CHAPTER 11 MANAGING LONG-LIVED RESOURCES: CAPITAL BUDGETING

SOLUTIONS

REVIEW QUESTIONS 11.2 The time value of money arises because a dollar today is worth more than a dollar tomorrow. Time value of money is important for project evaluation as cash inflows and outflows occur at different points in time thus, we need to put these different cash flows on equal footing to compare them. 11.5 1! "nitial outlay, 2! estimated life and salvage value, #! timing and amounts of operating cash flows, and $! cost of capital. 11.% &et present value is the total present value of all cash inflows and outflows. 'e compute net present value by discounting future cash inflows and outflows using present value tables for our selected discount rate! bac( into today)s dollars.

EXERCISES
11.#1 information. Treating each row of the table independently compute missing

*or each setting, we use the appropriate present value factors from the tables in +ppendi, -. The relevant table and the factor are given in parentheses for each setting. .etting 1 2 # $ 11.#6 a. -y the definition of the internal rate of return, the net present value from investing in injection molding machine should be 7ero. 8eferring to the solution to 11.#4, the present values of annuities of 152,%22 over 12 years discounted at this rate should equal 1522,222. "n other words, 152,%22 9 annuity factor : 1522,222, or annuity factor : 5.52. "nitial outlay 1225,222 $12.,.//
"T#$%& 1: '#()*+ /,322-

/ife
years!

0iscount rate
compounded annually!

*uture value
at the end of life!

5 12 6 .

123 123 140 123

$362,4 !
"T#$%& 2: '#()*+ 1,611-

1$22,222 $52,222 1#41,$22

1154,552 1152,222

-ala(rishnan, ;anagerial +ccounting 1e

*<8 "&.T8=>T<8 =.? <&/@

=sing the 8+T? 12, 52%22, A522222! function of the ?,cel .preadsheet, this annuity factor corresponds to a discount rate of 12,!.0 "+*123&3-, 'e also can use the trial and error method and the table in the +ppendi, to determine that the rate is between 12 and 1#3. This rate is less than 1$3, and, as per company policy, this project would be rejected. b. &o, it will not. The company has to go by what is the best alternative use of the funds. The only other use for the funds, as given in 11.#4, is to invest the money in shares to earn an e,pected return of 123. +nd, as we saw in 11.#4, investing in the injection molding machine is a better option. Therefore, stic(ing to the company policy and rejecting the project is not in the company)s best interest. 11.$2 a. 8ahul should ensure that the amount he invests is not greater than the present value of the cost savings the proposal generates, for it will be a negative net present value project otherwise. 8eferring to Table # in +ppendi, -, the appropriate annuity factor 5 years, 63! is #.55#. The present value of annual cost saving of 1245,222 for the ne,t five years is 1245,222 9 #.55# : $1,/4.,/ !, @ou also could calculate this amount in ?,cel as BC 2.26,5,245222! : 11,254,555!, or equivalently, you could spend 11,254,555 and not be worse off. The slight difference in the answers is due to rounding. b. Baybac( period : 11,256,245D245,222 5 3,443 5 4 6&#+7 "+*123&3-, c. &ote that the internal rate of return is also 63 because the net present value would e,actly be 7ero if 8ahul invests 11,256,245. @ou can verify this by entering A1254555 in cell +1 and 245222 in cells +2A+%. Then enter &BC 2.26,+1..+%! in cell +4 to get a &BC of A2.2$ the difference is due to rounding!.

PROBLEMS
11.$% a. The following table presents the net present value calculation for this option. "nitial investment : 152,222, /ife # years, 0iscount rate 12 percent 8&#+ A9)&+-)#: P+&7&2) P+&7&2) C1>1%#)?=& N&) C#7; =#%1& V#%1& P+&7&2) '%*< 9#()*+ V#%1& *9 ?29%*<7 @ear 2 .ale of old copier 112,222

@ear 1 ta, on gain! 11,452!a 1$4,522# @ear 1 1$2,522 # @ear 2 1#2,522 # @ear # &et present value 1125,6%6 A 152,222!

2.65# 2.65# 2.454 2.412

11,5%#! 1$2,$16 1##,64# 12#,1$2

112,$#4 152,655 16%,426 1125,6%6 $14,.6.

a. @ear 1 ta, on gain : 112,222A15,222!E2.25. +nnual afterAta, net cash inflow plus depreciation ta, shield. 0epreciation : 52,222D#! : 1#2,222. Therefore, the annual ta, saving from depreciation is 1#2,222 9 2.25 : 14,522.

b. =sing ?,cel .preadsheet, we can the internal rate of return to be 2 ,20, "f discounted at this rate, the net present value is 7ero subject to rounding off!. &otice that year 2 cash flow is A46,222 : 152,222! F 112,222 and year 1 flow is 1$5,452 : 11,452!F1$4,522. =se the formula "88 +1..+$! in ?,cel. >ells +1 through +$ contain the cash flow for now and years 1A# respectively.

c. The following table presents the net present value calculation for this option. "nitial investment : A, /ife # years, 0iscount rate 12 percent C1>1%#)?=& P+&7&2) 8&#+ V#%1& # 112,$1%.%4 @ear 1 2.65# 15,#21 15,#21 16,$1%.%4 # @ear 2 2.454 1%,412 11%,212 15,$1%.%4 # @ear # 2.412 1#,655 115,6%% &et present value $14,.66 # +nnual afterAta, net cash inflow plus depreciation ta, shield. 0epreciation : 5,222D#! : 11,%%%.%4. Therefore, the annual ta, saving from depreciation is 11,%%%.%4 9 2.25 : 1$1%.%4. P+&7&2) V#%1& &oteG The cost of the old copier is a sun( cost and should not be considered. d. The net present value from (eeping the old copier is 115,6%4 from part c!. The net present value from the replacement decision is 115,6%2. T;& )<* *@)?*27 #+& #%>*7) );& 7#>& 9+*> # 9?2#2(?#% @&+7@&()?=&H The net present value method assumes that the money that is freed up will earn a return of 123. e. The new copier is li(ely to yield better quality copies. The old copier may brea( down more often and is li(ely to be more difficult to maintain. The problem already states that the additional ris( of losing customers AA because the old copies lac(s the features the new copier offers AA has already been ta(en into account in the estimates. .till, these issues are hard to quantify and require managerial judgment. 11.$4 Total investment involved in purchasing the advanced milling machine and ma(ing it operational : 12,522,222 F 1522,222 : 1#,222,222. >osts that are incurred to ma(e the milling machine operational should be included in the investment cost. The variable material cost per unit using the milling machine : 16 9 1 A 2.22! : 1%.$2 The variable labor cost per unit using the milling machine : 112 9 1 2.$2! : 14.22. +nnual saving in variable costs per unit : 16 F 112 A 1%.$2 A 14.22 : 1%.$2. Total afterAta, annual cost savings : 222,222 units 9 1%.$2 per unit : 11,262,222 9 1 A 2.#5! : 16#2,222. +nnual depreciation for the milling machine : 1#,222,222D5 : 1%22,222 Ta, saving from depreciation : 1%22,222 9 2.#5 : 1212,222 A9)&+-)#: N&) C#7; '%*< P+&7&2) =#%1& 9#()*+

Thus, total net annual cash inflow per year for the ne,t five years if Iayant purchases the milling machine : 16#2,222 F 1212,222 : 11,2$2,222. Bresent value of net annual cash inflow of 11,2$2,222 for the ne,t years discounted at 1$3 : 11,2$2,222 9 +nnuity factor 5 @ears, 1$3! from Table # in +ppendi, : 11,2$2,222 9 #.$## : 1#,544,16%. Therefore, net present value of the milling machine purchase : 1#,544,16% #,222,222 : $! 11.$5 a. The following table presents the net present value calculations for the two proposalsG Broposal 1 +nnual afterAta, operating cash inflow : 1622,222 A #52,222 A 122,222! 9 1 A 2.#2! : 12$5,222 +nnual depreciation : 11,522,222D12 : 1152,222 +nnual ta, saving from depreciation : 1152,222 9 2.#2 : 1$5,222 Total annual cash inflow : 12$5,222 F 1$5,222 : 1252,222 +nnuity factor 12 years, 123! from Table # in +ppendi, - : 5.%52 Bresent value of annuity of 1252,222 12 years, 123! : 1252,222 9 5.%52 : 11,%#6,522 "nitial investment : 11,522,222 &et present value : 11,%#6,522 A 11,522,222 : $13.,!//. ,1.6,

Broposal 2 +nnual afterAta, operating cash inflow : 1622,222 A $45,222A122,222! 9 1 A 2.#2! : 1154,522 +nnual depreciation : 11,222,222D12 : 1122,222 +nnual ta, saving from depreciation : 1122,222 9 2.#2 : 1#2,222 Total annual cash inflow : 1154,522 F 1#2,222 : 1164,522 +nnuity factor 12 years, 123! from Table # in +ppendi, - : 5.%52 Bresent value of annuity of 1262,222 12 years, 123! : 1164,522 9 5.%52 : 11,255,#45 "nitial investment : 11,222,222 &et present value : 11,255,#45 A 11,222,222 : $!4,3 !. Therefore, the &BC method ran(s Broposal 1 higher than Broposal 2. b. The present value of future cash flows, calculated using "88 should e,actly equal the initial investment amount. That is, Total annual cash flows 9 +nnuity factor 12 years, "88! : "nitial investment. Broposal 1 1252,222 9 +nnuity factor 12 years, "88! : 11,522,222, or +nnuity factor 12 years, "88! : 11,522,222D1252,222 : 5.142 8eferring to Table # in +ppendi, -, for a 12 year life, this factor corresponds to be a little over 1$3. =sing ?,cel, we can determine this rate more precisely to be 14,220 Broposal 2 1164,522 9 +nnuity factor 12 years, "88! : 11,222,222, or +nnuity factor 12 years, "88! : 11,222,222D1164,522 : 5.### 8eferring to Table # in +ppendi, -, for a 12Ayear life, this factor corresponds to be a little below 1$3. =sing ?,cel, we can determine this rate more precisely to be 13,440 Therefore, the "88 method also ran(s Broposal 1 higher than Broposal 2. +lternatively, we can enter cash flows of A1,522,222 in cell +1 and 1252,222 in cells +2A +11. Then "88 +1..+11! gives the "88 for Broposal 1. + similar calculation applies for Broposal 2 >ell +1 : A1,222,222 and +2A+11 are 1164,522!. c. @es, Broposal 1 involves a larger outlay than Broposal 2, and larger projects tend to have larger &BC, all else equal. Jowever, in this problem, there is also another difference. Broposal 1 involves more upfront investment than Broposal 2, but the variable costs are less. Thus, the two proposals are very different in terms of the ris(s involved, as the ne,t part of this problem shows.

d. 8eferring to >hapter 5, operating leverage at any volume of activity : *i,ed costsDTotal costs. Broposal 1 +nnual fi,ed costs Cariable costs Total costs <perating leverage Broposal 2 +nnual fi,ed costs Cariable costs Total costs <perating leverage : 1252,222 including depreciation of 1152,222! : 1#52,222 : 1%22,222 : 252,222D%22,222 : /,41 "+*123&3: 1222,222 including depreciation of 1122,222! : 1$45,222 : 1%45,222 : 222,222D%45,222 : /,246 "+*123&3-

&ote that we are ignoring ta,es in calculating operating leverage because we are interested in the firm)s operating cost structure. Thus, Broposal 1 has higher operating leverage than Broposal 2 because of its higher fi,ed costs and lower variable costs.

CHAPTER 13 STRATEGIC PLANNING AND CONTROL

solutions
DISCUSSION QUESTIONS 13,1 +merica <nline, "nc. +</! offers a broad range of features including realAtime tal(, electronic mail, electronic maga7ines and newspapers, online classes and shopping, and "nternet access. "t generates revenues principally from consumers through membership fees, advertising, commissions on merchandise sales and other transactions, and from other businesses through the sale of networ( and production services. Koogle)s core competencies are in coming up with fast and efficient search engines, and its revenues are mostly from online advertisements, commissions from online intermediation. +n important element of strategy is to induce people to use its search engines. "t has been successful so much so that LKoogleM has come to be accepted as a verb in the ?nglish language as a synonym for LsearchM in the online world. 1#.15 <bviously, the issue is one of ethics. +bsent legal liability, a company might choose to dispose dangerous material in a careless manner to avoid costs of disposal. "n this case, cost is not a consideration The unfortunate =nion >arbide episode in -hopal, "ndia comes to mind!. Jowever, firms have a social responsibility to dispose ha7ardous material in an environmentally safe manner. Kood economic analysis would dictate that such costs be ta(en into account in decision ma(ing.

1#.21 "n general, target costing is effective for products with wellAdefined and discrete features because it helps ma(e proper tradeAoffs among price, quality, and functionality with respect to each product feature. Target costing is less effective in firms that deal with commodityAtype products because there is little scope for differentiating products by their features. Boultry and other animal products are commodity products with stable demand and little scope for differentiation. >ost control should in fact be the (ey focus for Tyson foods because of the low margins and high levels of competition. *actors such as cost efficient distribution channels, timely delivery of supplies are (ey to its success. 1#.24 >onceptually, there is no barrier to using a balanced scorecard for nonAprofit organi7ations such as a municipality or a notAforAprofit hospital. Jowever, the components will change to reflect the units) missions. *or e,ample, a municipality might trac( measures in categories such as financial, community, infraAstructure and learning. These categories broadly correspond to the financial, customer, processes and learning categories. Jowever, the measures will be quite different. *or e,ample, the financial measure might just be brea(ing even rather than ma(ing a profit, and might include targeted amounts of grants from the *ederal government. EXERCISES 1#.25 a. 'hile the end product is the same, the bundle of features offered differs greatly between travel websites and travel agents. The former assumes considerable (nowledge on the part of the traveler and offers a way to quic(ly compare multiple fares. The aim is to provide a great deal of information and cheap fares. -ut, the responsibility is on you to understand the information being provided. + travel agent provides considerably more handAholding. The agent may well advise the traveler on alternate modes of transportation, the best way to change currency, how to find a pac(age deal, and so on. The agent might even help with choice of a destination e.g., for a vacation!. T;& =#%1& @+*@*7?)?*2 ?7 );&+&9*+& 2*) %*< (*7) $1) #((&77 )* # <&#%); *9 )+#=&% ?29*+>#)?*2. <f course, the traveler has to pay for this information in the form of the travel agent)s commission from tic(et and other sales.! b. 'e find a similar tradeoff between 3?7(*12) )+#3&+7 such as .cottrade or -rown and company. These services allow you to tradeN they provide lots of information but little advice. "n contrast, a fullAservice bro(erage such as +K ?dwards will completely handle all of the details beginning with asset allocation and planning, down to e,ecuting individual trades and providing ta, advice!. Jere, the value proposition is advice and help rather than cost. >learly, the clientele differs for each (ind of firm. + person wellA versed in finance might choose a discount bro(er while persons with little idea about how to handle money might implicitly or e,plicitly! pay a fullAservice bro(er to handle the portfolio on their behalf.

1#.#2 c. >ompetitive advantage could arise because of a number of reasons. A((&77 )* %*<-(*7) ?2@1)7 e.g., labor or ore! or pro,imity to mar(ets could be a source of advantage. .omewhat less obvious, an #$?%?)6 )* ?22*=#)& could be a competitive advantage e.g., #;!. *irms with strong mar(eting programs, such as >oca >ola and BOK, derive an advantage from the Lbrand equityM goodwill associated with brands! they have built up over time. Toyota)s advantage arises from being able to >#2#A& ?)7 $17?2&77 @+*(&77&7, particularly manufacturing processes, better than anyone else. d. + firm might choose to leverage access by %*$$6?2A +&A1%#)*+7 to prevent other firms from accessing the same resources. + firm that relies on scale economies by #AA+&77?=&%6 7&&B?2A >#+B&) 7;#+& so that it might increase its volume of operations, and thereby lower costs. "nnovation might be helped by #%%*<?2A &>@%*6&&7 9+&&3*> e.g., time off! to e,periment and try out different things. >lassic innovators such as Koogle require employees to ta(e time off from their regular wor( to thin( about new ideas and products. ;anaging a business process requires (*27?7)&2) >*2?)*+?2A #23 &99*+). "t requires a relentless attention to detail and processes in place for identifying and eliminating waste. e. ;anagement control systems reflect the different needs associated with the differing strategies. + firm focused on volume places great emphasis on mar(etArelated data, particularly share and si7e. .uch firms also are li(ely to be cost leaders, meaning that their systems closely trac( and control costs. "nnovative firms are more li(e differentiators that we discussed in the te,t. These firms rely less on controls and more on price premiums. 'hile they may monitor the rate of innovation e.g., 3 sales from new products!, they are usually less focused on intense cost control. *irms li(e Toyota that manage processes pay intense attention to all aspects of cost. They have elaborate processes in place to identify waste no matter how small! and eliminate it. These firms therefore tend to have intensive planning and control systems.

13,33 a. Total sales revenue 0esired margin +llowable cost b. >urrent cost +llowable cost >ost Kap $,522 9 1$,522 122,252,222 21,#45,222 1%45,222 $,522 units 9 15,222 per unit 53 122,522,222 1,125,222 $21,3 !,///

Thus, we need to reduce costs by 121,#45,222 A 122,252,222 : $6 !,/// to achieve the cost target. 1#.#4 a. 'e would agree that the 7)#23#+3 7)#)?7)?(7 #+& %&#3?2A >&#71+&7. +s stated in the problem, the measures provide a statistical profile of a player)s game. These measures capture (ey ingredients for success, meaning that doing well on these measures is a good predictor of future performance. <f course, it is possible to collapse a number of these measures into a single statistic the number of tournaments won or the number of top ten finishes that might be equally, if not more predictive of future success. &evertheless, the individual measures are useful as diagnostic measures of a player)s game. Blayers and coaches can use these data to benchmar( against the competition and figure out which areas need the most wor(. b. The discrepancy occurs because <?22?2A # )*1+2#>&2) +&C1?+&7 );#) );& A*%9&+ 3&%?=&+ *2 #%% *9 );& 7)#23#+3 >&#71+&7. The golfer must be able to get the ball from the tee to the putting green, navigate ha7ards such as bun(ers, and effectively putt the ball. -eing an e,cellent putter i.e., getting the ball into the hole! helps the score. -ut, the golfer wins only if she can also get the green in a few shots. + wellArounded game with very good performance on all dimensions and e,cellence on a few seems to be the (ey for winning in highly competitive environments such as =.BK+ tournaments. "n a business conte,t, winning is delivering outstanding shareholder returns. Jowever, many pieces must fall into place for the desired outcome. The firm must be able to provide a valueAadding product or service in a cost efficient fashion. >reating and sustaining a competitive advantage requires that the firm manage its customers e,ternal! and internal processes well, while investing in learning and growth. c. The design of a course affects the premium placed on a particular s(ill. .ome courses have narrow fairways, meaning that accuracy landing on the fairway! has a greater weight than getting a longer drive. The greens in some course test the putting s(ills of even the best golfers on the planet. +s an analogy, we can thin( of the golf course as the e,ternal environment and the golfer)s s(ills on various dimensions as success factors. C*1+7& 3&7?A2 3?()#)&7 );& (+?)?(#%?)6 *9 &#(; 71((&77 9#()*r. The match between the golfer)s ability on various success factors then determines the odds of success. &oteG .imilar matching of s(ill sets occur in other sports as well. + grass court tennis tournament e.g., 'imbledon! places a greater emphasis on a serveAandAvolley game relative to a tournament played on hard courts e.g., the =. open!. + clay court tournament e.g., *rench open! has entirely different requirements. "n each instance, the court surface affects the bounce and speed of the ball.

1#.$2 a. Tony)s pi77a might consider the following measures when assessing itself from the customer)s viewpointG Bercent of orders delivered within 22 minutes targetG 1223! +verage price per delivered pi77a targetG 112! &umber of orders with e,tras such as drin(s or breadstic(s targetG 423! Bercent of orders for multiple pi77as targetG %23! The Kallery might trac( measures such as the followingG Bercent tip as proportion of billed amount target 22 percent! +mount billed per patron target 1112! &umber of dishes returned to the (itchen for rewor( targetG 2! Bercent repeat customers in a month target 423!

b. The measures differ because the two organi7ations target vastly different customer segments and offer differing value propositions. The value proposition for Tony)s Bi77a is a cheap, reliable source of filling food. The quality of the food, the ambience, and other such factors are of secondary importance. Tony ma(es money by serving pi77a on call throughout the night, and via mar(ups on ancillary items such as drin(s and breadstic(s. Jis goal is to stay price competitive with the other pi77a delivery chains. ?legance and a wonderful evening out is the value proposition offered by the Kallery. The overall ambience and the restaurant e,perience are central to this value proposition. The food selection and quality must be top notch, and the customer must be showered with attention, with no detail overloo(ed. The Kallery li(ely maintains an e,clusive list of its patrons, allowing it to discern individual tastes and offer suitable suggestions. *or e,ample, a patron may be partial to wines from .pain, and the wine steward can suggest a bottle from a recent purchase.! The trac(ed measures therefore focus on the success of this strategy. *or e,ample, a satisfied customer would leave a large tip. + large proportion of repeat customers at a fancy restaurant but not too large! are a sure sign that things are going well. 1#.$% 'e begin by calculating the contribution margin at the different prices .ales 1155.22 A >ontribution margin 145.%2 $23 ! : Cariable cost 1115.$2 A Cariable selling costs 1155E2.1! 15.52 : Cariable mfg. cost 155.52

'e can plug these data in to the 114$ price to get the contribution at that price. .ales Cariable mfg. cost Cariable selling costs 114$ E 2.1! : >ontribution margin 114$.22 155.52 114.$2 154.12

'e can now calculate e,pected profit under the two scenarios. &otice that the development cost is sun( and is not relevant for the computations. 1155 price 2,222,222 1155.2 million 1$2.2 million 25.2 million 115.2 million $44,2/ >?%%?*2 114$ price #,222,222 1141.#2 million 1%2.2 million #2.2 million 1#2 million $41,3/ >?%%?*2

.ales >ontribution margin >ost of factory .alvage value &et factory cost &et profit : >; net factory cost!

-ased purely on financial considerations and assuming accurate estimates!, the firm should go in for the high price A low volume niche. Jowever, the differential is small less than 123 of the e,pected profit!. The decision therefore has to turn on confidence in our estimates. Typically, firms would run scenario analyses to estimate the variance in profit. They also would consider the effect of this product)s pricing and volume on the sales of future products e.g., because of brand loyalty being built up!. O=&+#%%, );& 3&(?7?*2 ?7 2*) (%&#+ (1), &oteG 'e would probably go with the larger mar(et share strategy because we believe that this mar(et is li(ely to grow significantly. Ketting our brand in front of consumers might be the best longArun strategy. 1#.52 a. T;& (+?)?(#% 71((&77 9#()*+7 9*+ T&(;2* U, #+& ?)7 #()1#% #23 @&+(&?=&3 C1#%?)6. +s an educational institution, the university)s quality is a function of both its students and its faculty. The university)s reputation is central in drawing the best students and faculty to its campus. <nce there, it seems important to give faculty a free hand in designing the best possible and most rigorous curriculum that will push these already e,cellent students to a yet higher level. Techno =.)s actions are consistent with this strategy. "t draws from a worldwide pool of applicants. "t see(s not to limit applications to those that can afford it, see(ing instead to reach out to all that qualify. The school)s small si7e and focus on attracting the best faculty as evidenced by the high pay levels! also are consistent with this strategy of providing an education characteri7ed by e,ceptional rigor and quality. b.

T;&7& (;#2A&7 71+&%6 <&#B&2 );& (*+& (*>@&)&2(6 *9 );& U2?=&+7?)6, .urely not every school can or should follow the strategy used by Techno =. Jowever, it is difficult for the same university to be all things to all people. *ostering an elite intellectual climate requires certain attributes in terms of si7e and e,clusivity. 0iluting these attributes reduces the value that an elite program can add to its students and staff!. &evertheless, even after they recogni7e the pitfalls of this strategy, administrators might engage in valueAdestroying activities. This choice might result from the =niversity administration see(ing to satisfy multiple constituencies with potentially conflicting objectives. =nli(e a forA profit organi7ation, a governmentAsupported institution is subject to political pressures. These pressures could sometimes lead to subAoptimal action choices.

CHAPTER 14 DOB COSTING SOLUTIONS

REVIEW QUESTIONS 1$.2 + jobAcosting system accumulates and analy7es costs separately for each product or small batches of products. ?,amples of firms that use jobAcosting systems include law firms and firms that build custom houses. 1$.# + processAcosting system accumulates and analy7es costs by each process or a department! rather than by each job. ?,amples of firms that use processAcosting systems include steel mills and paper companies. 1$.$ 0irect materials and direct labor are traced, and overhead is allocated. 1$.5 'or( in process inventory is the inventory of unfinished products at the start of a period. >ost of goods manufactured is the cost of items finished and transferred from wor( in process inventory to finished goods inventory. >ost of goods sold is the cost of products sold in a period. "t is the cost of items transferred from finished goods inventory to the income statement. 1$.6 + normalAcosting system is a jobAcosting system that uses a predetermined overhead rate. EXERCISES 1$.2% 'e can use the inventory equation for the '"B account to answer the question. -eginning '"B F materials F labor F applied overhead! : ><K; F ?nding '"B. 'e (now the items on the left hand side. -ut, we need to calculate ?nding '"B, which will be the costs charged to job 2#2. 0irect materials 0irect labor 1$,252 12,522

;fg. overhead ?nding '"B

1#,452 112,522

12,522 9 11.52 per labor 1

'e use the total amounts charged to '"B to calculate the overhead rate as 1#%,222 applied overhead D12$,222 labor 1 : 11.52 per labor dollar.! Thus, we haveG ><K; : 122,522 F 25,222F2$,222 F #%,222! A 112,522 : $4 ,///. 1$.24 a. The e,pected fi,ed overhead is 1522,222 out of a total overhead amount of 11,222,222. Thus, the remaining 1422,222 constitutes variable overhead. Kiven the e,pected activity of 12,222 machine hours, we haveG V#+?#$%& *=&+;&#3 +#)& : 12,222 = 142 per machine hour. '?:&3 *=&+;&#3 +#)& : 12,222 = 152 per machine hour. T*)#% *=&+;&#3 +#)& : b. 'e compute the inventoriable cost of the job asG Iob cost : >ost of direct materials F cost of direct labor F allocated overhead. 8eferring to the solution from part PaQ, we calculated the total overhead rate to be 1122 per machine hour. Therefore, the cost of this job under the jobAcosting system isG Iob cost : 15,222 F 16,222 F 1122 per hour 9 $2 hours! : 114,622. P+?(& 5 $22,2!/ : 114,622 9 1.25 for the 253 mar( up!.
11,222,222 = 1122 per machine hour. 12,222 1522,222 1422,222

1$.25 .ince overhead was overapplied, then the products) cost for the period should decrease. -ecause +ce uses the proration method, we should allocate the overapplied overhead among the '"B, *K and ><K. accounts. The '"B account will decrease by 112,222 9 P125,222 D 125,222 F 145,222 F 1122,222!Q : 112,222 9 2.125 : 11,252. Thus, the adjusted balance is 125,222 A 11,252 : $23, !/. +lternatively, you could construct a table as followsG

Item >ost of Koods .old *inished Koods "nventory 'or(AinAprocess inventory Total

Amount 1122,22 2 145,222 125,222 222,222

Percent 52.23 #4.53 12.53 122.23

Allocated Amount of $10,000 15,222 1#,452 11,252 12,222

Adjusted Amount 155,222 141,252 $23, !/ 152,222

1$.#2 'e (now that <verhead rate : budgeted overhead D budgeted activity volume 15 per machine hour : 125,222 D budgeted hours -udgeted hours : !,///. &e,t, we (now that +pplied overhead actual overhead : underD overapplied overhead! "n this case, applied overhead is smaller than actual overhead because overhead is under applied. Thus, +pplied overhead : 12%,222 A1%,222 : 122,222. *urthermore, +pplied overhead : actual R of machine hours 9 rate per machine hour Blugging in the relevant values, we haveG +ctual number of machine hours : 122,222 D 15 per machine hour : 4,/// ;*1+7. 1$.#$ 'e (now that adjusted ><K. is larger than the unadjusted amount. Jence, overhead is underapplied. *urther, the adjustment is 1454,522 A 1422,222 : 1#4,522. Jowever, this is not the entire amount of the underapplied overhead. This is only the portion allocated to ><K.. =nder proration, ><K. would have received 1422,222 D 1422,222 F 15$,222 F 152,222! : 6#.##3 of the total underapplied overhead. Thus, the total underapplied overhead is 1#4,522D2.6#### : $4!,/// 123&+#@@%?&3.

1$.#5 a. ;anufacturing overhead rate : -udgeted overhead D -udgeted activity volume : 1245,222 D 22,222 ;achine hours : $13, ! @&+ >#(;?2& ;*1+ b. The ending balance of *inished Koods is Iob no. $21G Brior period)s production costs >urrent period)s production costsG 0irect materials 0irect labor +pplied overhead Total 1211,252 1##,222 115,222 1#$,#45 $243,.2!

+pplied overhead : 2,522 machine hours 9 11#.45 per machine hour c. +ctual overhead : 152,222 F 15#,222 F 12%,252 F 11%6,222 : 1254,252. +pplied overhead : Total machine hours 9 11#.45 per machine hour : 2,522 F %,622 F %,522 F 12,222! 9 11#.45 per machine hour : 1#62,252. Thus, overhead is underA or overapplied by : 254,252 A 1#62,252 : $.!,///- *+ $.!,/// *=&+#@@%?&3, 1$.$2 a. /one .tar Klasswor(s would apply factory overhead asG *actory overhead applied : <verhead rate per direct labor hour 9 actual direct labor hours. Thus, *actory overhead applied : 16 9 52,222 : $4//,///, b. 'e calculate underapplied overapplied! overhead asG

=nderapplied overapplied! overhead : +ctual overhead incurred +pplied overhead *rom part a!, we (now factory overhead applied : 1$22,222. +ctual factory overhead for the year : 1$15,222 : 11%2,222 indirect labor F 145,222 depreciation on manufacturing equipment F 1%2,222 factory fuel F 1122,222 factory rent. NoteG 'e do not include sales commissions because, under K++B, sales commissions are a period cost and not an inventoriable product cost. *or /one .tar, overhead was 123&+#@@%?&3 $6 $1!,/// : 1$15,222 1$22,222 for the year. 1$.$2 a. *or the previous year, .erene has total overhead of 1522,222 F 1%22,222! : 11,122,222, and 12,222 budgeted machine hours. Thus, its total overhead rate is $11/ @&+ >#(;?2& ;*1+. 8epeating the e,ercise for the current year, we calculate the total overhead rate as $1// @&+ >#(;?2& ;*1+. b. The manufacturing cost for a product comprises the cost of materials, labor, and overhead. =sing the overhead rates from part a!, we calculate the allocated overhead per unit as 1112 9 .25 per unit! : 124.52, and 1122 9 .25 per unit! : 125.22 for the previous and current years, respectively. +dding these costs to the cost of materials and labor yieldsG ;aterials F 0/ cost per unit +llocated overhead per unit C*7) @&+ 12?) c. The unit cost has come down by 12.52 per unit from the previous year to the current year. Jowever, this fact does not necessarily mean that the firm has reduced costs or increased efficiency. "n particular, each unit actually consumed 2.25 machine hours both last year and this year. Thus, there is no gain in efficiency. The decline in reported cost arises because the fi,ed overhead rate and, in turn, the total overhead rate has changed. Brevious @ear 1$5.22 124.52 $ 2,!/ >urrent @ear 1$5.22 125.22 $ /,//

The variable overhead rate has stayed the same because the total variable overhead has increased in direct proportion to machine hours. "n the prior year, .erene budgeted 12,222 machine hours and, in the current year, .erene budgeted 12,522 machine hours. +t a variable overhead rate of 1%2 per machine hour :1452,222D12,522 hours!, this increase of 2,522 machine hours corresponds e,actly to an increase in variable overhead of 1152,222. <n the other hand, the budgeted fi,ed overhead has stayed the same at 1522,222. Jowever, because budgeted machine hours have increased from 12,222 to 12,522, the fi,ed overhead rate has declined from 152 per machine hour to 1$2 per machine hour. This decline in fi,ed overhead rates is the only reason for the apparent decline in costs. .tated differently, the firm was able to utili7e its capacity better, resulting in less money lost to idle capacity. 'e are not comfortable, however, terming this higher utili7ation as reducing costs. &ote: "n general, as the volume of activity increases but the fi,ed overhead stays the same, the fi,ed overhead rate declines. Jowever, the variable overhead rate stays the same as long as the variable overhead increases in the same proportion. Thus, one way of distinguishing fi,ed and variable overhead items is to loo( at the trend in the respective rates over time as the volume of the allocation base fluctuates. Cariable overhead rates would remain relative stable, whereas fi,ed overhead rates would vary inversely with volume. 1$.$# a. /et us begin by first calculating the amount of underA or overapplied overhead. =nderapplied overapplied! overhead : +ctual overhead incurred +pplied overhead. *or the laborArelated pool, we haveG =nderapplied overhead : 11,$$5,$22 12.62 9 1,622,222! : 15,$22. *or the machineArelated pool, we haveG <verapplied overhead : 11,61%,552 122 9 6$,222! : 1#1,$52!. Thus, the total underA or overapplied overhead is 1#1,$52! F 15,$22 : $26,/!/ *=&+#@@%?&3. 'hen we write off underA or overapplied overhead to ><K., net income decreases or increases by a li(e amount. <verapplied overhead reduces ><K. and increases net income. Thus, the yearAend adjustment ?2(+&#7&7 M#%(*%>E7 2&) ?2(*>& )* $4 1,33/ : 1$$5,262 F 12%,252.

b. "n part a!, the adjustment resulted in net income increasing by the entire amount of the overapplied overhead. Jowever, by definition, when we prorate or allocate! overapplied overhead among ><K. and the inventory accounts, we allocate less than 12%,252 to ><K.. Thus, the amount of decrease in ><K., and the corresponding increase in net income, would be lower than that in Bart a!. Thus, M#%(*%>E7 ?2(*>& <*1%3 $& %*<&+ );#2 );& #27<&+ (*>@1)&3 ?2 @#+) F#G.

PROBLEMS
1$.$5 a. ;anufacturing <J rate : 11,426,222 D 2$ persons E 2,222 artisan hours per person! : $36 @&+ #+)?7#2 ;*1+ b. The unadjusted balance of >ost of Koods .old is the cost of Iob no. 121G Brior period)s production costs >urrent period)s production costsG 0irect materials 0irect labor 1,222 0/Js 9 152! <verhead 1,222 0/Js 9 1#%! Total 1222,222 11%2,222 1 52,222 1#%,222 $446,///

c. *irst, let us calculate the underA or overapplied overhead. 'e haveG +ctual overhead : 1164,522 F 152,222 F 1#2,222 F 1126,522 : 1#4%,222. +pplied overhead : 1#% per artisan hour E 1,222 F %,522 F #,222! hours : 1#46,222. <verapplied overhead : 1#46,222 A 1#4%,222 : 12,222. The adjusted cost of goods sold is therefore 1$$%,222 A 12,222 : $444,///. 1$.52 a. O=&+;&#3 +#)& 9*+ >#(;?2& *@&+#)?*27 :
1%22,222 : $./ @&+ >#(;?2& ;*1+. 4,522

O=&+;&#3 +#)& 9*+ #77&>$%6 :

$300,000 : $1! @&+ %#$*+ ;*1+. 20,000

b. +pplied overhead in ;achine operations : 162 9 12,222 : 15%2,222. +ctual overhead in ;achine operations : 1%52,222. Therefore, overhead was *=&+#@@%?&3 ?2 >#(;?2& *@&+#)?*27 $6 $31/,///. +pplied overhead in +ssembly : 115 9 22,222 : 1##2,222. +ctual overhead in +ssembly : 1245,222. Therefore, overhead was *=&+#@@%?&3 ?2 #77&>$%6 $6 $!!,///. c. >ost of Iob R>252 in wor(AinAprocess : 12,222 F 1%,222 F 162 9 $2! F 115 9 252! : 11$,552. The following table proArates the total overapplied overhead of 1#%5,222 1#12,222 F 155,222! to wor(AinAprocess, finished goods, and cost of goods sold accounts. +ccount 'or(AinAprocess *inished Koods >ost of Koods .old Total =nadjusted balance 11$,552 1152,222 1452,222 151$,552 Broportion +llocation of 1#%5,222 1.%#3 15,552 155,62$ 1255,22% 1#%5,222 +djusted balance 15,222 152,14% 1$52,44$ 15$5,552

1%.#53 61.563 1223

'ith proArating, ?2(*>& <?%% +?7& $6 $244,226 9*+ );& 6&#+. >learly, in this case, ;c;aster has significantly overAestimated its overhead rate. "n particular, the actual volume of operations is much higher 12,222 versus 4,522!. +lthough the overhead costs also increased, the actual overhead rate of 1%52,222D12,222 : 15$.1% for machining is significantly lower than the budgeted rate of 162 per machine hour. This error is the reason for the large overapplied overhead.

CHAPTER 1! PROCESS COSTING

SOLUTIONS

REVIEW QUESTIONS

15.2

*irms that mass produce relatively identical products.

15.2 "n process costing, different units of the same batch might be at different stages of completion either in '"B or *K!, whereas in job costing a job is either in process or completed. This means that under process costing, we need to allocate the costs of a batch between completed and inAprocess units. 15.4 -ecause processes often require inputs at different stages. ;aterials may be added at the beginning of the process, whereas conversion costs are incurred uniformly throughout the process. 15.1# overhead. EXERCISES 15.#1 This series of three e,ercises 15.#1 15.##! wal( students through the five steps of preparing a process costing report. This particular e,ercise concerns the first two steps, trac(ing physical units and computing equivalent units. =sing the information provided, we haveG Total S)&@ 1: T+#(B P;67?(#% '%*< -eginning inventory A Iune 1 .tarted during Iune Total physical units to account for =nits completed during Iune =nits in process on Iune #2 Total physical units accounted for 145,222 45,222 252,222 2 252,222 2!/,/// S)&@ 2: C*>@1)& EC1?=#%&2) U2?)7 145,222 145,222
1223 of 145,222! 1223 of 145,222!

.tandard process costing uses predetermined rates for materials, labor, and

Detail for each cost pool Materials Conversion

45,222
1223 of 45,222!

#2,222
2.$2 9 45,222!

2!/,///

2/!,///

&otice that the percentage of completion varies between materials and conversion costs. Thus, the number of equivalent units also varies. *or materials, each unit in '"B is equivalent to a finished unit as it has consumed all of the requisite materials. "n contrast, each unit is only 2.$2 of a finished unit in terms of conversion costs, because the unit in '"B is only $23 complete with respect to conversion costs. 15.#6 "gloo has only one cost pool because it only trac(s conversion costs. =sing the information provided, "gloo)s standard process costing report for Ianuary isG

Total S)&@ 1: T+#(B P;67?(#% '%*< -eginning inventory Ianuary 1 .tarted during Ianuary Total physical units to account for =nits completed during Ianuary =nits in process on Ianuary #1 Total physical units accounted for S)&@ 3: C*%%&() (*7)7 )* #%%*(#)& 2 152,222 152,222 1$5,222 5,222 152,222

Detail

S)&@ 2: C*>@1)& EC1?=#%&2) U2?)7 1$5,222

1223 of 1$5,222!

1,522
#23 of 5,222!

1$%,522

Using predetermined rates go to step 4

S)&@ 4: C#%(1%#)& );& +#)& @&+ &C1?=#%&2) 12?) Bredetermined standard rate per equivalent unit S)&@ !: A%%*(#)& C*7)7 =nits completed during Ianuary COGM! =nits in process on Ianuary #1 ?'"B! Total costs allocated 12,145,222 122,522 12,154,522

$1!,//

12,145,222
1$5,222 9 115!

122,522
1,522 9 115!

&e,t, let us compare the actual and standard costs for the wor( done to compute the variance. "tem +llocated costs from report presented above! +ctual >osts incurred this period given! Cariance +llocated per standard rates +ctual costs! Total 12,154,522 12,242,452 $ 3,2!/ U

"gloo)s conversion cost variance is unfavorable for Ianuary because actual costs e,ceeded standardDbudgeted costs by 14#,252. "gloo has e,perienced a relatively large almost $3 of e,pected cost! unfavorable variance and should investigate the cause s! for this variance and ta(e suitable corrective actions. 15.$1 0ems(i)s process costing report loo(s just li(e the regular report, e,cept that 0ems(i has three cost pools one for materials, one for conversion, and one for testing.

+dditionally, ending '"B has 23 of the testing done as testing is the final step in the production process. 2) Compute E uivalent Units !aterials" Conversion2 Testing# ") Trac$ physical flo% =nits in beginning inventory .tarted during Iuly Total units to account for =nits completed during Iuly =nits in process on Iuly #1 Total units accounted for #) Collect costs to allocate >osts incurred this period 2 $,222 $,222 #,522 522 $,222 12,#24,522 #,522 522 $,222 1%22,222 1152 1525,222 45,222 1%22,222 #,522 152 #,%52 11,255,222 1#22 11,252,222 $5,222 11,255,222 #,522 2 #,522 1%12,522 1145 1%12,522 2 1%12,522

4) Calculate the rate per e uivalent unit4 >ost per equivalent unit 1%25 &) 'llocate Costs& =nits completed during Iuly COGM! =nits in process on Iuly #1 E23?2A WIP! Total costs accounted for
1 2

$2,1. ,!// 12/,/// 12,#24,522

1223 of #,522N 1223 of 522. 1223 of #,522N #23 of 522. # 1223 of #,522N 23 of 522. $ 1152 : 1%22,222D$,222N 1#22 : 11,255,222D#,%52N 1145 : 1%12,522D#,522. 5 1525,222 : #,522 9 1152N 11,252,222 : 1#22 9 #,522N 1%12,522 : #,522 9 1145N 145,222 : 522 9 1152N 1$5,222 : 152 9 1#22.

Thus, 0ems(i)s COGM 31+?2A D1%6 5 $2,1. ,!// and its &23?2A WIP ?2=&2)*+6 5 $12/,///.

PROBLEMS 15.$$ The process costing report offers a convenient way to answer the questions collectively, as each question pertains to one of the steps in the template. =sing the information provided, we haveG Total S)&@ 1: T+#(B P;67?(#% '%*< -eginning inventory +pril 1 .tarted during +pril Total physical units to account for =nits completed during +pril =nits in process on +pril #2 Total physical units accounted for S)&@ 3: C*%%&() (*7)7 )* #%%*(#)& >osts from beginning inventory >osts incurred during Iune Total costs to account for S)&@ 4: C#%(1%#)& );& +#)& @&+ &C1?=#%&2) 12?) >ost per equivalent unit S)&@ !: A%%*(#)& C*7)7 =nits completed during ;arch COGM! =nits in process on ;arch #1 ?'"B! Total costs accounted for 25,222 125,222 1!/,/// 13!,///
152,222 15,222!

Detail

S)&@ 2: C*>@1)& EC1?=#%&2) U2?)7 13!,///

1223 of 1#5,222!

15,222 152,222 1225,222 #,546,452 $4,2/3, !/

,!//
523 of 15,222!

142,!// 1225,222 #,546,452 $4,2/3, !/

$24,!/
$,22#,452D1$2,522!

$3,4.2,!// $221,2!/ $4,2/3, !/

1#,562,522
1#5,222 9 125.52!

1221,252
4,522 9 125.52!

1$,22#,452

.ummari7ing our answersG # 5 13!,/// $ 5 13!,/// #23 ,!//, +&7@&()?=&%6 ( 5 $4,2/3, !/ 3 5 $24,!/ & 5 $3,4.2,!// #23 $221,2!/, +&7@&()?=&%6, &otice that data regarding the completion percentages in beginning inventory is not needed to solve this problem. /i(ewise, we only need the total costs in a cost pool and do

not need to (now whether the costs are from beginning inventory or were added the current period. This simplification is possible because we use the weighted average method for process costing the most popular method!. <ther methods such as *"*< require details not needed by the weighted average method. 15.$5 isG =sing the information provided, <range)s process costing report for Iuly

Total S)&@ 1: T+#(B P;67?(#% '%*< -eginning inventory Iuly 1 .tarted during Iuly Total physical units to account for =nits completed during Iuly =nits in process on Iuly #1 Total physical units accounted for S)&@ 3: C*%%&() (*7)7 )* #%%*(#)& >osts from beginning inventory >osts incurred during Iuly Total costs to account for S)&@ 4: C#%(1%#)& );& +#)& @&+ &C1?=#%&2) 12?) >ost per equivalent unit S)&@ !: A%%*(#)& C*7)7 =nits completed during Iuly COGM! =nits in process on Iuly #1 ?'"B! Total costs accounted for 45,222 152,222 22!,///

Detail for each cost pool Materials Conversion

S)&@ 2: C*>@1)& EC1?=#%&2) U2?)7 222,222 222,222 222,222 25,222 225,222

1223 of 222,222! 1223 of 222,222!

25,222
1223 of 25,222!

12,522
2.52 9 25,222!

22!,///

212,!//

1%,4%5,222 16,%22,522 125,#64,52 2

15,%25,222 11,$45,222 $1 ,1//,///

11,1$2,222 4,1$4,522 $.,2. ,!//

$ 6,//
14,122,222D225,222!

$34,//
6,264,522D212,522!

$23,///,// / $2,3. ,!// $2!,3. ,!/ /

115,222,222
222,222 9 14%!

14,622,222
222,222 9 1#5!

11,522,222
25,222 9 14%!

1$64,522
12,522 9 1#5!

114,122,222

16,264,522

Thus, );& =#%1& *9 O+#2A&E7 COGM ?7 $23,///,/// #23 );& =#%1& *9 ?)7 &23?2A WIP ?7 $2,3. ,!//, 15.5% "gloo has only one cost pool because it only trac(s conversion costs. =sing the information provided, "gloo)s standard process costing report for *ebruary isG Total S)&@ 1: T+#(B P;67?(#% '%*< -eginning inventory *ebruary 1 .tarted during *ebruary Total physical units to account for =nits completed during *ebruary =nits in process on *ebruary 26 Total physical units accounted for S)&@ 3: C*%%&() (*7)7 )* #%%*(#)& S)&@ 4: C#%(1%#)& );& +#)& @&+ &C1?=#%&2) 12?) Bredetermined standard rate per equivalent unit S)&@ !: A%%*(#)& C*7)7 =nits completed during *ebruary COGM! =nits in process on *ebruary 26 ?'"B! Total costs allocated 12,222,222 1%,222 12,22%,222 5,222 1$5,222 152,222 1$6,222 2,222 152,222 S)&@ 2: C*>@1)& EC1?=#%&2) U2?)7 1$6,222
1223 of 1$6,222!

Detail

$22
223 of 2,222!

1$6,$22

Using predetermined rates go to step 4

$1!,//

12,222,222
1$6,222 9 115!

1%,222
$22 9 115!

"gloo)s conversion cost variance for *ebruary equals the difference between the costs allocated to wor( done in *ebruary and the actual costs incurred in *ebruary. + negative number indicates an unfavorable variance because actual costs e,ceed standard costs!, whereas a positive number indicates a favorable variance because actual costs are less than standard costs!.

The actual conversion costs for *ebruary are given to us they equal 12,2$5,222. The costs allocated to wor( done in *ebruary are a bit harder to compute. 'e can compute this amount by ta(ing the total standard costs and subtracting the standard cost of the units in beginning '"B. 'e haveG "tem >ost of units in ?'"B and completed A .tandard cost of units in -?K"&&"&K '"B1 +llocation for wor( done this period
1

Total 12,22%,222 22,522 12,22#,522

5,222 physical units 9 #23 completion 9 115 per equivalent unit.

'e now have enough information to compute the required varianceG "tem +ctual >osts incurred during *ebruary +llocated costs for wor( done in *ebruary Cariance +llocated per standard rates +ctual costs! Total 12,2$5,222 12,22#,522 $41,!// U

"gloo e,perienced an unfavorable variance for *ebruary because the actual e,penditure of 12,2$5,222 is 1$1,522 higher than the e,pected or budgeted! e,penditure for the wor( done this period. ;oreover, "gloo should investigate the cause s! for this variance and ta(e suitable corrective actions.