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CHAPTER 17

FULL COSTS AND THEIR USES

Changes from the Eleventh Edition


Two new termsstrategic cost management and value chainswere introduced. All other changes were
minor.

Approach
This chapter introduces the general concept of cost and describes, in a preliminary way, methods of
recording costs in an accounting system. Some of the problems that many students seem to have are:

1. Students think that there is such a thing as "the" cost. They don't realize that the measurement of cost
always relates to some specific cost object, and that what is an item of cost for one cost object may
not be at all relevant for another cost object. As one way of overcoming this misconception, we have
emphasized the idea of "cost object" from the outset.

2. Students think in terms of product costs. This is because in financial accounting the students' principal
contact with "cost" was in connection with measuring inventory cost and cost of goods sold. They,
therefore, fail to appreciate that products (literally "goods") are only one of a number of possible cost
objects. They think, for example, that direct material and direct labor are always relevant costs, and
that the word "direct" means that the material and labor are directly associated with the product,
whereas for certain cost objects (e.g., advertising), direct material and direct labor are inappropriate
terms. Furthermore, an item of cost may be direct to a certain cost object, such as the cost of a
department or responsibility center, even though the item is indirect with respect to a product
manufactured in that responsibility center. It is true that we do focus on product costs in Chapters 17
and 18, but the definitions and statements are made broad enough so that they can be used without
modification when other cost objects are discussed.

3. Students think that the definitions are applied more precisely in practice than actually is the case.
They tend to regard an item of cost as being direct labor only if they can visualize the worker as
physically touching the product, for example. We do not attempt to describe the wide diversity that
exists in actual practice because this diversity tends to confuse beginning students. The point is that
students should not be overly concerned about drawing a fine line between direct and indirect costs,
or between manufacturing and non-manufacturing costs.

We have decided not to stress the idea that cost is a "sacrifice," which is central to many definitions of
cost. The word "sacrifice" implies something bad, something to be avoided, whereas a company gladly
incurs a cost when it believes it will receive revenue or some other benefit by doing so. We think it more
meaningful to students to think of cost as measuring the use of resources. They should visualize the
resources themselves the physical material, the hours of labor service and think of costs as being
monetary measures of how much of these resources were used for a given cost object.

In general, we think it desirable to use the word "product" as referring either to a good or to a service; that
is, products are the sum of goods and services. We cannot do this uniformly, however, because the term
"product cost" is in widespread use, whereas in the above terminology it really should be "goods cost."
(This is a small point, but it can create confusion if not properly handled. The author of this paragraph did
not comprehend the distinctions made above until many years after he had completed his first course in
cost accounting.)

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

The description of the cost flow through a pen factory is a central part of the pedagogy. Students should
be able to explain each line on the flowchart and each of the related journal entries.

We have tried to avoid the twin dangers of, on the one hand, being critical of cost accounting because it
does not yield costs that are entirely "true" or "accurate" and, on the other hand, creating the impression
that cost accounting does in fact provide true and accurate costs. Students tend to go too far toward one or
the other of these extremes, and it is difficult for them (as well as for many managers) to take the
appropriate middle ground. This middle ground, we believe, is that although it is impossible to measure
the costs of a cost object with absolute accuracy whenever indirect costs exist, it is nevertheless possible
to measure costs with sufficient accuracy so that they are useful to management for many purposes.
Managements would not continue to spend large amounts of money in the operation of cost accounting
systems if they did not believe that the results were worthwhile.

In recent years, full-cost pricing is being given an increasing amount of attention, for a number of reasons
the growth of cost-reimbursement pricing in hospitals and in government relationships of various types,
the fact that some foreign producers have been found to have sold goods in the U.S. at less than full cost,
and the growth in the understanding that business has a social responsibility to set "fair" prices, that is,
prices that do not produce extraordinarily high profits.

Students who have been exposed to economics should also realize that contribution pricing is not
slighted. As the text states, this topic is discussed in depth in Chapter 26, where it belongs, and in this
discussion a distinction is drawn between situations in which full-cost pricing is appropriate and
situations in which contribution pricing is appropriate. Of course, if students have not been exposed to a
course in economics of the type implied above, then this problem will not even arise.

It is desirable that the relationship between profit and assets employed be emphasized. This relationship
was introduced in Chapter 13, and it will come up several times in later chapters in this book. It is not an
easy relationship to grasp (especially the relationship between profit percentage, asset turnover, and return
on investment), but once the student understands it, he or she has a model that explains how the parts of a
business, and decisions on these parts, relate to one another. Since the general public (including
newspaper stories and television news programs) tends to think of profits as a percentage of sales, it is not
easy to get students to think in terms of the broader and more valid concept of return on investment.

Any discussion of pricing necessarily includes a discussion of profit. Some students are emotionally
antagonized by the basic concept of profit; they confuse "profit" and "profiteering," or they have the
impression that business extracts an unconscionable amount of profit from the consumer. If they are to
understand what normal pricing practices actually are, they must overcome this emotional block. It is
hoped that the reiteration of the point that a business must earn a reasonable return on its investment if it
is to survive may help in overcoming this block.

Cases
Delaney Motors raises the general issue of what is cost? and enables a discussion of the possible uses of
full cost information.

Lipman Bottle Company deals with the use of cost data in product pricing decisions.

Shelter Partnership, Inc., allows students to see the multiple purposes for which cost accounting is used
in a nonprofit organization and to consider whether additional cost accuracy is desirable.

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Problems
Problem 17-1: Martin Company
(000s omitted)
Raw Materials Inventory
Balance, Sept. 1..................................................................................................................................................................
80 Issued for use.................................................................................................
100
Purchases............................................................................................................................................................................
55 To balance......................................................................................................
35
135 135
Balance, October 1.............................................................................................................................................................
35

Work in Process Inventory


Balance, Sept. 1..................................................................................................................................................................
95 Goods manufactured......................................................................................
210
Direct material....................................................................................................................................................................
100 To balance......................................................................................................
120
Direct labor........................................................................................................................................................................
60 330
Overhead............................................................................................................................................................................
75
330
Balance, October 1.............................................................................................................................................................
120

Finished Goods Inventory


Balance, Sept. 1..................................................................................................................................................................
65 Cost of sales...................................................................................................
235
Goods manufactured..........................................................................................................................................................
210 To balance......................................................................................................
40
275 275
Balance, October 1.............................................................................................................................................................
40

Cost of Sales
235

Problem 17-2: Burtis Company


Calculation of normal selling price for 20x3 assuming continued use of full cost:

20x2 Increase 20x3


Direct material....................................................................................................................................................................
$ 4.00 $ .48* $ 4.48
Direct labor........................................................................................................................................................................
7.00 .84* 7.84
Indirect manufacturing.......................................................................................................................................................
4.80 .60 5.40
Selling and administrative..................................................................................................................................................
3.50 .00 3.50
Total full cost...............................................................................................................................................................
19.30 1.92 21.22
Profit (10%).......................................................................................................................................................................
1.93 .19 2.12
Selling price.......................................................................................................................................................................
$21.23 $2.11 $23.34
*12 percent increase for direct material (.12 x $4.00 = $.48) and for direct labor (.12 x $7.00 = $.84)
$6,000 increase with volume of 10,000 units = increase of $.60 per unit.

Problem 17-3: Micha Smith


a. Total costs $5,700 Desired profit $3,300
Fee per hour =
150 hours
= $60.00 per hour

b. Revenue, 100 hours @ $60..........................................................................................................................


$6,000
Costs............................................................................................................................................................
5,700
Profit............................................................................................................................................................
$ 300

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

Problem 17-4: Valade Company


a. Calculation of selling prices:

Total Product Product


Company ___J___ ___K___
Direct manufacturing cost...............................................................................................................................................................
$ 700,000 $400,000 $300,000
Indirect manufacturing cost.............................................................................................................................................................
280,000 160,000 120,000
Selling and administrative cost........................................................................................................................................................
140,000 80,000 60,000
Full cost...........................................................................................................................................................................................
1,120,000 640,000 480,000
Desired profit*................................................................................................................................................................................
280,000 160,000 120,000
Sales revenue..................................................................................................................................................................................
$1,400,000 $800,000 $600,000
Divide by units................................................................................................................................................................................
10,000 10,000
Selling price per unit.......................................................................................................................................................................
$80.00 $60.00
*The desired profit of 280,000 for the company as a whole is 25 percent of the companys full cost. Therefore, a 25 percent profit
margin percentage is applied to the full cost of each product to obtain the selling price.

The profit percentage is equal to:


(Desired profit + Selling and administrative cost) Full production cost. For Product A it equals
($160,000 + 80,000)/560,000 = 42.86% which is the same as for product K = ($120,000 + $60,000)/
$420,000 = 42.86%

b. Total Product Product


Company ___A___ ___B___
Sales revenue*........................................................................................................................................................................
$1,248,000 $384,000 $864,000
Full cost+...............................................................................................................................................................................
1,040,000 320,000 720,000
Profit......................................................................................................................................................................................
$ 208,000 $ 64,000 $144,000
*Sales Revenue
A: 5,000 units @ $76.80 = $384,000
B: 15,000 units @ $57.60 = $864,000

+Full Cost
$640,000
A: (5,000)
10,000 units
= $320,000

$480,000
B: (15,000 units) 10,000 units = $720,000

c. Profit margin pricing results in product prices containing identical profit percentages. However,
the product with the higher price will yield the higher total dollar profit. Therefore, a shift in
product mix toward lower price items will reduce total dollar profits for the company as a whole.

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2007 McGraw-Hill/Irwin Chapter 17

Cases

Case 17-3: Shelter Partnership, Inc.*


Note: This case is unchanged from the Eleventh Edition.
Approach
This case was written to illustrate the use of cost information and cost systems in a nonprofit setting. The
case is particularly interesting because managers at Shelter Partnership were actively considering whether
the possible undercosting of one of the organization's major elements (Shelter Resource Bank) might be
adversely affecting their fundraising.

Suggested Assignment Questions


Suggested questions appear at the end of the case.

Case Analysis
A. What is the main purpose of cost information at Shelter Partnership?

The class should discuss three purposes:

1. Product costing. Managers should know the costs of the different services the organization
provides. If the costs of a particular service are judged to exceed value, that particular service can
be discontinued.
For example, the Salvation Army managers analyzed the costs of their organization's various
programs. They decided to discontinue pick-up service of donated goods at private residences.
The cost of doing so was greater than the value of the goods received. Instead, they decided to
use donation centers in major traffic areas (which gave them economies of scale).
Students should understand, however, that use of cost information for product costing purposes is
limited in Shelter Partnership because this is not a client-supported organization. Most of the
revenues come from donations, not sales or service fees, and costing has little to do with pricing.
2. Fund raising. Cost estimates help determine the level of fundraising necessary to support Shelter
Partnership's activities. (Note that some students question Ruth Schwartz's assumption that higher
costs facilitate fund raising.)
3. Sourcing decisions. Managers can make decisions as to whether to have the organization provide
its own services or contract them to outsiders (make or buy).
Cost control purposes seem not to be greatly served by the cost system. Shelter Partnership did
not have reliable cost standards, so actuals vs. standards comparisons were not possible.
However, some actuals vs. history comparisons were useful.
B. The Shelter Partnership cost system:

*
This teaching note was prepared by Kenneth A. Merchant. Copyright 1998 by Kenneth A. Merchant.

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Cost Direct bank costs: Indirect costs


warehouse and donations
people
warehouse costs

Subjective estimates of
proportion of resources
consumed
trace

Resource Bank All other services


Service

C. Shelter Partnership provides four products or services:


a. technical fund raising and distribution
b. program development conferences, publicity
c. public policy support research studies, educational programs
d. Resource Bank
But Ms. Schwartz does not express interest in tracing costs to the individual services, with the
exception of the Resource Bank.

D. Is a single-stage cost system appropriate? Why or why not?

The students can quickly identify the cost pools and recognize how the costs are distributed across the
difference services. There are three main categories of cost pools: (1) personnel (which includes
salaries, benefits, and payroll tax expenses); (2) other operating costs; and (3) independent contractor
costs.
Some students will develop systems that add a "first-stage" allocation to the system, in which
expenditures from the budget line items are pooled according to a common cost driver. Then they
calculate burden rates for each cost pool and assign costs through a second stage allocation down to
the cost object (service or program) level. Their cost drivers are commonly labor dollars of the
''personnel pool," and floor space for the "other operating costs" pool, etc. The students will argue that
their scheme will make the costs of the various cost objects more "accurate." It is impossible to reach
consensus on that, but most students will agree with Ms. Schwartz that Shelter Partnership has no
particular need for this level of sophistication.
It would be time-consuming and therefore costly, to identify the activities performed and to attach
costs to each of these activities, thereby constructing a true activity-based (2-stage) cost system. The

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benefits would probably not exceed the costs.


E. How many cost centers should Shelter Partnership identify?

Shelter Partnership uses nine cost centers. There are two personnel cost centers because different
categories of people are allocated in different proportions to the Resource Bank. The costs of the
donations distribution and solicitation managers and warehouse staff are allocated 100% to the
Resource Bank. The costs of the administrative personnel (associate director, development director,
office managers, and receptionists) are allocated 50% to the Resource Bank and 50% to the other
three services.
Students will question why no personnel costs related to the executive director and program manager
are allocated to the Resource Bank. They will also question whether it is desirable to make salary
information essentially public by incorporating them into the allocations.
Shelter Partnership uses four costs centers for the other operating costs:
a. Warehouse expenses (100% assigned to the Resource Bank).
b. Office rent, office expenditures, postage, photocopying, printing, telephone, insurance, local
travel, community training/board education, training and education, and equipment (50%
assigned to the Resource Bank);
c. Nonlocal travel, newsletters, and publications (one-third assigned to Resource Bank);
d. (Not mentioned in text) Professional fees (assigned on a project-by-project basis).
Three cost centers are used for the independent contractor costs:
a. Trucking and warehouse temporary labor costs (traced 100% to the Resource Bank);
b. Accountant expense (50% assigned to Resource Bank):
c. Development consultant (which were zero in 1990) and the temporary consultant (0% to
Resource Bank).
Are these enough cost centers? Too many? The discussion should refer back to the purposes of the
cost information (Question 1).
F. Are Ruth Schwartz's estimates accurate enough?

This is a difficult question to answer, but it gets students thinking in the right direction. The students
realize that Ruth could interview her staff and get better estimates as to how they direct their time
toward the four services the organization provides. They also realize that, for the personnel and
independent contractor expenses, the allocation bases (which map directly into the percentages) are
labor hours, measured with respect to some "actual capacity" estimate of total labor time available for
all four services.
Ask the students what happens if, for example, the associate director quits and nobody else is hired to
replace him/her'? It is clear that the percentages would have to be recalculated because both the
numerator and denominator are changing. If the change is temporary, the use of standard
percentages seems appropriate.
The allocation basis used for the four cost centers related to other expenses (such as office and
expenditures) is not clear. Students can propose alternative allocation bases for each, on which the
percentages might have been based. Some students, of course, will propose that Shelter Partnership
do a study to better understand the purposes served by each of these various categories of expenses.
G. Is accuracy (or truth) the desired goal for Shelter Partnership's cost system?

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For internal decision making purposes, approximation of the real costs is probably desirable.
However, in communications to outside parties, Ms. Schwartz suggests that Shelter Partnership might
want to overstate the costs of the Resource Bank, or at least recognize the full costs of the Bank. She
thinks that higher costs will make the Bank appear more substantial and will be more likely to attract
the attention of foundations.
If accuracy is not the goal of the cost system, why should management even be concerned with truth?
Why not just assign almost every cost possible to the Resource Bank? This, of course, raises a
number of legal and ethical issues.
But if Ms. Schwartz's argument that higher costs will attract foundation attention is correct, then she
should have the cost system reflect the full costs of the Resource Bank. She should fully value the
donation of space from the General Services Administration and she should assign the bulk of the
insurance costs to the warehouse. Students will see that assignments like these make cost accounting
more an art than a science.
Some students may raise the counter argument that Ms. Schwartz also has incentives to understate the
costs of the Bank, to make it look more efficient. 1 Where are the controls on the organization's
internal accounting (cost) systems?
H. What do you think of Shelter Partnership's budgeting system?

At some point in the class, some attention can be usefully directed toward Shelter Partnership's
budgeting system. Budgeting plays (or should play) key roles for Shelter Partnership. It might be used
for resource planning and allocation purposes, and it might serve cost control roles.
The case does not provide much information about Shelter Partnership's budgeting system, but
Exhibit I shows that the organization has a budget and that it appears to be only an aggregated, line-
item budget. The organization would probably benefit from using program budgeting, instead of their
line-item-based system. And where should standards come from for efficiency (actuals vs. standard)
comparisons?
I. Should the Resource Bank be tracked and evaluated as a cost center or a revenue center?

It could be done either way. If the Bank is considered a profit center, a value will have to be imputed
to the donations.

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These games are apparently relatively common. See, for example, R. Khalaf, "The Accounting Games Charities Play," Forbes
(October 26, 1992), pp. 252-254.