Problem 9 (Effects of Changes in Sales, Expenses, and Assets in ROI)

1. Net operating income

Margin = Sales
P800,000
= P8,000,000 = 10%

2. Sales
Turnover = Average operating assets
P8,000,000
= P3,200,000 = 2.5
3.
ROI = Margin x Turnover
= 10% x 2.5 = 25%

Problem 10 (Transfer Pricing Basics)

Requirement (1)

a. The lowest acceptable transfer price from the perspective of the selling
division, the Electrical Division, is given by the following formula:

Total contribution margin

Variable cost + on lost sales
Transfer price =
per unit Number of units transferred
Because there is enough idle capacity to fill the entire order from the Motor
Division, there are no lost outside sales. And because the variable cost per
unit is P21, the lowest acceptable transfer price as far as the selling division
is concerned is also P21.
P0
Transfer price = P21 + = P21
10,000

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b. The Motor Division can buy a similar transformer from an outside supplier
for P38. Therefore, the Motor Division would be unwilling to pay more
than P38 per transformer.
Transfer price: Cost from buying from outside supplier = P38

c. Combining the requirements of both the selling division and the buying
division, the acceptable range of transfer prices in this situation is:
P21 : Transfer price : P38

Assuming that the managers understand their own businesses and that they
are cooperative, they should be able to agree on a transfer price within this
range and the transfer should take place.

d. From the standpoint of the entire company, the transfer should take place.
The cost of the transformers transferred is only P21 and the company saves
the P38 cost of the transformers purchased from the outside supplier.

Requirement (2)

a. Each of the 10,000 units transferred to the Motor Division must displace a
sale to an outsider at a price of P40. Therefore, the selling division would
demand a transfer price of at least P40. This can also be computed using
the formula for the lowest acceptable transfer price as follows:
(P40 – P21) x 10,000
Transfer price = P21 +
10,000

= P21 + (P40 – P21) = P40

b. As before, the Motor Division would be unwilling to pay more than P38
per transformer.

c. The requirements of the selling and buying divisions in this instance are
incompatible. The selling division must have a price of at least P40
whereas the buying division will not pay more than P38. An agreement to
transfer the transformers is extremely unlikely.

d. From the standpoint of the entire company, the transfer should not take
place. By transferring a transformer internally, the company gives up
revenue of P40 and saves P38, for a loss of P2.

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Problem 11 (Transfer Pricing with an Outside Market)

Requirement (1)

The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable cost + on lost sales
Transfer price =
per unit Number of units transferred

The Tuner Division has no idle capacity, so transfers from the Tuner Division
to the Assembly Division would cut directly into normal sales of tuners to
outsiders. The costs are the same whether a tuner is transferred internally or
sold to outsiders, so the only relevant cost is the lost revenue of P200 per tuner
that could be sold to outsiders. This is confirmed below:
(P200 – P110) x 30,000
Transfer price = P110 +
30,000

= P110 + (P200 – P110) = P200

Therefore, the Tuner Division will refuse to transfer at a price less than P200
per tuner.

The Assembly Division can buy tuners from an outside supplier for P200, less
a 10% quantity discount of P20, or P180 per tuner. Therefore, the Division
would be unwilling to pay more than P180 per tuner.

Transfer price : Cost of buying from outside supplier = P180

The requirements of the two divisions are incompatible. The Assembly
Division won’t pay more than P180 and the Tuner Division will not accept less
than P200. Thus, there can be no mutually agreeable transfer price and no
transfer will take place.

Requirement (2)

The price being paid to the outside supplier, net of the quantity discount, is
only P180. If the Tuner Division meets this price, then profits in the Tuner
Division and in the company as a whole will drop by P600,000 per year:

Lost revenue per tuner ....................................................... P200

Outside supplier’s price ..................................................... P180

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Loss in contribution margin per tuner ............................... P20

Number of tuners per year ................................................. × 30,000
Total loss in profits ............................................................ P600,000

Profits in the Assembly Division will remain unchanged, since it will be paying
the same price internally as it is now paying externally.

Requirement (3)

The Tuner Division has idle capacity, so transfers from the Tuner Division to
the Assembly Division do not cut into normal sales of tuners to outsiders. In
this case, the minimum price as far as the Assembly Division is concerned is
the variable cost per tuner of P11. This is confirmed in the following
calculation:
P0
Transfer price = P110 + = P110
30,000
The Assembly Division can buy tuners from an outside supplier for P180 each
and would be unwilling to pay more than that in an internal transfer. If the
managers understand their own businesses and are cooperative, they should
agree to a transfer and should settle on a transfer price within the range:

P110 : Transfer price : P180

Requirement (4)

Yes, P160 is a bona fide outside price. Even though P160 is less than the Tuner
Division’s P170 “full cost” per unit, it is within the range given in Part 3 and
therefore will provide some contribution to the Tuner Division.

If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in
potential profits:

Price per tuner .................................................. P160

Variable costs .................................................... 110
Contribution margin per tuner .......................... P 50

30,000 tuners × P50 per tuner = P1,500,000 potential increased profits

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This P1,500,000 in potential profits applies to the Tuner Division and to the
company as a whole.

Requirement (5)

No, the Assembly Division should probably be free to go outside and get the
best price it can. Even though this would result in lower profits for the
company as a whole, the buying division should probably not be forced to
purchase inside if better prices are available outside.

Requirement (6)

The Tuner Division will have an increase in profits:

Selling price ...................................................... P200

Variable costs .................................................... 110
Contribution margin per tuner .......................... P 90

30,000 tuners × P90 per tuner = P2,700,000 increased profits

The Assembly Division will have a decrease in profits:

Inside purchase price ........................................ P200

Outside purchase price ..................................... 160
Increased cost per tuner .................................... P 40

30,000 tuners × P40 per tuner = P1,200,000 decreased profits

The company as a whole will have an increase in profits:

Increased contribution margin in the Tuner Division .......................... P 90

Decreased contribution margin in the Assembly Division .................. 40
Increased contribution margin per tuner ............................................. P 50

30,000 tuners × P50 per tuner = P1,500,000 increased profits

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So long as the selling division has idle capacity and the transfer price is greater
than the selling division’s variable costs, profits in the company as a whole
will increase if internal transfers are made. However, there is a question of
fairness as to how these profits should be split between the selling and buying
divisions. The inflexibility of management in this situation damages the profits
of the Assembly Division and greatly enhances the profits of the Tuner
Division.

Problem 12 (Transfer Pricing; Divisional Performance)

Requirement (1)

The Electronics Division is presently operating at capacity; therefore, any sales

of the KK8 circuit board to the Clock Division will require that the Electronics
Division give up an equal number of sales to outside customers. Using the
transfer pricing formula, we get a minimum transfer price of:
Total contribution margin
Variable cost + on lost sales
Transfer price =
per unit Number of units transferred
Transfer price = P82.50 + (P125.00 – P82.50)
Transfer price = P82.50 + P42.50
Transfer price = P125.00
Thus, the Electronics Division should not supply the circuit board to the Clock
Division for P90 each. The Electronics Division must give up revenues of
P125.00 on each circuit board that it sells internally. Since management
performance in the Electronics Division is measured by ROI and dollar profits,
selling the circuit boards to the Clock Division for P9 would adversely affect
these performance measurements.

Requirement (2)

The key is to realize that the P100 in fixed overhead and administrative costs
contained in the Clock Division’s P697.50 cost per timing device is not
relevant. There is no indication that winning this contract would actually affect
any of the fixed costs. If these costs would be incurred regardless of whether
or not the Clock Division gets the oven timing device contract, they should be
ignored when determining the effects of the contract on the company’s profits.
Another key is that the variable cost of the Electronics Division is not relevant
either. Whether the circuit boards are used in the timing devices or sold to

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outsiders, the production costs of the circuit boards would be the same. The
only difference between the two alternatives is the revenue on outside sales
that is given up when the circuit boards are transferred within the company.

Selling price of the timing devices ......................................... P700.00

Less:
The cost of the circuit boards used in the timing devices
(i.e. the lost revenue from sale of circuit boards to
outsiders) ........................................................................ P125.00
Variable costs of the Clock Division excluding the circuit
board (P300.00 + P207.50) ............................................ 507.50 632.50
Net positive effect on the company’s profit ........................... P 67.50

Therefore, the company as a whole would be better off by P67.50 for each
timing device that is sold to the oven manufacturer.

Requirement (3)

As shown in part (1) above, the Electronics Division would insist on a transfer
price of at least P125.00 for the circuit board. Would the Clock Division make
any money at this price? Again, the fixed costs are not relevant in this decision
since they would not be affected. Once this is realized, it is evident that the
Clock Division would be ahead by P67.50 per timing device if it accepts the
P125.00 transfer price.

Selling price of the timing devices ........................................ P700.00

Less:
Purchased parts (from outside vendors) ............................ P300.00
Circuit board KK8 (assumed transfer price) ..................... 125.00
Other variable costs ........................................................... 207.50 632.50
Clock Division contribution margin ...................................... P 67.50

In fact, since the contribution margin is P62.50, any transfer price within the
range of P125.00 to P192.50 (= P125.00 + P67.50) will improve the profits of
both divisions. So yes, the managers should be able to agree on a transfer price.

Requirement (4)
It is in the best interests of the company and of the divisions to come to an
agreement concerning the transfer price. As demonstrated in part (3) above,
any transfer price within the range P125.00 to P192.50 would improve the

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profits of both divisions. What happens if the two managers do not come to an
agreement?

In this case, top management knows that there should be a transfer and could
step in and force a transfer at some price within the acceptable range. However,
such an action, if done on a frequent basis, would undermine the autonomy of
the managers and turn decentralization into a sham.

Our advice to top management would be to ask the two managers to meet to
discuss the transfer pricing decision. Top management should not dictate a
course of action or what is to happen in the meeting, but should carefully
observe what happens in the meeting. If there is no agreement, it is important
to know why. There are at least three possible reasons. First, the managers may
have better information than the top managers and refuse to transfer for very
good reasons. Second, the managers may be uncooperative and unwilling to
deal with each other even if it results in lower profits for the company and for
themselves. Third, the managers may not be able to correctly analyze the
situation and may not understand what is actually in their own best interests.
For example, the manager of the Clock Division may believe that the fixed
overhead and administrative cost of P100 per timing device really does have
to be covered in order to avoid a loss.
If the refusal to come to an agreement is the result of uncooperative attitudes
or an inability to correctly analyze the situation, top management can take
some positive steps that are completely consistent with decentralization. If the
problem is uncooperative attitudes, there are many training companies that
would be happy to put on a short course in team building for the company. If
the problem is that the managers are unable to correctly analyze the
alternatives, they can be sent to executive training courses that emphasize
economics and managerial accounting.

IV. Multiple Choice Questions

1. C 11. E 21. C 31. B

2. D 12. D 22. B 32. D
3. A 13. C 23. A 33. D
4. A 14. C 24. D 34. D
5. C 15. B 25. B 35. C
6. A 16. C 26. A 36. D
7. D 17. B 27. A 37. B
8. A 18. A 28. B 38. D
9. C 19. B 29. D 39. B

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10. A 20. A 30. A 40. D

CHAPTER 15

FUNCTIONAL AND ACTIVITY-BASED BUDGETING

I. Questions
1. No. Planning and control are different, although related, concepts.
Planning involves developing objectives and formulating steps to achieve
those objectives. Control, by contrast, involves the means by which
management ensures that the objectives set down at the planning stage are
attained.
2. Budgets have a dual purpose, for planning and for following up the
implementation of the plan. The great benefits from budgeting lie in the
quick investigation of deviations and in the subsequent corrective action.
Budgets should not be prepared in the first place if they are ignored, buried
in files, or improperly interpreted.
3. Two major features of a budgetary program are (1) the accounting
techniques which developed it and (2) the human factors which administer
it. The human factors are far more important. The success of a budgetary
system depends upon its acceptance by the company members who are
affected by the budget. Without a thoroughly educated and cooperative
management group at all levels of responsibility, budgets are a drain on
the funds of the business and are a hindrance instead of help to efficient
operations.
4. Manufacturing overhead costs are budgeted at normal operating capacity,
and the costs are applied to the products using a predetermined rate. The
predetermined rate is computed by dividing a factor that can be identified
with both the products and the overhead into the overhead budgeted at the
normal operating capacity. Budgets may also be used in costing products
in a standard cost accounting system.
5. The production division operates to produce the products that are sold.
Production and sales must be coordinated. Products must be manufactured
so that they will be available to meet sales delivery dates. Activity of the

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production division will depend upon the sales that can be made. Also,
the sales division is limited by the capabilities of the production
department in manufacturing products. Successful operations depend
upon a coordination of sales and production.
6. Labor hour required for production can be translated into labor pesos by
multiplying the number of hours budgeted by the appropriate labor rates.
The rates to be used will depend upon the rates established for job
classifications and the policy with respect to premium pay for overtime or
shift differences.
7. A long-range plan for the acquisition of plant assets is broken down and
entered in the current budget as the plan unfolds. The portion of the plan
which is to be executed in the next year is included in the budget for that
year.
8. A budget period is not limited to any particular unit of time. At a
minimum, a budget should cover at least one operating cycle. For
example, a budget should not cover a period when purchasing activity is
high and omit the period when sales volume and cash collection are
relatively high. The budget period should encompass the entire cycle
extending from the purchasing operation to the subsequent sale of the
products and the realization of the sales in cash. Ordinarily, a budget of
operations is prepared for a year which in turn is divided into quarters and
months. Long-term budgets, such as budgets for projects or capital
investments, may extend five to ten years or more into the future.
9. A rolling budget or a progressive budget or sometimes called continuous
budget, is a budget which is prepared throughout the year. As one month
elapses, a budget is prepared for one more month in the future. At any one
time for example, the company will have a budget for one year into the
future, when July of one year is over, a budget for the following July will
be added at the other end of the budget. This process of adding a new
month as a month expires is continuous.
10. Variances that are revealed by a comparison of actual results with a budget
are investigated if it appears that an investigation is warranted. The
investigation may show that stricter control measures are needed or that
some weaknesses in the operation should be corrected. It may also reveal
that the budget plan should be revised. The comparison is one step in the
control and direction of business operations.
11. A comparison of actual results with a budget can contribute information
that can be applied in the preparation of better budgets in the future.

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Subsequent investigation of variances provides management with a better

knowledge of operations. This knowledge can be applied in the
preparation of more realistic budgets for subsequent fiscal periods.
12. A self-imposed budget is one in which persons with responsibility over
cost control prepare their own budgets, i.e., the budget is not imposed from
above. The major advantages are: (1) the views and judgments of persons
from all levels of an organization are represented in the final budget
document; (2) budget estimates generally are more accurate and reliable,
since they are prepared by those who are closest to the problems; (3)
managers generally are more motivated to meet budgets which they have
participated in setting; (4) self-imposed budgets reduce the amount of
upward “blaming” resulting from inability to meet budget goals. One
caution must be exercised in the use of self-imposed budgets. The budgets
prepared by lower-level managers should be carefully reviewed to prevent
too much slack.
13. No, although this is clearly one of the purposes of the cash budget. The
principal purpose is to provide information on probable cash needs during
the budget period, so that bank loans and other sources of financing can
be anticipated and arranged well in advance of the actual time of need.
14. Zero-based budgeting requires that managers start at zero levels every year
and justify all costs as if all programs were being proposed for the first
time. In traditional budgeting, by contrast, budget data are usually
generated on an incremental basis, with last year’s budget being the
starting point.
15. A budget is a detailed quantitative plan for the acquisition and use of
financial and other resources over a given time period. Budgetary control
involves the use of budgets to control the actual activities of a firm.
16. 1. Budgets communicate management’s plans throughout the
organization.
2. Budgets force managers to think about and plan for the future.
3. The budgeting process provides a means of allocating resources to
those parts of the organization where they can be used most
effectively.
4. The budgeting process can uncover potential bottlenecks before they
occur.
5. Budgets coordinate the activities of the entire organization by
integrating the plans of its various parts. Budgeting helps to ensure
that everyone in the organization is pulling in the same direction.

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6. Budgets define goals and objectives that can serve as benchmarks for
evaluating subsequent performance.
17. A master budget represents a summary of all of management’s plans and
goals for the future, and outlines the way in which these plans are to be
accomplished. The master budget is composed of a number of smaller,
specific budgets encompassing sales, production, raw materials, direct
labor, manufacturing overhead, selling and administrative expenses, and
inventories. The master budget generally also contains a budgeted income
statement, budgeted balance sheet, and cash budget.
18. The flow of budgeting information moves in two directions—upward and
downward. The initial flow should be from the bottom of the organization
upward. Each person having responsibility over revenues or costs should
prepare the budget data against which his or her subsequent performance
will be measured. As the budget data are communicated upward, higher-
level managers should review the budgets for consistency with the overall
goals of the organization and the plans of other units in the organization.
Any issues should be resolved in discussions between the individuals who
prepared the budgets and their managers.

All levels of an organization should participate in the budgeting process—

not just top management or the accounting department. Generally, the
lower levels will be more familiar with detailed, day-to-day operating data,
and for this reason will have primary responsibility for developing the
specifics in the budget. Top levels of management should have a better
perspective concerning the company’s strategy.
19. Budgeting can assist a company forecast its workforce staffing needs
through direct labor and other budgets. By careful planning through the
budget process, a company can often smooth out its activities and avoid
erratic hiring and laying off employees.

II. Matching Type

1. C 6. A
2. H 7. B
3. E 8. J
4. F 9. D
5. I 10. G

III. Exercises

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Exercises 1 (Schedule of Expected Cash Collections)

Requirement 1

July August September Total

May sales:
P430,000 × 10%............. P 43,000 P 43,000
June sales:
P540,000 × 70%, 10% ... 378,000 P54,000 432,000
July sales:
P600,000 × 20%,
70%, 10%...................... 120,000 420,000 P 60,000 600,000
August sales:
P900,000 × 20%, 70% ... 180,000 630,000 810,000
September sales:
P500,000 × 20%............. 100,000 100,000
Total cash collections ......... P541,000 P654,000 P790,000 P1,985,000

Notice that even though sales peak in August, cash collections peak in
September. This occurs because the bulk of the company’s customers pay in
the month following sale. The lag in collections that this creates is even more
pronounced in some companies. Indeed, it is not unusual for a company to
have the least cash available in the months when sales are greatest.

Requirement 2

Accounts receivable at September 30:

From August sales: P900,000 × 10% ......................................... P 90,000

From September sales: P500,000 × (70% + 10%)......................... 400,000
Total accounts receivable............................................................ P490,000

Exercise 2 (Production Budget)

July August September Quarter

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Budgeted sales in units ................ 30,000 45,000 60,000 135,000

Add desired ending inventory* .... 4,500 6,000 5,000 5,000
Total needs ................................... 34,500 51,000 65,000 140,000
Less beginning inventory ............. 3,000 4,500 6,000 3,000
Required production .................... 31,500 46,500 59,000 137,000
* 10% of the following month’s sales

Exercise 3 (Materials Purchase Budget)

Quarter – Year 2 Year 3

First Second Third Fourth First
Required production of calculators .............. 60,000 90,000 150,000 100,000 80,000
Number of chips per calculator .................... × 3 × 3 × 3 × 3 × 3
Total production needs—chips..................... 180,000 270,000 450,000 300,000 240,000

Year 2
First Second Third Fourth Year
Production needs—chips .............. 180,000 270,000 450,000 300,000 1,200,000
Add desired ending inventory—
chips ......................................... 54,000 90,000 60,000 48,000 48,000
Total needs—chips........................ 234,000 360,000 510,000 348,000 1,248,000
Less beginning inventory—chips.. 36,000 54,000 90,000 60,000 36,000
Required purchases—chips........... 198,000 306,000 420,000 288,000 1,212,000
Cost of purchases at P2 per chip ... P396,000 P612,000 P840,000 P576,000 P2,424,000

Exercise 4 (Direct Labor Budget)

Requirement 1

Assuming that the direct labor workforce is adjusted each quarter, the direct
labor budget would be:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter Year
Units to be produced ..................... 5,000 4,400 4,500 4,900 18,800
Direct labor time per unit (hours) . × 0.40 × 0.40 × 0.40 × 0.40 × 0.40
Total direct labor hours needed ..... 2,000 1,760 1,800 1,960 7,520
Direct labor cost per hour ............. × P11.00 × P11.00 × P11.00 × P11.00 × P11.00
Total direct labor cost ................... P 22,000 P 19,360 P 19,800 P 21,560 P 82,720

Requirement 2

Assuming that the direct labor workforce is not adjusted each quarter and that
overtime wages are paid, the direct labor budget would be:

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1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter Year
Units to be produced ................... 5,000 4,400 4,500 4,900 18,800
Direct labor time per unit (hours) × 0.40 × 0.40 × 0.40 × 0.40 × 0.40
Total direct labor hours needed .. 2,000 1,760 1,800 1,960 7,520
Regular hours paid ...................... 1,800 1,800 1,800 1,800 7,200
Overtime hours paid ................... 200 - - 160 360
Wages for regular hours
(@ P11.00 per hour) .............. P19,800 P19,800 P19,800 P19,800 P79,200
Overtime wages
(@ P11.00 per hour × 1.5) ..... 3,300 - - 2,640 5,940
Total direct labor cost ................. P23,100 P19,800 P19,800 P22,440 P85,140

Exercise 5 (Manufacturing Overhead Budget)

Requirement 1

Kiko Corporation
Manufacturing Overhead Budget

1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter Year
Budgeted direct labor-hours............. 5,000 4,800 5,200 5,400 20,400
Variable overhead rate ..................... x P1.75 x P1.75 x P1.75 x P1.75 x P1.75
Variable manufacturing overhead .... P 8,750 P 8,400 P 9,100 P 9,450 P 35,700
Fixed manufacturing overhead ........ 35,000 35,000 35,000 35,000 140,000
Total manufacturing overhead ......... 43,750 43,400 44,100 44,450 175,700
Less depreciation ............................. 15,000 15,000 15,000 15,000 60,000
Cash disbursements for
manufacturing overhead .............. P28,750 P28,400 P29,100 P29,450 P115,700

Requirement 2

Total budgeted manufacturing overhead for the year (a) ........... P175,700
Total budgeted direct labor-hours for the year (b) ..................... 20,400
Predetermined overhead rate for the year (a) ÷ (b) .................... P 8.61

Exercise 6 (Selling and Administrative Budget)

Helene Company
Selling and Administrative Expense Budget

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1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter Year
Budgeted unit sales .................... 12,000 14,000 11,000 10,000 47,000
Variable selling and
administrative expense per
unit ........................................ x P2.75 x P2.75 x P2.75 x P2.75 x P2.75
Variable expense ....................... P33,000 P 38,500 P 30,250 P 27,500 P129,250
Fixed selling and administrative
expenses:
Advertising ........................... 12,000 12,000 12,000 12,000 48,000
Executive salaries ................. 40,000 40,000 40,000 40,000 160,000
Insurance............................... 6,000 6,000 12,000
Property taxes ....................... 6,000 6,000
Depreciation.......................... 16,000 16,000 16,000 16,000 64,000
Total fixed selling and
administrative expenses ........ 68,000 74,000 74,000 74,000 290,000
Total selling and administrative
expenses ................................ 101,000 112,500 104,250 101,500 419,250
Less depreciation ....................... 16,000 16,000 16,000 16,000 64,000
Cash disbursements for selling
and administrative expenses . P 85,000 P 96,500 P 88,250 P 85,500 P355,250

Exercise 7 (Cash Budget Analysis)

Quarter (000 omitted)

1 2 3 4 Year
Cash balance, beginning ............... P 9 * P 5 P 5 P 5 P 9
Add collections from customers ... 76 90 125 * 100 391 *
Total cash available ....................... 85 * 95 130 105 400
Less disbursements:
Purchase of inventory ............... 40 * 58 * 36 32 * 166
Operating expenses ................... 36 42 * 54 * 48 180 *
Equipment purchases ................ 10 * 8 * 8 * 10 36 *
Dividends ................................. 2 * 2 * 2 * 2 * 8
Total disbursements ...................... 88 110 * 100 92 390
Excess (deficiency) of cash
available over disbursements .... (3) * (15) 30 * 13 10

Financing:
Borrowings ............................... 8 20 * — — 28
Repayments (including interest) 0 0 (25) (7) * (32)
Total financing .............................. 8 20 (25) (7) (4)
Cash balance, ending .................... P5 P 5 P 5 P 6 P 6

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*Given.

IV. Problems

Problem 1 (Schedule of Expected Cash Collections and Disbursements)

Requirement 1

September cash sales .................................................................. P 7,400

September collections on account:
July sales: P20,000 × 18%...................................................... 3,600
August sales: P30,000 × 70% ................................................. 21,000
September sales: P40,000 × 10% ........................................... 4,000
Total cash collections ................................................................. P36,000

Requirement 2

Payments to suppliers:
August purchases (accounts payable)..................................... P16,000
September purchases: P25,000 × 20% ................................... 5,000
Total cash payments ................................................................... P21,000

Requirement 3

COOKIE PRODUCTS
Cash Budget
For the Month of September

Cash balance, September 1............................... P 9,000

Add cash receipts:
Collections from customers .......................... 36,000
Total cash available before current financing... 45,000
Less disbursements:
Payments to suppliers for inventory ............. P21,000
Selling and administrative expenses............. 9,000 *
Equipment purchases.................................... 18,000
Dividends paid.............................................. 3,000
Total disbursements .......................................... 51,000
Excess (deficiency) of cash available over
disbursements ............................................... (6,000)

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Financing:
Borrowings ................................................... 11,000
Repayments .................................................. 0
Interest .......................................................... 0
Total financing.................................................. 11,000
Cash balance, September 30............................. P 5,000
* P13,000 – P4,000 = P9,000.

Problem 2 (Production and Purchases Budget)

Requirement 1

Production budget:
July August September October
Budgeted sales (units) ............... 40,000 50,000 70,000 35,000
Add desired ending inventory ... 20,000 26,000 15,500 11,000
Total needs................................. 60,000 76,000 85,500 46,000
Less beginning inventory .......... 17,000 20,000 26,000 15,500
Required production .................. 43,000 56,000 59,500 30,500

Requirement 2

During July and August the company is building inventories in anticipation of

peak sales in September. Therefore, production exceeds sales during these
months. In September and October inventories are being reduced in
anticipation of a decrease in sales during the last months of the year.
Therefore, production is less than sales during these months to cut back on
inventory levels.

Requirement 3

Raw materials purchases budget:

Third
July August September Quarter
Required production (units) ............. 43,000 56,000 59,500 158,500
Material P214 needed per unit ......... × 3 lbs. × 3 lbs. × 3 lbs. × 3 lbs.
Production needs (lbs.) .................... 129,000 168,000 178,500 475,500

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Add desired ending inventory (lbs.). 84,000 89,250 45,750 * 45,750

Total Material P214 needs ............... 213,000 257,250 224,250 521,250
Less beginning inventory (lbs.) ....... 64,500 84,000 89,250 64,500
Material P214 purchases (lbs.) ......... 148,500 173,250 135,000 456,750

* 30,500 units (October production) × 3 lbs. per unit= 91,500 lbs.; 91,500 lbs. × 0.5
= 45,750 lbs.

As shown in requirement (1), production is greatest in September. However,

as shown in the raw material purchases budget, the purchases of materials is
greatest a month earlier because materials must be on hand to support the
heavy production scheduled for September.

Problem 3 (Cash Budget; Income Statement; Balance Sheet)

Requirement 1

Schedule of cash receipts:

Cash sales—June ........................................................................ P 60,000

Collections on accounts receivable:
May 31 balance....................................................................... 72,000
June (50% × 190,000)............................................................. 95,000
Total cash receipts ...................................................................... P227,000

Schedule of cash payments for purchases:

May 31 accounts payable balance .............................................. P 90,000

June purchases (40% × 200,000) ................................................ 80,000
Total cash payments ................................................................... P170,000

PICTURE THIS, INC.

Cash Budget
For the Month of June

Cash balance, beginning ............................................................. P 8,000

Add receipts from customers (above) ......................................... 227,000
Total cash available .................................................................... 235,000
Less disbursements:

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Purchase of inventory (above) ................................................ 170,000

Operating expenses ................................................................. 51,000
Purchases of equipment .......................................................... 9,000
Total cash disbursements ............................................................ 230,000
Excess of receipts over disbursements ....................................... 5,000
Financing:
Borrowings—note .................................................................. 18,000
Repayments—note ................................................................. (15,000)
Interest .................................................................................... (500)
Total financing ............................................................................ 2,500
Cash balance, ending .................................................................. P 7,500

Requirement 2

PICTURE THIS, INC.

Budgeted Income Statement
For the Month of June

Sales ......................................................................... P250,000

Cost of goods sold:
Beginning inventory ............................................. P 30,000
Add purchases ...................................................... 200,000
Goods available for sale ....................................... 230,000
Ending inventory .................................................. 40,000
Cost of goods sold ................................................ 190,000
Gross margin ............................................................ 60,000
Operating expenses (P51,000 + P2,000) .................. 53,000
Net operating income ............................................... 7,000
Interest expense ........................................................ 500
Net income ............................................................... P 6,500
Requirement 3

PICTURE THIS, INC.

Budgeted Balance Sheet
June 30

Assets
Cash ............................................................................................. P 7,500
Accounts receivable (50% × 190,000) ........................................ 95,000
Inventory ..................................................................................... 40,000

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Buildings and equipment, net of depreciation

(P500,000 + P9,000 – P2,000) ................................................ 507,000
Total assets .................................................................................. P649,500

Liabilities and Equity

Accounts payable (60% × 200,000) ............................................ P120,000
Note payable................................................................................ 18,000
Share capital ................................................................................ 420,000
Retained earnings (P85,000 + P6,500) ........................................ 91,500
Total liabilities and equity ........................................................... P649,500

Problem 4 (Sales, Production and Materials Purchases Budget)

Requirement 1

Nikko Manufacturing Company

Sales Budget
For the year ending December 31, 2005

Units Amount
First quarter 16,000 P 480,000
Second quarter 20,000 600,000
Third quarter 22,000 660,000
Fourth quarter 22,000 660,000
Total 80,000 P2,400,000

Requirement 2

Nikko Manufacturing Company

Statement of Production Required
For 2005

Quarter
1st 2nd 3rd 4th Total
Units to be sold 16,000 20,000 22,000 22,000 80,000
Add: Desired ending inventory (20%) 4,000 4,400 4,400 5,000 5,000
Total units required 20,000 24,400 26,400 27,000 85,000
Less: Beginning inventory 3,000 4,000 4,400 4,400 3,000

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Units to be produced 17,000 20,400 22,000 22,600 82,000

Requirement 3

Nikko Manufacturing Company

Statement of Raw Materials Purchase Requirements
For 2005

Quarter
1st 2nd 3rd 4th Total
Units required for production 51,000 61,200 66,000 67,800 246,000
Add: Desired ending inventory 12,240 13,200 13,560 15,000 15,000
Total units 63,240 74,400 79,560 82,800 261,000
Less: Beginning inventory 12,500 12,240 13,200 13,560 12,500
Raw Materials to be Purchased 50,740 62,160 66,360 69,240 248,500

Problem 5 (Schedule of Expected Cash Collections; Cash Budget)

Requirement 1

Schedule of expected cash collections:

Month
April May June Quarter
From accounts receivable P141,000 P 7,200 P148,200
From April sales:
20% × 200,000 ............ 40,000 40,000
75% × 200,000 ............ 150,000 150,000
4% × 200,000 .............. P 8,000 8,000

From May sales:

20% × 300,000 ............ 60,000 60,000
75% × 300,000 ............ 225,000 225,000
From June sales:
20% × 250,000 ............ 50,000 50,000
Total cash collections ...... P181,000 P217,200 P283,000 P681,200

Requirement 2

Cash budget:

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Month
April May June Quarter
Cash balance, beginning.. P 26,000 P 27,000 P 20,200 P 26,000
Add receipts:
Collections from
customers ................. 181,000 217,200 283,000 681,200
Total available ................. 207,000 244,200 303,200 707,200
Less disbursements:
Merchandise purchases 108,000 120,000 180,000 408,000
Payroll ......................... 9,000 9,000 8,000 26,000
Lease payments ........... 15,000 15,000 15,000 45,000
Advertising .................. 70,000 80,000 60,000 210,000
Equipment purchases... 8,000 — — 8,000
Total disbursements ......... 210,000 224,000 263,000 697,000
Excess (deficiency) of
receipts over
disbursements .............. (3,000) 20,200 40,200 10,200
Financing:
Borrowings .................. 30,000 — — 30,000
Repayments ................. — — (30,000) (30,000)
Interest ......................... — — (1,200) (1,200)
Total financing................. 30,000 — (31,200) (1,200)
Cash balance, ending P 27,000 P 20,200 P 9,000 P 9,000

Requirement 3

If the company needs a minimum cash balance of P20,000 to start each month,
the loan cannot be repaid in full by June 30. If the loan is repaid in full, the
cash balance will drop to only P9,000 on June 30, as shown above. Some
portion of the loan balance will have to be carried over to July, at which time
the cash inflow should be sufficient to complete repayment.

Problem 6 (Flexible Budget)

Summer Machine Company

Flexible Overhead Budget
Department 1

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Capacity
100% 90% 80% 70% 60%
Machine Hours 200,000 180,000 160,000 140,000 120,000
Variable Overhead P1,300,000 P1,170,000 P1,040,000 P 910,000 P 780,000
Fixed Overhead 300,000 300,000 300,000 300,000 300,000
Total P1,600,000 P1,470,000 P1,340,000 P1,210,000 P1,080,000

Manufacturing Overhead rate per machine hour P8.00

Summer Machine Company

Flexible Overhead Budget
Department 2

Capacity
100% 90% 80% 70% 60%
Direct Labor Hours 200,000 180,000 160,000 140,000 120,000
Machine Hours 400,000 360,000 320,000 280,000 240,000
Variable Overhead P1,400,000 P1,260,000 P1,120,000 P 980,000 P 840,000
Fixed Overhead 500,000 500,000 500,000 500,000 500,000
Total P1,900,000 P1,760,000 P1,620,000 P1,480,000 P1,340,000

Manufacturing Overhead rate per machine hour P4.75

Problem 7 (Cash Budget with Supporting Schedules)

1. Collections on sales: July August Sept. Quarter

Cash sales ......................................... P 8,000 P14,000 P10,000 P 32,000
Credit sales:
May: P30,000 × 80% × 20% ........ 4,800 4,800
June: P36,000 × 80% × 70%,
20% .......................................... 20,160 5,760 25,920
July: P40,000 × 80% × 10%,
70%, 20% ................................. 3,200 22,400 6,400 32,000
Aug.: P70,000 × 80% × 10%,
70% .......................................... 5,600 39,200 44,800
Sept.: P50,000 × 80% × 10% ....... 4,000 4,000
Total cash collections ....................... P36,160 P47,760 P59,600 P143,520

2. a. Merchandise purchases budget:

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July August Sept. Oct.

Budgeted cost of goods sold .......... P24,000 P42,000 P30,000 P27,000
Add desired ending inventory* ...... 31,500 22,500 20,250
Total needs ..................................... 55,500 64,500 50,250
Less beginning inventory ............... 18,000 31,500 22,500
Required inventory purchases ........ P37,500 P33,000 P27,750

*75% of the next month’s budgeted cost of goods sold.

b. Schedule of expected cash disbursements for merchandise purchases:

Quarte
July August Sept. r
Accounts payable, June 30 .................... P11,700 P11,700
July purchases ....................................... 18,750 P18,750 37,500
August purchases .................................. 16,500 P16,500 33,000
September purchases ............................. 13,875 13,875
Total cash disbursements....................... P30,450 P35,250 P30,375 P96,075
3. Ju Products, Inc.
Cash Budget
For the Quarter Ended September 30

July August Sept. Quarter

P P P
Cash balance, beginning .................... 8,000 8,410 8,020 P 8,000
Add collections from sales ................. 36,160 47,760 59,600 143,520
Total cash available ........................ 44,160 56,170 67,620 151,520
Less disbursements:
For inventory purchases ................. 30,450 35,250 30,375 96,075
For selling expenses ....................... 7,200 11,700 8,500 27,400
For administrative expenses ........... 3,600 5,200 4,100 12,900
For land .......................................... 4,500 0 0 4,500
For dividends ................................. 0 0 1,000 1,000
Total disbursements ........................... 45,750 52,150 43,975 141,875

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Excess (deficiency) of cash available

over disbursements ......................... (1,590) 4,020 23,645 9,645
Financing:
Borrowings ..................................... 10,000 4,000 14,000
Repayment ..................................... 0 0 (14,000) (14,000)
Interest............................................ 0 0 (380) (380)
Total financing ................................... 10,000 4,000 (14,380) (380)
P P P
Cash balance, ending ......................... 8,410 8,020 9,265 P 9,265

* P10,000 × 1% × 3 = P300
P4,000 × 1% × 2 = 80
P380

V. Multiple Choice Questions

1. B 11. C 21. C
2. B 12. B 22. C
3. C 13. C 23. D
4. E 14. B 24. C
5. C 15. D 25. C
6. C 16. C 26. C
7. D 17. A 27. D
8. C 18. B 28. A
9. A 19. E 29. C
10. D 20. B 30. D

Supporting computations:

Questions 16 to 20:

January February
Cost of sales P1,400,000 P1,640,000
Add: Desired Minimum Inventory 492,000 456,000
Total 1,892,000 2,096,000
Less: Beginning Inventory (1,400,000 x 0.3) (17) 420,000 492,000

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Gross Purchases (16) 1,472,000 1,604,000

Less: Cash discount 14,720 16,040
Net cost of purchases P1,457,280 P1,587,960

Payments of Purchases
60% - month of purchase P874,368 P 952,776
40% - following month 582,912
Total (18) P1,535,688

(19)
February
Cash
Gross Discount Net
Current month’s sales (with
discount) 35% P595,000 P11,900 P583,100
Current month’s sales (without
discount) 15% 255,000 0 255,000

Previous month’s sales (with

discount) 4.5% 67,500 1,350 66,150
Previous month’s sales (without
discount) 40.5% 607,500 607,500
P1,525,000 P13,250 P1,511,750

(20)Total Collections in February P1,511,750

Add: Cash sales 350,000
Total P1,861,750

(21)Estimated cash receipts

Collections from customers P1,350,000
Proceeds from issuance of common stock 500,000
Proceeds from short-term borrowing 100,000
Total P1,950,000
Less: Estimated cash disbursements
For cost and expenses P1,200,000
For income taxes 90,000
Purchase of fixed asset 400,000
Payment on short-term borrowings 50,000
Total 1,740,000
Cash balance, Dec. 31 P 210,000

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(22)Net income P120,000

Add: Depreciation 65,000
Working capital provided from operations P185,000
Add: Increase in income taxes payable P 80,000
Increase in provision for doubtful
accounts receivable 45,000 125,000
Total P310,000
Less: Increase in accounts receivable P 35,000
Decrease in accounts payable 25,000 60,000
Increase in cash P250,000

(23)Cash Receipts for February 2005

From February sales (60% x 110,000) P 66,000
From January sales 38,000
Total P104,000

(24)Pro-forma Income Statement, February 2005

Sales P110,000
Cost of sales (75%) 82,500
Gross profit P 27,500
Less: Operating expenses 16,500
Depreciation 5,000
Bad debts 2,200 23,700
Net operating income P 3,800

(25)Accounts Payable on February 28, 2005 will be the unpaid purchases in

February - (75% x P120,000) = P90,000.

Questions 26 to 29:

Net sales P2,000,000

Less: Cost of sales
Finished goods inventory, Jan. 1 P 350,000
Add: Cost of goods manufactured (Sch. I) 1,350,000 *
Total available for sale P1,700,000
Less: Finished goods inventory, Dec. 31 400,000 1,300,000 (26)
Gross Profit P 700,000
Less: Operating and financial expenses
Selling P 300,000
Administrative 180,000

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Finance 20,000 500,000

Net income before taxes P 200,000

* Determined by working back from net income to sales.

Schedule I

Raw materials used

Raw materials inventory, Jan. 1 P 250,000
Add: Purchases 491,000 (29)
Total available 741,000
Less: Raw materials inventory, Dec. 31 300,000
Raw materials used P 441,000
Direct labor 588,000
Manufacturing overhead 441,000 (28)
Total Manufacturing Cost P1,470,000 (27)
Add: Work-in-process inventory, Jan. 1 200,000
Total P1,670,000
Less: Work-in-process inventory, Dec. 31 320,000
Cost of goods manufactured P1,350,000

(30)Variable factory overhead

P150,000
P3.125
48,000
Fixed factory overhead
P240,000
5.000
48,000
Total factory overhead P8.125

CHAPTER 16

STANDARD COSTS AND OPERATING

PERFORMANCE MEASURES

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I. Questions
1. Standard costs are superior to past data for comparison with actual costs
because they ask the question “Is present performance better than the
past?”.
2. No. Cost control and cost reduction are not the same, but cost reduction
does affect the standards which are used as basis for cost control. Cost
reduction means finding ways to achieve a given result through improved
design, better methods, new layouts and so forth. Cost reduction results
in setting new standards. On the other hand, cost control is a process of
maintaining performance at or as new existing standards as is possible.
3. Managerial judgment is the basis for deciding whether a given variance is
large enough to warrant investigation. For some items, a small amount of
variance may spark scrutiny. For some items, 5%, 10% or 25% variances
from standard may call for follow-up. Management may also derive the
standard deviation based on past cost data.
4. The techniques for overhead control differ because
1) The size of individual overhead costs usually does not justify elaborate
individual control systems;
2) The behavior of individual overhead item is either impossible or
difficult to trace to specific lots or operations; and
3) Various overhead items are the responsibility of different people.
5. In the year-to-year planning of fixed costs, managers must consider:
1) the projected maximum and minimum levels of activity,
2) prices of cost factors, and
3) changes in facilities and organization.

6. Four criteria for selecting a volume base are:

1) Cause of cost variability.
2) Adequacy of control over the base.
3) Independence of activity unit.
4) Ease of understanding.
7. Non-volume factors which cause costs to vary are:
1) Changes in plant and equipment.

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2) Changes in products made, materials used, or methods of

manufacturing.
3) Changes in prices paid for cost factors.
4) Changes in managerial policy toward costs.
5) Lag between cost incurrence and measurement of volume.
8. A budget is usually expressed in terms of total pesos, whereas a standard
is expressed on a per unit basis. A standard might be viewed as the
budgeted cost for one unit.
9. Under management by exception, managers focus their attention on
operating results that deviate from expectations. It is assumed that results
that meet expectations do not require investigation.
10. Separating an overall variance into a price variance and a quantity variance
provides more information. Moreover, prices and quantities are usually
the responsibilities of different managers.
11. The materials price variance is usually the responsibility of the purchasing
manager. The materials quantity variance is usually the responsibility of
the production managers and supervisors. The labor efficiency variance
generally is also the responsibility of the production managers and
supervisors.
12. If used as punitive tools, standards can breed resentment in an organization
and undermine morale. Standards must never be used as an excuse to
conduct witch-hunts, or as a means of finding someone to blame for
problems.
13. Several factors other than the contractual rate paid to workers can cause a
labor rate variance. For example, skilled workers with high hourly rates
of pay can be given duties that require little skill and that call for low
hourly rates of pay, resulting in an unfavorable rate variance. Or unskilled
or untrained workers can be assigned to tasks that should be filled by more
skilled workers with higher rates of pay, resulting in a favorable rate
variance. Unfavorable rate variances can also arise from overtime work
at premium rates.
14. Poor quality materials can unfavorably affect the labor efficiency variance.
If the materials create production problems, a result could be excessive
labor time and therefore an unfavorable labor efficiency variance. Poor
quality materials would not ordinarily affect the labor rate variance.
15. If labor is a fixed cost and standards are tight, then the only way to generate
favorable labor efficiency variances is for every workstation to produce at

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capacity. However, the output of the entire system is limited by the

capacity of the bottleneck. If workstations before the bottleneck in the
production process produce at capacity, the bottleneck will be unable to
process all of the work in process. In general, if every workstation is
attempting to produce at capacity, then work in process inventory will
build up in front of the workstations with the least capacity.
16. A quantity standard indicates how much of an input should be used to
make a unit of output. A price standard indicates how much the input
should cost.
17. Chronic inability to meet a standard is likely to be demoralizing and may
result in decreased productivity.
18. A variance is the difference between what was planned or expected and
what was actually accomplished. A standard cost system has at least two
types of variances. A price variance focuses on the difference between the
standard price and the actual price of an input. A quantity variance is
concerned with the difference between the standard quantity of the input
allowed for the actual output and the actual amount of the input used.

II. Matching Type

1. E 3. C 5. A 7. J 9. I
2. G 4. H 6. D 8. B 10. F

III. Exercises

Exercise 1 (Setting Standards; Preparing a Standard Cost Card)

Requirement 1

Cost per 2 kilogram container ............................................... P6,000.00

Less: 2% cash discount ......................................................... 120.00
Net cost.................................................................................. P5,880.00
Add freight cost per 2 kilogram container
(P1,000 ÷ 10 containers) ................................................... 100.00
Total cost per 2 kilogram container (a) ................................. P5,980.00
Number of grams per container
(2 kilograms × 1000 grams per kilogram) (b) ................... 2,000
Standard cost per gram purchased (a) ÷ (b) .......................... P 2.99

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Requirement 2

Beta ML12 required per capsule as per bill of materials ..... 6.00 grams
Add allowance for material rejected as unsuitable
(6 grams ÷ 0.96 = 6.25 grams;
6.25 grams – 6.00 grams = 0.25 grams) ........................... 0.25 grams
Total...................................................................................... 6.25 grams
Add allowance for rejected capsules
(6.25 grams ÷ 25 capsules) ............................................... 0.25 grams
Standard quantity of Beta ML12 per salable capsule ........... 6.50 grams

Requirement 3

Standard Quantity Standard Price Standard Cost

Item per Capsule per Gram per Capsule
Beta ML12 6.50 grams P2.99 P19.435

Exercise 2 (Material Variances)

Requirement 1

Number of chopping blocks ......................................................... 4,000

Number of board feet per chopping block.................................... × 2.5
Standard board feet allowed ......................................................... 10,000
Standard cost per board foot......................................................... × P1.80
Total standard cost ........................................................................ P18,000

Actual cost incurred ..................................................................... P18,700

Standard cost above...................................................................... 18,000
Total variance—unfavorable ........................................................ P 700
Requirement 2

Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed for
Actual Price Standard Price Output, at Standard Price
(AQ × AP) (AQ × SP) (SQ × SP)
P18,700 11,000 board feet × 10,000 board feet ×
P1.80 per board foot P1.80 per board foot
= P19,800 = P18,000

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Price Variance, Quantity Variance,

P1,100 F P1,800 U

Total Variance, P700 U

Alternatively:
Materials Price Variance = AQ (AP – SP)
11,000 board feet (P1.70 per board foot* – P1.80 per board foot) =
P1,100 F
* P18,700 ÷ 11,000 board feet = P1.70 per board foot.

Materials Quantity Variance = SP (AQ – SQ)

P1.80 per board foot (11,000 board feet – 10,000 board feet) = P1,800 U

Exercise 3 (Labor and Variable Overhead Variances)

Requirement 1

Number of units manufactured ................................................. 20,000

Standard labor time per unit ..................................................... × 0.4*
Total standard hours of labor time allowed .............................. 8,000
Standard direct labor rate per hour ........................................... × P6
Total standard direct labor cost ................................................ P48,000
*24 minutes ÷ 60 minutes per hour = 0.4 hour

Actual direct labor cost ............................................................ P49,300

Standard direct labor cost ......................................................... 48,000
Total variance—unfavorable .................................................... P 1,300

Requirement 2

Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
P49,300 8,500 hours × P6 per hour 8,000 hours* × P6 per hour
= P51,000 = P48,000
Rate Variance, Efficiency Variance,
P1,700 F P3,000 U
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*20,000 units × 0.4 hour per unit = 8,000 hours

Alternative Solution:

Labor Rate Variance = AH (AR – SR)

8,500 hours (P5.80 per hour* – P6.00 per hour) = P1,700 F
*P49,300 ÷ 8,500 hours = P5.80 per hour

Labor Efficiency Variance = SR (AH – SH)

P6 per hour (8,500 hours – 8,000 hours) = P3,000 U

Requirement 3

Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
P39,100 8,500 hours × P4 per hour 8,000 hours × P4 per hour
= P34,000 = P32,000
Spending Variance, Efficiency Variance,
P5,100 U P2,000 U

Total Variance, P7,100 U

Alternative Solution:

Variable Overhead Spending Variance = AH (AR – SR)

8,500 hours (P4.60 per hour* – P4.00 per hour) = P5,100 U
*P39,100 ÷ 8,500 hours = P4.60 per hour
Variable Overhead Efficiency Variance = SR (AH – SH)
P4 per hour (8,500 hours – 8,000 hours) = P2,000 U

Exercise 4 (Working Backwards from Labor Variances)

Requirement 1

If the total variance is P330 unfavorable, and if the rate variance is P150
favorable, then the efficiency variance must be P480 unfavorable, since the

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rate and efficiency variances taken together always equal the total variance.

Knowing that the efficiency variance is P480 unfavorable, one approach to the
solution would be:
Efficiency Variance = SR (AH – SH)
P6 per hour (AH – 420 hours*) = P480 U
P6 per hour × AH – P2,520 = P480**
P6 per hour × AH = P3,000
AH = 500 hours
* 168 batches × 2.5 hours per batch = 420 hours
** When used with the formula, unfavorable variances are positive and
favorable variances are negative.

Requirement 2

Knowing that 500 hours of labor time were used during the week, the actual
rate of pay per hour can be computed as follows:
Rate Variance = AH (AR – SR)
500 hours (AR – P6 per hour) = P150 F
500 hours × AR – P3,000 = –P150*
500 hours × AR = P2,850
AR = P5.70 per hour

* When used with the formula, unfavorable variances are positive and
favorable variances are negative.

Exercise 5 (Direct Labor Variances)

1. Number of meals prepared ................................................... 6,000

Standard direct labor-hours per meal ................................... × 0.20
Total direct labor-hours allowed .......................................... 1,200
Standard direct labor cost per hour ...................................... × P9.50
Total standard direct labor cost ............................................ P11,400

Actual cost incurred ............................................................. P11,500

Total standard direct labor cost (above) ............................... 11,400
Total direct labor Unfavorable
variance ............................................................................
P 100

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2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
(AH × AR) (AH × SR) (SH × SR)
1,150 hours × 1,150 hours × 1,200 hours ×
P10.00 per hour P9.50 per hour P9.50 per hour
= P11,500 = P10,925 = P11,400
  
Rate Variance, Efficiency Variance,
P575 U P475 F

Total Variance, P100 U

Alternatively, the variances can be computed using the formulas:

Labor rate variance = AH(AR – SR)

= 1,150 hours (P10.00 per hour – P9.50 per hour)
= P575 U

Labor efficiency variance = SR(AH – SH)

= P9.50 per hour (1,150 hours – 1,200 hours)
= P475 F

Exercise 6 (Variable Overhead Variances)

1. Number of items shipped .................................................................. 140,000

Standard direct labor-hours per item................................................. × 0.04
Total direct labor-hours allowed ....................................................... 5,600
Standard variable overhead cost per hour ......................................... × P2.80
Total standard variable overhead cost ............................................... P15,680

Actual variable overhead cost incurred ............................................. P15,950

Total standard variable overhead cost (above).................................. 15,680
Total variable overhead variance ...................................................... P 270 Unfavorable

2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
(AH × AR) (AH × SR) (SH × SR)

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5,800 hours × 5,800 hours × 5,600 hours ×

P2.75 per hour* P2.80 per hour P2.80 per hour
= P15,950 = P16,240 = P15,680
  
Variable overhead spending Variable overhead
variance, P290 F efficiency variance, P560 U

Total variance, P270 U

*P15,950÷ 5,800 hours =P2.75 per hour

Alternatively, the variances can be computed using the formulas:

Variable overhead spending variance:

AH(AR – SR) = 5,800 hours (P2.75 per hour – P2.80 per hour)
= P290 F

Variable overhead efficiency variance:

SR(AH – SH) = P2.80 per hour (5,800 hours – 5,600 hours)
= P560 U

IV. Problems

Problem 1 (Comprehensive Variance Analysis)

Requirement 1
a.
Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed for
the Actual Price Standard Price Output, at the Standard Price
(AQ × AP) (AQ × SP) (SQ × SP)
25,000 pounds x 25,000 pounds x 20,000 pounds* x
P2.95 per pound P2.50 per pound P2.50 per pound
= P73,750 = P62,500 = P50,000
Price Variance,
P11,250 U
19,800 pounds x P2.50 per pound
= P49,500
Quantity Variance,
P500 F
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* 5,000 metal molds × 4.0 pounds per metal mold = 20,000 pounds

Alternatively:
Materials Price Variance = AQ (AP – SP)
25,000 pounds (P2.95 per pound – P2.50 per pound) = P11,250 U
Materials Quantity Variance = SP (AQ – SQ)
P2.50 per pound (19,800 pounds – 20,000 pounds) = P500 F

b.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
3,600 hours x 3,600 hours x 3,000 hours* x
P8.70 per hour P9.00 per hour P9.00 per hour
= P31,320 = P32,400 = P27,000
Rate Variance, Efficiency Variance,
P1,080 F P5,400 U

Total Variance, P4,320 U

* 5,000 metal molds × 0.6 hour per metal mold = 3,000 hours
Alternatively:
Labor Rate Variance = AH (AR – SR)
3,600 hours (P8.70 per hour – P9.00 per hour) = P1,080 F
Labor Efficiency Variance = SR (AH – SH)
P9.00 per hour (3,600 hours – 3,000 hours) = P5,400 U

c.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
P4,320 1,800 hours × P2 per hour 1,500 hours* × P2 per hour
= P3,600 = P3,000
Spending Variance, Efficiency Variance,
P720 U P600 U

Total Variance, P1,320 U

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*5,000 metal molds × 0.3 hours per metal mold = 1,500 hours

Alternatively:
Variable Overhead Spending Variance = AH (AR – SR)
1,800 hours (P2.40 per hour* – P2.00 per hour) = P720 U
* P4,320 ÷ 1,800 hours = P2.40 per hour
Variable Overhead Efficiency Variance = SR (AH – SH)
P2.00 per hour (1,800 hours – 1,500 hours) = P600 U

Requirement 2

Summary of variances:

Material price variance ....................................................... P11,250 U

Material quantity variance .................................................. 500 F
Labor rate variance ............................................................. 1,080 F
Labor efficiency variance ................................................... 5,400 U
Variable overhead spending variance ................................. 720 U
Variable overhead efficiency variance ................................ 600 U
Net variance ........................................................................ P16,390 U

The net unfavorable variance of P16,390 for the month caused the plant’s
variable cost of goods sold to increase from the budgeted level of P80,000 to
P96,390:

Budgeted cost of goods sold at P16 per metal mold ..................... P80,000
Add the net unfavorable variance (as above) ............................... 16,390
Actual cost of goods sold.............................................................. P96,390

This P16,390 net unfavorable variance also accounts for the difference
between the budgeted net operating income and the actual net loss for the
month.

Budgeted net operating income ................................................... P15,000

Deduct the net unfavorable variance added to cost of goods
sold for the month.................................................................... 16,390

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Net operating loss ........................................................................ P(1,390)

Requirement 3

The two most significant variances are the materials price variance and the
labor efficiency variance. Possible causes of the variances include:

Materials Price Outdated standards, uneconomical quantity

Variance: purchased, higher quality materials, high-
cost method of transport.

Labor Efficiency Poorly trained workers, poor quality

Variance: materials, faulty equipment, work
interruptions, inaccurate standards,
insufficient demand.

Problem 2

1. 1,000 units 4. 14,900 lbs.

2. 25,000 lbs. 5. 3,100 hours
3. P2.01 per lb. 6. P3.98 per hour

Problem 3

Material mix variance:

Actual quantity x Standard price
Material A (8,000 x P0.30) P2,400
Material B (2,400 x P0.20) 480
Material C (2,800 x P0.425) 1,190 P4,070
Less: Total actual input x Average
Standard price (13,200 x 0.30*) 3,960
Unfavorable Mix Variance P 110
P 720
* Average Standard price = 2,400 = P0.30

Material yield variance:

Total actual input at Average Standard price P3,960
Less: Total actual output at Standard raw material cost
(10,000 x 0.36**) 3,600
Unfavorable yield variance P 360

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P 720
** Standard Material Cost = = P0.36
2,000

Problem 4 (Comprehensive Variance Analysis; Journal Entries)

Requirement 1

a.
Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed for
Actual Price Standard Price Output, at Standard Price
(AQ × AP) (AQ × SP) (SQ × SP)
21,120 yards x 21,120 yards x 19,200 yards* x
P3.35 per yard P3.60 per yard P3.60 per yard
= P70,752 = P76,032 = P69,120
Price Variance, Quantity Variance,
P5,280 F P6,912 U

Total Variance, P1,632 U

* 4,800 units × 4.0 yards per unit = 19,200 yards

Alternatively:
Materials Price Variance = AQ (AP – SP)
21,120 yards (P3.35 per yard – P3.60 per yard) = P5,280 F
Materials Quantity Variance = SP (AQ – SQ)
P3.60 per yard (21,120 yards – 19,200 yards) = P6,912 U

b. Raw Materials (21,120 yards @ P3.60 per yard) . 76,032

Materials Price Variance
(21,120 yards @ P0.25 per yard F) .......... 5,280
Accounts Payable
(21,120 yards @ P3.35 per yard).............. 70,752

Work in Process (19,200 yards @ P3.60 per

yard) ................................................................. 69,120
Materials Quantity Variance
(1,920 yards U @ P3.60 per yard).................... 6,912
Raw Materials (21,120 yards @ P3.60 per
yard) ......................................................... 76,032

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Requirement 2

a.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
6,720 hours* x 6,720 hours x 7,680 hours** x
P4.85 per hour P4.50 per hour P4.50 per hour
= P32,592 = P30,240 = P34,560
Rate Variance, Efficiency Variance,
P2,352 U P4,320 F

Total Variance, P1,968 F

* 4,800 units × 1.4 hours per unit = 6,720 hours

** 4,800 units × 1.6 hours per unit = 7,680 hours

Alternatively:
Labor Rate Variance = AH (AR – SR)
6,720 hours (P4.85 per hour – P4.50 per hour) = P2,352 U
Labor Efficiency Variance = SR (AH – SH)
P4.50 per hour (6,720 hours – 7,680 hours) = P4,320 F

b. Work in Process (7,680 hours @ P4.50 per hour) 34,560

Labor Rate Variance
(6,720 hours @ P0.35 per hour U) ................... 2,352
Labor Efficiency Variance
(960 hours F @ P4.50 per hour) ............... 4,320
Wages Payable (6,720 hours @ P4.85 per
hour) ......................................................... 32,592

Requirement 3

Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
6,720 hours x 6,720 hours x 7,680 hours x
P2.15 per hour P1.80 per hour P1.80 per hour
P14,448 = P12,096 = P13,824

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Spending Variance, Efficiency Variance,

P2,352 U P1,728 F

Total Variance, P624 U

Alternatively:
Variable Overhead Spending Variance = AH (AR – SR)
6,720 hours (P2.15 per hour – P1.80 per hour) = P2,352 U
Variable Overhead Efficiency Variance = SR (AH – SH)
P1.80 per hour (6,720 hours – 7,680 hours) = P1,728 F

Requirement 4

No. This total variance is made up of several quite large individual variances,
some of which may warrant investigation. A summary of variances is shown
on the next page.

Materials:
Price variance ............................. P5,280 F
Quantity variance........................ 6,912 U P1,632 U
Labor:
Rate variance .............................. 2,352 U
Efficiency variance ..................... 4,320 F 1,968 F
Variable overhead:
Spending variance ...................... 2,352 U
Efficiency variance ..................... 1,728 F 624 U
Net unfavorable variance ................ P 288 U

Requirement 5

The variances have many possible causes. Some of the more likely causes
include:

Materials variances:
Favorable price variance: Fortunate buy, inaccurate standards, inferior quality
materials, unusual discount due to quantity purchased, drop in market price.

Unfavorable quantity variance: Carelessness, poorly adjusted machines,

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unskilled workers, inferior quality materials, inaccurate standards.

Labor variances:
Unfavorable rate variance: Use of highly skilled workers, change in wage
rates, inaccurate standards, overtime.

Favorable efficiency variance: Use of highly skilled workers, high quality

materials, new equipment, inaccurate standards.

Variable overhead variances:

Unfavorable spending variance: Increase in costs, inaccurate standards, waste,
theft, spillage, purchases in uneconomical lots.

Favorable efficiency variance: Same as for labor efficiency variance.

V. Multiple Choice Questions

1. C 11. B 21. A 31. A 41. B

2. C 12. A 22. C 32. B 42. C
3. A 13. B 23. C 33. B 43. D
4. B 14. C 24. C 34. D 44. A
5. A 15. A 25. C 35. B 45. B
6. B 16. D 26. D 36. B
7. C 17. D 27. E 37. C
8. C 18. A 28. B 38. D
9. B 19. D 29. B 39. D
10. B 20. B 30. A 40. A

CHAPTER 17

APPLICATION OF QUANTITATIVE TECHNIQUES IN

PLANNING, CONTROL AND DECISION MAKING - I

I. Questions
1. a. Decision tree analysis provides a systematic framework for analyzing
a sequence of interrelated decisions which may be made over time.

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Decision making is formulated in terms of the consequence of acts,

events and consequences because it is believed that present decisions
affect future profitability. The study and understanding of alternative
scenarios is encouraged with the use of decision tree analysis.
b. Advantages of Decision Tree Analysis
1. Clarifies the choices, risks, and monetary gains involved in an
investment problem.
2. Presents the relevant information more clearly.
3. Combines action choices with different possible events or results
of action which are partially affected by chance or other
uncontrollable circumstances.
4. Encourages the focus on the relationship between current and
future decisions.
5. Utilizes such analytical techniques as present value and
discounted cash flow.
6. Considers various alternatives with greater ease.
Weaknesses of Decision Tree Analysis
1. Not all events that can happen can be/are identified.
2. Not all the decisions that must be made on a subject under analysis
are listed because choices are usually not restricted to two or three.
3. If a large number of choices is involved, decision tree analysis by
hand becomes complicated.
4. Uncertain alternatives are generally treated as if they were
discrete, well-defined possibilities.
2. Refer to page 665 of the textbook.
II. Multiple Choice Questions

6. A 6. C 31. B 41. B 46. B

7. A 7. B 32. D 42. C 47. D
8. B 8. D 33. C 43. D 48. B
9. B 9. A 34. B 44. D 49. B
10. B 10. D 35. A 45. A 50. D

CHAPTER 18

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APPLICATION OF QUANTITATIVE TECHNIQUES IN

PLANNING, CONTROL AND DECISION MAKING - II

I. Questions
1. PERT is superior to Gantt Charts in complex projects because:
a. PERT charts are flexible and can reflect slippage or changes in plans,
but Gantt charts simply plot a bar chart against a calendar scale.
b. PERT charts reflect interdependencies among activities; Gantt charts
do not.
c. PERT charts reflect uncertainties or tolerances in the time estimates
for various activities; Gantt charts do not.
2. The use of PERT provides a structured foundation for planning complex
projects in sufficient detail to facilitate effective control.
A workable sequence of events that comprise the project are first
identified. Each key event should represent a task; then the interdependent
relationships between the events are structured.
After the network of events is constructed, cost and time parameters are
established for each package. Staffing plans are reviewed and analyzed.
The “critical path” computation identifies sequence of key events with
total time equal to the time allotted for the project’s completion. Jobs
which are not on the critical path can be slowed down and the slack
resources available on these activities reallocated to activities on the
critical path.
Use of PERT permits sufficient scheduling of effort by functional areas
and by geographic location. It also allows for restructuring scheduling
efforts and redeployment of workers as necessary to compensate for delays
or bottlenecks. The probability of completing this complex project on time
and within the allotted budget is increased.
3. Time slippage in noncritical activities may not warrant extensive
managerial analysis because of available slack, but activity cost usually
increases with time and should be monitored.
4. The critical path is the network path with the longest cumulative expected
activity time. It is critical because a slowdown along this path delays the
entire project.

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5. Crashing the network means finding the minimum cost for completing the
project in minimum time in order to achieve an optimum tradeoff between
cost and time. The differential crash cost of an activity is the additional
cost of that activity for each period of time saved.
6. Slack is the amount of time an event can be delayed without affecting the
project’s completion date. Slack can be utilized by management as a
buffer against bottlenecks that may occur on the critical path.
7. Unit gross margin are typically computed with an allocation of fixed costs.
Total fixed costs generally will not change with a change in volume within
the relevant range. Unitizing the fixed costs results in treating them as
though they are variable costs when, in fact, they are not. Moreover, when
multiple products are manufactured, the relative contribution becomes the
criterion for selecting the optimal product mix. Fixed costs allocations can
distort the relative contributions and result in a suboptimal decision.
8. This approach will maximize profits only if there are no constraints on
production or sales, or if both products use all scarce resources at an equal
rate. Otherwise management would want to maximize the contribution
per unit of scarce resource.
9. The opportunity cost of a constraint is the cost of not having additional
availability of the constrained resources. This is also called a shadow
price.
10. The feasible production region is the area which contains all possible
combinations of production outputs. It is bounded by the constraints
imposed on production possibilities. The production schedule which
management chooses must come from the feasible production region.
11. The accountant usually supplies the contribution margin data that is used
in formulating a profit-maximizing objective function. In addition, the
accountant participates in the analysis of linear programming outputs by
assessing the costs of additional capacity or of changes in product mix.
12. a. Hourly fee for inventory audit (C)
b. Salary of purchasing supervisor (N)
c. Costs to audit purchase orders and invoices (P)
d. Taxes on inventory (C)
e. Stockout costs (P)
f. Storage costs charged per unit in inventory (C)
g. Fire insurance on inventory (C)
h. Fire insurance on warehouse (N)
i. Obsolescence costs on inventory (C)

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j. Shipping costs per shipment (P)

13. Although the inventory models are developed by operations researchers,
statisticians and computer specialists, their areas of expertise do not extend
to the evaluation of the differential costs for the inventory models.
Generally, discussions of inventory models take the costs as given. It is
the role of the accountant to determine which costs are appropriate for
inclusion in an inventory model.
14. Cost of capital represents the interest expense on funds if they were
borrowed or opportunity cost if funds were provided internally or by
owners. It is included as carrying cost of inventory because funds are tied
up in inventory.
15. Costs that vary with the average number of units in inventory:
Inventory insurance P 2.80
Inventory tax 2.05 (P102.25 x 2%)
Total P 4.85
Costs that vary with the number of units purchased:
Purchase price P102.25
Insurance on shipment 1.50
Total P103.75
Total carrying cost = (25% x P103.75) cost of capital + P4.85 = P25.94 +
P4.85 = P30.79
Order costs:
Shipping permit P201.65
Costs to arrange for the shipment 21.45
Unloading 80.20
Stockout costs 122.00
Total P425.30

II. Problems

Problem 1 (Solution is found on the next page.)

Problem 2

Requirement (a)

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The critical path through each of the three alternative paths calculated as the
longest is 0 - 1 - 6- 7- 8.

0-1-2-5-8 2 + 8 + 10 + 14 = 34
0-1-3-4-7-8 2+8+7+5+3 = 25
0-1-6-7-8 2 + 26 + 9 + 3 = 40*
________
* critical

Requirement (b)

40 - 3 - 5 = 32

Requirement (c)

If path 4 - 7 has an unfavorable time variance of 10, this means it takes a total
time of 15 to finish this activity rather than 5. This gives the path 0 - 1 - 3 - 4
- 7 - 8 a total time of 35, but since this is less than the critical path of 40, it has
no effect.

Requirement (d)

The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the
expected times.

Problem 3

No, they didn’t make a right decision, since they included fixed costs which
do not differ in the short run. If they had used contribution margin instead of
gross margin, they would have had P5 for G1 and P6.50 for G2, therefore they
would have decided to produce G2 exclusively.

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Problem 1
Requirement (a)

TASKS 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

H Order 1 Order 3 Order 4 Order 2

o
b
b
i
n
g

M X X X
X Order 1 X X Order 3 X X X Order 4 Order 2
a
c
h
i
n
i
n
g

___________
X Dead Time

Requirement (b)

28 days are required for the four orders.

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Problem 4

Order costs = Insurance + Other order costs

P = P860 + P18 = P878

Carrying costs = Out-of-pocket Cost of capital

+
costs on inventory
S = P65 + 20% x P222 = P119.40

a. Carrying costs:
QS 250 x P109.40
= = P13,675.00
2 2

Order costs:
AP 1,500 x P878
= = P 5,268.00
Q 250

Total P18,943.00

b. Economic order quantity:


2 x 1,500 x P878
Q* = =  24,077 = 155 units
P109.40

Carrying costs:
QS 155 x P109.40
= = P 8,478.50
2 2

Order costs:
AP 1,500 x P878
= = P 8,496.77
Q 155

Total P16,975.27
Problem 5

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It is necessary to evaluate the annual carrying costs and expected stockout

costs at each safety-stock level. The carrying cost will be P24.40 for each unit
in safety stock. With the given order size, there are 15 orders placed a year
(i.e., 39,000/2,600 = 15). Based on these computations, we prepare the
following schedule:

Safety Carrying Costs Expected Stockout Total

Stock of Safety Stock Costs Costs
0 0 0.50 x 15a x P1,650 = P12,375 P12,375
150 150 x P24.40 = P3,660 0.20 x 15a x P1,650 = P 4,950 8,610
175 175 x P24.40 = P4,270 0.05 x 15a x P1,650 = P 1,273.5 5,507.5 (optional)
250 250 x P24.40 = P6,100b 0.01 x 15a x P1,650 = P 247.5 6,347.5

Additional computations:
a
15 is the number of orders per year.
b
It should be evident that at this level the carrying costs alone exceed the total costs
at a safety stock of 175 units. Therefore, it is not possible for this or any safety-
stock level larger than 250 to be less costly than 175 units. Indeed, given a total cost
at 175 units of P5,507.5, stockout costs would have to occur with probability zero
for any safety stock greater than 225.72 units (i.e., P5,507.5 / P24.40 = P225.72).

III. Multiple Choice Questions

1. C 11. D 21. D 31. C

2. B 12. C 22. C 32. D
3. D 13. A 23. C 33. A
4. B 14. A 24. D 34. C
5. D 15. A 25. D 35. D
6. C 16. C 26. B 36. C
7. A 17. C 27. D 37. D
8. A 18. D 28. E 38. D
9. A 19. C 29. B
10. C 20. D 30. A

CHAPTER 19

RELEVANT COSTS FOR DECISION MAKING

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I. Questions
1. Quantitative factors are those which may more easily be reduced in terms
of pesos such as projected costs of materials, labor and overhead.
Qualitative factors are those whose measurement in pesos is difficult and
imprecise; yet a qualitative factor may be easily given more weight than
the measurable cost savings. It can be seen that the accountant’s role in
making decisions deals with the quantitative factors.
2. Relevant costs are expected future costs that will differ between
alternatives. In view of the definition of relevant costs, historical costs are
always irrelevant because they are not future costs. They may be helpful
in predicting relevant costs but they are always irrelevant costs per se.
3. The differential costs in any given situation is commonly defined as the
change in total cost under each alternative. It is not relevant cost, but it is
the algebraic difference between the relevant costs for the alternatives
under consideration.
4. Analysis:

Future costs: Replace Rebuild

New Truck P10,200
Less: Proceeds from
disposal, net 1,000
P 9,200 P8,500
Advantage of rebuilding P700

The original cost of the old truck is irrelevant but its disposal value is
relevant. It is recommended that the truck should be rebuilt because it will
involve lesser cash outlay.

5. No. Variable costs are relevant costs only if they differ in total between the
alternatives under consideration.

6. Only those costs that would be avoided as a result of dropping the product
line are relevant in the decision. Costs that will not differ regardless of
whether the product line is retained or discontinued are irrelevant.

7. Not necessarily. An apparent loss may be the result of allocated common

costs or of sunk costs that cannot be avoided if the product line is dropped.
A product line should be discontinued only if the contribution margin that
will be lost as a result of dropping the line is less than the fixed costs that

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would be avoided. Even in that situation the product line may be retained
if its presence promotes the sale of other products.

8. Allocations of common fixed costs can make a product line (or other
segment) appear to be unprofitable, whereas in fact it may be profitable.

9. In cost-plus pricing, prices are set by applying a markup percentage to a

product’s cost.

10. The price elasticity of demand measures the degree to which a change in
price affects unit sales. The unit sales of a product with inelastic demand
are relatively insensitive to the price charged for the product. In contrast,
the unit sales of a product with elastic demand are sensitive to the price
charged for the product.

11. The profit-maximizing price should depend only on the variable

(marginal) cost per unit and on the price elasticity of demand. Fixed costs
do not enter into the pricing decision at all. Fixed costs are relevant in a
decision of whether to offer a product or service, but are not relevant in
deciding what to charge for the product or service. Because price affects
unit sales, total variable costs are affected by the pricing decision and
therefore are relevant.

12. The markup over variable cost depends on the price elasticity of demand.
A product whose demand is elastic should have a lower markup over cost
than a product whose demand is inelastic. If demand for a product is
inelastic, the price can be increased without cutting as drastically into unit
sales.

II. Exercises

Exercise 1 (Identifying Relevant Costs)

Case 1 Case 2
Not Not
Item Relevant Relevant Relevant Relevant

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a. Sales

revenue

.................................................
X X
b. Direct

materials

.................................................
X X
c. Direct

labor

.................................................
X X
d. Variable manufacturing

overhead

.................................................
X X
e. Book value – Model E7000

machine

.................................................
X X
f. Disposal value – Model E7000

machine

.................................................
X X

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g. Depreciation – Model E7000

machine

.................................................
X X
h. Market value – Model F5000

machine

(cost)

.................................................
X X
i. Fixed manufacturing

overhead

.................................................
X X
j. Variable selling

expense

.................................................
X X
k. Fixed selling

expense

.................................................
X X
l. General administrative

overhead

.................................................
X X

Exercise 2 (Identification of Relevant Costs)

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Requirement 1

Fixed cost per mile (P3,500* ÷ 10,000 miles) ............................... P0.35

Variable operating cost per mile .................................................... 0.08
Average cost per mile .................................................................... P0.43

* Depreciation.................................................. P2,000
Insurance ....................................................... 960
Garage rent.................................................... 480
Automobile tax and license .......................... 60
Total .............................................................. P3,500

Requirement 2

The variable operating costs would be relevant in this situation. The

depreciation would not be relevant since it relates to a sunk cost. However,
any decrease in the resale value of the car due to its use would be relevant.
The automobile tax and license costs would be incurred whether Ingrid decides
to drive her own car or rent a car for the trip during summer break and are
therefore irrelevant. It is unlikely that her insurance costs would increase as a
result of the trip, so they are irrelevant as well. The garage rent is relevant
only if she could avoid paying part of it if she drives her own car.

Requirement 3

When figuring the incremental cost of the more expensive car, the relevant
costs would be the purchase price of the new car (net of the resale value of the
old car) and the increases in the fixed costs of insurance and automobile tax
and license. The original purchase price of the old car is a sunk cost and is
therefore irrelevant. The variable operating costs would be the same and
therefore are irrelevant. (Students are inclined to think that variable costs are
always relevant and fixed costs are always irrelevant in decisions. This
requirement helps to dispel that notion.)

Exercise 3 (Make or Buy a Component)

Requirement 1

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Per Unit
Differential
Costs 15,000 units
Make Buy Make Buy
Cost of purchasing ..................................... P200 P3,000,000
Direct materials .......................................... P 60 P 900,000
Direct labor ................................................ 80 1,200,000
Variable manufacturing overhead .............. 10 150,000
Fixed manufacturing overhead, traceable1 . 20 300,000
Fixed manufacturing overhead, common... 0 0 0 0
Total costs .................................................. P170 P200 P2,550,000 P3,000,000

Difference in favor of continuing to make

the parts ................................................. P30 P450,000

1
Only the supervisory salaries can be avoided if the parts are purchased. The remaining
book value of the special equipment is a sunk cost; hence, the P3 per unit depreciation
expense is not relevant to this decision. Based on these data, the company should
reject the offer and should continue to produce the parts internally.

Requirement 2

Make Buy
Cost of purchasing (part 1) ............................................ P3,000,000
Cost of making (part 1) ................................................. P2,550,000
Opportunity cost—segment margin forgone on a
potential new product line ......................................... 650,000
Total cost ....................................................................... P3,200,000 P3,000,000
Difference in favor of purchasing from the outside
supplier ....................................................................... P200,000

Thus, the company should accept the offer and purchase the parts from the outside
supplier.

Exercise 4 (Evaluating Special Order)

Only the incremental costs and benefits are relevant. In particular, only the
variable manufacturing overhead and the cost of the special tool are relevant
overhead costs in this situation. The other manufacturing overhead costs are
fixed and are not affected by the decision.

Per Total

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Unit 10 bracelets
Incremental revenue ................................ P3,499.50 P34,995.00
Incremental costs:
Variable costs:
Direct materials................................ 1,430.00 14,300.00
Direct labor ...................................... 860.00 8,600.00
Variable manufacturing overhead.... 70.00 700.00
Special filigree ................................. 60.00 600.00
Total variable cost ............................... P2,420.00 24,200.00
Fixed costs:
Purchase of special tool ................... 4,650.00
Total incremental cost ............................. 28.850.00
Incremental net operating income ........... P 6.145.00
Even though the price for the special order is below the company’s regular
price for such an item, the special order would add to the company’s net
operating income and should be accepted. This conclusion would not
necessarily follow if the special order affected the regular selling price of
bracelets or if it required the use of a constrained resource.

Exercise 5 (Utilization of a Constrained Resource)

Requirement 1

X Y Z
(1) Contribution margin per unit ....................................... P18 P36 P20
(2) Direct labor cost per unit ............................................. P12 P32 P16
(3) Direct labor rate per hour ............................................ 8 8 8
(4) Direct labor-hours required per unit (2) ÷ (3) .............. 1.5 4.0 2.0
Contribution margin per direct labor-hour (1) ÷ (4) .... P12 P 9 P10

Requirement 2

The company should concentrate its labor time on producing product X:

X Y Z
Contribution margin per direct labor-hour ... P12 P9 P10
Direct labor-hours available......................... × 3,000 × 3,000 × 3,000
Total contribution margin ............................ P36,000 P27,000 P30,000

Although product X has the lowest contribution margin per unit and the second
lowest contribution margin ratio, it has the highest contribution margin per

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direct labor-hour. Since labor time seems to be the company’s constraint, this
measure should guide management in its production decisions.

Requirement 3

The amount Jaycee Company should be willing to pay in overtime wages for
additional direct labor time depends on how the time would be used. If there
are unfilled orders for all of the products, Jaycee would presumably use the
additional time to make more of product X. Each hour of direct labor time
generates P12 of contribution margin over and above the usual direct labor
cost. Therefore, Jaycee should be willing to pay up to P20 per hour (the P8
usual wage plus the contribution margin per hour of P12) for additional labor
time, but would of course prefer to pay far less. The upper limit of P20 per
direct labor hour signals to managers how valuable additional labor hours are
to the company.

If all the demand for product X has been satisfied, Jaycee Company would
then use any additional direct labor-hours to manufacture product Z. In that
case, the company should be willing to pay up to P18 per hour (the P8 usual
wage plus the P10 contribution margin per hour for product Z) to manufacture
more product Z.

Likewise, if all the demand for both products X and Z has been satisfied,
additional labor hours would be used to make product Y. In that case, the
company should be willing to pay up to P17 per hour to manufacture more
product Y.

Exercise 6 (Sell or Process Further)

Product A Product B Product C

Sales value after further processing .. P80,000 P150,000 P75,000
Sales value at split-off point ............. 50,000 90,000 60,000
Incremental revenue.......................... 30,000 60,000 15,000
Cost of further processing ................. 35,000 40,000 12,000
Incremental profit (loss).................... P(5,000) 20,000 3,000

Products B and C should be processed further, but not Product A.

Exercise 7 (Identification of Relevant Costs)

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Requirement 1

The relevant costs of a fishing trip would be:

Fuel and upkeep on boat per trip ............................. P25

Junk food consumed during trip* ............................ 8
Snagged fishing lures .............................................. 7
Total ......................................................................... P40

* The junk food consumed during the trip may not be completely relevant. Even
if Shin were not going on the trip, he would still have to eat. The amount by
which the cost of the junk food exceeds the cost of the food he would otherwise
consume would be the relevant amount.

The other costs are sunk at the point at which the decision is made to go on
another fishing trip.

Requirement 2

If he fishes for the same amount of time as he did on his last trip, all of his
costs are likely to be about the same as they were on his last trip. Therefore, it
really doesn’t cost him anything to catch the last fish. The costs are really
incurred in order to be able to catch fish and would be the same whether one,
two, three, or a dozen fish were actually caught. Fishing, not catching fish,
costs money. All of the costs are basically fixed with respect to how many fish
are actually caught during any one fishing trip, except possibly the cost of
snagged lures.

Requirement 3
In a decision of whether to give up fishing altogether, nearly all of the costs
listed by Shin’s wife are relevant. If he did not fish, he would not need to pay
for boat moorage, new fishing gear, a fishing license, fuel and upkeep, junk
food, or snagged lures. In addition, he would be able to sell his boat, the
proceeds of which would be considered relevant in this decision. The original
cost of the boat, which is a sunk cost, would not be relevant.
These three requirements illustrate the slippery nature of costs. A cost that is
relevant in one situation can be irrelevant in the next. None of the costs are
relevant when we compute the cost of catching a particular fish; some of them
are relevant when we compute the cost of a fishing trip; and nearly all of them

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are relevant when we consider the cost of not giving up fishing. What is even
more confusing is that CG is correct; the average cost of a salmon is P167,
even though the cost of actually catching any one fish is essentially zero. It
may not make sense from an economic standpoint to have salmon fishing as a
hobby, but as long as Shin is out in the boat fishing, he might as well catch as
many fish as he can.

Exercise 8 (Dropping or Retaining a Segment)

Requirement 1
No, the housekeeping program should not be discontinued. It is actually
generating a positive program segment margin and is, of course, providing a
valuable service to seniors. Computations to support this conclusion follow:

Contribution margin lost if the housekeeping program

is dropped .................................................................. P(80,000)
Fixed costs that can be avoided:
Liability insurance .................................................... P15,000
Program administrator’s salary ................................. 37,000 52,000
Decrease in net operating income for the organization
as a whole.................................................................. P(28,000)

Depreciation on the van is a sunk cost and the van has no salvage value since
it would be donated to another organization. The general administrative
overhead is allocated and none of it would be avoided if the program were
dropped; thus it is not relevant to the decision.

The same result can be obtained with the alternative analysis below:

Difference:
Net
Total If Operating
House- Income
Current keeping Is Increase or
Total Dropped (Decrease)
Revenues .......................................................... P900,000 P660,000 P(240,000)
Variable expenses ............................................. 490,000 330,000 160,000
Contribution margin ......................................... 410,000 330,000 (80,000)
Fixed expenses:

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Depreciation* ............................................... 68,000 68,000 0

Liability insurance........................................ 42,000 27,000 15,000
Program administrators’ salaries .................. 115,000 78,000 37,000
General administrative overhead .................. 180,000 180,000 0
Total fixed expenses ......................................... 405,000 353,000 52,000
Net operating income (loss) ............................. P 5,000 P(23,000) P (28,000)

*Includes pro-rated loss on disposal of the van if it is donated to a charity.

Requirement 2

To give the administrator of the entire organization a clearer picture of the

financial viability of each of the organization’s programs, the general
administrative overhead should not be allocated. It is a common cost that
should be deducted from the total program segment margin. Following the
format for a segmented income statement, a better income statement would be:
Home Meals on House-
Total Nursing Wheels keeping
Revenues ........................................... P900,000 P260,000 P400,000 P240,000
Variable expenses .............................. 490,000 120,000 210,000 160,000
Contribution margin .......................... 410,000 140,000 190,000 80,000
Traceable fixed expenses:
Depreciation .................................. 68,000 8,000 40,000 20,000
Liability insurance ........................ 42,000 20,000 7,000 15,000
Program administrators’ salaries ... 115,000 40,000 38,000 37,000
Total traceable fixed expenses ........... 225,000 68,000 85,000 72,000
Program segment margins ................. 185,000 P 72,000 P105,000 P 8,000
General administrative overhead ....... 180,000
Net operating income (loss) .............. P 5,000

Exercise 9 (Special Order)

Requirement 1

Monthly profits would be increased by P9,000:

Total for
Per 2,000
Unit Units
Incremental revenue ......................................................... P12.00 P24,000
Incremental costs:

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Variable costs:
Direct materials ........................................................ 2.50 5,000
Direct labor ............................................................... 3.00 6,000
Variable manufacturing overhead ............................. 0.50 1,000
Variable selling and administrative........................... 1.50 3,000
Total variable cost......................................................... P 7.50 15,000

Fixed costs:
None affected by the special order ........................... 0
Total incremental cost ...................................................... 15,000
P
Incremental net operating income .................................... 9,000

Requirement 2

The relevant cost is P1.50 (the variable selling and administrative costs). All
other variable costs are sunk, since the units have already been produced. The
fixed costs would not be relevant, since they would not be affected by the sale
of leftover units.

Exercise 10 (Make or Buy a Component)

The costs that are relevant in a make-or-buy decision are those costs that can
be avoided as a result of purchasing from the outside. The analysis for this
exercise is:
Per Unit
Differential
Costs 20,000 Units
Make Buy Make Buy
Cost of purchasing ............................................ P23.50 P470,000
Cost of making:
Direct materials ............................................ P 4.80 P 96,000
Direct labor ................................................... 7.00 140,000
Variable manufacturing overhead ................. 3.20 64,000
Fixed manufacturing overhead ..................... 4.00 * 80,000
Total cost ...................................................... P19.00 P23.50 P380,000 P470,000

* The remaining P6 of fixed manufacturing overhead cost would not be relevant, since
it will continue regardless of whether the company makes or buys the parts.

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The P150,000 rental value of the space being used to produce part R-3
represents an opportunity cost of continuing to produce the part internally.
Thus, the completed analysis would be:
Make Buy
Total cost, as above............................................................... P380,000 P470,000
Rental value of the space (opportunity cost) ........................ 150,000
Total cost, including opportunity cost .................................. P530,000 P470,000

Net advantage in favor of buying ............................................... P60,000

Profits would increase by P60,000 if the outside supplier’s offer is accepted.

Exercise 11 (The Economists’ Approach to Pricing)

Requirement (1)

Cecile makes more money selling the ice cream cones at the lower price, as
shown below:
P17.90 P13.90
Price Price
Unit sales ................................................... 860 1,340

Sales ........................................................... P15,394.00 P18,626.00

Cost of goods sold @ P4.10 ....................... 3,526.00 5,494.00
Contribution margin ................................... 11,868.00 13,132.00
Fixed expenses ........................................... 425.00 425.00
Net operating income ................................. P11,443.00 P12,707.00

Requirement (2)

The price elasticity of demand is computed as follows:

d =
In(1 + % change in quantity sold)
In(1 + % change in price)
1,340 – 860
In(1 + )
860
=
13.90 – 17.90
In(1 + )
17.90
In(1 + 0.55814)
=
In(1 – 0.22346)
In(1.55814) 18-329
=
In(0.77654)
0.44349
= = –1.75
–0.25291
Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

Requirement (3)

The profit-maximizing price can be estimated using the following formulas:

Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 1.333
1 + (–1.75)
Profit-maximizing Profit-maximizing Variable cost
= 1 + x
price markup on variable cost per unit

= (1 + 1.3333) x P4.10 = P9.60

This price is much lower than the prices Cecile has been charging in the past.
Rather than immediately dropping the price to P9.60, it would be prudent to
drop the price a bit and see what happens to unit sales and to profits. The
formula assumes that the price elasticity is constant, which may not be the
case.

Exercise 12 (Target Costing)

Sales (50,000 batteries × P65 per battery) ............................... P3,250,000

Less desired profit (20% × P2,500,000) .................................. 500,000
Target cost for 50,000 batteries ............................................... P2,750,000

Target cost per battery = (P2,750,000 ÷ 50,000 batteries)

= P55 per battery

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Exercise 13 (Pricing a New Product)

The selling price of the new amaretto cappuccino product should at least cover
its variable cost and its opportunity cost. The variable cost of the new product
is P4.60 and its opportunity cost can be computed by multiplying the
opportunity cost of P34 per minute of order filling time by the amount of time
required to fill an order for the new product:

Selling price of Variable cost of

 +
the new product the new product

Opportunity cost Amounts of the constrained

per unit of the resource required by a unit
x
constrained resource of the new product

Selling price of 45 seconds

 P4.60 + P34 per minute +
the new product 60 seconds per minute

Selling price of
 P4.60 + P34 per minute + 0.75 minute
the new product

Selling price of
 P4.60 + P25.50 = P30.10
the new product
Hence, the selling price of the new product should at least cover both its variable
cost of P4.60 and its opportunity cost of P25.50, for a total of P30.10.

III. Problems

Problem 1 (Accept or Reject an Order)

Product A Product B
Selling price per unit P1.20 P1.40
Less Variable costs/unit:
Materials 0.50 0.70
Labor 0.20 0.24
Factory overhead (25%) 0.10 0.14

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0.80 1.08
Contribution margin/unit P0.40 P0.32
Multiplied by number of units to be sold 21,000 units 30,000 units
Total contribution margin P8,400 P9,600

Product B should be accepted because its total contribution margin is higher

than that of Product A.

Problem 2 (Eliminate or Retain a Product Line)

Requirement 1

No, production and sale of the round trampolines should not be discontinued.
Computations to support this answer follow:

Contribution margin lost if the round trampolines

are discontinued............................................. P(80,000)
Less fixed costs that can be avoided:
Advertising – traceable.................................. P41,000
Line supervisors’ salaries .............................. 6,000 47,000
Decrease in net operating income for the
company as a whole ...................................... P(33,000)

The depreciation of the special equipment represents a sunk cost, and therefore
it is not relevant to the decision. The general factory overhead is allocated and
will presumably continue regardless of whether or not the round trampolines
are discontinued; thus, it is not relevant.

Requirement 2

If management wants a clear picture of the profitability of the segments, the

general factory overhead should not be allocated. It is a common cost and
therefore should be deducted from the total product-line segment margin. A
more useful income statement format would be as follows:

Trampoline
Total Round Rectangular Octagonal
Sales ................................. P1,000,000 P140,000 P500,000 P360,000
Less variable expenses ..... 410,000 60,000 200,000 150,000

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Contribution margin ......... 590,000 80,000 300,000 210,000

Less fixed expenses:
Advertising – traceable. 216,000 41,000 110,000 65,000
Depreciation of special
equipment ................. 95,000 20,000 40,000 35,000
Line supervisors’
salaries ...................... 19,000 6,000 7,000 6,000
Total traceable fixed
expenses ....................... 330,000 67,000 157,000 106,000
Product-line segment
margin .......................... 260,000 P 13,000 P143,000 P104,000
Less common fixed
expenses ....................... 200,000
Net operating income
(loss) ............................. P 60,000

Problem 3 (Product Mix)

Requirement 1
Product Line
A B C D
Selling price per unit P30 P25 P10 P8
Variable cost per unit 25 10 5 4
Contribution margin / unit P5 P15 P 5 P4
Divided by no. of hours required
for each unit 5 hrs. 10 hrs. 4 hrs. 1 hr.
Contribution per hour P1 P1.5 P1.25 P4

Product ranking:
1. D 2. B 3. C 4. A

Based on the above analysis, first priority should be given to Product D. The
company should use 4,000 out of the available 96,000 hrs. to produce 4,000
units of product D. The remaining 92,000 hrs. should be used to produce 9,200
units of Product B. Hence, the best product combination is 4,000 units of
Product D and 9,200 units of Product B.

Requirement 2

If there were no market limitations on any of the products, the company should
use all the available 96,000 hours in producing 96,000 units of product D only.

The difference in profit between the two alternatives is computed as follows:

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Contribution margin of combination (1)

Product D (4,000 x P 4.00) P 16,000
Product B (9,200 x P15.00) 138,000
Total contribution margin of D and B P154,000
Less contribution margin of D only
(96,000 x P4) 384,000
Difference, excess over profit in combination (1) P230,000
Problem 4 (Accept or Reject a Special Order)

Requirement 1
The company should accept the special order of 4,000 @ P10 each because
this selling price is still higher than the additional variable cost to be incurred.
Whether or not variable marketing expenses will be incurred, the decision is
still to accept the order.

Supporting computations:
(a) Assume no additional variable marketing cost will be incurred.
Selling price per unit P10.00
Less variable manufacturing costs:
Direct materials P5.00
Direct labor 3.00
Variable overhead 0.75 8.75
Contribution margin/unit P 1.25
Multiplied by number of units of order 4,000 units
Total increase in profit P5,000
(b) Assume additional variable marketing cost will be incurred.
Selling price per unit P10.00
Less variable costs (P8.75 + P0.25) 9.00
Contribution margin / unit P 1.00
Multiplied by number of units of order 4,000 units
Total increase in contribution margin P4,000

Requirement 2
P8.75, the total variable manufacturing cost.

Requirement 3
Direct materials P5.00
Direct labor 3.00

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Variable factory overhead 0.75

Total cost of inventory under direct costing P8.75

Requirement 4

Present contribution margin

[10,000 units x (P15 - P9)] P60,000
Less proposed contribution margin
[(P14 - P9) x 11,000 units] 55,000
Decrease in contribution margin P 5,000
The company should not reduce the selling price from P15 to P14 even if
volume will go up because total contribution margin will decrease.

Problem 5 (CVP Analysis used for Decision Making)

Requirement (a)

Units sold per month No. of months Probability

4,000 6 20%
5,000 15 50%
6,000 9 30%
30 100%

Requirement (b)
Production
4,000 units 5,000 units 6,000 units
Sales (4,000 x P40) P160,000 P160,000 P160,000
Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 - - -
Total P100,000 P125,000 P150,000
Contribution margin P 60,000 P 35,000 P 10,000
Sales (5,000 x P40) P200,000 P200,000 P200,000
Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 45,000 - -
Total P145,000 P125,000 P150,000
Contribution margin P 55,000 P 75,000 P 50,000

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Sales (6,000 x P40) P240,000 P240,000 P240,000

Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 90,000 45,000 0
Total P190,000 P170,000 P150,000
Contribution margin P 50,000 P 70,000 P 90,000

Requirement (c)

Sales Order Contribution Margin Probability Expected Value

4,000 P35,000 0.20 P 7,000
5,000 75,000 0.50 37,500
6,000 70,000 0.30 21,000
Average Contribution Margin P65,500

Problem 6 (Pricing)

Requirement A:
Operating
Result at Full
2005 2006 Capacity
Sales P 100,000 P 400,000 P 480,000
Less Variable cost 130,000 520,000 624,000
Contribution margin (P 30,000) (P120,000) (P144,000)
Less Fixed cost 40,000 40,000 40,000
Net income (loss) (P 70,000) (P160,000) (P184,000)

The company had been operating at a loss because the product had been selling
with a negative contribution margin. Hence, the more units are sold, the higher
the loss will be.

Requirement B: P60.14

Requirement C: P74.29

Requirement D: P56.58

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Problem 7 (Make or Buy)

Cost of Making Cost of Buying

Outside purchase P90,000
Direct materials P15,000
Direct labor 30,000
Variable manufacturing overhead 10,000
Fixed manufacturing overhead* 15,000
Total cost P70,000 P90,000

* 1/3 x P45,000 = P15,000

Therefore, the annual advantage to make the parts is P20,000.

Problem 8 (Close or Retain a Store)

Requirement 1

The simplest approach to the solution is:

Gross margin lost if the store is closed .................................... P(228,000)

Less costs that can be avoided:
Direct advertising ................................................................ P36,000
Sales salaries ........................................................................ 45,000
Delivery salaries .................................................................. 7,000
Store rent ............................................................................. 65,000
Store management salaries (new employee would not be
hired to fill vacant position at another store) ................... 15,000
General office salaries ......................................................... 8,000
Utilities ................................................................................ 27,200
Insurance on inventories (2/3 × P9,000) .............................. 6,000
Employment taxes* ............................................................. 9,000 218,200
Decrease in company net operating income if the Ortigas
Store is closed ...................................................................... P( 9,800)

*Salaries avoided by closing the store:

Sales salaries ........................................................................................ P45,000
Delivery salaries ................................................................................... 7,000
Store management salaries ................................................................... 15,000
General office salaries .......................................................................... 8,000
Total salaries ........................................................................................ 75,000
Employment tax rate ............................................................................ × 12%

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Employment taxes avoided .................................................................. P 9,000

Requirement 2

The Ortigas Store should not be closed. If the store is closed, overall company
net operating income will decrease by P9,800 per quarter.

Requirement 3

The Ortigas Store should be closed if P200,000 of its sales are picked up by
the Makati Store. The net effect of the closure will be an increase in overall
company net operating income by P76,200 per quarter:
Gross margin lost if the Ortigas Store is closed ............................................ P(228,000)
Gross margin gained at the Makati Store:
P200,000 × 43% ....................................................................................... 86,000
Net loss in gross margin ................................................................................ (142,000)
Costs that can be avoided if the Ortigas Store is closed (part 1) ................... 218,200
Net advantage of closing the Ortigas Store ................................................... P 76,200

Problem 9 (Shutting Down or Continuing to Operate a Plant)

Requirement 1

Product KK-8 yields a contribution margin of P14 per gallon (P35 – P21 =
P14). If the plant closes, this contribution margin will be lost on the 22,000
gallons (11,000 gallons per month × 2 = 22,000 gallons) that could have been
sold during the two-month period. However, the company will be able to avoid
certain fixed costs as a result of closing down. The analysis is:
Contribution margin lost by closing the plant for two
months (P14 per gallon × 22,000 gallons).......................... P(308,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost
(P60,000 × 2 months = P120,000) ................................. P120,000
Fixed selling costs
(P310,000 × 10% × 2 months) ....................................... 62,000 182,000
Net disadvantage of closing, before start-up costs.................. (126,000)
Add start-up costs ................................................................... (14,000)
Disadvantage of closing the plant ........................................... P(140,000)
No, the company should not close the plant; it should continue to operate at
the reduced level of 11,000 gallons produced and sold each month. Closing

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will result in a P140,000 greater loss over the two-month period than if the
company continues to operate. Additional factors are the potential loss of
goodwill among the customers who need the 11,000 gallons of KK-8 each
month and the adverse effect on employee morale. By closing down, the needs
of customers will not be met (no inventories are on hand), and their business
may be permanently lost to another supplier.

Alternative Solution:
Difference—
Net
Operating
Income
Plant Kept Increase
Open Plant Closed (Decrease)
Sales (11,000 gallons × P35 per gallon × 2)............. P 770,000 P 0 P(770,000)
Less variable expenses (11,000
gallons × P21 per gallon × 2) .............................. 462,000 0 462,000
Contribution margin ................................................. 308,000 0 (308,000)
Less fixed costs:
Fixed manufacturing overhead cost
(P230,000 × 2;
P170,000 × 2) ................................................ 460,000 340,000 120,000
Fixed selling cost (P310,000 × 2; P310,000 ×
90% × 2) ......................................................... 620,000 558,000 62,000
Total fixed cost ........................................................ 1,080,000 898,000 182,000
Net operating loss before start-up costs ................... (772,000) (898,000) (126,000)
Start-up costs ........................................................... (14,000) (14,000)
Net operating loss .................................................... P (772,000) P(912,000) P(140,000)

Requirement 2

Ignoring the additional factors cited in part (1) above, Kristin Company should
be indifferent between closing down or continuing to operate if the level of
sales drops to 12,000 gallons (6,000 gallons per month) over the two-month
period. The computations are:

Cost avoided by closing the plant for two months (see above) ...... P182,000
Less start-up costs .......................................................................... 14,000
Net avoidable costs ......................................................................... P168,000

Net avoidable costs P168,000

=
Contribution margin per gallon P14 per gallon

= 12,000 gallons

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Verification: Operate at
12,000
Gallons Close for
for Two Two
Months Months
Sales (12,000 gallons × P35 per gallon) .................................. P 420,000 P 0
Less variable expenses (12,000 gallons × P21 per gallon) ...... 252,000 0
Contribution margin ................................................................. 168,000 0
Less fixed expenses:
Manufacturing overhead (P230,000 and P170,000 × 2
months) ............................................................................ 460,000 340,000
Selling (P310,000 and P279,000 × 2 months) ..................... 620,000 558,000
Total fixed expenses ................................................................. 1,080,000 898,000
Start-up costs............................................................................ 0 14,000
Total costs ................................................................................ 1,080,000 912,000
Net operating loss .................................................................... P (912,000) P(912,000)

Problem 10 (The Economists’ Approach to Pricing)

Requirement (1)

The postal service makes more money selling the souvenir sheets at the lower
price, as shown below:
P500 Price P600 Price
Unit sales .................................................. 50,000 40,000

Sales .......................................................... P25,000,000 P24,000,000

Cost of goods sold @ P60 per unit ........... 3,000,000 2,400,000
Contribution margin.................................. P22,000,000 P21,600,000

Requirement (2)

The price elasticity of demand, as defined in the text, is computed as follows:

d =
In(1 + % change in quantity sold)
In(1 + % change in price)
40,000 – 50,000
In(1 + )
50,000
=
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600.00 – 500.00
In(1 + )
500.00
In(1 – 0.2000)
=
In(1 + 0.2000)
In(0.8000)
=
In(1.2000)

= –0.2231
0.1823
= –1.2239

Requirement (3)

The profit-maximizing price can be estimated using the following formulas:

Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 4.4663
1 + (–1.2239)
Profit-maximizing Profit-maximizing Variable cost
= 1 + x
price markup on variable cost per unit

= (1 + 4.4663) x P60 = P328

This price is much lower than the price the postal service has been charging in
the past. Rather than immediately dropping the price to P328, it would be
prudent for the postal service to drop the price a bit and observe what happens
to unit sales and to profits. The formula assumes that the price elasticity of
demand is constant, which may not be true.

The critical assumption in the calculation of the profit-maximizing price is that

the percentage increase (decrease) in quantity sold is always the same for a
given percentage decrease (increase) in price. If this is true, we can estimate
the demand schedule for souvenir sheets as follows:
Price* Quantity Sold§
P600 40,000
P500 50,000
P417 62,500

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P348 78,125
P290 97,656
P242 122,070
P202 152,588
P168 190,735
P140 238,419
P117 298,024
*
The price in each cell in the table is computed by taking 5/6 of the price just
above it in the table. For example, P500 is 5/6 of P600 and P417 is 5/6 of P500.
§
The quantity sold in each cell of the table is computed by multiplying the
quantity sold just above it in the table by 50,000/40,000. For example, 62,500
is computed by multiplying 50,000 by the fraction 50,000/40,000.

The profit at each price in the above demand schedule can be computed as
follows:

Price Quantity Sales Cost of Sales Contribution

(a) Sold (b) (a) × (b) P60 × (b) Margin
P600 40,000 P24,000,000 P2,400,000 P21,600,000
P500 50,000 P250,00,000 P3,000,000 P22,000,000
P417 62,500 P26,062,500 P3,750,000 P22,312,500
P348 78,125 P27,187,500 P4,687,500 P22,500,000
P290 97,656 P28,320,200 P5,859,400 P22,460,800
P242 122,070 P29,540,900 P7,324,200 P22,216,700
P202 152,588 P30,822,800 P9,155,300 P21,667,500
P168 190,735 P32,043,500 P11,444,100 P20,599,400
P140 238,419 P33,378,700 P14,305,100 P19,073,600
P117 298,024 P34,868,800 P17,881,400 P16,987,400

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The contribution margin is plotted below as a function of the selling price:

23,000,000

22,000,000
Contribution Margin

21,000,000

20,000,000

19,000,000

18,000,000

17,000,000
100.00 200.00 300.00 400.00 500.00 600.00
Selling Price

The plot confirms that the profit-maximizing price is about P328.

Requirement (4)

If the postal service wants to maximize the contribution margin and profit from
sales of souvenir sheets, the new price should be:
Profit-maximizing price = 5.4663 × P70 = P383
Note that a P100 increase in cost has led to a P55 (P383 – P328) increase in
the profit-maximizing price. This is because the profit-maximizing price is
computed by multiplying the variable cost by 5.4663. Since the variable cost
has increased by P100, the profit-maximizing price has increased by P100 ×
5.4663, or P55.

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Some people may object to such a large increase in price as “unfair” and some
may even suggest that only the P10 increase in cost should be passed on to the
consumer. The enduring popularity of full-cost pricing may be explained to
some degree by the notion that prices should be “fair” rather than calculated
to maximize profits.

Problem 11 (Ranking Alternatives and Managing with a Constraint)

Requirement (1)

This problem can be solved by first computing the profitability index of each
customer and then ranking the customers based on that profitability index:
Ji Eun’s
Incremental Time Profitability
Profit Required Index
Customer (A) (B) (A) ÷ (B)
Lalaine P1,400 4 P350

Emily 1,240 4 P310

Anna 1,600 5 P320

Catherine 960 3 P320

Gee 1,900 5 P380

Ann

Lily 2,880 8 P360

Lourdes 930 3 P310

Ma. 1,360 4 P340

Cecilia

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Sheila 2,340 6 P390

Raya

Jane 2,040 6 P340

Cumulative
Ji Eun’s Amount of Ji
Profitability Time Eun’s Time
Customer Index Required Required
Sheila Raya ..... P390 6 6
Gee Ann .......... P380 5 11
Lily P360 8 19
Lalaine ............ P350 4 23
Jane P340 6 29
Ma. Cecilia ...... P340 4 27
Anna ................ P320 5 38
Catherine ......... P320 3 41
Emily ............... P310 4 45
Lourdes ........... P310 3 48
Given that Ji Eun should not be asked to work more than 33 hours, the four
customers below the line in the above table should be told that their
reservations have to be cancelled.

Requirement (2)

The total profit on wedding cakes for the weekend after canceling the four
reservations would be:

Sheila Raya ...... P 2,34

0
Gee Ann ........... 1,900
Lily 2,880
Lalaine ............. 1,400
Jane 2,040
Ma. Cecilia ....... 1,36
0

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Total ................. P11,92

0

Notes:
● Both Ji Eun’s time and the cakes would have to be very carefully scheduled
to make sure that all cakes are completed on time. We have assumed that
the 33 hours of Ji Eun’s time that are available for cake decorating do not
include hours that have been set aside as a buffer to provide protection
from inevitable disruptions in the schedule.
● If the cumulative amount of Ji Eun’s time required did not exactly consume
the total amount of time available, some adjustment might be required in
which reservations are cancelled to ensure that the most profitable plan is
selected.

Requirement (3)

To avoid disappointing customers, reservations should probably not be

accepted for any particular weekend after 33 hours of Ji Eun’s time have been
committed for that weekend’s cakes. To ensure that only the most profitable
cake reservations are accepted, a reservation for any cake with a profitability
index of less than P340 should probably not be accepted. This was the cutoff
point for the cakes in the first weekend in June. This cutoff may need to be
adjusted upward or downward over time—the cakes that were reserved for the
first weekend in June may not be representative of the cakes that would be
reserved for other weekends. If too many reservations are turned down and Ji
Eun’s time is not fully utilized, then the cutoff should be adjusted downward.
If too few reservations are turned down and Ji Eun’s time is once again
overbooked or profitable cake orders are turned away, then the cutoff should
be adjusted upward.

Requirement (4)

Ms. Hye Young should consider changing the way prices are set so that they
include a charge for Ji Eun’s time. On average, the prices may be the same,
but they should be based not only on the size of the cakes, but also on the
amount of cake decorating that the customer desires. The charge for Ji Eun’s
time should be her hourly rate of pay (including any fringe benefits) plus the
opportunity cost of at least P340 per hour. Because Ji Eun will not be working
more than 33 hours per week, if another cake reservation is accepted, some
other cake reservation will have to be cancelled. Ms. Hye Young would have

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to give up at least P34 profit per hour to accept another cake reservation.

Requirement (5)

Making Ji Eun happy involves not asking her to work more than 33 hours per
week decorating cakes. Making customers happy involves not canceling their
reservations, not raising prices, and providing top quality wedding cakes. Ms.
Hye Young can accomplish both of these objectives and increase her profits
by clever management of the constraint—Ji Eun’s time. The possibilities
include:
 Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on
unnecessary tasks. For example, Ji Eun should not be asked to cream butter
by hand for frostings if a machine could do the job as well with less labor
time.
 Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on
tasks that can be done by other persons. For example, an assistant can be
assigned to prepare frosting and to clean up, relieving Ji Eun of those tasks.
As long as the cost of the assistant’s time is less than P34 per hour, the
result will be higher profits and more pleased customers.
 Ms. Hye Young should consider assigning an apprentice to Ji Eun. The
apprentice could relieve Ji Eun of some of her workload while learning the
skills to eventually expand the company’s cake decorating capacity.
 Ms. Hye Young might consider subcontracting some of the less demanding
cake decorating to another baker. This would be profitable as long as the
charge is less than P340 per hour.
IV. Multiple Choice Questions
1. C 11. D 21. D 31. A
2. C 12. A 22. A 32. D
3. B 13. D 23. D 33. C
4. B 14. A 24. E 34. A
5. A 15. D 25. B 35. C
6. B 16. C 26. D
7. C 17. A 27. D
8. B 18. C 28. C
9. A 19. B 29. A
10. B 20. C 30. A

Supporting computations for nos. 16 - 29:

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16. Sales [(100,000 x 90%) x (P5.00 x 120%)] P540,000

Less: Variable costs (P300,000 x 90%) 270,000
Contribution margin P270,000
Less: Fixed costs 150,000
Operating income P120,000

17. Direct materials P 4

Direct labor 5
Overhead 2
Selling cost 3
Minimum selling price per unit P14

18. Relevant cost to make (10,000 x P24) P240,000

Purchase cost P300,000
Less: Savings in manufacturing cost P45,000
Avoidable fixed overhead 50,000 95,000
Net purchase price P205,000
Difference in favor of “buy” alternative P 35,000

19. Increase in sales (60,000 x P3) P180,000

Less: Increase in variable cost (60,000 x P2.50) 150,000
Net increase in income P 30,000
20. R S T
Sales (10,000 x P20) P200,000 P200,000 P200,000
Less: Variable costs
R (P12 x 10,000) 120,000
S (P 8 x 10,000) 80,000
T (P 4 x 10,000) 40,000
Contribution margin P 80,000 P120,000 P160,000

21. R S T
Sales (P16 x 15,000) P240,000 P240,000 P240,000
Less: Variable costs
R (P12 x 15,000) 180,000
S (P 8 x 15,000) 120,000
T (P 4 x 15,000) 60,000
Contribution margin P 60,000 P120,000 P180,000
Less: Fixed costs 40,000 80,000 120,000
Operating income P 20,000 P 40,000 P 60,000

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22. Old operating income:

Contribution margin P80,000
Less: Fixed cost 40,000
P40,000
New operating income 20,000
Difference - decrease P20,000

23. Sales P1,200,000

Less: Variable costs
Direct materials P300,000
Direct labor 400,000
Factory overhead 80,000
Marketing expenses 70,000
Administrative expenses 50,000 900,000
Contribution margin P 300,000
Less: Fixed costs
Factory overhead P 50,000
Marketing expenses 30,000
Administrative expenses 20,000
Increase in fixed costs 10,000 110,000
Profit P 190,000

24. Sales P1,200,000

Less: Variable costs
Direct materials P275,000
Direct labor 375,000
Factory overhead 80,000
Marketing expenses 70,000
Administrative expenses 50,000 850,000
Contribution margin P 350,000
Less: Fixed costs
Factory overhead P 50,000
Marketing expenses 30,000
Administrative expenses 20,000
Decrease in fixed costs
(P25,000  4) (6,250) 93,750
Profit P 256,250

25. Direct materials (P2 x 5,000) P10,000

Direct labor (P8 x 5,000) 40,000
Variable overhead (P4 x 5,000) 20,000

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Total variable costs P70,000

Add: Avoidable fixed overhead 10,000
Total P80,000
26. Avoidable fixed overhead P 4
Direct materials 4
Direct labor 16
Variable overhead 18
Total P42
Multiplied by: Number of units to be produced 20,000
Total relevant costs to make the part P840,000

27. Purchase cost (P1.25 x 10,000) P12,500

Variable costs to make 10,000
Savings of making the blade P 2,500
28. Selling price per unit P17
Less: Variable costs of goods sold per unit
([P320,000 - P80,000]  20,000 units) 12
Contribution margin per unit P 5
Multiplied by units to be sold under Special Order 2,000
Increase in operating income P10,000
29. Budgeted operating income:
Contribution margin (P2,000,000 x 30%) P600,000
Less fixed costs 400,000
Net operating income P200,000
Operating income under the proposal:
Sales P2,000,000
Less Variable costs
([70% x P2,000,000] x 80%) 1,120,000
Contribution margin P 880,000
Less fixed costs 520,000 360,000
Increase in budgeted operating profit P160,000

CHAPTER 20

CAPITAL BUDGETING DECISIONS

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I. Questions
1. A capital investment involves a current commitment of funds with the
expectation of generating a satisfactory return on these funds over a
relatively extended period of time in the future.
2. Cost of capital is the weighted minimum desired average rate that a
company must pay for long-term capital while discounted rate of return is
the maximum rate of interest that could be paid for the capital employed
over the life of an investment without loss on the project.
3. The basic principles in capital budgeting are:
1. Capital investment models are focused on the future cash inflows and
outflows - rather than on net income.
2. Investment proposals should be evaluated according to their
differential effects on the company’s cash flows as a whole.
3. Financing costs associated with the project are excluded in the analysis
of incremental cash flows in order to avoid the “double-counting” of
the cost of money.
4. The concept of the time value of money recognizes that a peso of
present return is worth more than a peso of future return.
5. Choose the investments that will maximize the total net present value
of the projects subject to the capital availability constraint.
4. The major classifications as to purpose are:
1. Replacement projects
- those involving replacements of worn-out assets to avoid
disruption of normal operations, or to improve efficiency.
2. Product or process improvement
- projects that aim to produce additional revenue or to realize cost
savings.
3. Expansion
- projects that enhance long-term returns due to increased profitable
volume.
5. Greater amounts of capital may be used in projects whose combined
returns will exceed any alternate combination of total investment.
6. No. This implies that any equity funds are cost free and this is a dangerous
position because it ignores the opportunity cost or alternative earnings that
could be had from the fund.
7. Yes, if there are alternative earnings foregone by stockholders.

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8. Capital budgeting screening decisions concern whether a proposed

investment project passes a preset hurdle, such as a 15% rate of return.
Capital budgeting preference decisions are concerned with choosing from
among two or more alternative investment projects, each of which has
passed the hurdle.
9. The “time value of money” refers to the fact that a peso received today is
more valuable than a peso received in the future. A peso received today
can be invested to yield more than a peso in the future.
10. Discounting is the process of computing the present value of a future cash
flow. Discounting gives recognition to the time value of money and makes
it possible to meaningfully add together cash flows that occur at different
times.
11. Accounting net income is based on accruals rather than on cash flows. Both
the net present value and internal rate of return methods focus on cash
flows.
12. One simplifying assumption is that all cash flows occur at the end of a
period. Another is that all cash flows generated by an investment project
are immediately reinvested at a rate of return equal to the discount rate.
13. No. The cost of capital is not simply the interest paid on long-term debt.
The cost of capital is a weighted average of the individual costs of all
sources of financing, both debt and equity.
14. The internal rate of return is the rate of return on an investment project
over its life. It is computed by finding that discount rate that results in a
zero net present value for the project.
15. The project profitability index is computed by dividing the net present
value of the cash flows from an investment project by the investment
required. The index measures the profit (in terms of net present value)
provided by each peso of investment in a project. The higher the project
profitability index, the more desirable is the investment project.
16. Neither the payback method nor the simple rate of return method considers
the time value of money. Under both methods, a peso received in the future
is weighed the same as a peso received today. Furthermore, the payback
method ignores all cash flows that occur after the initial investment has
been recovered.

II. Matching Type

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1. A 6. H
2. C 7. D
3. F 8. G
4. B 9. J
5. I 10. E

III. Exercises

Exercise 1 (Simple Rate of Return Method)

The annual incremental net operating income is determined by comparing the

operating cost of the old machine to the operating cost of the new machine and
the depreciation that would be taken on the new machine:

Operating cost of old machine.......................................... P33,000

Less operating cost of new machine................................. 10,000
Less annual depreciation on the new machine (P80,000
÷ 10 years) .................................................................... 8,000
Annual incremental net operating income ........................ P15,000

Cost of the new machine .................................................. P80,000

Less scrap value of old machine....................................... 5,000
Initial investment .............................................................. P75,000

Simple rate Annual incremental net operating income

of return =
Initial investment
P15,000
= = 20%
P75,000
Exercise 2 (Basic Present Value Concepts)

1. a. P400,000 × 0.794 = P317,600.

b. P400,000 × 0.712 = P284,800.

2. a. P5,000 × 4.355 = P21,775.

b. P5,000 × 3.685 = P18,425.

3. The factor for 10% for 20 years is 8.514. Thus, the present value of
Tom’s winnings would be:

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P50,000 × 8.514 = P425,700.

Whether or not Tom really won a million pesos depends on your point of
view. She will receive a million pesos over the next 20 years; however, in
terms of its value right now she won much less than a million pesos as
shown by the present value computation above.

Exercise 3 (After-Tax Costs)

a. Management consulting fee ............................ P100,000

Multiply by 1 – 0.30 ........................................ × 0.70
After-tax cost ................................................... P 70,000

b. Increased revenues .......................................... P40,000

Multiply by 1 – 0.30 ........................................ × 0.70
After-tax cash flow (benefit) ........................... P28,000

c. The depreciation deduction is P210,000 ÷ 7 years = P30,000 per year,

which has the effect of reducing taxes by 30% of that amount, or P9,000
per year.

Exercise 4 (Basic Net Present Value Analysis)

Amount of
12% Present Value
Year(s) Cash Flows
Factor of Cash Flows
Purchase of the stock....... Now P(18,000)
1.000 P(18,000)
Annual dividends* .......... 1-4 P720
3.037 2,187
Sale of the stock .............. 4 P22,500
0.636 14,310
Net present value ............. P( 1,503)
*900 shares × P0.80 per share per year = P720 per year.

No, Ms. Cruz did not earn a 12% return on the share. The negative net present
value indicates that the rate of return on the investment is less than the discount
rate of 12%.

Exercise 5 (Internal Rate of Return and Net Present Value)

Factor of the internal Required investment

rate of return =
Annual cash inflow
P136,700
= = 5.468
P25,000
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1.

A factor of 5.468 represents an internal rate of return of 16%.

2. Amount of 16% Present Value

Item Year(s) Cash Flows Factor of Cash Flows
Initial investment ............ Now P(136,700) 1.000 P(136,700)
Net annual cash inflows .. 1-14 P25,000 5.468 136,700
Net present value............. P 0

The reason for the zero net present value is that 16% (the discount rate)
represents the machine’s internal rate of return. The internal rate of return is
the rate that causes the present value of a project’s cash inflows to just equal
the present value of the investment required.

3. Factor of the internal Required investment

rate of return =
Annual cash inflow
P136,700
= = 6.835
P20,000
The 6.835 factor is closest to 6.982, the factor for the 11% rate of return. Thus,
to the nearest whole percent, the internal rate of return is 11%.

Exercise 6 (Basic Net Present Value and Internal Rate of Return Analysis)

1. Amount of 15% Present Value of

Item Year(s) Cash Flows Factor Cash Flows
Initial investment ......... Now P(40,350) 1.000 P(40,350)
Annual cash inflows .... 1-4 P15,000 2.855 42,825
Net present value ......... P 2,475

Yes, this is an acceptable investment. Its net present value is positive, which

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indicates that its rate of return exceeds the minimum 15% rate of return
required by the company.

2. Factor of the internal Investment required

rate of return =
Net annual cash inflow
P111,500
= = 5.575
P20,000

A factor of 5.575 represents an internal rate of return of 16%.

3. Factor of the internal Investment required

rate of return =
Net annual cash inflow
P14,125
= = 5.650
P2,500
A factor of 5.650 represents an internal rate of return of 12%. The company
did not make a wise investment because the return promised by the
machine is less than the required rate of return

IV. Problems

Problem 1 (Equipment Replacement Sensitivity Analysis)

Requirement 1
Total Present Value
A. New Situation:
Recurring cash operating costs (P26,500 x 2.69) P 71,285
Cost of new equipment 44,000
Disposal value of old equipment now (5,000)
Present value of net cash outflows P110,285
B. Present Situation:
Recurring cash operating costs (P45,000 x 2.69) P121,050
Disposal value of old equipment four years hence
(P2,600 x 0.516) (1,342)
Present value of net cash inflows P119,708
Difference in favor of replacement P 9,423

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Requirement 2
P44,000 – P5,000
Payback period for the new equipment =
P18,500
= 2.1 years
Requirement 3

Let X = annual cash savings

Let O = net present value

X (2.69) + P5,000 - P44,000 - P1,342 = O

2.69X = P40,342
X = P14,997

If the annual cash savings decrease from P18,850 to P14,997 or by P3,503, the
point of indifference will be reached.

Another alternative way to get the same answer would be to divide the net
present value of P9,423 by 2.690.

Problem 2

Annual cash expenses of the manual bookkeeping

machine system, P9,800 x 12 P117,600
Annual cash expenses of computerized data processing 53,600
Annual cash savings before taxes P 64,000

Year 1 Year 2 Year 3

Annual cash savings (a) P64,000 P64,000 P64,000
Depreciation 20,000 16,000 12,800
Inflow before tax P44,000 P48,000 P51,200
Income tax (50%) (b) 22,000 24,000 25,600
Cash inflow after tax (a - b) P42,000 P40,000 P38,400

After Tax
Cash Inflows PV Factor PV
Year 1 P42,000 x 0.909 P 38,178
Year 2 40,000 x 0.826 33,040
Year 3 38,400 x 0.750 28,800
Year 3 Salvage 20,000 x 0.750 15,000
Year 3 Tax loss 15,600* x 0.750 11,700

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P126,718
Investment (I) 100,000
Net present value (NPV) P 26,718
_________________
* The P15,600 tax benefit of the loss on the disposal of the computer at the end of
year 3 is computed as follows:
Estimated salvage value P 20,000
Estimated book value:
Historical cost P100,000
Accumulated depreciation 48,800 51,200
Estimated loss P(31,200)

Tax rate 50%

Tax effect of estimated loss P(15,600)

Since the net present value is positive, the computer should be purchased
replacing the manual bookkeeping system.

Problem 3

Requirement 1

(a) Purchase price of new equipment P(300,000)

Disposal of existing equipment:
Selling price P 0
Book value 60,000
Loss on disposal P60,000
Tax rate 0.4
Tax benefit of loss on disposal 24,000
Required investment (I) P(276,000)

(b) Increased cash flows resulting from

change in contribution margin:
Using new equipment [18,000 (P20 - P7)] * P234,000
Using existing equipment [11,000 (P20 - P9)] 121,000
Increased cash flows 113,000
Less: Taxes (0.40 x P113,000) 45,200
Increased cash flows after taxes P 67,800
Depreciation tax shield:
Depreciation on new equipment

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(P300,000  5) P60,000
Depreciation on existing equipment
(P60,000  5) 12,000
Increased depreciation charge P48,000
Tax rate 0.40
Depreciation tax shield 19,200
Recurring annual cash flows P 87,000
_________________
* The new equipment is capable of producing 20,000 units, but ETC Products can
sell only 18,000 units annually.
The sales manager made several errors in his calculations of required investment
and annual cash flows. The errors are as follows:
Required investment:
- The cost of the market research study (P44,000) is a sunk cost because it was
incurred last year and will not change regardless of whether the investment
is made or not.
- The loss on the disposal of the existing equipment does not result in an actual
cash cost as shown by the sales manager. The loss on disposal results in a
reduction of taxes, which reduces the cost of the new equipment.
Annual cash flows:
- The sales manager considered only the depreciation on the new equipment
rather than just the additional depreciation which would result from the
acquisition of the new equipment.
- The sales manager also failed to consider that the depreciation is a noncash
expenditure which provides a tax shield.
- The sales manager’s use of the discount rate (i.e., cost of capital) was
incorrect. The discount rate should be used to reduce the value of future cash
flows to their current equivalent at time period zero.

Requirement 2

Present value of future cash flows (P87,000 x 3.36) P292,320

Required investment (I) 276,000
Net present value P 16,320

Problem 4

Requirement 1: P(507,000)

Requirement 2: P(466,200)

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Requirement 3: P(23,400)

Problem 5

1. The net annual cost savings is computed as follows:

Reduction in labor costs .......................................................... P240,000

Reduction in material costs ..................................................... 96,000
Total cost reductions................................................................ 336,000
Less increased maintenance costs (P4,250 × 12) .................... 51,000
Net annual cost savings ........................................................... P285,000

2. Using this cost savings figure, and other data provided in the text, the net
present value analysis is:
Present
Amount of 18% Value of
Year(s) Cash Flows Factor Cash Flows
Cost of the machine ................. Now P(900,000) 1.000 P (900,000)
Installation and software .......... Now P(650,000) 1.000 (650,000)
Salvage of the old machine ...... Now P70,000 1.000 70,000
Annual cost savings ................. 1-10 P285,000 4.494 1,280,790
Overhaul required .................... 6 P(90,000) 0.370 (33,300)
Salvage of the new machine .... 10 P210,000 0.191 40,110
Net present value ..................... P (192,400)

No, the etching machine should not be purchased. It has a negative net
present value at an 18% discount rate.

3. The intangible benefits would have to be worth at least P42,813 per year
as shown below:
Required increase in net present value P192,400
= = P42,813
Factor for 10 years 4.494
Thus, the new etching machine should be purchased if management
believes that the intangible benefits are worth at least P42,813 per year to
the company.

Problem 6

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(1) × (2) Present

(2) After-Tax Value of
(1) Tax Cash 12% Cash
Items and Computations Year(s) Amount Effect Flows Factor Flows
Investment in new trucks...................... Now P(450,000) P(450,000) 1.000 P(450,000)
Salvage from sale of the old trucks ...... Now P30,000 1 – 0.30 P21,000 1.000 21,000
Net annual cash receipts ...................... 1-8 P108,000 1 – 0.30 P75,600 4.968 375,581
Depreciation deductions* ..................... 1-8 P56,250 0.30 P16,875 4.968 83,835
Overhaul of motors ............................... 5 P(45,000) 1 – 0.30 P(31,500) 0.567 (17,861)
Salvage from the new trucks ................ 8 P20,000 1 – 0.30 P14,000 0.404 5,656
Net present value ................................. P 18,211

* P450,000 ÷ 8 years = P56,250 per year

Since the project has a positive net present value, the contract should be
accepted.
Problem 7

1. Factor of the internal Required investment

rate of return =
Annual cash inflow
P142,950
= = 3.812
P37,500
A factor of 3.812 equals an 18% rate of return.

Verification of the 18% rate of return:

Amount of Present Value

Cash 18% of Cash
Item Year(s) Flows Factor Flows
Investment in equipment ....... Now P(142,950) 1.000 P(142,950)
Annual cash inflows .............. 1-7 P37,500 3.812 142,950
Net present value ................... P 0

2.
Factor of the internal Required investment
rate of return =
Annual cash inflow

We know that the investment is P142,950, and we can determine the factor for
an internal rate of return of 14% by looking at the PV table along the 7-period
line. This factor is 4.288. Using these figures in the formula, we get:
P142,950
= 4.288
Annual cash inflow

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Therefore, the annual cash inflow would have to be:

P142,950 ÷ 4.288 = P33,337.

3. a. 5-year life for the equipment:

The factor for the internal rate of return would still be 3.812 [as computed
in (1) above]. Reading along the 5-period line of the PV table, a factor of
3.812 is closest to 3.791, the factor for 10%. Thus, to the nearest whole
percent, the internal rate of return is 10%.

b. 9-year life for the equipment:

The factor of the internal rate of return would again be 3.812. From the PV
table, reading along the 9-period line, a factor of 3.812 is closest to 3.786,
the factor for 22%. Thus, to the nearest whole percent, the internal rate of
return is 22%.

The 10% return in part (a) is less than the 14% minimum return that Dr.
Blue wants to earn on the project. Of equal or even greater importance, the
following diagram should be pointed out to Dr. Blue:

As this illustration shows, a decrease in years has a much greater impact

on the rate of return than an increase in years. This is because of the time
value of money; added cash inflows far into the future do little to enhance
the rate of return, but loss of cash inflows in the near term can do much to
reduce it. Therefore, Dr. Blue should be very concerned about any potential
decrease in the life of the equipment, while at the same time realizing that
any increase in the life of the equipment will do little to enhance her rate
of return.

4. a. The expected annual cash inflow would be:

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P37,500 x 120% = P45,000

P142,950
= 3.177
P45,000

Reading along the 7-period line of the PV table, a factor of 3.177 is closest
to 3.161, the factor for 25%, and is between that factor and the factor for
24%. Thus, to the nearest whole percent, the internal rate of return is 25%.

b. The expected annual cash inflow would be:

P37,500 x 80% = P30,000

P142,950
= 4.765
P30,000

Reading along the 7-period line of the PV table, a factor of 4.765 is closest
to 4.712, the factor for 11%. Thus, to the nearest whole percent, the internal
rate of return is 11%.

Unlike changes in time, increases and decreases in cash flows at a given

point in time have basically the same impact on the rate of return, as shown
below:

5. Since the cash flows are not even over the five-year period (there is an extra
P61,375 cash inflow from sale of the equipment at the end of the fifth year),
some other method must be used to compute the internal rate of return. Using
trial-and-error or more sophisticated methods, it turns out that the actual
internal rate of return will be 12%:

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Amount of Present
Cash 12% Value of
Item Year(s) Flows Factor Cash Flows
Investment in the equipment ........ Now P(142,950) 1.000 P(142,950)
Annual cash inflow ...................... 1-5 P30,000 3.605 108,150
Sale of the equipment ................... 5 P61,375 0.567 34,800
Net present value .......................... P 0

Problem 8

1. The income statement would be:

Sales revenue....................................................... P200,000

Less commissions (40% × P200,000) ................. 80,000
Contribution margin ............................................ 120,000
Less fixed expenses:
Maintenance .................................................... P50,000
Insurance ......................................................... 10,000
Depreciation* .................................................. 36,000
Total fixed expenses ............................................ 96,000
Net operating income .......................................... P 24,000

*P180,000 ÷ 5 years = P36,000 per year

2. The initial investment in the simple rate of return calculations is net of the
salvage value of the old equipment as shown below:

Simple Annual incremental net operating income

rate of return =
Initial investment

Yes, the games=would beP24,000

purchased. The return P24,000
= exceeds the 14% =threshold
16% set
by the company. P180,000 – P30,000 P150,000

3. The payback period would be:

Payback Investment required

period =
Net annual cash inflow
P180,000 – P30,000 P150,000
= = = 2.5 years
P60,000* P60,000
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*Net annual cash inflow = Net operating income + Depreciation

= P24,000 + P36,000 = P60,000.

Yes, the games would be purchased. The payback period is less than the 3
years.

IV. Multiple Choice Questions

1. D 11. D 21. C 31. D

2. C 12. D 22. B 32. C
3. B 13. D 23. C 33. C
4. B 14. C 24. D 34. D
5. A 15. C 25. C 35. D
6. C 16. D 26. C 36. B
7. D 17. D 27. D 37. B
8. B 18. B 28. B 38. B
9. B 19. A 29. D 39. D
10. A 20. A 30. A 40. B

CHAPTER 21

DECENTRALIZED OPERATIONS AND

SEGMENT REPORTING
I. Questions
1. Decentralization means that decision making in an organization isn’t
confined to a few top executives, but rather is spread throughout the
organization with managers at various levels making key operating
decisions relating to their sphere of responsibility.
2. The benefits include: (1) a spreading of decision-making responsibility
among managers, thereby relieving top management from day-to-day
problem solving and allowing them to focus their time on long-range
planning; (2) training in decision making for lower-level managers,
thereby preparing them to assume greater responsibility; (3) greater job
satisfaction and greater incentive for lower-level managers; (4) better

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decisions, since decisions are made at the level where the problem is best
understood; and (5) a more effective basis for measuring managerial
performance through the creation of profit and investment centers.
3. The three business practices are (a) omission of some costs in the
assignment process, (b) the use of inappropriate allocation methods, and
(c) allocation of common costs to segments.
4. The contribution margin represents the portion of sales revenue
remaining after deducting variable expenses. The segment margin
represents the margin still remaining after deducting traceable fixed
expenses from the contribution margin. Generally speaking, the
contribution margin is most useful as a planning tool in the short run,
when fixed costs don’t change. The segment margin is most useful as a
planning tool in the long run, when fixed costs will be changing, and as a
tool for evaluating long-run segment performance. One concept is no
more useful to management than the other; the two concepts simply relate
to different planning horizons.
5. A segment is any part or activity of an organization about which a
manager seeks cost, revenue, or profit data. Examples of segments
include departments, operations, sales territories, divisions, product lines,
and so forth.
6. Under the contribution approach, costs are assigned to a segment if and
only if the costs are traceable to the segment (i.e., could be avoided if the
segment were eliminated). Common costs are not allocated to segments
under the contribution approach.
7. A traceable cost of a segment is a cost that arises specifically because of
the existence of that segment. If the segment were eliminated, the cost
would disappear. A common cost, by contrast, is a cost that supports more
than one segment, but is not traceable in whole or in part to any one of
the segments. If the departments of a company are treated as segments,
then examples of the traceable costs of a department would include the
salary of the department’s supervisor, depreciation of machines used
exclusively by the department, and the costs of supplies used by the
department. Examples of common costs would include the salary of the
general counsel of the entire company, the lease cost of the headquarters
building, corporate image advertising, and periodic depreciation of
machines shared by several departments.

II. Problems

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Problem 1 (Working with a Segmented Income Statement)

Requirement 1

P75,000 × 40% CM ratio = P30,000 increased contribution margin in Cebu.

Since the fixed costs in the office and in the company as a whole will not
change, the entire P30,000 would result in increased net operating income for
the company.

It is incorrect to multiply the P75,000 increase in sales by Cebu’s 25% segment

margin ratio. This approach assumes that the segment’s traceable fixed
expenses increase in proportion to sales, but if they did, they would not be
fixed.

Requirement 2

a. The segmented income statement follows:

Segments
Total Company Manila Cebu
Amount % Amount % Amount %
Sales ...................................... P800,00 100.0 P200,00 100 P600,00 100
0 % 0 % 0 %
Less variable expenses ..........
420,000 52.5 60,000 30 360,000 60
Contribution margin .............. 380,000 47.5 140,000 70 240,000 40
Less traceable fixed
expenses ............................
168,000 21.0 78,000 39 90,000 15
Office segment margin .......... 212,000 26.5 P 62,000 P150,00
31% 0 25%
Less common fixed expenses
not traceable to segments ...

120,000 15.0
Net operating income ............ P 92,000
11.5%

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b. The segment margin ratio rises and falls as sales rise and fall due to the
presence of fixed costs. The fixed expenses are spread over a larger base
as sales increase.

In contrast to the segment ratio, the contribution margin ratio is a stable

figure so long as there is no change in either the variable expenses or the
selling price of a unit of service.

Problem 2 (Segmented Income Statement)

Requirement 1
Geographic Market
Total Company East Central West
Amount % Amount % Amount % Amount %
Sales ................................................ P1,500,000 100.0 P400,000 100 P600,000 100 P500,000 100
Less variable expenses ...................... 588,000 39.2 208,000 52 180,000 30 200,000 40
Contribution margin .......................... 912,000 60.8 192,000 48 420,000 70 300,000 60
Less traceable fixed expenses ............ 770,000 51.3 240,000 60 330,000 55 200,000 40
Geographic market segment margin .. 142,000 9.5 P(48,000) (12) P 90,000 15 P100,000 20
Less common fixed expenses not
traceable to geographic markets* . 175,000 11.7
Net operating income (loss)............... P (33,000) (2.2)

* P945,000 – P770,000 = P175,000.

Requirement 2

Incremental sales (P600,000 × 15%).................................................... P90,000

Contribution margin ratio ..................................................................... × 70%
Incremental contribution margin .......................................................... 63,000
Less incremental advertising expense .................................................. 25,000
Incremental net operating income ........................................................ P38,000

Yes, the advertising program should be initiated.

Problem 3 (Basic Segmented Income Statement)

Total CD DVD
Sales* ......................................................... P750,000 P300,000 P450,000
Variable expenses** ................................... 435,000 120,000 315,000
Contribution margin ................................... 315,000 180,000 135,000

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Traceable fixed expenses ........................... 183,000 138,000 45,000

Product line segment margin ...................... 132,000 P 42,000 P 90,000
Common fixed expenses not traceable to
products .................................................. 105,000
Net operating income ................................. P 27,000

* CD: 37,500 packs × P8.00 per pack = P300,000;

DVD: 18,000 packs × P25.00 per pack= P450,000.
** CD: 37,500 packs × P3.20 per pack = P120,000;
DVD: 18,000 packs × P17.50 per pack= P315,000.

III. Multiple Choice Questions

1. B 6. A 11. A
2. C 7. C 12. B
3. B 8. B
4. B 9. D
5. B 10. C

CHAPTER 22

BUSINESS PLANNING

I. Questions
1. Strategy, plans, and budgets are interrelated and affect one another.
Strategy describes how an organization matches its own capabilities with
the opportunities in the marketplace to accomplish its overall objectives.
Strategy analysis underlies both long-run and short-run planning. In turn,
these plans lead to the formulation of budgets. Budgets provide feedback
to managers about the likely effects of their strategic plans. Managers
use this feedback to revise their strategic plans.
2. Budgeted performance is better than past performance for judging
managers. Why? Mainly because the inefficiencies included in past
results can be detected and eliminated in budgeting. Also, new
opportunities in the future, which did not exist in the past, may be ignored
if past performance is used.

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3. A company that shares its own internal budget information with other
companies can gain multiple benefits. One benefit is better coordination
with suppliers, which can reduce the likelihood of supply shortages.
Better coordination with customers can result in increased sales as
demand by customers is less likely to exceed supply. Better coordination
across the whole supply chain can also help a company reduce inventories
and thus reduce the costs of holding inventories.
4. The sales forecast is typically the cornerstone for budgeting, because
production (and, hence, costs) and inventory levels generally depend on
the forecasted level of sales.
5. Sensitivity analysis adds an extra dimension to budgeting. It enables
managers to examine how budgeted amounts change with changes in the
underlying assumptions. This assists managers to monitor those
assumptions that are most critical to a company attaining its budget or
make timely adjustments to plans when appropriate.

6. Factors reducing the effectiveness of budgeting of companies include:

1. Lack of a well-defined strategy,
2. Lack of a clear linkage of strategy to operational plans,
3. Lack of individual accountability for results, and
4. Lack of meaningful performance measures.

II. Problems

Problem 1 (Budgeted Income Statement)

Globalcom Company
Budgeted Income Statement for 2006
(in thousands)

Net sales P6,996

Equipment (P6,000 x 1.06 x 1.10) 1,908
Maintenance contracts (P1,800 x 1.06)
Total net sales P8,904
Cost of goods sold (P4,600 x 1.03 x 1.06) 5,022
Gross margin 3,882
Operating costs:
Marketing costs (P600 + P250) 850
Distribution costs (P150 x 1.06) 159

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Customer maintenance costs (P1,000 + P130) 1,130

Administrative costs 900
Total operating costs 3,039
Operating income P 843

Problem 2 (Comprehensive Operating Budget)

Requirement 1

Schedule 1: Revenue Budget

For the Year Ended December 31, 2006

Units Selling Price Total Revenues

Skateboards 1,000 P450 P450,000
Total

Requirement 2

Schedule 2: Production Budget (in Units)

for the Year Ended December 31, 2006
Skateboards
Budgeted unit sales (Schedule 1) 1,000
Add target ending finished goods inventory 200
Total requirements 1,200
Deduct beginning finished goods inventory 100
Units to be produced 1,100

Requirement 3

Schedule 3A: Direct Materials Usage Budget

For the Year Ended December 31, 2006
Wood Fiberglass Total
Physical Budget
To be used in production 5,500
(Wood: 1,100 x 5.00 b.f.
Fiberglass: 1,100 x 6.00 yards) 6,600
5,500 6,600
Cost Budget
Available from beginning inventory
(Wood: 2,000 b.f. x P28.00 56,000
Fiberglass: 1,000 b.f. x 4.80) 4,800

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To be used from purchases this period

(Wood: (5,500 – 2,000) x P30.00 105,000
Fiberglass: (6,600 – 1,000) x 28,000
P5.00)
Total cost of direct materials to be P161,000 P32,800 P193,800
used

Schedule 3B: Direct Materials Purchases Budget

For the Year Ended December 31, 2006
Wood Fiberglass Total
Physical Budget
Production usage (from Schedule 3A) 5,500 6,600
Add target ending inventory 1,500 2,000
Total requirements 7,000 8,600
Deduct beginning inventory 2,000 1,000
Purchases 5,000 7,600
Cost Budget
(Wood: 5,000 x P30.00 P150,000
Fiberglass: 7,600 x P5.00) P38,000
P150,000 P38,000 P188,000
Requirement 4

Schedule 4: Direct Manufacturing Labor Budget

For the Year Ended December 31, 2006

Cost Driver DML Hours per Total Wage

Labor Category Units Driver Unit Hours Rate Total
Manufacturing labor 1,100 5.00 5,500 P25.00 P137,500

Requirement 5

Schedule 5: Manufacturing Overhead Budget

For the Year Ended December 31, 2006

At Budgeted Levels of 5,500

Direct Manufacturing Labor-Hours
Variable manufacturing overhead
costs (P7.00 x 5,500) P 38,500
Fixed manufacturing overhead 66,000
costs
Total manufacturing overhead P104,500
costs

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Requirement 6
P104,500
Budgeted manufacturing overhead rate: = P19.00 per hour
5,500
Requirement 7

Budgeted manufacturing overhead cost per output unit:

P104,500
=
1,100
= P95.00 per output unit

Requirement 8

Schedule 6A: Computation of Unit Costs of Manufacturing Finished

Goods in 2006
Cost per Unit
of Inputa Inputsb Total
Direct materials
Wood P30.00 5.00 P150.00
Fiberglass 5.00 6.00 30.00
Direct manufacturing labor 25.00 5.00 125.00
Total manufacturing overhead 95.00
P400.00
a
cost is per board foot, yard or per hour
b
inputs is the amount of input per board

Requirement 9

Schedule 6B: Ending Inventory Budget

December 31, 2006
Units Cost per Unit Total
Direct materials
Wood 1,500 P 30.00 P 45,000
Fiberglass 2,000 5.00 10,000
Finished goods
Skateboards 200 400.00 80,000
Total Ending Inventory P135,000

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Requirement 10

Schedule 7: Cost of Goods Sold Budget

for the year Ended December 31, 2006

From
Schedule Total
Beginning finished goods
inventory, January 1,
2006 Given P 37,480
Direct materials used 3A P193,800
Direct manufacturing labor 4 137,500
Manufacturing overhead 5 104,500
Cost of goods manufactured 435,800
Cost of goods available for
sale 473,280
Deduct ending finished
goods inventory,
December 31, 2006 6B 80,000
Cost of goods sold P393,280

Requirement 11

Budgeted Income Statement for Pacific

for the Year Ended December 31, 2006
Revenues Schedule 1 P450,000
Costs
Cost of goods sold Schedule 7 393,280
Gross margin 56,720
Operating costs
Marketing costs
(P250 x 30) P 7,500
Other costs 30,000 37,500
Operating income P 19,220

III. Multiple Choice Questions

6. A 11. A 11. D
7. B 12. B 12. D
8. C 13. D 13. B
9. D 14. A 14. C

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10. D 15. C 15. A

CHAPTER 23

STRATEGIC COST MANAGEMENT;

BALANCED SCORECARD

I. Questions
1.
Strategy Weakness
Cost leadership The tendency to cut costs in a way that
undermines demand for the product or
service.
Differentiation The firm’s tendency to undermine its strength
by attempting to lower costs or by lacking a
continual and aggressive marketing plan to
reinforce the perceived difference.
Focus The market niche may suddenly disappear
due to technological change in the industry or
change in consumer tastes.
2. The balanced scorecard is an accounting report that includes the firm’s
critical success factors in four areas: customer satisfaction, financial
performance, internal business processes, and innovation and learning
(human resources). The primary objective of the balanced scorecard is to
serve as an action plan, a basis for implementing the strategy expressed in
the critical success factors.
3. The balanced scorecard is important to integrate both financial and non-
financial information into management reports. Financial measures
reflect only a partial- and short-term measure of the firm’s progress.
Without strategic non-financial information, the firm is likely to stray
from its competitive course and to make strategically wrong product
decisions – to choose the wrong products, the wrong customers. The

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balanced scorecard provides a basis for a more complete analysis than is

possible with financial data alone.
4. An analyst can incorporate other factors such as the growth in the overall
market and reductions in selling prices resulting from productivity gains
into a strategic analysis of operating income. To do so, the analyst
attributes the sources of operating income changes to the particular factors
of interests. For example, the analyst will combine the operating income
effects of strategic price reductions and any resulting growth with the
productivity component to evaluate a company’s cost leadership strategy.
5. A company’s balanced scorecard should be derived from and support its
strategy. Since different companies have different strategies, their
balanced scorecards should be different.
6. The difference between the delivery cycle time and the throughput time is
the waiting period between when an order is received and when production
on the order is started. The throughput time is made up of process time,
inspection time, move time, and queue time. These four elements can be
classified between value-added time (process time) and non-value-added
time (inspection time, move time, and queue time).
7. The balanced scorecard is constructed to support the company’s strategy,
which is a theory about what actions will further the company’s goals.
Assuming that the company has financial goals, measures of financial
performance must be included in the balanced scorecard as a check on the
reality of the theory. If the internal business processes improve, but the
financial outcomes do not improve, the theory may be flawed and the
strategy should be changed.
8. If a company has an MCE of less than 1, it means the production process
includes non-value-added time. An MCE of 0.40, for example, would
mean that 40% of the throughput time consists of actual processing, and
that the other 60% consists of moving, inspection, and other non-value-
added activities.

II. Problem (Measures of Internal Business Process Performance)

Requirement 1
a, b, and c
Month
1 2 3 4
Throughput time in days:

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Process 0.6 0.5 0.5 0.4

time
........................................................
Inspection 0.7 0.7 0.4 0.3
time
........................................................
Move 0.5 0.5 0.4 0.5
time
........................................................
Queue 3.6 3.6 2.6 1.7
time
........................................................
Total throughput 5.4 5.3 3.9 2.9
time
........................................................
Manufacturing cycle efficiency
(MCE):
Process time  Throughput 11.1% 9.4% 12.8% 13.8%
time
........................................................
Delivery cycle time in days:
Wait 9.6 8.7 5.3 4.7
time
........................................................
Total throughput 5.4 5.3 3.9 2.9
time
........................................................
Total delivery cycle 15.0 14.0 9.2 7.6
time
........................................................

Requirement 2

The general trend is favorable in all of the performance measures except for
total sales. On-time delivery is up, process time is down, inspection time is
down, move time is basically unchanged, queue time is down, manufacturing
cycle efficiency is up, and the delivery time is down. Even though the
company has improved its operations, it has not yet increased its sales. This
may have happened because management attention has been focused on the
factory – working to improve operations. However, it may be time now to

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exploit these improvements to go after more sales – perhaps by increased

product promotion and better marketing strategies. It will ultimately be
necessary to increase sales so as to translate the operational improvements into
more profits.

Requirement 3

a and b
Month
5 6
Throughput time in days:
Process time .................................................... 0.4 0.4
Inspection time ............................................... 0.3
Move time....................................................... 0.5 0.5
Queue time .....................................................
Total throughput time ..................................... 1.2 0.9

Manufacturing cycle efficiency (MCE):

Process time  Throughput time.................. 33.3% 44.4%

As a company pares away non-value-added activities, the manufacturing cycle

efficiency improves. The goal, of course, is to have an efficiency of 100%.
This will be achieved when all non-value-added activities have been
eliminated and process time equals throughput time.

III. Multiple Choice Questions

11. D 16. C
12. D 17. D
13. C 18. C
14. A 19. D
15. A 20. A

CHAPTER 24

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ADVANCED ANALYSIS AND

APPRAISAL OF PERFORMANCE:
FINANCIAL AND NONFINANCIAL

I. Questions
1. Return on investment (ROI) is the ratio of profit to amount invested for
the business unit.
2. The measurement issues for ROI are:
a. The effect of accounting policies, which affect the determination of
net income.
b. Other measurement issues for income, which include the handling of
non-recurring items in the income statement, differences in the effect
of income taxes across units, differential effect of foreign currency
exchange, and the effect of cost allocation when two or more units
share a facility or cost.
c. Measuring investment: which assets to include.
d. Measuring investment: allocating the cost of shared assets.
3. The advantages of return on investment are:
a. It is intuitive and easily understood.
b. It provides a useful basis for comparison among SBUs.
c. It is widely used.
The limitations of return on investment are:
a. It has an excessive short-term focus.
b. Investment planning uses discounted cash flow analysis while
managers are evaluated on ROI.
c. It contains a disincentive for new investment by the most profitable
units.
4. The key advantage of residual income is that it deals effectively with the
limitation of ROI, that is ROI has a disincentive for the managers of the
most profitable units to make new investments. With residual income, no
matter how profitable the unit, there is still an incentive for new profitable
investment. In contrast, a key limitation is that since residual income is
not a percentage, it suffers the same problem of profit SBUs in that it is
not useful for comparing units of significantly difference sizes. It favors
larger units that would be expected to have larger residual incomes, even

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with relatively poor performance. Moreover, relatively small changes in

the desired minimum rate of return can dramatically affect the residual
income for different size units. And, in contrast to ROI, some managers
do not find residual income to be as intuitive and as easily understood.
5. Economic value added (EVA) is a business unit’s income after taxes and
after deducting the cost of capital. The idea is very similar to what we
have explained as residual income. The objectives of the measures are the
same – to effectively motivate investment SBU managers and to properly
measure their performance. In contrast to residual income, EVA uses the
firm’s cost of capital instead of a desired rate of return. For many firms
the desired rate of return and the cost of capital will be nearly the same,
with small differences due to adjustments for risk and for strategic goals
such as the desired growth rate for the firm. Also, while residual income
is intended to deal with the undesirable effects of ROI, EVA is used to
focus managers’ attention on creating value for shareholders, by earning
profits greater than the firm’s cost of capital.
6. Examples of financial and nonfinancial measures of performance are:
Financial: ROI, residual income, and return on sales.
Nonfinancial: Manufacturing lead time, on-time performance, number
of new product launches, and number of new patents filed.
7. The six steps in designing an accounting-based performance measure are:
a. Choose performance measures that align with top management’s
financial goal(s).
b. Choose the time horizon of each performance measure in Step 1.
c. Choose a definition of the components in each performance measure
in Step 1.
d. Choose a measurement alternative for each performance measure in
Step 1.
e. Choose a target level of performance.
f. Choose the timing of feedback.
8. Yes. Residual income (RI) is not identical to return on investment (ROI).
ROI is a percentage with investment as the denominator of the
computation. RI is an absolute amount in which investment is used to
calculate an imputed interest charge.
9. Economic value added (EVA) is a specific type of residual income
measure that is calculated as follows:
Economic After tax Weighted Total Assets
value added = operating  Average Cost x minus Current
(EVA) income of Capital Liabilities
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10. Definitions of investment used in practice when computing ROI are:

a. Total assets available.
b. Total assets employed.
c. Working capital (current assets minus current liabilities) plus other
assets.
d. Equity.
11. Present value is the asset measure based on DCF estimates. Current cost
is the cost of purchasing an asset today identical to the one currently held
if identical assets can currently be purchased; it is the cost of purchasing
the services provided by that asset if identical assets cannot currently be
purchased. Historical-cost-based measures of ROI compute the asset base
as the original purchase cost of an asset minus any accumulated
depreciation.
Some commentators argue that present value is future-oriented and current
cost is oriented to current prices, while historical cost is past-oriented.
12. Special problems arise when evaluating the performance of divisions in
multinational companies because
a. The economic, legal, political, social, and cultural environments differ
significantly across countries.
b. Governments in some countries may impose controls and limit selling
prices of products.
c. Availability of materials and skilled labor, as well as costs of
materials, labor, and infrastructure may differ significantly across
countries.
d. Divisions operating in different countries keep score of their
performance in different currencies.
13. a. Consider each activity and the organization itself from the customer’s
perspective,
b. Evaluate each activity using customer-validated measures of
performance,
c. Consider all facets of activity performance that affect customers and
are comprehensive, and
d. Provide feedback to help organization members identify problems
and opportunities for improvement.

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II. Exercises

Exercise 1 (ROI and Residual Income)

Requirement 1

A quick inspection of the data shows mortgage loans with a higher ROI to be
more successful. But see requirement 2 below.

Requirement 2

Division A Division B
(Mortgage Loans) (Consumer Loans)
Total Assets P2,000 P10,000
Operating Income 400 1,500
Return on 25% 15%
Investment

Residual Income:
(a) * at 11% P180 P400
(b) ** at 15% 100 0
(c) *** at 17% 60 (200)

* P400 – (P2,000 x 0.11) = P1,500 – (P10,000 x 0.11) = P

P180 400
** P400 – (P2,000 x 0.15) = P1,500 – (P10,000 x 0.15) = P
P100 0
*** P400 – (P2,000 x 0.17) = P P1,500 – (P10,000 x 0.17) =
60 P(200)

There is no simple answer to which is more successful in terms of residual

income. Division B is more successful at low rates, while A is more successful
at high rates. This reflects an important limitation of residual income; larger
divisions (Division B in this case) are favored when the desired return used to
determine residual income is relatively low.
Exercise 2 (Return on Investment; Comparisons of Three Companies)

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Companies in the Same Industry

A B C
Sales P1,500,000 P 750,000 P3,750,000
Income 200,000 75,000 18,750
Investment (assets) 500,000 7,500,000 2,500,000
Return on sales 13% 10% 0.5%
Asset turnover 3 0.1 1.5
Return on investment 40% 1% 0.75%

Exercise 3 (ROI, RI, ROS, Management Incentives)

Requirement 1

If Magic Industries uses return on investment to measure the Jump-Start

Division’s (JSD’s) performance, Tan may be reluctant to invest in the new
plant because, as shown below, return on investment for the plant of 19.2% is
lower than JSD’s current ROI of 24%.

Operating income for new plant P480,000

New investment P2,500,000
Return on investment for new plant 19.2%

Investing in the new plant would lower JSD’s ROI and, hence, limit Tan’s
bonus.

Requirement 2

The residual income computation for the new plant is as follows:

Residual income = Income - (Imputed interest x Investment)
Investment P2,500,000
Operating income for new plant P 480,000
Charge for funds
(Investment, P2,500,000 x 15%) 375,000
Residual income P 105,000

Investing in the new plant would add P105,000 to JSD’s residual income.
Consequently, if Magic Industries could be persuaded to use residual income
to measure performance, Tan would be more willing to invest in the new plant.

Requirement 3

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Operating income 480,000

Return on Sales (ROS) = = = 20%
Sales 2,400,000
If Magic Industries uses ROS to determine Tan’s bonus, Tan will be more
willing to invest in the new plant because ROS for the new plant of 20%
exceeds the current ROS of 19%.

The advantages of using ROS are (a) that it is simpler to calculate and (b) that
it avoids the negative short-run effects of ROI measures that may induce Tan
to not make the investment in the new plant. Tan may favor ROS because she
believes that eventually increases in ROS will increase ROI and RI.

The main disadvantage of using ROS is that it ignores the amount of

investment needed to earn a return. For example, ROS may be high but not
high enough to justify the level of investment needed to earn the required
return on an investment.

III. Problems

Problem 1 (RI, EVA)

Requirement 1
Truck Rental Transportation
Division Division
Total assets P650,000 P950,000
Current liabilities 120,000 200,000
Investment
(Total assets – current 530,000 750,000
liabilities)
Required return (12% x 63,600 90,000
Investment)
Operating income before tax 75,000 160,000
Residual income
(Operating income before
tax – required return) 11,400 70,000

Requirement 2

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After-tax cost of debt financing = (1 – 0.4) x 10% = 6%

After-tax cost of equity financing = 15%

Weighted average P900,000 x 6% + 600,000 x 15%

= = 9.6%
cost of capital P900,000 + 600,000

Required return for EVA

9.6% x Investment
(9.6% x P530,000; 9.6% x
P750,000) P50,880 P72,000

Operating income after tax

0.6 x operating income before 45,000 96,000
tax

EVA (Operating income after

tax – required return) (5,880) 24,000

Requirement 3

Both the residual income and the EVA calculations indicate that the
Transportation Division is performing better than the Truck Rental Division.
The Transportation Division has a higher residual income (P70,000 versus
P11,400) and a higher EVA [P24,000 versus P(5,880)]. The negative EVA for
the Truck Rental Division indicates that, on an after-tax basis, the division is
destroying value – the after-tax economic return from the Truck Rental
Division’s assets is less than the required return. If EVA continues to be
negative, Lighthouse may have to consider shutting down the Truck Rental
Division.

Problem 2 (ROI, RI, Measurement of Assets)

The method for computing profitability preferred by each manager follows:

Manager of Method Chosen

S Residual income based on net book value
P Residual income based on gross book value
F ROI based on either gross or net book value

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Supporting Calculations:

Return on Investment Calculations

Operating Income Operating Income
Division Gross Book Value Net Book Value*
S P94,700  P800,000 = 11.84% (3) P94,700  P370,000 = 25.59% (3)
P P91,700  P760,000 = 12.07% (2) P91,700  P350,000 = 26.20% (2)
F P61,400  P500,000 = 12.28% (1) P61,400  P220,000 = 27.91% (1)

Residual Income Calculations

Division Operating Income – 10% Gross BV Operating Income – 10% Net BV*
S P94,700 – P80,000 = P14,700 (2) P94,700 – P37,000 = P57,700 (1)
P P91,700 – P76,000 = P15,700 (1) P91,700 – P35,000 = P56,700 (2)
F P61,400 – P50,000 = P11,400 (3) P61,400 – P22,000 = P39,400 (3)

* Net book value is gross book value minus accumulated depreciation.

The biggest weakness of ROI is the tendency to reject projects that will lower
historical ROI even though the prospective ROI exceeds the required ROI. RI
achieves goal congruence because subunits will make investments as long as
they earn a rate in excess of the required return for investments. The biggest
weakness of residual income is it favors larger divisions in ranking
performance. The greater the amount of the investment (the size of the
division), the more likely that larger divisions will be favored assuming that
income grows proportionately.

Problem 3 (Multinational Performance Measurement, ROI, RI)

Requirement 1

(a)
Operating income Operating income
Phil. Division’s ROI in 2005 = = P8,000,000 = 15%
Total assets

Hence, operating income = 15% x P8,000,000 = P1,200,000.

(b)
9,180,000 kronas
Swedish Division’s ROI in 2005 in kronas = 60,000,000 kronas = 15.3%

Requirement 2

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Convert total assets into pesos at December 31, 2004 exchange rate, the rate
prevailing when the assets were acquired (8 kronas = P1)

60,000,000 kronas
24,000,000 kronas = = P7,500,000
8 kronas per peso

Convert operating income into pesos at the average exchange rate prevailing
when during 2005 when operating income was earned equal to
9,180,000 kronas
= P1,080,000
8.5 kronas per peso
P1,080,000
Comparable ROI for Swedish Division = = 14.4%
P7,500,000

The Swedish Division’s ROI calculated in kronas is helped by the inflation

that occurs in Sweden in 2005. Inflation boosts the division’s operating
income. Since the assets are acquired at the start of the year on 1-1-2005, the
asset values are not increased by the inflation that occurs during the year. The
net effect of inflation on ROI calculated in kronas is to use an inflated value
for the numerator relative to the denominator. Adjusting for inflationary and
currency differences negates the effects of any differences in inflation rates
between the two countries on the calculation of ROI. After these adjustments,
the Phil. Division shows a higher ROI than the Swedish Division.

Requirement 3

Phil. Division’s RI in 2005 = P1,200,000 – 12% x P8,000,000

= P1,200,000 – P960,000 = P240,000

Swedish Division’s RI in 2005 (in Phil. pesos) is

P1,080,000 – 12% x P7,500,000 = P1,080,000 – P900,000 = P180,000.

The Phil. Division’s RI also exceeds the Swedish Division’s RI in 2005 by

P60,000 (P240,000 – P180,000).

Problem 4 (ROI Performance Measures Based on Historical Cost and

Current Cost)

Requirement 1

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ROI using historical cost measures:

P130,000
Luzon Division = 38.24%
P340,000

P220,000
Visayas Division = 19.13%
P1,150,000

Mindanao Division P380,000 = 23.46%

P1,620,000

The Luzon Division appears to be considerably more efficient than the Visayas
and Mindanao Divisions.

Requirement 2

The gross book values (i.e., the original costs of the plants) under historical
cost are calculated as the useful life of each plant (12) x the annual
depreciation:

Luzon 12 x P 70,000 = P 840,000

Visayas 12 x P100,000 = P1,200,000
Mindanao 12 x P120,000 = P1,440,000

Step 1: Restate long-term assets from gross book value at historical costs to
gross book value at current cost as of the end of 2005.
Gross book value
Construction cost index in 2005
of long-term assets x
at historical cost Construction cost index in year of construction

Luzon P 840,000 x (170  100) = P1,428,000

Visayas P1,200,000 x (170  136) = P1,500,000
Mindanao P1,440,000 x (170  160) = P1,530,000
Step 2: Derive net book value of long-term assets at current cost as of the end
of 2005. (Estimated useful life of each plant is 12 years).
Gross book value
of long-term assets Estimated useful life remaining
at current cost at x
Estimated total useful life
the end of 2005

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Luzon P1,428,000 x (2  12) = P 238,000

Visayas P1,500,000 x (9  12) = P1,125,000
Mindanao P1,530,000 x (11  12) = P1,402,500

Step 3: Compute current cost of total assets at the end of 2005. (Assume
current assets of each plant are expressed in 2005 pesos.)
Current assets at the end Net book value of long-term assets at
of 2005 (given) + current cost at the end of 2005 (Step 2)
Luzon P200,000 + P238,000 = P 438,000
Visayas P250,000 + P1,125,000 = P1,375,000
Mindanao P300,000 + P1,402,500 = P1,702,500

Step 4: Compute current-cost depreciation expense in 2005 pesos.

Gross book value of long-term assets at current cost at the end of 2005
(from Step 1) x (1  12)

Luzon P1,428,000 x (1  12) = P119,000

Visayas P1,500,000 x (1  12) = P125,000
Mindanao P1,530,000 x (1  12) = P127,500

Step 5: Compute 2005 operating income using 2005 current-cost

depreciation.

Historical-cost Current-cost depreciation Historical-cost

operating income – in 2005 pesos (Step 4) –
depreciation

Luzon P130,000 – (P119,000 – P70,000) = P 81,000

Visayas P220,000 – (P125,000 – P100,000) = P195,000
Mindanao P380,000 – (P127,500 – P120,000) = P372,500

Step 6: Compute ROI using current-cost estimate for long-term assets and
depreciation.
Operating income for 2005 using 2005 current cost depreciation (Step 5)
Current cost of total assets at the end of 2005 (Step 3)
Luzon P 81,000  P 438,000 = 18.49%
Visayas P195,000  P1,375,000 = 14.18%

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Mindanao P372,500  P1,702,500 = 21.88%

ROI: Historical Cost ROI: Current Cost

Luzon 38.24% 18.49%
Visayas 19.13% 14.18%
Mindanao 23.46% 21.88%

Use of current cost results in the Mindanao Division appearing to be the most
efficient. The Luzon ROI is reduced substantially when the ten-year-old plant
is restated for the 70% increase in construction costs over the 1995 to 2005
period.

Requirement 3

Use of current costs increases the comparability of ROI measures across

divisions’ operating plants built at different construction cost price levels. Use
of current cost also will increase the willingness of managers, evaluated on the
basis of ROI, to move from divisions with assets purchased many years ago to
division with assets purchased in recent years.

IV. Multiple Choice Questions

16. A 11. B 21. C 31. A

17. B 12. D 22. D 32. A
18. C 13. C 23. C 33. B
19. C 14. A 24. A 34. A
20. D 15. C 25. C 35. C
21. B 16. C 26. D 36. B
22. A 17. A 27. A 37. D
23. C 18. C 28. C
24. B 19. B 29. D
25. A 20. A 30. D

CHAPTER 25

MANAGING PRODUCTIVITY AND

MARKETING EFFECTIVENESS

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I. Questions
1. Productivity is the relationship between the output and the input resources
required for generating the output.
2. A critical success factor for a firm that competes as a cost leader is to be
the low cost provider. A low cost provider needs to perform the required
tasks for the same output with fewer resources than its competitors.
3. Among criteria that often are used in assessing productivity and their
advantages and disadvantages are:
Using a prior year’s productivity as the criterion
Advantages:
 Data readily available
 Facilitates monitoring of continuous improvements
Disadvantages:
 Difficult to assess adequacy of productivity improvements
 Hard to compare productivity improvements between the years

Using the best performance as the criterion

Advantages:
 Provides as the benchmark the utmost performance
 Motivates people to strive for the maximum potential
Disadvantages:
 The standard can be too high for the operation and frustrating to
workers
 Data may be difficult to obtain
 The criteria on which the operation is based may not be comparable
4. An operational productivity is the ratio of the output to the number of units
of an input resource.
A financial productivity measures the relationship between the output and
the cost of one or more of the input resources.

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5. A partial productivity is a productivity measure that focuses only on the

relationship between the amount of one of the input resources and the
output attained.
A total productivity measures the relationship between the output and the
total input costs of all the required input resources for the output.
6. Manufacturing personnel often prefer operational productivity measures
over financial productivity measures because all the input data for
computing operational productivity measures are either results of their
activities or resources consumed for these activities. Financial
productivity measures use costs of resources that often are results of
activities by personnel outside of manufacturing functions.
7. Measurements of marketing effectiveness include market share, sales
price, sales mix, and sales quantity variances.
8. Sales quantity variance is a component of sales volume variance. A sales
volume variance can be the result of both sales mix and sales quantity
variances.
9. A market size variance measures the effect on the contribution margin and
operating income of a firm because of changes in the total market size for
all firms in the same industry or product segment. A market share variance
examines the effect on the contribution margin and operating income of a
firm because of deviations of the firm’s actual market shares from its
budgeted market shares.
10. a. No. A multi-product firm can still have an unfavorable sales volume
variance even if it sells more than the budgeted units of sales. The
unfavorable sales volume variance is a result of selling more of less
profitable products and less of more profitable products.
b. A favorable sales quantity variance reflects the marketing manager’s
excellent performances only if there is no adverse change in selling
prices, sales mix, or market size. A favorable sales quantity variance
is hardly favorable to the firm if the firm has lowered its selling prices
or sold more of low-priced, low-margin and less of high-priced, high-
margin products. Increases in the total market size in which the firm
operates often also leads to a favorable sales quantity variance. A
favorable sales quantity variance in an expanding total market may not
be favorable to the firm strategically if the firm also has an unfavorable
market share variance.

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A firm can have a favorable market size variance and an unfavorable

market share variance if the proportional increase of the firm’s total
sales is less than those of the total market.
c. Yes. The Wall Street Journal reported on April 14, 1994 (p. B4) that
Colgate-Palmolive had slashed marketing spending to reach its
ambitious target of 15 percent annual earnings growth. The firm, for
example, spent P88.8 million on advertising in 1993, compared with
P97.5 million in 1992. The firm met the goal of a 15 percent increase
in per share earnings and its CEO, Mr. Mark, expected the company
to announce a similar increase for first quarter earnings soon. The
market share of the firm, however, have decreased in all categories.
11. The sales volume variance is the sum of sales quantity and sales mix
variances. The sales quantity variance is the sum of market size and
market share variances.

II. Problems

Problem 1 (Operational and Financial Partial Productivity)

Requirement 1

Star Company
Comparative Income Statement
For the years 2005 and 2006

2005 2006
Sales 15,000 x P40 P600,000 18,000 x P40 P720,000
= =
Variable cost of sales:
Materials 12,000 x P 8 P 12,600 x P10 P126,000
= 96,000 =
Labor 6,000 x P20 = 120,000 5,000 x P25 = 125,000
Power 1,000 x P 2 = 2,000 x P 2 = 4,000
2,000
Total variable costs of P218,000 P255,000
sales
Contribution margin P382,000 P465,000

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Change in profits from 2005: P465,000 – P382,000 = P83,000 increase

Requirement 2

Operational Partial Productivity

2006 2005
DM 18,000 / 12,600 = 15,000 / 12,000 =
1.4286 1.25
DL 18,000 / 5,000 = 15,000 / 6,000 =
3.6 2.5
Power 18,000 / 2,000 = 9 15,000 / 1,000 = 15

Requirement 3

Total cost of production factors

2006 2005
DM 12,600 x P10 = P126,000 12,000 x P
8 = P 96,000
DL 5,000 x P25 = P125,000 6,000 x P20 = P120,000
Power 2,000 x P 2 = P 4,000 1,000 x P 2 = P 2,000

Financial Partial Productivity

2006 2005
DM 18,000 / 126,000 = 15,000 / 96,000 =
0.1429 0.15625
DL 18,000 / 125,000 = 15,000 / 120,000 =
0.144 0.125
Power 18,000 / 4,000 = 15,000 / 2,000 =
4.5 7.5

Requirement 4

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Both direct materials and direct labor operation partial productivity improved
from 2005 to 2006. In 2006 the firm was able to manufacture more output
units for each unit of materials placed into production and for each hour spent
on production. The operational productivity of power in 2006 deteriorated
from 2005. It is likely that the firm used more equipment in production in
2006 that reduced consumption of materials and production hours.

The financial partial productivity for both direct materials and power
deteriorated from 2005 to 2006. Increases in direct materials costs were more
than the improvements in operational partial productivity for direct materials.
Like the operational partial productivity, the financial partial productivity for
direct labor also improved. The extent of improvements, however, is much
lower in financial partial productivity. The direct labor operational partial
productivity improved 44 percent in 2006 over those of 2005. The financial
partial productivity, however, improved only 15.2 percent between the two
years. The decrease in financial partial productivity is likely a result of
increases in direct labor wages.

Requirement 5

Operating Data for Decomposing Financial Productivity Measure

2006 2006 2006 2005

Output, Output Output Output
1/2006 1/2005 1/2005 1/2005
Productivity Productivity Productivity Productivity
2006 Input 2006 Input 2005 Input 2005 Input
cost cost cost cost

(1) Output
(unit):
18,000 18,000 18,000 15,000

(2) 1/Productivity
DM: 12,000/15,0 12,000/15,0 12,000/15,0
12,600/18,0 00 00 00
00 = 0.7 = 0.8 = 0.8 = 0.8

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DL: 6,000/15,00 6,000/15,00 6,000/15,00

5,000/18,00 0 0 0
0 = 0.2778 = 0.4 = 0.4 = 0.4
Power: 1,000/15,00 1,000/15,00 1,000/15,00
2,000/18,00 0 0 0
0 = 0.1111 = 0.0667 = 0.0667 = 0.0667

(3) Cost per unit of input

DM: P10 P10 P 8 P 8
DL: P25 P25 P20 P20
Power: P 2 P 2 P 2 P 2

(4) Output x (1/Productivity) x Input cost

DM: 18,000 x 0.7 x 10 18,000 x 0.8 x 10 18,000 x 0.8 x 8 15,000 x 0.8 x 8
= P126,000 = P144,000 = P115,200 = P96,000
DL: 18,000 x 0.2778 x 18,000 x 0.4 x 25 18,000 x 0.4 x 20 15,000 x 0.4 x 20
25 = P180,000 = P144,000 = P120,000
= P125,010
Power: 18,000 x 0.1111 x 18,000 x 0.0667 x 18,000 x 0.0667 x 2 15,000 x 0.0667 x 2
2 = P4,000 2 = P2,401 = P2,001
= P2,401
Total P255,010 P326,401 P261,601 P218,001

Decompositi
on
DM: 18,000 / 18,000 / 18,000 / 15,000 /
126,000 144,000 115,200 96,000
= 0.1429 = 0.125 = 0.15625 = 0.15625

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DL: 18,000 / 18,000 / 18,000 / 15,000 /

125,010 180,000 144,000 = 120,000
= 0.1440 = 0.1 0.125 = 0.125
Power: 18,000 / 18,000 / 15,000 /
18,000 / 2,401 2,401 2,001
4,000 = 7.4969 = 7.4969 = 7.4963
= 4.5

Productivity Input price Output change

change change

DM: 0.1429 – 0.125 – 0.15625 0.15625 –

0.125 = 0.03125 U 0.15625
= 0.0179 F =0
DL: 0.144 – 0.1 0.1 – 0.125 0.125 – 0.125
= 0.044 F = 0.025 U =0
Power: 4.5 – 7.4969 – 7.4969 7.4969 – 7.4963
7.4969 =0 = 0.0006
= 2.9969 U (rounding)

Summary of
Result
Change as % of 2005 Productivity
Productivity Input Price Total Productivity Input Price Total
Change Change Change Change Change Change
DM: 0.0179 F 0.03125 0.01335 11.46% 20% U 8.54% U
U U F
DL: 0.044 F 0.025 U 0.019 F 35.2% F 20% U 15.2% F
Power: 2.9969 U 0 2.9969 39.98% U 0 39.98% U
U

Requirement 6

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Productivity for both direct materials and direct labor improved in 2006. The
percentages of improvements in productivity are 11.46 and 35.2 for direct
materials and direct labor, respectively, of the 2005 productivity. However,
cost increases in direct materials and direct labor reduced the gains in
productivity on these two manufacturing factors

Problem 2 (Direct Labor Rate and Efficiency Variances, Productivity

Measures, and Standard Costs)

Requirement 1

Assembly Department Direct Labor Variances

2005:
Total actual direct labor hours: 25 x 20,000 = 500,000
Total standard direct labor hours: 24 x 20,000 = 480,000

P30 x 500,000 P28 x 500,000 P28 x 480,000

= P15,000,000 = P14,000,000 = P13,440,000

Rate variance Efficiency variance

= P1,000,000 U = P560,000 U

2006:
Total actual direct labor hours: 20 x 20,000 = 400,000
Total standard direct labor hours: 21 x 20,000 = 420,000

P36 x 400,000 P35 x 400,000 P35 x 420,000

= P14,400,000 = P14,000,000 = P14,700,000

Rate variance Efficiency variance

= P400,000 U = P700,000 F

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Testing Department Direct Labor Variances

2005:
Total actual direct labor hours: 12 x 20,000 = 240,000
Total standard direct labor hours: 14 x 20,000 = 280,000

P20 x 240,000 P21 x 240,000 P21 x 280,000

= P4,800,000 = P5,040,000 = P5,880,000

Rate variance Efficiency variance

= P240,000 F = P840,000 F
2006:
Total actual direct labor hours: 10 x 20,000 = 200,000
Total standard direct labor hours: 11 x 20,000 = 220,000

P24 x 200,000 P25 x 200,000 P25 x 220,000

= P4,800,000 = P5,000,000 = P5,500,000

Rate variance Efficiency variance

= P200,000 F = P500,000 F

Recap:
Assembly Testing Department
Department
2005 2006 2005 2006
Rate P1,000,000 P400,00 P240,00 P200,00
variance U 0U 0F 0F
Efficienc P560,00 P700,00 P840,00 P500,00
y 0U 0F 0F 0F
variance
Requirement 2

Assembly Department Operational Partial Productivity

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2005: 20,000 / 500,000 = 0.04

2006: 20,000 / 400,000 = 0.05

Testing Department Operational Partial Productivity

2005: 20,000 / 240,000 = 0.0833

2006: 20,000 / 200,000 = 0.1

Requirement 3

Assembly Department Financial Partial Productivity

2005: 20,000 / P15,000,000 = 0.001333

2006: 20,000 / P14,400,000 = 0.001389

Testing Department Financial Partial Productivity

2005: 20,000 / P4,800,000 = 0.004167

2006: 20,000 / P4,800,000 = 0.004167
Requirement 4

Operational partial productivity

2005 2006 Change
Assembly 0.04 0.05 0.01 F 25%

F
Testing 0.0833 0.1 0.0167 20%
F
F
Financial partial productivity
2005 2006 Change
Assembly 0.001333 0.001389 0.000056 4.2%
F
F
Testing 0.004167 0.004167 -0- -0-

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Operational partial productivity improved in both departments from 2005 to

2006. The financial partial productivity in the Assembly also improved while
the Testing remains unchanged.

Requirement 5

The standards in a standard costing system often are determined independently

and incorporate changes in operating factors. The standard for the operation
of a year may change because of changes in, for example, technology, quality
of materials, experience of production workers, designs, or processes.

Productivity measures use as the criterion the productivity of a prior year

without adjusting for changes occurred or the expected changes for the current
year. As a result, assessments of productivity may depict an entirely different
picture than those of variance analyses in a standard costing system.

Problem 3 (Sales Variance)

Requirement 1

Selling price variances (in 000)

Flexible budget sales:
Master Budget for 2005 Budgeted Total Units Flexible
Total Selling Price Sold in Budget
Sales Units Per Unit 2005 Sales
Premium P36,000  240 = P150 x 180 = P27,000
Regular P43,200  360 = P120 x 540 = P64,800
Premium Regular
Selling Selling
Flexible Price Flexible Price
Actual Budget Variance Actual Budget Variance
Barrels 180 180 540 540
Sales P28,800 P27,000 P1,800 F P62,100 P64,800 P2,700
U

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Total selling price variance of the firm = P1,800 F + P2,700 U = P900 U

Requirement 2

Sales volume variances for the period for each of the products and for the firm

Flexible budget variable expenses:

Master Budget for 2005 Budgeted Total Flexible
Total Variable Units Budget
Variable Number Expenses Sold in Variable
Expenses of Per Unit 2005 Expenses
Units
Premium P21,600  240 = P90 x 180 = P16,200
Regular P27,000  360 = P75 x 540 = P40,500

Premium Regular
Sales Sales
Flexible Master Volume Flexible Master Volume
Budget Budget Variance Budget Budget Variance
Barrels 180
180 540 360
Sales P27,000 P36,000 P64,800 P43,200
Variable
expenses 16,200 21,600 40,500 27,000
Contribution
margin P10,800 P14,400 P3,600 P24,300 P16,200 P8,100 F
U

Fixed
expenses 10,000 10,000 5,000 5,000
– –
Operating
income P 800 P 4,400 P19,300 P11,200 P8,100 F

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P3,600
U

Total sales volume variance of the firm = P3,600 U + P8,100 F = P4,500 F

Requirement 3
Sales quantity variances for the firm and for each of the products. (See next
page.)

Requirement 4
Sales mix variances for the period for each of the products and for the firm
(000 omitted).
Calculation for sales mixes:
Budgeted Actual
Total Sales Sales Total Sales Sales
in Units Mix in Units Mix
Premium 240 0.40 180 0.25
Regular 360 0.60 540 0.75
600 1.00 720 1.00

Flexible Budget Master Budget

Total actual units of all products Total actual units Total budgeted units of
sold x Actual sales mix x of all products sold sales for all products x
Standard contribution margin x Budgeted sales Budgeted sales mix x
per unit mix x Standard Standard contribution
contribution margin margin per unit
per unit

Premium
720 x 0.25 x P60 = 720 x 0.40 x P60 = 600 x 0.40 x P60 = P14,400
P10,800 P17,280

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Sales mix variance Sales quantity variance

= P6,480 U = P2,880 F

Sales volume variance

= P10,800 – P14,400
= P3,600 U

To verify: Sales volume variance

= Sales mix variance + Sales quantity variance
= P6,480 U + P2,880 F
= P3,600 U
Regular
720 x 0.75 x P45 = 720 x 0.60 x P45 = 600 x 0.60 x P45 = P16,200
P24,300 P19,440

Sales mix variance Sales quantity variance

= P4,860 F = P3,240 F

Sales volume variance

= P24,300 – P16,200
= P8,100 F

To verify: Sales volume variance

= Sales mix variance + Sales quantity variance
= P4,860 F + P3,240 F
= P8,100 F

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Total
Sales mix variance = P6,480 U + P4,860 F = P1,620 U
Sales quantity variance = P2,880 U + P3,240 F = P6,120 F

Requirement 5

Verification

Sales mix variance + Sales quantity variance = Sales

volume variance
Premium P6,480 U P2,880 F P3,600 U
Regular P4,860 F P3,240 F P8,100 F
Total P1,620 U P6,120 F P4,500 F

Requirement 6

Market size variances. (See below.)

Requirement 7

Market share variances (000 omitted. See below.)

Weighted average budgeted contribution margin per

unit
Master budget total contribution margin P30,600
Master budget total sales units  600
Weighted-average budgeted contribution margin
per unit P 51
Calculation for market shares:
Budgeted:Total sales in units 600  Total sales of
the industry 1,500 = 0.40
Actual: Total sales in units 720  Total sales of the
industry 1,600 = 0.45

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Calculation for variances:

Actual total Actual total Budgeted total
market size x market x market size x
Actual market Budgeted Budgeted market
share x market share share x Average
Average x Average budgeted
budgeted budgeted contribution margin
contribution contribution per unit
margin per margin per
unit unit
1,600 x 0.45 x 1,600 x 0.40 x 1,500 x 0.40 x P51
P51 P51
= P36,720 = P32,640 = P30,600

Market share Market size variance

variance
= P4,080 F = P2,040 F

Sales quantity variance

= P4,080 F + P2,040 F
= P6,120 F

Requirement 8

The sum of market size variance and market share variance and verification
that this total equals the sales quantity variance.

Total market size Total market share Total quantity variance

variance + variance =
P2,040 F P4,080 F P6,120 F

Problem 4 (Productivity and Ethics)

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Requirement 1

The operational partial productivity deteriorates slightly from 0.0051 in 2005

(500/99,000) to 0.005 in 2006 (560/112,000). Manipulating accounting
numbers in order to show a desirable result is an unethical behavior regardless
the intention.

Requirement 2

Tan should not follow the order without following a consistent accounting
method. If the firm believes that certain cost items should be reclassified as
indirect costs, the same procedure should be followed for all years. Tan should
then go back and revise operating results of previous years.

Problem 5 (Small Business Market Size and Share Variances)

Requirement 1

Budget Actual
Empre Empre
ss’ ss’
Design Indust Shar Design Indust
s ry e s ry Share
W 50 500 10.0 45 425 45/4
S % 25
D 25 200 12.5 35 150 35/1
H % 50
Requirement 2

Weighted Average Budgeted Contribution Margin Per Unit:

(50 welcome signs x P2) + (25 doghouses x P5.20) / 75 = P3.07

Market Share Variance

Welcome Signs: (45/425 – 0.1) x 425 x P3.07 = P7.68 F
Doghouses: (35/150 – 25/200) x 150 x P3.07 = P49.89 F

Requirement 3

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Market Size Variance

Welcome Signs: (45 – 500) x 50/500 x P3.07 = P23.03 U
Doghouses: (150 – 200) x 25/200 x P3.07 = P19.19 U

Requirement 4

Among possible reasons are quality changes, pricing changes, less producers
due to seasonal variations, and market no longer there.

Requirement 5

Among alternatives are improving costs through adopting activity based

costing, making different signs, using less expensive wood, finding
competitive advantage.

III. Multiple Choice Questions

21. A 16. A 31. A

22. C 17. B 32. D
23. B 18. A 33. C
24. D 19. B 34. D
25. A 20. C
26. C 21. D
27. C 22. B
28. B 23. C
29. C 24. A
30. D 25. D

Supporting Computations:

Operational partial productivity

2005 2006
Input Input
Resource Partial Resource Partial
Output Used Productivity Output Used Productivity
X-45 60,000  75,000 = 0.8 64,000  89,600 = 0.7143

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(1)
Direct
labor 60,000  10,000 = 6.0 64,000  10,847 = 5.9002

Financial partial productivity (2)

2005 2006
Cost of Cost of
Input Input
Units of Resource Partial Units of Resource Partial
Output Used Productivity Output Used Productivity
X-45 60,000  P540,000 = 0.1111 64,000  P609,280 = 0.1050

(3)
Direct
labor 60,000  300,000 = 0.2 64,000  P347,104 = 0.1844
Total productivity in units (4)
2005 2006
(a) Total units 60,000 64,000
manufactured
(b) Total variable
manufacturing costs P840,000 P956,384
incurred
(c) Total productivity (a) 0.071429 (0.066919
 (b) 5)
(d) Decrease in 0.071429 – 0.00451
productivity 0.066919 = (6)
Total productivity in sales pesos
2005 2006
(a) Total sales P1,500,000 P1,600,000
(b) Total variable
manufacturing costs P840,000 P956,384
incurred

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(c) Total productivity (a) P1.7857 ( P1.6730

 (b) 5)
(d) Decrease in P1.7857 – P0.1127 (6)
productivity P1.6730 =
(7) Operational partial productivity:
Actual Production 9,500
Operational Partial Productivity = = = 1.06
Actual Input 8,950

(8) Financial partial productivity:

2005 2006
(1) Output 400,000 486,000
(2) Direct materials:
Quantity 160 180
Unit cost x P3,375 x P3,125
Total direct materials cost P540,000 P562,500
(3) DM financial partial
productivity (1) (2) 0.7407 0.864
(4) Direct labor:
Hour spent 10,000 13,500
Hourly wage x P26 x P25
Total direct labor cost P260,000 P337,500
(5) DL financial partial
productivity (1) (4) 1.5385 1.44

(9) Total productivity:

2005 2006
(1) Output 400,000 486,000
Total cost:
Direct materials cost P540,000 P562,500

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Direct labor cost 260,000 337,500

(2) Total cost P800,000 P900,000
(3) Total productivity (1) (2) 0.5 0.54

Market Share

Firm Total Market Market Share

Actual 100,000 / 2,000,000 = 5%
Budget 90,000 / 1,500,000 = 6%

1. Market size variance: (2,000,000 – 1,500,000) x 0.06 x P8 = P240,000 F (10)

2. Market share variance: (5% - 6%) x 2,000,000 x P8 = P160,000 U (11)
3. Sales quantity variance: (100,000 – 90,000) x P8 = P 80,000 F (12)

(13)
Product A Product B Total
Budgeted sales
unit 30,000 60,000 90,000
Budgeted
contribution x x
margin per unit P4.00 P10.00
Budgeted total
contribution
margin P120,000 P600,000 P720,000
Budgeted
average
contribution
margin per unit P8.00
(14)
Product Product Total
A B
Actual units sold 35,000 65,000
Budgets sales unit – –
30,000 60,000

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Differences in sales
units 5,000 5,000
Budgeted contribution x x
margin per unit P4.00 P10.00
Sales volume
contribution margin P20,000 P50,000 P70,000
variance F F F

Sales mixes:
Budgeted Actual
Unit % Unit %
Product A 30,000 1/3 35,000 35
Product B 60,000 2/3 65,000 65
TOTAL 90,000 100 100,000 100

(15)Sales mix contribution margin variance:

Product A: (0.35 – 1/3) x 100,000 x P4 = P 6,667 F
Product B: (0.65 – 2/3) x 100,000 x P10 = 16,667 U
Total sales mix contribution margin variance P10,000 U

(16)Sales quantity contribution margin variance:

Product A: (100,000 – 90,000) x 1/3 x P4 = P13,333 F
Product B: (100,000 – 90,000) x 2/3 x P10 = 66,667 F
Total sales quantity contribution margin variance P80,000 F

(17)Weighted average budget contribution margin per unit:

P8.00 (calculated in no. 13)
Market size contribution margin variance:
(2,000,000 – 1,500,000) x 90,000 / 1,500,000 x P8 = P240,000 F

(18)Market share contribution margin variance:

(100,000 / 2,000,000 – 90,000 / 1,500,000) x 2,000,000 x P8 =

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P160,000 U

(19)Flexible budget contribution margin variance:

Flexible
Budget
Total Contribution margin Contribution
Actual Operating Flexible Budget Margin Variance
Result
Product A 35,000 x P3 = 35,000 x P4 = P 35,000 U
P105,000 P140,000
Product B 65,000 x P12 = 65,000 x P10 = P130,000 F
P780,000 P650,000
TOTAL P885,000 P790,000 P 95,000 F

(20)Total contribution margin price variance (given) P50,000 F

Sales price variance:
Product A: (P12 – P10) x 35,000 = P70,000 F
Product B: (P24 – P25) x 65,000 = P65,000 U
Total sales price variance – 5,000 F
Total variable cost price variance P45,000 F

(21)Total flexible budget contribution margin variance P95,000 F

Total contribution margin price variance (given) 50,000 F
Total variance cost efficiency variance P45,000 F

(22)Sales mix ratio:

Actual Budget
Quantity Ratio Quantity Ratio
R66 1,000 0.50 1,200 0.75
R100 1,000 0.50 400 0.25
TOTAL 2,000 1.00 1,600 1.00
R66 sales quantity variance: (2,000 – 1,600) x 0.75 x P10 = P3,000 F

(23)R100 sales mix variance: (0.5 – 0.25) x 2,000 x P70 = P35,000 F

(24)Total sales volume variance:

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R66: (1,000 – 1,200) x P10 = P 2,000 U

R100: (1,000 – 400) x P70 = 42,000 F
Total P40,000 F

CHAPTER 26

EXECUTIVE PERFORMANCE MEASURES

AND COMPENSATION

I. Questions
1. Incentive compensation is a monetary reward that is based on measured
performance. Organizations where employees have been given the
responsibility to make decisions are best suited for incentive
compensation systems.
2. The four guidelines are: fairness, participation, basic wage level, and
independent wage policy.
Fairness deals with the ratio of salaries of the highest paid to lowest paid
employees.
Participation states that all employees should be included in a
compensation plan. Although, they do not need to be included in the same
one.
Basic wage level states that a market wage should be paid, and incentive
compensation should not be used to adjust the market wage downward.
Independent wage policy states that the incentive compensation system
for the most senior levels of the organization should be set by a group that
is independent of senior management.
3. a. based on salary – easy to administer, likely to be considered fair, and,
to the extent that salary reflects the relative ability to contribute to
results, is based on contribution;

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based on equal share – easy to administer, likely to be considered fair,

and reflects how people often divide up rewards when left to their own
devices;
based on position – same as based on salary;
based on individual performance – ties reward most closely to
performance and likely to have the highest motivational impact.
b. based on salary – may convince lower level employees that they have
little to contribute, does not necessarily reflect contributions;
based on equal share – may have little motivational effect, may lead
to feeling of inequity if some people contribute nothing;
based on position – same as based on salary;
based on individual performance – may be difficult and costly to
administer, may lead to arguments about interpreting the performance
measure.
4. A cash bonus is a cash reward tied to measured performance. A cash
bonus is a bonus that is best related to activities oriented to short-run
performance that should be rewarded immediately to provide a
reinforcement effect. Cash bonuses are best tied to measures of achieved
operating performance such as quality improvement, sales increases, and
success at short-run cost control.
Profit-sharing is a cash bonus incentive compensation plan where the total
of all cash bonuses paid to all employees is determined by a formula
involving the organization’s, or an organization unit’s, reported profit.
Profit-sharing is used to focus organization members on team activities to
improve the organization’s short-term performance.
Gain-sharing is a cash bonus incentive compensation plan where the total
of all cash bonuses paid to all employees is determined by a formula
involving cost performance (on materials or labor that the group is deemed
able to control) relative to some standard. Gain sharing is best used when
there is a visible and agreed performance standard and the employees can
work as a group to improve performance relative to that standard.
A stock option plan is a process where employees, deemed to be able to
affect the value of an organization’s shares, are given the option to
purchase those shares at a specified price which is usually higher than the
share price at the time the option is issued. Stock options are best used to

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focus attention of senior people, who can affect the organization’s long-
run performance by their decisions, on long-run performance.

II. Problems

Problem 1

Requirement (a)

P20,000,000 – (0.18 x P60,000,000) = P9,200,000

P9,200,000 x 0.20 = P1,840,000
Therefore, P2,000,000 would be larger.

Requirement (b)

P50,000 / P12,000,000 x P2,000,000 = P8,333.33

Problem 2

Requirement (a)

P30,000,000 – (0.18 x P72,000,000) = P17,040,000

P17,040,000 x 0.25 = P4,260,000
Therefore, P4,260,000 would be larger.

Requirement (b)

P40,000 / P10,000,000 x P4,260,000 = P17,040

III. Multiple Choice Questions

26. C 21. C 35. C

27. A 22. B 36. D
28. D 23. D 37. B
29. C 24. B 38. D
30. B 25. A
31. D 26. D

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32. D 27. C
33. A 28. B
34. D 29. B
35. B 30. B

CHAPTER 27

MANAGING ACCOUNTING IN
A CHANGING ENVIRONMENT

I. Questions
1. The American Heritage Dictionary defines quality as “1. a characteristic
or attribute of something; property; a feature. 2. the natural or essential
character of something. 3. excellence; superiority.”
Quality for a product or service can be defined as a “product or service
that conforms with a design which meets or exceeds the expectations of
customers at a price they are willing to pay.”
2. Procter & Gamble defines TQM as “the unyielding and continually
improving effort by everyone in an organization to understand, meet, and
exceed the expectations of customers.” Typical characteristics of TQM
include focusing on satisfying customers, striving for continuous
improvement, and involving the entire workforce.
TQM is a continual effort and never completes. Global competition, new
technology, and ever-changing customer expectations make TQM a
continual effort for a successful firm.
3. The core principles of TQM include (1) focusing on satisfying the
customer, (2) striving for continuous improvement, and (3) involving the
entire work force.
4. Continuous improvement (Kaizen) in total quality management is the
belief that quality is not a destination; rather, it is a way of life and firms
need to continuously strive for better products with lower costs.
In today’s global competition, where firms are forever trying to
outperform the competition and customers present ever-changing

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expectations, a firm can never reach the ideal quality standard and needs
to continuously improve quality and reduce costs to remain competitive.
5. The Institute of Management Accountants (IMA) believes an effective
implementation of total quality management will take between three and
five years and involves the following tasks:
Year 1
 Create a quality council and staff
 Conduct executive quality training programs
 Conduct quality audits
 Prepare gap analysis
 Develop strategic quality improvement plans
Year 2
 Conduct employee communication and training programs
 Establish quality teams
 Create measurement systems and set goals
Year 3
 Revise compensation / appraisal / recognition systems
 Launch external initiatives with suppliers
 Review and revise
6. Reward and recognition are the best means of reinforcing the emphasis on
TQM. Moreover, proper reward and recognition structures can be very
powerful stimuli to promote TQM. Efforts and progress will most likely
be short-lived if no change is made to the compensation / appraisal /
recognition systems to make them in line with the objectives of the firm’s
TQM.
7. The purposes of conducting a quality audit are to identify strengths and
weaknesses in quality practices and levels of a firm’s quality and to help
the firm identify the target areas for quality improvements.
8. A gap analysis is a type of benchmarking that includes analyzing the
differences in practices between the firm and the best-in-class. The
objective of gap analyses is to identify strengths, weaknesses, and target
areas for quality improvement.
9. Some examples of costs associated with cost of quality categories are:
Prevention costs: Training costs such as instructors’ fees, purchase of
training equipment, tuition for external training, training wages and

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salaries; salaries for quality planning and executions, cost of preventive

equipment, printing and promotion costs for quality programs, awards for
quality.
Appraisal costs: Costs of raw materials, work-in-process, and finished
goods inspections.
Internal failure costs: Scrap, rework, loss due to downgrades, reinspection
costs, and loss due to work interruptions.
External failure costs: Sales returns and allowance due to quality
deficiency, warranty cost, and canceled sales orders due to quality
deficiency.
10. Prevention costs rise during the early years of implementing TQM as the
firm engages in education to prepare its employees and in the planning and
promotion of the quality program. Appraisal costs will also likely rise
during the early years of TQM, because the firm needs to ensure that
quality is actually being achieved. The increase in appraisal cost,
however, is most likely to occur at a slower pace than those of the
prevention costs because at the beginning of a TQM program there will be
substantial increases in quality training and in promotion to raise
awareness on the importance of quality.
The firm may see some decreases in internal and external failure costs in
the early years of implementing a TQM. However, these two costs most
likely will remain at about the same level as before during the first several
years of TQM. Many firms may actually see internal failure cost rise,
because of the higher standard demanded by the TQM or the higher level
of employees’ awareness on the critical importance of perfection in every
step of the process. As the firm makes progress in TQM, both internal
failure and external failure costs should decrease.
11. Costs of conformance are costs incurred to ensure that products or services
meet quality standards and include prevention costs and appraisal costs.
Internal and external failure costs are costs of non-conformance. They are
costs incurred or opportunity costs because of rejection of products or
services.
12. Better prevention of poor quality often reduces all other costs of quality.
With fewer problems in quality, appraisal is needed because the products
are made right the first time. Fewer defective units also reduce internal
and external failure costs as the occasion for repairs, rework, and recalls
decrease.

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It is easier to design and build quality in than try to inspect or repair quality
in. Theoretically, if prevention efforts are completely successful, there
will be no need to incur appraisal costs and there will be no internal failure
or external failure costs. In practice, appraisal costs usually do not
decrease, partly because management needs to ensure that quality is there
as expected. Nonconformance costs, however, decrease at a much faster
pace than prevention costs increase.
13. The role of management accountants in total quality management includes
gathering all relevant quality information, participating actively in all
phases of the quality program, and reviewing and disseminating quality
cost reports.
14. To meet the challenges of total quality management, management
accountants need to have a clear understanding of TQM methodology.
They must be able to design, create, or modify information systems that
measure and monitor quality and evaluate progress toward total quality as
expected of each organizational unit and the total enterprise.
15. Just-in-time (JIT) purchasing is the purchase of goods or materials such
that a delivery immediately precedes demand or use. Benefits include
lower inventory holdings (reduced warehouse space required and less
money tied up in inventory) and less risk of inventory obsolescence and
spoilage.
16. The sequence of activities involved in placing a purchase order can be
facilitated by use of the Internet. A company can streamline the
procurement process for its customers – e.g., having online a complete
price list, information about expected shipment dates, and a service order
capability that is available 24 hours a day with email or fax confirmation.
17. Just-in-time (JIT) production is a “demand-pull” manufacturing system
that has the following features:
 Organize production in manufacturing cells,
 Hire and retain workers who are multiskilled,
 Aggressively pursue total quality management (TQM) to
eliminate defects,
 Place emphasis on reducing both setup time and manufacturing
lead time, and
 Carefully select suppliers who are capable of delivering quality
materials in a timely manner.

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18. Reengineering is the fundamental rethinking and redesign of business

processes to achieve improvements in critical measures of performance
such as cost, quality, service, speed, and customer satisfaction.
19. The three main measures used in the theory of constraints are:
a. Throughput contribution equal to sales revenue minus direct materials
costs.
b. Investments (inventory) equal to the sum of materials costs of direct
materials inventory, work-in-process inventory and finished goods
inventory, research and development costs, and costs of equipment
and buildings.
c. Other operating costs equal to all operating costs (other than direct
materials) incurred to earn throughput contribution.
20. The four key steps in managing bottleneck resources are:
Step 1: Recognize that the bottleneck operation determines throughput
contribution.
Step 2: Search for, and find the bottleneck.
Step 3: Keep the bottleneck busy, and subordinate all nonbottleneck
operations to the bottleneck operation.
Step 4: Increase bottleneck efficiency and capacity.
21. (a) Product warranty costs should be lower because a world-class
manufacturer (WCM) will make fewer defectives.
(b) Salaries of quality control inspectors should be lower because a WCM
will have its workers inspect as they go, rather than having separate
inspections. Nor will a WCM inspect incoming materials and
components because it will deal only with vendors whose quality has
been demonstrated.
(c) Amounts paid to vendors for parts and components should be higher
because a WCM will not search out the lowest prices, but will seek
high-quality components delivered when needed.
(d) Wages rates for direct laborers should be higher because a WCM’s
workers will multiskilled and should therefore command premium
wages.
(e) Total supervisory salaries should be lower because a WCM’s workers
will not need as much supervision.
(f) Warehousing costs should be lower because a WCM will produce as
needed and so will not require storage space for materials or finished
product.

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22. At the final assembly stage in a JIT system, a signal is sent to the preceding
workstation as to the exact parts and materials that will be needed over the
next few hours for the final assembly of products. Only those parts and
materials are provided. The same signal is sent back through each
preceding workstation so that a smooth flow of parts and materials is
maintained with no buildup of inventories at any point. Thus, all
workstations respond to the “pull” exerted by the final assembly stage.
The “pull” approach just described can be contrasted to the “push”
approach used in conventional systems. In a conventional system,
inventories of parts and materials are built up—often simply to keep
everyone busy. These semi-completed parts and materials are “pushed”
forward to the next workstation whether or not there is actually any
customer demand for the products they will become part of. The result is
large stockpiles of work in process inventories.
23. A number of benefits accrue from reduced setup time. First, reduced setup
time allows a company to produce in smaller batches, which in turn
reduces the level of inventories. Second, reduced setup time allows a
company to spend more time producing goods and less time getting ready
to produce. Third, the ability to rapidly change from making one product
to making another allows the company to respond more quickly to
customers. Finally, smaller batches make it easier to spot manufacturing
problems before they result in a large number of defective units.

II. Exercises

Exercise 1 (Quality Cost Classification)

Inter Exter
nal nal
Preven Apprai Failur Failur
tion sal e e
a. Warranty repairs x
b. Scrap x
c. Allowance granted
due to blemish x

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d. Contribution margins
of lost sales x
e. Tuition for quality
courses x
f. Raw materials
inspections x
g. Work-in-process
inspection x
h. Shipping cost for
replacements x
i. Recalls x
j. Attorney’s fee for
unsuccessful defense
of complaints about
quality x
k. Inspection of
reworks x
l. Overtime caused by
reworking x
m. Machine
maintenance x
n. Tuning of testing
equipment x
Exercise 2 (Cost of Quality Report)

Requirements 1 & 2
Bali Company
Cost of Quality Report
For 2005 and 2006

Cost of Quality 2006 2005

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Category Peso % Peso %

Prevention costs:
Quality manual P 40,000 P 50,000
Product design 300,000 P 340,000 5.67 270,000 P320,000 5.33
Appraisal costs:
Testing P 80,000 80,000 1.33 P 60,000 60,000 1.00
Internal failure costs:
Rework P200,000 P250,000
Retesting 50,000 90,000
Disposal of defective
units 90,000 340,000 5.67 85,000 425,000 7.08
External failure costs:
Product recalls P360,000 P500,000
Field service 230,000 590,000 9.83 350,000 850,000 14.17
Total cost of quality P1,350,000 22.50 P1,655,000 27.58

a. There were slight increases in both prevention and appraisal costs from
2005 to 2006. Each of these two cost of quality increased by
approximately 0.33 percent of the total sales. These two costs increased
by P40,000 over the two years.
b. Both internal failure costs and external failure costs decreased
substantially in 2006 as compared to those in 2005. The firm experienced
a 1.41 percent decrease in internal failure and a 4.34 percent decrease in
external failure costs with the total savings of P345,000. The savings was
863 percent of the increases in prevention and appraisal costs.

Requirement 3

Among nonfinancial measures the firm may want to monitor are:

 The number of defects or the processes yield (ratio of good output to
total output)
 The percentage of defective units shipped to customers to total units
of products shipped
 The number of customer complaints
 Difference between delivery date requested by the customer

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 On-time delivery percentage (total units shipped on or before the

scheduled date to the total units shipped)
 Surveys of customer satisfaction

It should be noted that nonfinancial measures by themselves often have limited

meaning. Nonfinancial measures are more informative when trends of the
same measure over time are examined.

Exercise 3 (Cost of Quality Category)

Requirement 1

Costs of Preventi Apprais Internal External

Quality on al Failure Failure
Rework P
6,000
Recalls P15,000
Reengineering P
efforts 9,000
Repair 12,000
Replacements 12,000
Retesting 5,000
Supervision P18,000
Scrap 9,000
Training 15,000
Testing of
incoming
materials 7,000
Inspection of
work in
process 18,000
Downtime 10,000

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Product
liability
insurance 9,000
Quality audits 5,000
Continuous
improvement 1,000
Warranty
repairs 15,000

Requirement 2

Total spent by
category P25,000 P48,000 P42,000 P51,000
Requirement 3

The company is currently spending the least on preventive costs. They should
concentrate their efforts on preventive costs because they prevent poor quality
products from being manufactured.

By increasing amount spent on prevention, they could reduce spending on the

other cost of quality categories.

Exercise 4 (Cost of Quality Analysis, Nonfinancial Quality Measures)

Requirements 1 and 2

2006 2005
Revenues P12,500,000 P10,000,000
Percenta Percenta
ge of ge of
Revenue Revenue
s (2) = s (4) =
(1)  (3) 
Cost P12,500 Cost P10,000
Costs of Quality (1) ,000 (3) ,000

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Prevention costs
Design P240,0 P100,0
engineering 00 00
Preventive
maintenance 90,000 35,000
Training 120,00
0 45,000
Supplier
evaluation 50,000 20,000
Total
prevention 500,00 200,00
costs 0 4.0% 0 2.0%

Appraisal costs
Line inspection 110,00
85,000 0
Product-testing
equipment 50,000 50,000
Incoming
materials
inspection 40,000 20,000
Product-testing
labor 220,00
75,000 0
Total
appraisal costs 250,00 400,00
0 2.0% 0 4.0%
Internal failure
costs

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Scrap 200,00 250,00

0 0
Rework 135,00 160,00
0 0
Breakdown
maintenance 40,000 90,000
Total internal
failure costs 375,00 500,00
0 3.0% 0 5.0%
External failure
costs
Returned 145,00
goods 0 60,000
Customer
support 30,000 40,000
Product liability 100,00 200,00
claims 0 0
Warranty
repair 200,00 300,00
0 0

475,00 600,00
0 3.8% 0 6.0%
Total costs of P1,600, P1,700,
quality 000 12.8% 000 17.0%
Between 2005 and 2006, Gabriel’s costs of quality have declined from 17% of
sales to 12.8% of sales. The analysis of individual costs of quality categories
indicates that Gabriel began allocating more resources to prevention activities
– design engineering, preventive maintenance, training and supplier
evaluations in 2006 relative to 2005. As a result, appraisal costs declined from
4% of sales to 2%, costs of internal failure fell from 5% of sales to 3%, and
external failure costs decreased from 6% of sales to 3.8%. The one concern
here is that, although external failure costs have decreased, the cost of returned

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goods has increased. Gabriel’s management should investigate the reasons for
this and initiate corrective action.

Requirement 3

Examples of nonfinancial quality measures that Gabriel Corporation could

monitor are:

a. Number of defective grinders shipped to customers as a percentage of total

units of grinders shipped.
b. Ratio of good output to total output at each production process.
c. Employee turnover.

Exercise 5 (Costs of Quality Analysis, Nonfinancial Quality Measures)

Requirements 1 and 2

Revenues, Costs of Quality and Costs of Quality as a

Percentage of Revenues for Victoria

Revenues = P2,000 x 10,000 units = P20,000,000

Percentage of
Revenues
Costs (2) = (1) 
Costs of Quality (1) P20,000,000
Prevention costs
Design engineering (P75 x
6,000 hours) P 450,000 2.25%
Appraisal costs
Testing and inspection
(P40 x 1 hour x 10,000
units) 400,000 2.00%
Internal failure costs
Rework (P500 x 5% x
10,000 units) 250,000 1.25%
External failure costs

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Repair (P600 x 4% x
10,000 units) 240,000 1.20%

Total costs of quality P1,340,000 6.70%

Revenues, Costs of Quality and Costs of Quality as a

Percentage of Revenues for Vancouver

Revenues = P1,500 x 5,000 units = P7,500,000

Percentage of
Revenues
Costs (2) = (1) 
Costs of Quality (1) P7,500,000
Prevention costs
Design engineering (P75
x 1,000 hours) P 75,000 1.00%
Appraisal costs
Testing and inspection
(P40 x 0.5 x 5,000
units) 100,000 1.33%
Internal failure costs
Rework (P400 x 10% x
5,000 units) 200,000 2.67%
External failure costs
Repair (P450 x 8% x
5,000 units) 180,000 2.40%

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Estimated forgone
contribution margin
on lost sales [(P1,500
– P800) x 300] 210,000 2.80%
Total external failure
costs 390,000 5.20%
Total costs of quality P765,000 10.20%

Costs of quality as a percentage of sales are significantly different for

Vancouver (10.20%) compared with Victoria (6.70%). Canada spends very
little on prevention and appraisal activities for Vancouver, and incurs high
costs of internal and external failures. Canada follows a different strategy with
respect to Victoria, spending a greater percentage of sales on prevention and
appraisal activities. The result: fewer internal and external failure costs and
lower overall costs of quality as a percentage of sales compared with
Vancouver.

Requirement 3

Examples of nonfinancial quality measures that Canada Industries could

monitor as part of a total quality-control effort are:

a. Outgoing quality yield for each product

b. Returned refrigerator percentage for each product
c. On-time delivery
d. Employee turnover

III. Problems

Problem 1 (Quality Improvement, Relevant Cost Analysis)

Requirement 1

Cost of new equipment and installation P12,000,000

Training 3,000,000
Total additional cost of the new process P15,000,000

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Requirement 2

Quality cost if no change is made:

Rework 3,000 x 40% x P2,000 = P 2,400,000

Repair 3,000 x 15% x P2,500 = 1,125,000
Appraisal 600,000
Inspection 3,000 x P50 = 150,000
Lost contribution:
Contribution margin per unit P12,000 x 85% - P2,500 = P7,700
Lost sales 3,000  0.8 – 3,000 = x 750 5,775,000
Total current cost of
quality P10,050,000

Quality cost with the new process:

Warranty repair 3,000  0.8 x 5% x P1,000 = – 187,500
Savings from the new process each year P 9,862,500
Years effective x 3
Total P29,587,500

Appraisal and inspection cost in Year 1 – 750,000

Total savings over 3 years P28,837,500

Requirement 3

Yes. The cost of the new process is P15,000,000 and the expected benefits is
P28,837,500 over three years. The firm can expect to earn a return of over
90%.

Requirement 4

The following factors should be considered before making the final decision:

a. Accuracy of cost estimates including

 Contribution margin per unit
 Costs of current repair and rework
 Cost of repair with the new process
 Cost of the new process
b. Reliability of estimations of
 Rates of rework and repair

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 Lost sales
 Amount of time before the current product become obsolete
c. Reaction of competitors

Requirement 5

The member of the board would be right if we ignore the financial payoff of
the new process and if the firm is going to be in business for only three years.
Having high quality products, especially for a high-end product such as the
one the firm is selling, is crucial for a long term success.

Problem 2 (Preparing a Cost of Quality Report)

The Adoracion Company

Comparative Costs of Quality Report

Increase
Costs (Decrease
Categories 2005 2006 )
Prevention
costs:
Training P P P
75,000 100,000 25,000
Product
design 150,000 175,000 25,000
Total 225,000 275,000 50,000
prevention

Appraisal
costs:
Testing 50,000 150,000 100,000
Calibratio
n 75,000 100,000 25,000
Total 125,000 250,000 125,000
appraisal

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Internal
failure costs:
Rework 325,000 100,000 (225,000
)
Retesting
250,000 200,000 (50,000)
Total 575,000 300,000 (275,000
internal )
failure

External
failure costs:
Warranty 150,000 75,000 (75,000)
repairs
Product 400,000 200,000 (200,000
recalls )
Product
liability 125,000 75,000 (50,000)
Total
external 675,000 350,000 (325,000
failure )
Total costs P1,600,00 P1,175,00 P
of quality 0 0 (425,000
)
Problem 3 (JIT Production, Relevant Benefits, Relevant Costs)

Requirement 1

Incremental Incremental
Costs under Costs under

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Current JIT Production

Production System
Relevant Items System
Annual tooling costs – P150,000
Required return on investment
12% per year x P900,000 of
average inventory per year P108,000
12% per year x P200,000 of
average inventory per year 24,000
Insurance, space, materials
handling, and setup costs 200,000 140,000a
Rework costs 350,000 280,000b
Incremental revenues from
higher selling prices – (90,000)c
Total net incremental costs P658,000 P504,000
Annual difference in favor of
JIT production P154,000
a
P200,000 (1 – 0.30) = P140,000
b
P350,000 (1 – 0.20) = P280,000
c
P3 x 30,000 units = P90,000

Requirement 2

Other nonfinancial and qualitative factors that Francisco should consider in

deciding whether it should implement a JIT system include:

a. The possibility of developing and implementing a detailed system for

integrating the sequential operations of the manufacturing process.
Direct materials must arrive when needed for each subassembly so that
the production process functions smoothly.
b. The ability to design products that use standardized parts and reduce
manufacturing time.
c. The ease of obtaining reliable vendors who can deliver quality direct
materials on time with minimum lead time.
d. Willingness of suppliers to deliver smaller and more frequent orders.
e. The confidence of being able to deliver quality products on time.
Failure to do so would result in customer dissatisfaction.

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f. The skill levels of workers to perform multiple tasks such as minor

repairs, maintenance, quality testing and inspection.

Problem 4 (JIT Purchasing, Relevant Benefits, Relevant Costs)

Requirement 1
Incremental
Costs under Incremental
Current Costs under
Purchasing JIT Purchasing
System Policy
Required return on investment
20% per year x P600,000 of
average inventory per year P120,000
20% per year x P0 of
inventory per year P 0
Annual insurance costs 14,000 0
Warehouse rent 60,000 (13,500)a

Overtime costs
No overtime 0
Overtime premium 40,000
Stockout costs
No stockouts 0
P6.50b contribution margin
per unit x 20,000 units 130,000
Total incremental costs P194,000 P156,500
Difference in favor of JIT
purchasing P37,500
a
P(13,500) = Warehouse rental revenues, [(75% x 12,000) x P1.50].
b
Calculation of unit contribution margin
Selling price (P10,800,000  900,000 units) P12.00
Variable costs per unit:

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Variable manufacturing costs per unit

(P4,050,000  900,000 units) P4.50
Variable marketing and distribution
costs per unit
(P900,000  900,000 units) 1.00
Total variable costs per unit 5.50
Contribution margin per unit P6.50

Note that the incremental costs of P40,000 for overtime premiums to make the
additional 15,000 units are less than the contribution margin from losing these
sales equal to P97,500 (P6.50 x 15,000). Josefina would rather incur overtime
than lose 15,000 units of sales.

Problem 5 (Theory of Constraints, Throughput Contribution, Relevant

Costs)

Requirement 1

Finishing is a bottleneck operation. Hence, producing 1,000 more units will

generate additional throughput contribution and operating income.

Increase in throughput contribution (P72 – P32) x 1,000 P40,000

Incremental costs of the jigs and tools 30,000
Net benefit of investing in jigs and tools P10,000

Zashi should invest in the modern jigs and tools because the benefit of higher
throughput contribution of P40,000 exceeds the cost of P30,000.

Requirement 2

The Machining Department has excess capacity and is not a bottleneck

operation. Increasing its capacity further will not increase throughput
contribution. There is, therefore, no benefit from spending P5,000 to increase
the Machining Department’s capacity by 10,000 units. Zashi should not
implement the change to do setups faster.

Problem 6 (Theory of Constraints, Throughput Contribution, Relevant

Costs)

Requirement 1

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Finishing is a bottleneck operation. Hence, getting an outside contractor to

produce 12,000 units will increase throughput contribution.

Increase in throughput contribution (P72 – P32) x 12,000 P480,000

Incremental contracting costs P10 x 12,000 120,000
Net benefit of contracting 12,000 units of finishing P360,000

Zashi should contract with an outside contractor to do 12,000 units of finishing

at P10 per unit because the benefit of higher throughput contribution of
P480,000 exceeds the cost of P120,000. The fact that the costs of P10 are
double Zashi’s finishing cost of P5 per unit are irrelevant.

Requirement 2

Operating costs in the Machining Department of P640,00, or P8 per unit, are

fixed costs. Zashi will not save any of these costs by subcontracting machining
of 4,000 units to Rainee Corporation. Total costs will be greater by P16,000
(P4 per unit x 4,000 units) under the subcontracting alternative. Machining
more filing cabinets will not increase throughput contribution, which is
constrained by the finishing capacity. Zashi should not accept Rainee’s offer.
The fact that Rainee’s costs of machining per unit are half of what it costs
Zashi in-house is irrelevant.

Problem 7 (Theory of Constraints, Throughput Contribution, Quality)

Requirement 1

Cost of defective unit at machining operation which is not a bottleneck

operation is the loss in direct materials (variable costs) of P32 per unit.
Producing 2,000 units of defectives does not result in loss of throughput
contribution. Despite the defective production, machining can produce and
transfer 80,000 units to finishing. Therefore, cost of 2,000 defective units at
the machining operation is P32 x 2,000 = P64,000.

Requirement 2

A defective unit produced at the bottleneck finishing operation costs Zashi

materials costs plus the opportunity cost of lost throughput contribution.
Bottleneck capacity not wasted in producing defective units could be used to

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generate additional sales and throughput contribution. Cost of 2,000 defective

units at the finishing operation is:

Lost of direct materials P32 x 2,000 P 64,000

Forgone throughput contribution (P72 – P32) x 2,000 80,000
Total cost of 2,000 defective units P144,000

Alternatively, the cost of 2,000 defective units at the finishing operation can
be calculated as the lost revenue of P72 x 2,000 = P144,000. This line of
reasoning takes the position that direct materials costs of P32 x 2,000 =
P64,000 and all fixed operating costs in the machining and finishing operations
would be incurred anyway whether a defective or good unit is produced. The
cost of producing a defective unit is the revenue lost of P144,000.

Problem 8

Requirement (a)

The following table reclassified the cost-of-quality expenses:

Anthony Foods
Quality Costs
2005-2006
(Millions)

2005 2006
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Quality assurance
administration P 6.20 P 6.52 P 6.86 P 7.19 P 7.93 P 8.74 P 9.61 P10.53
Training 13.10 14.39 15.90 17.46 21.12 25.50 30.37 36.35
Process
engineering 2.20 2.46 2.76 3.11 3.87 4.86 6.13 7.58
Prevention 27.76 32.92 39.10 46.11
21.50 23.37 25.52 54.46

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Inspection 1.40 1.56 1.75 1.95 2.39 2.96 3.63 4.46

Testing 1.60 1.72 1.85 1.99 2.29 2.62 3.01 3.45
Appraisal 3.00 3.28 3.60 3.94 4.68 5.58 6.64 7.91
Rework 15.80 12.65 10.03 8.49 7.25 6.16 5.56 5.00
Scrap 10.32 8.92 7.72 7.00 6.34
17.60 14.48 11.92
Internal failure 18.81 16.17 13.88 12.56
33.40 27.13 21.95 11.34
Returns 26.90 21.09 16.35 13.53 11.32 9.50 8.43 7.52
Customer
complaint dept. 3.90 3.45 3.03 2.76 2.50 2.27 2.14 2.01
Lost sales 28.42 24.45 21.08 19.20
49.20 40.31 33.11 17.44
External failure 44.71 38.27 32.85 29.77
80.00 64.85 52.49 26.97
Total costs P137.90 P118.63 P103.56 P95.22 P92.04 P91.41 P95.08 P100.68

Requirement (b)

From the preceding data we see that prevention and appraisal costs are
increasing while internal and external failure costs have been decreasing. The
following graph plots three series: prevention and appraisal costs, failure
costs, and total quality costs.

140

120

100
80

60

40
20
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2005 Quarters 2006

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Appraisal and prevention costs

Failure costs
Total quality costs

A preliminary conclusion from the graph is that Anthony Foods is probably

now spending too much on trying to improve quality. Assuming that the
underlying production processes have not changed over time, quality costs
were minimized in the second quarter of 2006. Since then, the additional
money spent on appraisal and prevention has yielded smaller internal- and
external-failure costs savings.

Problem 9 (Applying TQM in Manufacturing versus Administration)

The ability of TQM to deliver cost savings and performance enhancements

depends directly on how easy it is to measure and observe the output of the
process. If a TQM team’s output is easy to measure, it is easier to hold the
team members responsible for improving quality. If quality improvements are
difficult to observe, then holding team members responsible imposes more risk
on them. It is easier for them to argue that they didn’t achieve their goals
because they were hard to observe. If the benefits from TQM are lower
because it is more difficult to observe the TQM output, less will be invested in
such activities.

Measuring quality improvements in a manufactured process tends to be easier

than a service. Engineering standards can be set for a manufactured good and
conformance to the standards can be relatively easy to measure. But the output
of many administrative departments is multidimensional and often hard to
observe. Manufacturing involves repetitive processes with few exceptions.
Administrative functions often involve handling numerous exceptions. It is
likely to be easier to observe quality improvements in a television set than it is
in a human resources department or a legal department.

IV. Multiple Choice Questions

31. C 26. C

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32. B 27. A
33. C 28. C
34. D 29. B
35. D 30. C
36. A 31. D
37. C 32. D
38. C 33. D
39. D 34. A
40. D 35. A

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