CHAPTER 10 Cost Analysis for Management Decision Making

Review Summary
  1.   Absorption costing or full costing assigns direct materials and direct labor costs and a share of both fixed and variable factory overhead costs to units of production. In variable costing also known as direct costing, only direct materials, direct labor, and variable factory overhead are charged to the product, while fixed manufacturing costs are expensed totally in the period incurred.
        If the number of units produced differs from the number of units sold, reported net income under absorption costing will differ from reported net income under variable costing. This difference is caused by the elimination of fixed manufacturing expenses from inventories in variable costing. Generally, when production exceeds sales, absorption costing shows a higher profit than does variable costing, and when sales exceed production, the reverse occurs. Managers prefer income statements prepared on a variable costing basis because the variable cost of goods sold fluctuates directly with sales volume, and the influence of production levels on profit is eliminated.
        The use of variable costing for financial reporting is not accepted by the American Institute of Certified Public Accountants, the Internal Revenue Service, the Securities and Exchange Commission, or the Financial Accounting Standards Board. The position of these groups generally is based on their opposition to excluding fixed costs from inventories. Companies using variable costing internally adjust to absorption costing when preparing income tax returns and when reporting externally.
  2.   Segment reporting provides data that can be used by management to evaluate the operations and profitability of individual divisions, product lines, sales territories, etc. Segment profitability analysis requires that all costs be classified as either direct costs, which can be traced to a specific segment, or indirect costs, which are common to all segments. The variable costs and direct fixed costs are subtracted from sales to obtain the segment margin, which measures the ability of the segment to recover both the assigned variable costs and direct fixed costs necessary to keep the company solvent. Segment profitability analysis is useful for making long-run decisions such as product pricing policies, decisions to retain or eliminate specific segments and analysis of segment managers’ performance.
  3.   Cost-volume-profit analysis is a technique that uses the degrees of cost variability to measure the effects of changes in volume on resulting profits. The break-even point is defined as the point at which sales revenue is adequate to manufacture and sell a product, but not enough to generate a profit.  The contribution margin ratio is determined by dividing the contribution margin (sales minus variable costs) by sales revenue. The contribution margin per unit is the difference between the sales price per unit and the variable costs per unit. Formulas for break-even computations follow:
Break-even sales volume in dollars =
Break-even sales volume in units =
  4.   Significant uses of cost-volume-profit analysis include aiding in budgetary control, improving and balancing sales, analyzing the impact of volume changes, and analyzing the impact of sales price changes and changes in costs. The break-even chart is a graphically depiction of the break-even point.
  5.   If management wishes to determine the amount of sales units or dollars needed to earn a certain income, known as the target volume, it may revise the break-even formula as follows:
Total fixed costs + Net income
                Target volume (dollars) =
1 – Variable costs / Sales revenue
If income taxes are present, the pre-tax income required to earn a certain net income must first be determined before the target volume can be computed. In a multi-product firm, a weighted-average contribution margin must be computed before the break-even sales volume or target volume can be determined.
  6.   The margin of safety indicates how much sales may decrease from a projected sales figure before the company will incur a loss, and it is computed as follows:
Margin of safety (dollars) = Sales revenue – Break-even sales revenue
The margin of safety expressed as a percentage of sales, in either dollars or units, is called the margin of safety ratio and is computed as follows:
Margin of safety ratio =
        Since the margin of safety is related directly to net income, the margin of safety ratio can be used to calculate net income as a percentage of sales:
Net income percentage = Contribution margin ratio × Margin of safety ratio
  7.   Differential analyses are studies that highlight the significant cost and revenue data of alternatives. The difference in revenue between two alternatives is called differential revenue. The difference in cost between two alternatives is called differential cost. The amount of extra profit earned from choosing the better of the alternatives is known as differential income. Is it advantageous to sell a product at a special price? If there is excess capacity and the selling price per unit exceeds the variable costs per unit, the order should be accepted as long as it doesn’t violate federal pricing legislation or alienate current customers. This approach is called contribution pricing, meaning accepting a selling price as long as it exceeds variable cost. Another decision involves buying a part versus making it. If excess capacity exists, only the differential materials, labor, and overhead costs should be compared to the outside purchase price in deciding whether to make or buy.
  8.   Efficient control of all costs should include both the production costs and distribution costs. Distribution costs are costs incurred to sell and deliver the product. In allocating distribution costs to products and other cost objects, a reasonable basis for allocation, such as square inches of newspaper space for advertising costs, should be devised.

Part I

Instructions: Indicate your answer in the Answers column by writing a “T” for True or an “F” for False.

Answers

  1.   The variable costing method charges the product with only the production costs that vary directly with volume................................................................................................        _________
  2.   Under both absorption and variable costing, nonmanufacturing costs are charged against income in the period incurred................................................................................        _________
  3.   Under absorption costing, fixed factory overhead expenses appear as an expense on each period’s income statement..................................................................................        _________
  4.   If production exceeds sales, profits reported under absorption costing will be less than profits reported under variable costing...........................................................................        _________
  5.   Variable costing does not conform to generally accepted accounting principles for costing inventories........................................................................................... _________
  6.   Direct costs are excluded from the computation of the segment margin........        _________
  7.   In computing the break-even sales volume in units, the total fixed cost is divided by the contribution margin per unit.....................................................................................        _________
  8.   In constructing a break-even chart, a fixed cost line is drawn parallel to the X-axis.              _________
  9.   If a firm produces multiple products, the sales mix must be computed before a break-even point can be determined.......................................................................................        _________
10.   A limitation of cost-volume-profit analysis is that it assumes that all factors except volume will remain constant for a period of time...................................................................        _________
11.   The margin of safety is computed by subtracting the fixed costs from the total contribution margin.   _________
12.   A study that highlights the significant cost data of alternatives is referred to as differential cost analysis........................................................................................... _________
13.   To decide in favor of accepting an order at a special reduced price, there should be excess production capacity and the sales price per unit should exceed the incremental cost per unit.                 _________
14.   In deciding to make a part in its own plant or to buy it from a supplier, the relevant costs are the purchase price of the part and the manufacturer’s fixed factory overhead..        _________
15.   Distribution costs are a component of inventory costs under absorption costing  _________

Part II

Instructions: In the Answers column, place the letter from the list below that identifies the term that best matches the statement. No letter should be used more than once.
a.  Absorption costing                    g.  Distribution costs               l.  Cost-volume-profit
b.  Break-even point                      h.  Segment margin                     analysis
c.  Contribution pricing                   i.  Manufacturing margin      m.  Margin of safety ratio
d.  Variable costing                         j.  Margin of safety               n.  Product costs
e.  Contribution margin                  k.  Target volume                  o.  Differential income
f.  Contribution margin ratio

Answers

_____    1.   This charges the product with only the production costs that vary with volume.
_____    2.   This represents sales less variable cost of goods sold.
_____    3.   This charges the product with both fixed and variable manufacturing expenses.
_____    4.   The amount of sales in units or dollars needed to cover costs and earn a certain profit.
_____    5.   The practice of accepting a selling price as long as it exceeds variable cost.
_____    6.   The excess of segment revenue over direct costs assigned to the segment.
_____    7.   An analytical technique that uses the degrees of cost variability for measuring the effect of changes in volume on profits.
_____    8.   Where sales revenue is adequate to cover all costs to manufacture and sell the product but no profit is earned.
_____    9.   The difference between the sales revenue and the total variable expenses.
_____  10.   The amount by which sales can decrease before the company will suffer a loss.
_____  11.   The amount of extra profit earned from choosing the better of two alternatives.
_____  12.   These are costs incurred to sell and deliver the product.
_____  13.   A relationship computed by dividing the difference between the total sales and the break-even point sales by the total sales.
_____  14.   When inventory is sold, these are recognized as expenses and matched with the related revenue.
_____  15.   It expresses the relationship, in percentage terms, between contribution margin and sales.

Part III

Instructions: In the Answers column, place the letter of the choice that most correctly completes each item.

Answers

_____    1.   To institute a variable costing system, it is necessary to know:
a.  The variable and fixed components of all costs related to production
b.  The controllable and noncontrollable components of all costs related to production
c.  Standard production rates and times for all elements of production
d.  The contribution margin and break-even point for all goods in production
_____    2.   A company has operating income of $50,000 using variable costing for a given period. Beginning and ending inventories for that period were 18,000 units and 13,000 units, respectively. If the fixed factory overhead application rate is $1 per unit, the operating income using absorption costing is:
a.  $45,000
b.  $55,000
c.  $50,000
d.  Not determinable from the information given
_____    3.   Kristal Radio Shop has a Stereo and a Satellite department.  The sales price for the stereo model is $100 with variable costs of $80.  The sales price and variable costs for the satellite model are $200 and $170, respectively.  Kristal sold 10,000 stereo models and 4,000 satellite models.  Total fixed costs for Kristal were $300,000, which were allocated equally between the departments.  Upon further analysis, it was determined that each department had a manager that worked solely for that department.  The salary of the Stereo manager was $50,000 and the salary of the Satellite manager was $60,000.  None of the other fixed costs could be traced directly to either department.  What is the segment margin for the Satellite department?
a.  $(30,000)
b.  $60,000
c.  $120,000
d.  $50,000
_____    4.   Tundra Company sells Icee at $8 per unit. In the current year, fixed cost is expected to be $200,000 and variable cost is estimated at $4 per unit. The units of Icee that Tundra must sell to generate operating income of $40,000 are:
a.  50,000                                                    
b.  100,000                                                   
c.  60,000
d.  120,000
_____    5.   Tradewinds Bikes sells a regular and a deluxe model.  The sales price for the regular model is $200 with variable costs of $140.  The sales price and variable costs for the deluxe model are $300 and $220, respectively.  Tradewinds sells three times as many regular models as they do deluxe models.  Fixed costs are $136,500.  How many bikes must Tradewinds sell to break even?
a.  1,680
b.  1,950
c.  1,820
d.  2,100
_____    6.   If the fixed cost for a product increases and the variable cost (as a percentage of sales dollars) increases, what will be the effect on the contribution margin ratio and the break-even point, respectively?
    Contribution                          Break-Even
Margin Ratio                               Point
a.    Decreased                               Increased
b.    Increased                                 Decreased
c.    Decreased                               Decreased
d.    Increased                                 Increased
_____    7.   To obtain the target volume stated in dollars of sales, divide the total fixed cost plus desired net income by:
a.  Variable cost per unit
b.  (Sales price per unit – variable cost per unit) ÷ sales price per unit
c.  Fixed cost per unit
d.  Variable cost per unit ÷ sales price per unit
_____    8.   The manufacturing capacity of Venice Company’s facilities is 30,000 units of a product a year. A summary of operating results for the previous year ended December 31, follows:
Sales (18,000 units @ $100 per unit)..........................      $1,800,000
Variable manufacturing and selling costs.....................         990,000
Contribution margin..................................................           810,000
Fixed costs...............................................................         495,000
Operating income.....................................................      $  315,000
A foreign distributor has offered to buy 15,000 units at $90 per unit during the current year. Assume that all of Venice’s costs would be at the same levels and rates this year as in the prior year. If Venice accepted this offer and rejected some business from regular customers so as not to exceed capacity, what would be the total operating income this year?
a.  $390,000                                                 
b.  $705,000                                                 
c.  $840,000
d.  $855,000
_____    9.   Bach Company sells Aria at a selling price of $21 per unit. Bach’s cost per unit based on the full capacity of 200,000 units follows:
Direct materials..............................................................       $ 4
Direct labor....................................................................           5
Overhead (two-thirds of which is fixed)............................         6
$15
A special order offering to buy 20,000 units was received from a foreign distributor. The only selling costs that would be incurred on this order are $3 per unit for shipping. Bach has sufficient existing capacity to manufacture the additional units. In negotiating a price for the special order, Bach should consider that the minimum selling price per unit should exceed:
a.  $14                                                         
b.  $15                                                         
c.  $16
d.  $18

____    10.   Carmella Company temporarily has unused production capacity. The idle plant facilities can be used to manufacture a low-margin item. This low-margin item should be produced if it can be sold for more than its:
a.  Fixed cost
b.  Variable manufacturing cost
c.  Variable manufacturing and marketing costs
d.  Variable marketing cost
Part IV
Comparative income statements—variable and absorption costing

Highlands Manufacturing Company has determined the cost of manufacturing a unit of product to be as follows, based on normal production of 50,000 units per year:
Direct materials............................................             $10
Direct labor..................................................                 8
Variable factory overhead..............................               6
$24
Fixed factory overhead..................................               6
$30
Operating statistics for the months of July and August are as follows:
                                                                             July           August
Units produced.............................................           6,000           4,000
Units sold....................................................           4,000           6,000
Selling and administrative expenses................       $25,000        $25,000
The selling price is $40 per unit. There were no inventories on July 1, and there is no work in process at August 31.

Instructions: Complete the comparative income statements on the next page for July and August for Highlands under:
  1.   absorption costing
  2.   variable costing
Highlands Manufacturing Company
Income Statement
For the Month Ended July 31, 20xx
                                                                                               Absorption           Variable
Costing              Costing
Sales ………………………………………………………….     $                          $
Cost of goods sold............................................................                                                    
Underapplied/overapplied factory overhead*.......................                          
Gross margin....................................................................      $             
Manufacturing margin.......................................................                                 $
Less:
Fixed factory overhead................................................
Selling and administrative expenses..............................                                                    
Net income (loss) ………………………………………………  $                          $                 
*Calculation of overapplied factory overhead:
Fixed factory overhead per year ……………………………………………      $                   
Fixed factory overhead per month …………………………………………      $
Fixed factory overhead applied to production ……………………………..       $                   
Fixed overhead per month.....................................................................                          
Fixed factory overhead overapplied ……………………………………….       $                   
Highlands Manufacturing Company
Income Statement
For the Month Ended August 31, 20xx
                                                                                               Absorption           Variable
Costing              Costing
Sales ………………………………………………………….     $                           $
Cost of goods sold............................................................                                                    
Underapplied/overapplied factory overhead**.....................                          
Gross margin …………………………………………………… $
Manufacturing margin.......................................................                                 $
Less:
Fixed factory overhead................................................
Selling and administrative expenses..............................                                                    
Net income (loss) ……………………………………………      $                          $                 
**Calculation of underapplied factory overhead:
Fixed factory overhead applied to production ……………………………..       $
Fixed factory overhead per month..........................................................                          
Fixed factory overhead underapplied ………………………………………      $                   

Part V

Calculating break-even point, margin of safety, target volume with taxes, and preparing break-even chart

The following data of Shannon Co. are given for May:
Normal capacity.......................       1,600 units for the month
Fixed cost................................       $80,000 per month
Variable cost.............................       $60 per unit
Sales price...............................       $150 per unit

Instructions:
  1.   Determine the break-even point in dollars (round to the nearest whole dollar).
2.   Determine the break-even point in units (round to the nearest whole unit).
3.   When operating at normal plant capacity, compute the margin of safety in units and the margin of safety ratio (round to the nearest whole unit and whole percent).

    
4. Prepare a break-even chart, using the form below. Label and identify each element of the chart.

5.   Determine the target volume in units needed to earn an after-tax income of $10,000 per month, assuming a tax rate of 30%. (Round to the nearest whole unit.)

Part VI

Using differential analysis—special customer order

Although Julian Company has the capacity to produce 10,000 units per month, current plans call for monthly production and sales of only 8,000 units at $15 each. Costs per unit at the 8,000-unit level follow:
Direct materials............................................      $ 4.00
Direct labor..................................................          2.50
Variable factory overhead..............................          2.00
Fixed factory overhead..................................          1.75
Variable marketing expense...........................            .50
Fixed administrative expense.........................        1.25
$12.00

Instructions:
  1.   Determine whether the company should accept a special order for 1,000 units @ $8.00 per unit that was brought to it by a potential customer.  (Assume that variable marketing expenses would not be incurred on the order.)
            2. Determine the maximum unit price that the company should be willing to pay an outside supplier to manufacture 10,000 units of this product. Assume comparable quality and that $2,500 of fixed factory overhead would not be incurred if the product were made outside.