1. overview of absorption costing and variable costing · pdf fileabsorption costing -...

Absorption Costing - Overview

1. Overview of Absorption costing and Variable Costing

2. Review how costs for Manufacturing are transferred to the product

3. Job Order Vs. Process Costing

4. Overhead Application

- Under applied Overhead

- Over applied overhead

5. Problems with Absorption Costing

6. Concluding Comments

www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in

1www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in

WWW.BSSVE.IN

Absorption Costing

The focus of this class is on how to allocate manufacturing costs to the

product.

- Direct Materials

- Direct Labor

- Overhead

Absorption costing is a process of tracing the variable costs of

production and the fixed costs of production to the product.

Variable Costing traces only the variable costs of production to the

product and the fixed costs of production are treated as period

expenses.



WWW.BSSVE.IN

Absorption Costing

There are three different types of Absorption Costing Systems:

- Job Order Costing

- Process Costing

- ABC Costing

In Job Order Costing costs are assigned to the product in Batches or lots.

- Printing

- Furniture manufacturing

- Bicycle Manufacturing

In Process Costing, costs are systematically assigned to the product, since there are no discreet batches to assign costs.

- Oil Distilling

- Soda Manufacturing

ABC Costing assigns cost from cost centers to the product

- Best in a multi product firm, where there are different volumes



WWW.BSSVE.IN

Absorption Costing

A simplified view of Production:

Introduce Raw

Materials

Manufacture

Product

Store finished

goods

Sell Finished

Goods

1. Direct materials 1. Direct labor 1. Production process

are purchased applied to completed

2. Direct materials product 2. Goods are shipped

are placed into 2. Overhead costs for sale

production are incurred



WWW.BSSVE.IN

Absorption Costing

How do we account for the production process?

1. Direct materials are purchased and recorded as an asset.

2. As direct materials are placed into production, their cost

is transferred from the raw materials account to the Work-

in-Process account (an asset)

3. As direct labor costs are incurred they are recorded in a

labor expense account. Throughout the year they are

transferred from the labor expense account to Work-in-

process account (an asset).



WWW.BSSVE.IN

Absorption Costing

4. Overhead costs are initially accumulated in expense

accounts (electricity, depreciation, etc..). Throughout the

year they are transferred to Work-in-process.

5. When goods are completed, their costs (direct materials,

direct labor and overhead) are transferred out of Work-in-

process, and into Finished Goods.

6. When foods are sold, their costs are transferred out of

finished goods inventory (an asset) and into Cost of goods

sold (an expense).



WWW.BSSVE.IN

Absorption Costing

Important points to take away from how we account for manufacturing costs:

1. Initial expenditures on raw materials, direct labor, and overhead are

CAPITALIZED (recorded as assets) in Work in process and finished goods

inventory.

2. They are transferred to expense accounts when the finished goods are sold

(they go to cost of goods sold).

3. Generally the cost of goods manufactured, (the costs incurred in

manufacturing the product) will not equal the cost of goods sold.

- This means that in any year some of the costs associated with manufacturing

the product will not flow through the income statement as an expense, they

will remain in the inventory accounts as assets!



WWW.BSSVE.IN

Absorption Costing

Consider the following example:

A company is formed to manufacture computers. It starts the year with $2000 in cash and equity. During the year the company incurs $500 in payroll costs, $500 in rent for the plant, and $500 in raw materials. During the year he makes 100 computers.

What will his profits (or loss) be if he sells no computers?

What will his profits be if he sells all 100 computers at $20 per computer?



WWW.BSSVE.IN

Job Order Costing

Job Order Costing is one method of allocating the costs of manufacturing to the product.

In Job order costing the manufacturing costs are allocated to the product by batch.

Job order costing is appropriate when the firm makes products in small batches, and each batch consumes different amounts of direct labor, direct materials, and processing time/energy.

A survey in “Cost and Management Accounting Practices..” in the Management Accounting Research Centre indicate that job order costing is the primary method of costing in the following industries:

- Electorics

- Machinery

- Computers

- Furniture and fixtures



WWW.BSSVE.IN

Job Order Costing

Consider a computer manufacturing company. They have a plant that receives an order for 50 computers. They need to determine how much it costs to manufacture these computers.

The batch of 50 computers starts with the introduction of direct materials:

- 50 Computer Cases

- 50 Motherboards

- 50 CD drives, and floppy drives

Individuals mount equipment, add additional memory etc, to meet the specifications of the job.

Special machines are also used to attach the disk drives.



WWW.BSSVE.IN

Job Order Costing

In Job order costing the manufacturing costs are allocated to the product by batch. Thus the company allocates manufacturing costs to the 50 Computers ordered.

The Job is assigned a Lot #. Lets call this Lot # 1118.

When the Parts warehouse provides 50 motherboards, cd roms etc… to the manufacturing group, they allocate the costs of these raw Materials to LOT #1118.

The individuals that assemble these computers record the time spent assembling Lot 1118 on their time sheets. The accounting system will allocate the payroll costs at the hourly wage rate to the job.

Finally, the cost of the plant, the cost of the specialized machines, the utilities, the accounting system that tracks costs within the plant, the accountant running the system etc… must be allocated to the product. This is known as overhead allocation.



WWW.BSSVE.IN

Job Order Costing

Lot # 1118

Direct Materials:

50 Motherboards @ $200 per board $10,000

50 Floppy Disk Drives @ $50 per drive $ 2,500

50 CD Rom drives @ $20 per dirve $ 1,000

50 Cases @ $20 per case $ 1,000

Total Direct Materials $14,500

Direct Labor and Overhead

Employee #4323 40 hours @ $25 per hour $1,000

Overhead Allocation $100 per direct Labor hour $4,000

Total Direct Labor and Overhead $5,000

Total Cost $19,500



WWW.BSSVE.IN

Job Order Costing

A natural question to ask with this example, is how do we determine

the overhead allocation rate?

1. Estimate total Overhead for the plant for the year.

2. Select an activity base to allocate overhead costs to the product.

3. Estimate expected usage of the activity base.

4. Overhead allocation Rate = Estimated Overhead Costs

Estimated Activity Base



WWW.BSSVE.IN

Job Order Costing

Suppose the company estimates overhead costs for the plant to be to be $1,000,000 and direct labor hours to be 1000 hours.

What is the overhead application rate?

What happens if the employees only work 900 hours?

What happens if the employees work 1100 hours?

What happens if the price of heating oil is greater than expected?



WWW.BSSVE.IN

Job Order Costing

What happens to the under or over applied overhead?

1. Write-off directly to cost of goods sold.

2. Write off proportionately to WIP, Finished goods and

Cost of goods sold.

3. Re-allocate costs to all products to “correctly” allocate

overhead to WIP, Finished goods, and Cost of goods sold.



WWW.BSSVE.IN

Rosen Corp (Problem 9-4)

See the exercise “Rosen Corp.”: Problem 9-4 in Zimmerman,

Jerold L. Accounting for Decision Making and Control (4th Edition).

McGraw-Hill/Irwin, 2002, pp 478-9.



WWW.BSSVE.IN

Process Costing

A process cost system is used when a manufacturing

company makes large volumes of identical products.

(pharmaceuticals, bottles of Pepsi, gallons of oil)

Each unit consumes the same amount of direct materials,

direct labor and indirect costs (overhead)

Instead of assigning costs to jobs, then averaged across the

job to get a per unit cost, process costing assigns costs to

the product through each process the product goes through.



WWW.BSSVE.IN

Process Costing

Consider a Cola Manufacturer

Mixing Bottling Distribution

Direct materials (sugar, water, coloring)are mixed.

They are poured into a bottle.

Carbonation is added.

They are capped.



WWW.BSSVE.IN

Process Costing

How does process costing differ from job

costing?

Survey indicates that Process costing is most

often used in the following industries:

1. Oil refining (100%)

2. Chemicals

3. Pharmaceuticals

4. Food and Beverage



WWW.BSSVE.IN

Absorption Costing - Problems

1. In an absorption cost system such as Job order costing,

what happens to plant profitability if additional output is

produced and not sold?

2. Suppose you allocate overhead using direct labor hours,

and a special order comes in that requires the factory be

completely recalibrated, to process the job. Will this cost

be traced back to the job?



WWW.BSSVE.IN

Variable Costing

Variable costing tries to reduce the incentive to over

produce by charging fixed overhead costs to expense in the

period they are incurred, and allocating only variable costs.

Increasing production does not allow a firm to move fixed

costs out of COGS and into inventory.



WWW.BSSVE.IN

First Eastern Bank (problem 9-13)

See the exercise “First Eastern Bank”: Problem 9-13 in

Zimmerman, Jerold L. Accounting for Decision Making and

Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 483-4.



WWW.BSSVE.IN

Frames Inc (problem 9-23)

See the exercise “Frames Inc.”: Problem 9-23 in Zimmerman,

Jerold L. Accounting for Decision Making and Control

(4th Edition). McGraw-Hill/Irwin, 2002, pp 491-2.



WWW.BSSVE.IN

Summary

1. Discussion of Absorption costing

- Strengths and weaknesses

- How is it done.

- Potential Solutions to some of the problems.

2. Reviewed how we account for manufacturing costs Highlighted

how manufacturing costs are transferred to the product

3. In depth coverage of Job Order Costing and Overhead application

4. Set up discussion of ABC costing



WWW.BSSVE.IN

Overview

1. Basinger vs Main Line

2. Terminology

3. Cost Drivers

4. Breakeven Analysis

5. Other problems

6. Summary

1



WWW.BSSVE.IN

Basinger vs Mainline

To read the Basinger vs. Mainline case, see:

Barton, Thomas L., William G. Shenkir and Brian C. Marinas.

Instructional Case - Main Line vs. Basinger: A Case in Relevant

Costs and Incremental Analysis. Issues in Accounting

Education. Sarasota: Spring 1996. Vol. 11, Iss. 1, pp 163, 2 pgs.

2



WWW.BSSVE.IN

Cost Behavior

How do total costs change with changes in units of

production?

To

tal Co

st

Quantity

3



WWW.BSSVE.IN

Cost Behavior

How do per unit costs change with changes in volume?

To

tal Co

st

Quantity

4



WWW.BSSVE.IN

Terminology

Fixed Costs Period Costs

Variable Costs Product Costs

Average Costs

Direct costs

Marginal Costs Indirect Costs

Opportunity Costs Direct Materials

Sunk Costs Direct Labor

Avoidable Costs Overhead

5



WWW.BSSVE.IN

Cost Drivers

• Up until this point we have focused on how costs change

with changes in output or units sold.

• There are other “cost drivers” that may better describe the

behavior of a cost than the output of the manufacturing

process.

• Consider the following manufacturing process for insect

traps (which I was involved in as an undergraduate.)

6



WWW.BSSVE.IN

Cost Drivers

Most insect traps work because of Pheromones.

Each insect has a different Pheromone, thus to make a particular type of insect trap, you need to mix different chemicals.

We can break up the production process into the following activities.

To make an insect trap you must:

1. Set up for mixing

2. Mix chemicals

3. Kiln chemicals

4. Make the traps. 7



WWW.BSSVE.IN

Cost Drivers

To set up to mix 16 ounces to 1600 ounces of a pheromone for kilning takes 50 hours of labor @ $20 per hour.

An individual Kiln can only handle up to 100 pounds of a pheromone, then a new kiln has to be setup.

Thus setup costs are fixed cost for up to 100 pounds of a pheromone.

So how much would it cost (in terms of labor dollars) to make 250 lbs of fruit fly pheromone?

8



WWW.BSSVE.IN

Cost Drivers

What was your first inclination to do in calculating

the cost of making the fruit fly pheromone?

What happens in costing this product when we add

layers to the production process like assembly,

disposal, shipping, receiving?

ABC costing suggests that instead of tracking set

up costs per pound of pheromone, it makes pore

sense to track set-up costs per batch kilned.

9



WWW.BSSVE.IN

Breakeven Analysis

Consider the following format of the income statement

Revenues

-Variable costs

Contribution Margin

-Fixed Costs

Profit

Where the contribution margin equals fixed costs, we have hit the break even point.

If we have some desired profit level, we can “work backwards” to determine the number of units we need to produce and sell to reach the desired profit. 10



WWW.BSSVE.IN

Operating Leverage

Operating Leverage represents the ratio of fixed costs to

total costs.

Firms with higher operating leverage will experience

relatively larger changes in income when there are changes

in volume.

This because firms with more operating leverage have

relatively larger per unit contribution margins.

11



WWW.BSSVE.IN

Amy’s Boards (Prob 2-41)

See the exercise “Amy’s Boards”: Problem 2-41

in Zimmerman, Jerold L. Accounting for Decision Making and


12



WWW.BSSVE.IN

Emrich Processing

See the exercise “Emrich Processing”: Problem 2-11



13



WWW.BSSVE.IN

X Corporation Jet (Prob 2-16)

The exercise “X Corporation Jet” is not available in the fourth edition

of the textbook (the one this class uses). It can be found in the third

edition:

Problem 2-16 in Zimmerman, Jerold L. Accounting for Decision

Making and Control (3rd Edition). McGraw-Hill/Irwin, 1999, pp 68.

14



WWW.BSSVE.IN

Eastern University (P2-26)

See the exercise “Eastern University”: Problem 2-26 in Zimmerman, Jerold L. Accounting for Decision Making and Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 84.

15



WWW.BSSVE.IN

Summary

1. Focus on how managerial accounting information is used

in a decision making process:

- Incremental analysis

- Contribution margin

- Break even analysis

2. Review of cost terminology

3. Highlight the importance of relevant range, and cost

drivers

4. Once again reinforce the idea that we need to

“Be aware of reported costs”

16



WWW.BSSVE.IN

Balanced Scorecard

Assignment:

1. Outline the central concepts to the balanced scorecard.

2. Develop a balanced scorecard for M.I.T’s Sloan School of Business.

- Mission Statement

- Strategies to accomplish mission or value statement.

- Select performance measures from four perspectives.

3. In your proposed system should compensation be linked to performance? If so whose compensation?

4. How effective do you think the balance scorecard would be in an academic institution like MIT?



WWW.BSSVE.IN

Budgeting - Overview1. Budgets as a mechanism of partitioning decision rights and as a mechanism for control.

- Decision management

- Decision control

2. Incentives

- Performance measurement

- Compensation

- Horizon problem

- Perverse Incentives

3. Types of budgets

- Line Item Budgets

- Lapsing Budget

- Flexible Budget

- Zero based budgets

- Incremental Budgets



WWW.BSSVE.IN

Budgeting

Theoretically, budgets serve two roles:

1. Allocate Decision Rights:

- Decision Initiation – Budget Preparation

- Decision Implementation – Operating Decisions

2. Control Behavior

- Decision Ratification

- Decision Monitoring

Budgets are also used as a method of measuring performance, a mechanism to plan expenditures, and to reward performance.



WWW.BSSVE.IN

Budgeting

Let’s make sure we know what budgets are from a practical

perspective:

1. They are plans for 1 to 10 years for all of the business units.

2. The budgets serves as a mechanism for coordinating production and sales

3. Estimates are compared to actual as a means of evaluating performance.

4. Budget variances are often used as a means of punishing and rewarding behavior.

5. Budgets are updated to reflect outcomes.



WWW.BSSVE.IN

Budgeting

Firms often use budgets to measure the performance of managers.

When budgets are used to measure performance we need to think about the concepts of:

- Controllable Variances

- Uncontrollable Variances



WWW.BSSVE.IN

Rosebud (Prob 6-28)

See the exercise “Old Rosebud Farms”: Problem 6-28 in





WWW.BSSVE.IN

BudgetingWe also need to think about how do you account for

volume effects?

What happens when there is a reduction in volume?

Does it matter if it is controllable?

- Static vs. Flexible Budgets.



WWW.BSSVE.IN

Golf World (prob 6-9)

See the exercise “Golf World”: Problem 6-9 in Zimmerman, Jerold L. Accounting for Decision Making and Control (4th

Edition). McGraw-Hill/Irwin, 2002, pp 301-2.



WWW.BSSVE.IN

Budgeting -Textbook sales

When budgets are used to measure performance, they are also often used in the compensation scheme.

Consider the following compensation scheme used in textbook sales.

The head office forecasts sales for each sales territory using the ratcheting principle.

The sales rep prepares a budget for complementary books and over night visits that is approved by the head office.

Sales reps are compensated a fixed salary and receive a fixed bonus for reaching their budgeted revenues

They receive a small fractional increase bonus money for each dollar of sales generated over the budgeted amount through 110% of the budget

Larger bonuses if budgeted revenues are exceeded by more than 10%.



WWW.BSSVE.IN

Budgeting -Textbook sales

What are the sales rep’s incentives?

What mechanisms does the sales rep have to influence actual outcomes

What do you think the sales pattern of a textbook rep looks like over time?

What incentives does the rep have if incentive pay is based on budgeted income instead of budgeted revenue?



WWW.BSSVE.IN

Budgeting

Types of Budgets

1. Line item budgets

2. Lapsing Budget

3. Zero based budgets

4. Incremental Budgets



WWW.BSSVE.IN

Budgeting

What is a line item budget?

How are decision rights allocated in line item budgets?

How does a line item budget control behavior?

What incentives do line item budgets provide?



WWW.BSSVE.IN

Budgeting

What is a lapsing budget?

How are decision rights allocated in lapsing budgets?

How does a lapsing budget control behavior?

What incentives do lapsing budgets provide?



WWW.BSSVE.IN

Budgeting

What is a zero based budget?

How are decision rights allocated in zero based

budgets?

How does a zero based budget control behavior?

What incentives do zero based budgets provide?



WWW.BSSVE.IN

Budgeting

What is an incremental budget?

How are decision rights allocated in incremental

budgets?

How does an incremental budget control

behavior?

What incentives do incremental budgets provide?



WWW.BSSVE.IN

Budgets - Summary

Budgets are an important mechanism in the allocation of decision rights.

Budgets are often used to measure performance

Budgets are also used as a mechanism for control.

There is a tradeoff between decision control and decision management

Identify the strengths and weaknesses of various types of budgets.



WWW.BSSVE.IN

Cost Allocations – Overview

1. Motivation for the importance of cost allocations.

2. How do we allocate costs?

3. Effects of cost allocations?

4. Examples

5. Concluding comments



WWW.BSSVE.IN

Why are cost allocations important?

Consider the apartment you shared with someone that was

not related to you, how did you pay for the following?

- Rent - Electric

- Phone - Cable

- Food - Gas

Does the method you allocate costs matter? Why?

Will the method you select affect the total cost incurred?



WWW.BSSVE.IN

Cost Allocations

Consider a very simple example where an individual buys an office building and rents the building to tenants.

The owner of the office building has a problem. She has to pay for common area maintenance costs such as:

- Lighting and heating in the lobby and halls

- Snow removal and parking lot maintenance.

- Security

- Building Management

- Roof maintenance

- Property taxes

All of the tenets in the office building benefit from these expenditures.

What should the manager do?



WWW.BSSVE.IN

Cost Allocations

1. What happens if the manager does not charge the tenants for these costs?

2. What happens if the manager charges an average rate per tenant?

3. How are these costs consumed? What is the cost object?

4. What costs need to be assigned?

5. How would you assign them?



WWW.BSSVE.IN

Cost Allocations

How would you assign the costs of a

maintenance department to the tenants of

the building?

Why doesn’t the tenants rent include a

CAM charge? Why is this separate from

the rent?



WWW.BSSVE.IN

Cost Allocations

Now think of the firm as the office building and each of

the tenants as a product the firm manufactures.

Common area costs include the cost of the plant, the

payroll department, the janitorial staff, the benefits office,

the accountants, etc…

These costs must be allocated to the products.

How the costs are allocated is going to affect the profits of

the entire firm, and the behavior of the manager.



WWW.BSSVE.IN

Why Allocate Costs

- Third Party reimbursements

- Rate regulated industries

- Governmental subsidies

- Cost plus contracts

- External Reporting/Taxes

- FASB and IRS requires allocation.

- Costing products accurately is important.

- Decision Making

- Control



WWW.BSSVE.IN

Cost Allocations

Southwestern Bell Telephone Co. has acknowledged that some Washington lobbying expenses incurred by its parent corporation were improperly included in the company's regulated interstate rate base.

The lobbying expenses totaled about $1.4 million over a five-year period and included money spent to promote changes in the Modified Final Judgment, according to documents submitted this month to the Federal Communications Commission.

Charles Mason 04/30/1990

Telephony COPYRIGHT 1990 Intertec Publishing Corporation



WWW.BSSVE.IN

Cost Allocations

As part of its costs related to treating Medicaid patients, St.

Elizabeth Medical Center in Covington included $13,466

for Cincinnati Reds box seats. Owensboro-Daviess County

Hospital included a $35,000 payment to settle a sexual-

harassment case against a doctor. And Columbia Suburban

Hospital in Jefferson County put down $117,700 worth of

free meals for doctors. These were among the expenses

that Kentucky hospitals submitted as part of their costs in

reports to the state Medicaid program.

KAY STEWART, The Courier-Journal 10/06/1996

The Courier-Journal



WWW.BSSVE.IN

Cost Allocation

According to Strategic Cost Management, Free Press,

1993.

There is a billion-dollar-a-year market in strategic cost management consulting services dominated by such firms as Bain & Company, Boston Consulting Group, Booz-Allen & Hamilton, McKinsey etc.



WWW.BSSVE.IN

Cost Allocation

There are also consulting firms that develop niche groups

that are experts in cost allocations for example:

Brattle Group – Energy Department

We address the economic and financial issues raised by the

allocation of costs over time or among different services

and customers.



WWW.BSSVE.IN

What costs are allocated?

In a single product firm, that has one customer, and only one division there is no need to worry about cost allocations.

Most companies are:

- Multi Divisional

- Offer a variety of Products

- Thousands of Customers

Divisions, products, and customers consume common costs at different rates, or in different amounts.

An effective cost allocation system will more accurately trace the shared costs of production to the divisions, products and customers that consume those costs.



WWW.BSSVE.IN

What are the common Costs of production ?

Overhead

1. How are overhead costs consumed in the plant?

2. Can these costs be traced back to products?

3. What costs can and can not be traced back to individual products?

- Electricity - Maintenance

- Plant costs - Benefits department

- CEO time - Customer service

4. How do we allocated the costs that can not be traced back to the product?

5. Does the method used to allocate these costs matter?



WWW.BSSVE.IN

Cost Allocations

The method of allocating costs and the amount of costs allocated are important for the following reasons:

1. The method of allocating costs will determine the use of common assets.

- Internal Taxation

- Internal Subsidization

2. The method of allocation may also affect whether divisions compete or coordinate.

- Insulating Allocation

- Non-insulating allocation.

3. Cost allocations affect performance and compensation.



WWW.BSSVE.IN

Jolsen International

(Prob 7-7)

See the exercise “Jolsen International”: Problem 7-7 in





WWW.BSSVE.IN

Bio Labs (Prob 7-13)

See the exercise “Bio Labs”: Problem 7-13 in Zimmerman, Jerold

L. Accounting for Decision Making and Control (4th Edition).

McGraw-Hill/Irwin, 2002, pp 368.



WWW.BSSVE.IN

Nixon and Ross (prob 7-19)

See the exercise “Nixon and Ross”: Problem 7-19 in Zimmerman, Jerold L. Accounting for Decision Making and Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 373-5.



WWW.BSSVE.IN

Cosmo Inc (Prob 8-3)

See the exercise “Cosmo Inc.”: Problem 8-3 in Zimmerman,

Jerold L. Accounting for Decision Making and Control

(4th Edition). McGraw-Hill/Irwin, 2002, pp 417-8.



WWW.BSSVE.IN

Cost Allocations Part I - Summary

1. Cost allocations are important for a variety of reasons.

2. The methods used to allocate costs can influence a manager’s behavior:

- Tax on a particular activity

- Insulate manager

- Subsidize the use of common assets.

3. Start on how cost allocations are done.



WWW.BSSVE.IN

Methods of Allocating

Costs - Overview

1. Review the three Method of Allocating Costs.

- Direct Method

- Step Down Method

- Reciprocal Method

2. Discuss the strengths and weaknesses of each method

3. Winery Problem – platform for discussing Joint Cost Allocations

4. Review remaining cost allocation problems.

5. Summarize and Review.



WWW.BSSVE.IN

State College Community Hospital

State College Community Hospital has 2 Service Departments:

1. Maintenance

2. Food Services

The Hospital also has three patient care units:

1. General Medicine

2. OB

3. Surgery

Using the following information, we will allocate the costs of these 2 service departments to the 3 patient care units using the:

1. Direct Method

2. Stepdown Method – Maintenance First

3. Stepdown Method – Food Services First

4. Reciprocal Method



WWW.BSSVE.IN


Amount of Cost to be allocated:

Maintenance $8,000,000

Food Services $3,000,000

Allocation Methods:

Maintenance Costs are allocated based on square footage assigned to

the unit.

Food Service Costs are allocated based on number of meals served to

the unit.



WWW.BSSVE.IN


Expected Utilization Rates

Sq Footage

Meals

Served

Food Services 10,000 30,000

Maintenance 10,000 10,000

Surgery 20,000 40,000

OB 30,000 30,000

General Medicine 30,000 90,000

Total 100,000 200,000



WWW.BSSVE.IN


Allocate Based on Direct Method

Allocated

Maintenance

Costs

Allocated

Food Service

Costs

Food Services

Maintenance

Surgery

OB

General Medicine

Total



WWW.BSSVE.IN


How do we allocate costs using the Direct Method?

1. All Costs of the Service Departments are allocated to the product.

2. Calculate Expected Utilization Rates

Maintenance Food Service

Surgery 25% 25%

OB 37.5% 18.75%

General Medicine 37.5% 56.25%

3. Multiply Expected Utilization Rate and amount of cost to be allocated.



WWW.BSSVE.IN


Step-Down Method Maintenance First

Allocated

Maintenance

Costs

Allocated

Food Service

Costs

Food Services

Maintenance

Surgery

OB

General Medicine

Total



WWW.BSSVE.IN


How do we allocate costs using the Step-Down Method allocating Maintenance First?

1. All Costs of the Maintenance Department’s to the four other divisions in the firm.


Department Expected use Allocated Cost

Food Services 1/9

Surgery 2/9

OB 3/9

General Medicine 3/9




WWW.BSSVE.IN


4. Then take the cost of Food Services + the allocated cost of

Maintenance and allocate those costs to the patient care departments.

Food Services 3,000,000

Allocated Maintenance 888,888

Adjusted food service cost 3,888,888

Expected Use Allocated Cost

Surgery 25%

OB 18.75%

General Medicine 56.25%

Total 100%



WWW.BSSVE.IN


Step-Down Method Food Service First

Allocated

Maintenance

Costs

Allocated

Food Service

Costs

Food Services

Maintenance

Surgery

OB

General Medicine

Total



WWW.BSSVE.IN


How do we allocate costs using the Step-Down Method allocating Food Service First?

1. All Costs of the Food Service Department’s to the four other divisions in the firm.


Department Expected use Allocated Cost

Maintenance 1/17

Surgery 4/17

OB 3/17

General Medicine 9/17




WWW.BSSVE.IN


4. Then take the cost of Maintenance + the allocated cost of Food

Services and allocate those costs to the patient care departments.

Maintenance 8,000,000

Allocated Food Service 176,470

Adjusted food service cost 8,176,470


Surgery 25%

OB 37.5%

General Medicine 37.5%

Total 100%



WWW.BSSVE.IN


Reciprocal Method:

1. Determine total cost to be allocated for each department.

M = 8,000,000 + .10(M) + .05(F)

F = 3,000,000 + .15(F) + .10(M)

Maintenance = $9,144,722

Food Service = $4,605,000

2. Assign Costs Based on utilization rates for each department



WWW.BSSVE.IN


Maintenance:


Surgery 20% ?

OB 30% ?

General Medicine 30% ?

Total 80% ?

Food Service:

Expected Use Allocated Cost Food + Maintenance

Surgery 20% ? ?

OB 15% ? ?

General Medicine 45% ? ?

Total 80% ? ?



WWW.BSSVE.IN

Direct Cost Allocation

Strengths:

1. Easy to Calculate

2. Easy to Implement

Weaknesses:

1. Misstates Opportunity Costs

2. Does not charge service departments for the use of

other service departments



WWW.BSSVE.IN

Step-Down Allocation

Strengths:

1. Reduces the subsidization of service department

use of other service departments

Weaknesses:

1. Misstates Opportunity Costs

2. Some service departments are not charged for the

use of other service departments.

3. Selection of which department is allocated first

results in different cost allocations.



WWW.BSSVE.IN

Reciprocal Method

Strengths:

1. Theoretically correct method of allocating costs

2. Closest measurement of opportunity cost

Weaknesses:

1. Seldom Used because math is misunderstood

2. Assumes all costs are variable, fixed costs should be

allocated based on expected use, which introduce problems

we have already discussed.



WWW.BSSVE.IN

Joint Costs

1. Joint costs are similar to common costs, but instead of an assembly

process we are talking about a disassembly process.

2. Be very Careful in using Joint Cost allocations in :

- Pricing Decisions.

- Product Line profitability

3. Use Net Realizable Value (NRV) for decisions on product line

profitability such as:

- Process beyond split-off.

- Sell at split-off

- Discard as waste



WWW.BSSVE.IN

Net Realizable Value

Net realizable value is the same ides as a contribution

Margin:

Total Product A Product B

Selling Price 100 70 30

- Costs Incurred

80 55 25

Net Realizable Value 20 15 5

- Allocated Joint Cost 10 7.5 2.5

Profits 10 7.5 2.5

beyond Splitoff



WWW.BSSVE.IN

Net Realizable Value

Decision Rules for Net Realizable Value:

1. If total NRV exceeds total allocated joint costs you should incur the

joint costs and disassemble the product.

2. If NRV for a product is positive consider incurring costs beyond

split-off.

3. Compare the NRV to the selling price without additional processing.

If NRV greater than selling price without additional processing, then

incur additional processing.

4. If NRV is negative, compare NRV to disposal cost. Choose the

least costly option.



WWW.BSSVE.IN

Summary

1. Cost Allocations are important

- Performance Measurement

- Decision Making

- Internal Tax

- Subsidy

2. Review of how to calculate allocations using Direct Method, Reciprocal Method, and Step-Down Method.

3. Strengths and Weaknesses of each method.

4. Role of NRV in Joint Cost Decisions



WWW.BSSVE.IN

Overview

• Introductions

• Overview of class

• Course requirements

• Introduction to managerial accounting

• The Smith Center

• Summary



WWW.BSSVE.IN

Introduction

• Undergraduate degree from Bucknell University

• 2 years at Price Waterhouse (CPA)

• 4 years at the Equitable

• Ph’d from Penn State

• Married with two children

• Research Interests

– Accounting for Mergers and Acquisitions

– Role of accounting information in financial contracts.

• Experience with managerial accounting



WWW.BSSVE.IN

Course Overview - Objectives

1. Become familiar with what accounting information is typically used within the firm.

- Strategic implications

- Limitations

2. Develop an understanding of how accounting information is used by managers in the decision making process.

3. Consider how accounting information can be used to motivate members of the firm or as a mechanism to control their behavior.



WWW.BSSVE.IN

Course Overview – Who should take this class

Are you going to be a manager?

Are you going to be a consultant?

Are you going to be an entrepreneur?



WWW.BSSVE.IN

Course Overview - Requirements

This class is designed to allow you to develop an

understanding of the concepts by applying the material

covered to real life problems and cases. I have designed

the grading system for this class to meet this objective.

Your grade will be computed as follows:

Group Case 20%

Individual Cases 40%

Take home Final 40%



WWW.BSSVE.IN

Course Overview

Throughout the course we will develop an understanding of three basic concepts:

1. How costs behave

2. The nature of the firm

3. How accounting systems report costs

These building blocks will be used to gain insights on the role of accounting information in a variety of settings.



WWW.BSSVE.IN

Managerial Accounting

What is managerial accounting?



WWW.BSSVE.IN

The Smith Center

In 1992, State University committed to building the Smith Center (A 15,000 seat basketball Arena). The following projected financial information was available to the University prior to engaging in the project:

Costs:

Building $54 million

Parking $ 2 million

Funding:

Private Contributions $23 million

State Funding $33 million



WWW.BSSVE.IN

The Smith Center

In the year after the Smith Center was built there were conflicting

stories on the profitability of the Smith Center, and the profitability of

the athletic department.

The state legislature reported that the athletic department made over 18

million and the basketball program made over 2.2 million.

The University reported a marginal profit for the basketball program,

and breakeven results for the entire athletic department.

How can there be two different “profits” for the same economic entity?



WWW.BSSVE.IN

The Smith Center

The following is a hypothetical scenario

describing how these could be two different

measurements of profit for the same

economic entity. Lets first focus on the

universities estimate.



WWW.BSSVE.IN

The Smith Center

State University’s estimates on Profitability of the Smith Center:

Revenue:

Basketball Ticket Revenue $2 million

Parking $.5 million

Donations to Basketball program $1 million

Television Revenue $2.2 million

Allocated shared revenue $.2 million

Costs

Utilities $1 million

Tuition cost of supporting a

basketball team $810,000

Cost of supporting coaches

and administrators: $700,000

Payroll Costs $200,000

Allocation of shared expenses $1 million



WWW.BSSVE.IN

The Smith Center - Factors

What are allocated Costs?

- Orthopedic Surgeon

- Team Physicians

- Trainers

- Athlete medical Expenses

- Sports Information Department

- Academic Support Center

These cost total $23 million and are allocated equitably over the 23 varsity programs.

What would happen if the allocation were changed to a per athlete basis?

Does it matter?



WWW.BSSVE.IN


What are allocated revenues?

State University has a 4.2 million dollar endorsement contract with Pepsi. This revenue is also allocated equitably over the 23 Varsity programs.

Does an equitable allocation make sense?

What happens if the allocation is changed to sports which are broadcast to a national audience, or the number of national appearances?

Does it matter?



WWW.BSSVE.IN


What are the opportunity costs of providing $56 million of financing

for the Smith Center?

Develop a school of information technology.

Expand the library.

Expand the football stadium



WWW.BSSVE.IN


How are utility costs assigned to the team?

In the Smith Center there are only 3 teams that use the facility, men’s

and women’s basketball and wrestling. In Rec Hall 15 teams use the

facilities.

Basketball and wrestling are winter sports, how are utility costs for the

rest of the year assigned?



WWW.BSSVE.IN


Can State University generate additional revenue at the Smith Center?

- Concerts

- WWF

- Product Expo

Will State University use the facility for other purposes?

- Commencement

- Job Fair

- Tail gates etc…



WWW.BSSVE.IN


How do you allocate the costs of the 56 million dollars raised since

there is no interest associated with raising these funds?

- Cost of Debt?

- Cost of Equity?

- Cost of next best available alternative?



WWW.BSSVE.IN

The Smith Center

Should State University open the Smith

Center?

Important considerations:



WWW.BSSVE.IN

Summary

Important Concepts to take away from this class:

1. Opportunity Costs

2. Cost allocations are important in a wide variety of contexts.

3. Incremental cost analysis.

For tomorrows class, please read Main line vs Bassinger, it is on the web, and skim chapter 2 of the textbook. We will spend some time on problems: 2-16 (X Corporation Jet), 2-26 (University Parking), 2-41 (Amy’s Boards).



WWW.BSSVE.IN

Performance Measurement and Transfer Pricing

1. Performance Measurement

- Cost Center

- Profit Center

- Investment Center

2. Controllability Principle

3. Transfer Pricing

- Market Based

- Variable Cost

- Full Cost

- Negotiated Transfer



WWW.BSSVE.IN

Allocation of Decision Rights

As we discussed on Monday, in firms owners often have to

allocate decision rights to managers.

Firms are often divided into subunits.

The decision rights assigned to a subunit are used to

classify the unit as a:

1. Cost Center

2. Profit Center

3. Investment Center



WWW.BSSVE.IN

Cost Centers

Decision rights

1. labor

2. Supplies

3. Materials

Performance measures

1. Minimize total cost for a selected level of output.

2. Maximize total output for a given budget.

Problems:

Quality for Quantity Tradeoff

Average cost crates incentive to overproduce



WWW.BSSVE.IN

Profit Centers

Decision Rights

1. Input Mix (see Cost Centers)

2. Product Mix

3. Selling Price

Performance Measurement

-

Problems

Accounting profits compared to budget or some expectation.

- Interdependencies of profit centers.

- Transfer Pricing

- Cost Allocation



WWW.BSSVE.IN

Investment Centers

Decision Rights:

1. Input Mix

2. Product Mix

3. Selling Prices

4. Capital Investment

Performance measures

1. Net Income

2. Return on Investment

3. Residual Income

4. EVA



WWW.BSSVE.IN

Performance Measures -Net Income

Net income is generally defined as the revenues of the

investment center less the costs of the investment center.

Where the costs include the allocated costs or overhead.

Strengths:

Weaknesses:



WWW.BSSVE.IN

Performance Measures - ROI

Return on Investment is generally defined as the net

income of the investment center divided by some measure

of assets (typically total assets or net assets)

Strengths:.

Weaknesses:



WWW.BSSVE.IN

Performance Measures – Residual Income

Residual Income is a variant of ROI. Residual income is

calculated as the investment center’s Net income less a

targeted return times assets (or net assets).

Strengths:

Weaknesses:



WWW.BSSVE.IN

Performance Measures - EVA

EVA is basically the same as residual income. There are three

adjustments:

1. Accounting earnings are adjusted.

2. They use WACC, weighted average cost of capital.

3. Highlights how compensation should be linked to EVA.

Strengths:

Weaknesses:



WWW.BSSVE.IN

Canadian Sub (Prob 5-1)

See the exercise “Canadian Submarine”: Problem 5-1


Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 230.



WWW.BSSVE.IN

Quincy’s Insurance

Sometime in the late 1980’s early 1990’s The Bull Dog insurance company stopped selling Major Medical Insurance.

Policies still needed to be serviced.

Bull Dog Insurance contracted with Quincy’s to administer the line of business.

Quincy’s pays claims, handles complaints, and makes policy changes.

Quincy’s is compensated an annual fee and a bonus. All costs incurred in administrating the book of business are paid by Quincy’s



WWW.BSSVE.IN


Quincy’s Bonus has three key ingredients:

1. $250,000 based on reduction of claim backlog.

2. Per file bonus for paying more than the base number of

claims established in the contract.

3. A bonus based on the size of the book of business.

What types of behavior does this compensation package

encourage?



WWW.BSSVE.IN


1. Low skilled laborers.

2. High Turnover.

3. Easy claim payments

4. “Super” customer service.

5. Quality control was done in house, there was no penalty

for poor quality.



WWW.BSSVE.IN

Stale Mart (Prob 5-19)

See the exercise “Stale Mart”: Problem 5-19 in Zimmerman,

Jerold L. Accounting for Decision Making and Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 240-1.



WWW.BSSVE.IN

Controllability Principle

What metric should be selected to evaluate a unit’s performance?

How is the performance evaluation mechanism affected by random shocks?

Does the performance evaluation system induce dysfunctional behavior.



WWW.BSSVE.IN

Accounting Information used in transfer pricing

Perfect information vs. Asymmetric information

Types of transfer pricing:

1. Market Based

2. Variable Cost

3. Full Cost

4. Negotiated



WWW.BSSVE.IN

Accounting Information used in transfer pricing

Transfer pricing is important to

- Cost Centers

- Profit Centers

- Investment Centers



WWW.BSSVE.IN

Transfer Pricing – Internal Audit

Internal audit is traditionally a cost center.

What happens if you allow audit to price its product and charge units?

Key Lessons:

- Incentives to be efficient?

- Incentives to consult?

- Potential Disputes?

Alternatives:

- Compensation for cost cutting and innovations.



WWW.BSSVE.IN

Lewis Corporation (Prob 5-9)

See the exercise “Lewis Corporation”: Problem 5-9 in





WWW.BSSVE.IN

Pepsi Co. (Prob 5-17)

See the exercise “Pepsi Co.”: Problem 5-17 in Zimmerman, Jerold L. Accounting for Decision Making and Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 239.



WWW.BSSVE.IN

Summary

1. Develop an understanding of cost Centers,

profit centers and investment centers.

2. Consider the different means of measuring

performance and the strengths and weaknesses of

each alternative.

3. Develop an understanding of the importance of

transfer pricing within the firm.



WWW.BSSVE.IN

Standard Costs – Overview

1. What are standard Costs.

2. Why do we set standard costs?

3. How do we set the standards?

4. Calculating Variances: DM and DL

- Disaggregating variances into price and volume.

- Difference between labor and direct materials.

- How do we use variances in evaluating performance?

5. Calculating Overhead variances.

6. The incentives created when Standard cost systems are implemented



WWW.BSSVE.IN

Standard Costs

What are standard Costs?

Standard costs are the expected costs of manufacturing the product.

Standard Direct Labor Costs = Expected wage rate X Expected

number of hours

Standard Direct Materials cost = Expected cost of raw materials X

Expected number of units of raw material.

Standard overhead costs = Expected fixed OH + Expected Variable

Overhead X Expected number of units to be produced.



WWW.BSSVE.IN

Standard Costs

What is a standard Cost system?

A standard cost system is a method of setting cost targets and

evaluating performance.

Targets or expected costs are set based on a variety of criteria, and

actual performance relative to expected targets is measured.

Significant differences between expectations and actual results are

investigated.

Consistent with the themes developed throughout this class, standard

cost systems are a means of helping managers with decision making

and control.



WWW.BSSVE.IN

Standard Costs

Target Costing

1. The market place determines the selling price of the

future product

2. The company determines the profit margin they desire

to achieve on this product.

3. The difference between the selling price and the profit

margin is the target cost



WWW.BSSVE.IN

Standard Costs

Why use a standard cost system?

1. Standards are important for decision making

- How we produce our product.

- How we price our product.

- Contract billing

2. Monitor manufacturing

- Large variances may indicative of problems in production.

3. Performance measurement

- Deviations between actual and standards are often used as

measures of a manager’s performance

- Who sets the standard?



WWW.BSSVE.IN

Standard Costs

How do we set the standards?

Theoretically the standard should be the expected cost of producing the

product.

General practices:General practices:

1. Prior years performance

2. Expected future performance under normal operating

conditions.

3. Optimistic (Motivator)



WWW.BSSVE.IN

Standard Costs

Important considerations in setting standards:

1. Why are senior managers using standards?

- Pricing

- Performance measurement

- Production decisions

2. What happens if managers fail to meet the standards?

3. Standards are supposed to represent the opportunity cost of

production.



WWW.BSSVE.IN

Standard Costs

Consider the following information on Beer manufacturing:

Expected DM and DL for producing 1000 gallons of beer

Standard Quantity Standard Price Total

Raw Materials:

Wheat 100 lbs $50.00 per pound 5000

Hops 200 lbs $50.00 per pound 10000

Barley 200 lbs $50.00 per pound 10000

Direct Labor 500 hours $20.00 per hour 10000

Total 35,000



WWW.BSSVE.IN

Standard Costs

Actual results associated with the purchase of 1000 gallons of beer

Quantity Quantity used Materials and Total

Purchased in Production labor price

Raw Materials:

Wheat 100 lbs 100 lbs $55.00 per

pound

5500

Hops 300 lbs 150 lbs $50.00 per

pound

7500

Barley 500 lbs 250 lbs $40.00 per

pound

10000

Direct Labor 550 hours $22.00 per hour 12100

Total 35100



WWW.BSSVE.IN

Standard Costs

Raw Material Price Variance:

Raw Materials Actual

price

Standard

Price Variance

Quantity

Purchased

Total

Variance

Wheat ? ? ? ? lbs ?

Hops ? ? ? ? lbs ?

Barley ? ? ? ? lbs ?



WWW.BSSVE.IN

Standard Costs

Raw Material Quantity Variance:

Raw Materials Quantity

Used

Standard

Quantity Variance

Standard

Price

Total

Variance

Wheat ? lbs ? lbs ? ? ?

Hops ? lbs ? lbs ? ? ?

Barley ? lbs ? lbs ? ? ?



WWW.BSSVE.IN

Standard Costs

What do we do with the raw materials price variance?

Who do we hold responsible?

What do we do with the raw materials quantity variance?

Who do we hold responsible?



WWW.BSSVE.IN

Standard Costs

Direct Labor Wage Variance:

Actual

price

Standard

Price Variance

Actual

Hours

Total

Variance

Direct Labor 22.00 20.00 2.00 550 $1100.00

There is a $1100 unfavorable wage variance



WWW.BSSVE.IN

Standard Costs

Direct Labor Efficiency Variance:

Actual

Hours

Standard

Hours Variance

Standard

rate

Total

Variance

Direct Labor 550 500 50 20 $1000.00

There is a $1000 unfavorable Efficiency variance



WWW.BSSVE.IN

Arrow Industries (problem 12-3)

See the exercise “Arrow Industries”: Problem 12-3 in





WWW.BSSVE.IN

Howard Binding (Problem 12-16)

See the exercise “Howard Binding”: Problem 12-16 in





WWW.BSSVE.IN

Standard Costs

There are three types of overhead variances that are commonly computed in standard

cost systems. Before we describe each of these variances we need to do a brief review

on overhead.

1. Overhead consists of both fixed costs and variable costs.

2. Overhead is allocated to the product using an activity base.

Thus overhead variances can occur for three reasons

1. the activity base estimate is different than the actual activity base.

2. The amount spent for fixed overhead differs from the standard.

3. The amount spent on variable overhead (the rate per unit) differs from the standard.



WWW.BSSVE.IN

Standard Costs

Overhead spending variance

This variance is designed to measure how much

overhead was actually incurred compared to the

overhead that should have been incurred at the

actual volume for the activity base.

Spending variance = Actual overhead – budgeted

fixed costs – budgeted variable overhead

allocation rate * actual activity base.



WWW.BSSVE.IN

Standard Costs

Overhead efficiency variance

This variance is a measure of the effect of the difference in the amount of an activity base incurred compared to the expected amount of the activity base.

Using additional machine hours or direct labor hours causes additional variable overhead

Efficiency variance = Variable overhead allocation rate * ( actual activity base – budgeted activity base)



WWW.BSSVE.IN

Western Sugar (Problem 13-9)

See the exercise “Western Sugar”: Problem 13-9 in Zimmerman,

Jerold L. Accounting for Decision Making and Control (4th Edition).

McGraw-Hill/Irwin, 2002, pp 660-1.



WWW.BSSVE.IN

Standard Costs

Overhead volume variance

The overhead volume variance measures the cost or benefits of using less or more than expected capacity.

Volume Variance = Fixed Overhead *(Budgeted volume – actual volume)

budgeted volume

If budgeted volume = actual volume, then you have derived no extra benefits or costs associated with capacity.

When budgeted volume is less than expected volume, then the fixed costs associated with providing capacity are greater than expectations



WWW.BSSVE.IN

Standard Costs

When standards are used to measure performance, then the manager has an incentive to insure production costs come in below standards. Consider the following good and bad incentives:

1. Direct Material Price standards create the incentive to purchase materials in large volume to get price discounts.

2. Direct Material Price standards create the incentive to reduce the quality of the material purchased.

3. Standards create the incentive for cross monitoring. When managers are held responsible for costs that are outside of their control, they will monitor other managers to ensure they meet standards.

4. Managers also have the incentive to control costs so long as they do not exceed the standard. No incentive to reduce costs below standard.



WWW.BSSVE.IN

Standard Costs

What controls can you implement to discourage

the harmful incentives and encourage the

productive incentives?

Just-in-time inventory

System of Quality Control

Engineering specifications

Controllability of Costs

Non-linear reward system for cost reduction.



WWW.BSSVE.IN

Activity Based Costing

How do we use Activity Based Costing?

1. Costs are accumulated in activity centers (a.k.a. Cost Centers such as order

processing or special components)

2. Managers select an activity base for the center to apply the cost to the product.

- Multiple cost drivers in the firm

- Use non-financial measures to reduce the tax on production

activities.

- Four Basic types of Cost Drivers:

1. Unit level

2. Batch Level

3. Product Level

4. Production Sustaining Costs

3. Costs are allocated to the product as the product passes through the activity center.



WWW.BSSVE.IN


What are the benefits of using Activity Based Costing Systems?

1. More costs are traced to the product.

2. Activity Based Costing Requires managers to obtain a better understanding of:

- How costs are consumed by individual products.

- The different activities that produce products.

- The indirect costs associated with these activities.

- How indirect costs relate to cost drivers.

3. Product costs are more accurate.

Proponents argue that having more accurate costs will help in decision making



WWW.BSSVE.IN


Key Points regarding Activity Based Costing:

1. Useful for developing a more accurate measure of the cost of

multiple products with different levels of manufacturing sophistication

and different volumes of production.

2. Managers must recognize that overhead varies by factors other than

volume of production for the product.

3. The managers ability to successfully identify these cost drivers will

ultimately determine the usefulness of an ABC costing system.



WWW.BSSVE.IN


What are the costs of implementing an Activity Based Cost system?

1. Updating the accounting system and maintaining an ABC system requires

additional time and money.

2. Managers select cost drivers in their activity centers. There is a tradeoff

between decision making and control.

3. While ABC systems may more accurately measure costs, they ignore the

benefits of a multi-product production strategy.

4. Generally ABC system demonstrate that low volume products are more

costly to produce than high volume products. This is a very costly method to

derive this result.



WWW.BSSVE.IN

Overview

The Economics of Organizations

1. Finish up the problems from last class

2. Key assumptions and important concepts underlying the

analysis of how managers can better motivate and

control behavior.

3. Measuring and Evaluating Performance

4. Allocating Decision rights

5. Integration

6. Summary



WWW.BSSVE.IN

Emrich Processing

See the exercise “Emrich Processing”: Problem 2-11





WWW.BSSVE.IN

Problem – Corporate Jet Co.

A firm with three divisions has two facilities, one in

Chicago, one in Orlando.

Everyday some of the executives in the Chicago

office fly to the Orlando office, and others return.

The Company is considering buying their own jet.

What are the factors the firm must consider in their

decision to purchase the jet?



WWW.BSSVE.IN

Agency Costs

Most economic models assume people attempt to maximize their well being (known as utility).

Agency Problem: Agents will undertake actions to maximize their utility regardless of whether their actions maximize profits.

Moral Hazard - Insurance

Adverse Selection - Hiring/fuse

Short Horizon - project selection

Free rider - Group Projects



WWW.BSSVE.IN

Napster

File Sharing community to allow a group of

individuals to share files through the internet.

The current innovation in this technology is

known as Gnutella.

It is a form of peer-to-peer technology.

How can peer-to-peer technology be designed to

reduce their agency problems?



WWW.BSSVE.IN

Free Riders

How do firms reduce the costs associated with free riders?

In a multidivisional firm, there are often “public goods” provided by

the main headquarters to all of the divisions. How does the firm

discourage free riders and the over use of the common good?

- Copy centers

- Building space

- Human resources

- Parking spaces

- Capital



WWW.BSSVE.IN

University Physician (Prob 4-6)

See the exercise “University Physician”: Problem 4-6





WWW.BSSVE.IN

Private Country Clubs (P4-16)

See the exercise “Private Country Clubs”: Problem 4-17 in





WWW.BSSVE.IN

The Equitable

Mutual Insurance Company until 1993. Was a member of the Fortune 100.

Ownership of the company is maintained by the policyholders.

This means no single person owns a significant interest in the firm (no traded equity either)

What are some of the problems that are likely to arise from the mutual form of organizational structure?



WWW.BSSVE.IN

Agency Costs

What are the factors that limit the agency costs a firm

will incur?

1. The principle’s ability to monitor and thereby control

the agent

Monitor until:

Marginal Costs > Marginal Benefits

How can the firm’s internal accounting system be used

to monitor the agent?



WWW.BSSVE.IN

Agency Costs

Consider Michael Eisner’s 1996 employment contract with Disney:

1. 10 year contract

2. Base salary of $750,000

3. Bonus based on Disney meeting targeted EPS.

4. Stock Options on 8 million shares of stock extending a period of 15 years.



WWW.BSSVE.IN

Agency Costs

Other Factors that limit the Agency costs of the firm:

- The market for corporate control.

- The competitiveness of the labor market.

- External Competition.



WWW.BSSVE.IN

Decision Rights

For a team to produce more efficiently than each of the individuals, decision rights must be allocated among the members of the team.

When the owner allocates decision rights, she must consider the following:

1. Shirking

2 Influence Costs

3. Separation of decision making and

decision control.



WWW.BSSVE.IN

Decision Rights and Accounting Systems

How is accounting information important in the allocation

of decision rights?

The principle should implement controls within the

accounting system to reduce the costs associated with

allocating decision rights. For example:

• Requiring competitive bids on purchases over a certain

dollar amounts.

• Requiring approval of purchases over certain dollar

amounts.

• Measuring firm performance that is reflective of

managerial effort.



WWW.BSSVE.IN

Priceline.com

What is priceline.com?

Why doesn’t Delta replicate priceline.com on their

own ?

Why did priceline.com work for airplane tickets

and not for supermarkets or gas sales?



WWW.BSSVE.IN

Value Added Retailing

AT&T is in the business of providing phone service.

One division provides phone lines for internet retailers or providers.

These companies typically need reliable connections to the WEB and

costly equipment to provide these services.

AT&T has three divisions that jointly handle these transactions:

- Sales department for telephone lines

- Installation unit

- Billing department for both groups

What are some of the problems with this organizational design?



WWW.BSSVE.IN

Markets vs. Firms

When do transactions get conducted inside the firm vs. in a competitive market?

For a firm to survive, it must be less costly to internally produce the good than going to an external market.

Consider the following 2 examples:

Priceline.com

Value added retailing



WWW.BSSVE.IN

The Role of Accounting in Organizational

Architecture

Accounting systems role within the firm.

1. Performance Measurement

2. Performance Evaluation

3. Allocation of Decision Rights



WWW.BSSVE.IN

Summary

1. Refresher on organizational problems

within the firm

2. Managerial accounting plays an

important role in reducing agency costs.

- Motivate employees

- Control their behavior



WWW.BSSVE.IN

Final Exam

Weber’s Customized Electronics

Overview

Weber’s Customized Electronics was founded in 1990. T.J. Weber, an engineer with 20 years in the airline industry, founded the company. The company initially supplied customized electronic components to the military. As the company prospered, the firm expanded by purchasing some of their competitors, and bidding on outsourced business from the commercial airline industry.

By April 2002, Weber’s had become a multidivisional corporation (twelve in total) producing a variety of customized electronic components for the airline and automobile industries as well as the military.

The Electronics Testing Division (ETD) is one of the twelve divisions. ETD provides centralized testing for the electronic components produced in the other 11 divisions. ETD was created in 1997 as a result of a strategic reorganization of the company. As Weber’s expanded in the 1990’s each division separately employed various machinery and personnel to test the integrated circuits (I.C.’s), diodes, transistors, capacitors, resistors, transformers, relays and crystals that were used in the various products. The costs of the machinery and the personnel in each division were substantial, and management believed that consolidating testing into one central division that serviced the other eleven divisions in the corporation would result in substantial cost savings.

ETD was organized as a cost center. The other eleven divisions would provide products to the division to be tested, and the costs of testing these products were transferred back to the divisions at full cost (direct labor cost and allocated burden for overhead, there are no direct materials used in this division). Although ETD is a captive division, the other divisions in Weber’s were allowed to use outside testing services if ETD could not meet their cost or service requirement. Furthermore, ETD was permitted to use 20% of their capacity to test the circuits, diodes, transistors, capacitors, resistors, transformers, relays and crystals of outside companies.1 The department has no budget for advertising or marketing services, thus most outside customers were obtained by word of mouth.

ETD employed approximately 65 hourly personnel and 40 administrative and technical staff members. Budgeted expenses were 7.9 million in 2002 (See Exhibit 1)

Testing Procedures

ETD had tested 30 million components in 2001 and expected to test between 35 and 40 million components in 2002. Component testing was required for two reasons. First, if defective components were not caught early in the manufacturing cycle, the cost of repair could be substantial. Studies indicated that a defective capacitor caught before its use in

The division was expected to make a 15% profit margin on outside business. 1



WWW.BSSVE.IN

the manufacturing process, cost two cents to repair. If the defect was not caught until the product was out in the field, the costs of replacing the capacitor could run in to the thousands of dollars, greatly exceeding the cost of the electronic component. Second, a large proportion of Weber’s work was defense related. Military specifications frequently required extensive testing of components used in aerospace and naval products. By 2002, ETD had the ability to test 6500 different types of components. Typically the division would test 500 different components a month and between 3000 and 3500 different components per year. Each division or outside customer would send components to ETD in lots. ETD would then test each lot and the defective pieces would be identified and separated for retooling. In 2002, ETD expected to receive 12,000 lots of components.

ETD performs both electrical and manufacturing testing. Electrical Testing involves measuring the electrical characteristics of the components and comparing these measurements with the component’s specifications. For example, the specifications of an amplifier may have called for a 1-volt input to be amplified into a 10-volt output. ETD would deliver a 1-volt charge to the amplifier, and then measure whether the amplifier’s output was in conformance with specifications.

Mechanical testing included solderability, component burn-in, thermal shock, lead straightening and leak detection. Solderability involved the inspection of components to ensure they held solder. Burn-in involves the extended powering of components at high temperatures. Thermal shock involves the cycling of components between high and low temperatures. Lead straightening was the detection and correction of bent leads on components. Leak detection involved the examining of hermetically sealed I.C.s for leaks.

Components varied significantly in the number and the type of electrical and mechanical testing procedures they required. This variation resulted in about 200 different standard process flows for the division. One manager in the division was responsible for determining the process flows in the facility. He organized the monthly testing runs based on the different combinations of tests and specifications the customer requests. Based on these combinations, he would determine the routing of the product between testing equipment and the type of tests performed at each station. I.C.s, for example, could follow up to twelve different flows through the facilities. Some of the I.C.’s only require electrical testing at room temperature; others required solderability and leak detection as well as thermal shock and burn-in tests.

Each type of component required separate software development, custom tools, and occasionally custom fixtures were also required. Software, tools, and fixtures were developed by the engineering group, which was made up of specialists in software development, equipment maintenance, calibration and repair, tooling and fixturing, and testing operation. Software engineers developed programs for specific applications. The programs were then retained in the software library for future use. During 2002 ETD has added another 1300 software programs to the library, increasing the total in the software library to over 6500 different software programs. ETD also had an inventory of 1500 tools and fixtures, of which 300 had been developed in the past year. The large number



WWW.BSSVE.IN

of tools and fixtures allowed the testing of components with a variety of leads, pin combinations, and mating configurations.

ETD monitored the costs and the processes that were necessary to test the various components Weber’s produced, and they often compared their costs to bids from their competitors. On complex parts that require screening, environmental conditioning, the division was consistently cheaper than outside vendors. Where only elementary testing was required, low technology outside laboratories were often cheaper, especially on large lots. The division manager at ETD, Susan Swampscott, believed that the advantage that the division brought customers over the outside labs was that the latter had almost no engineering support, while ETD has engineering resources available to quickly design and implement tests on complex parts in a cost-effective manner. The shift to more technically sophisticated services has prompted a shift in the labor mix from direct to indirect personnel. The division expected to see a crossover between engineering head count and hourly headcount some time in the next three years.

The testing facility was divided into three rooms. The stock room housed administrative personnel, and also was designed for receiving incoming components for testing, and for sorting outgoing products that had already been tested. The main testing room contained the equipment used for electrical testing. The mechanical room contained the equipment used for mechanical testing. 30 people worked in the mechanical room and another 30 people worked in the main testing room. The remaining 5 people worked in the stock room.

Recently there had been some innovations at Weber’s that were likely to affect the testing of components. First, Weber’s has been moving towards producing high-technology components, creating the need for automatic testing on sophisticated equipment. Automatic testing will lead to longer test cycles and more data per part. For example, digital components are currently tested for up to 100 conditions (a condition is a combination of electrical input and output state). The new generation of digital components is so much more complex that they require the verification of up to 10,000 conditions. These components require expensive highly automated equipment and less direct labor to complete the tests.

Second, in 2002, Weber’s adopted a Just-in-Time inventory system for all of its divisions. As part of the adoption of this system, Weber’s implemented a vendor certification program, where Weber’s engineers verified that vendor’s production process would result in pieces of components that met required engineering specifications. As each division determines which of their vendors must be certified, the testing of some of the pieces of Weber’s electrical components will be pushed back to the vendor. ETD was expecting to move from the primary tester of several components to a quality inspector of these components. Thus instead of testing every component in a lot, ETD would use statistical sampling and test a percentage of the components to insure that the vendors supplied pieces that met the firms engineering standards. Early indications suggest that the JIT system will lead to an increased number of smaller lots being received by ETD, and vendor certification will reduce the number of tests that ETD will have to perform. ETD



WWW.BSSVE.IN

forecasts that over the next three years, 30% of the products produced by Weber’s will have been initially tested by certified vendors.

Cost Accounting System

The cost accounting system measures two components of cost: Direct Labor and Overhead. The Overhead costs were accumulated into a single cost pool. All of the overhead costs associated each of the testing rooms, the stock room, and the costs of engineering, software development, and tooling/fixtures development were accumulated in this pool. Total overhead costs were divided by the sum of testing and engineering labor dollars to arrive at a burden rate per direct labor dollar. The division costed each lot of components. The overhead allocated to each lot by multiplying the actual direct labor dollars associated with the lot by the burden rate. Thus the total cost associated with testing a lot of components is the sum of the direct labor and overhead. In 2002, the facility wide burden rate was 145% of each direct labor dollar. (See Exhibit 1 for a description of the overhead costs, and the calculation of the burden rate for 2002.)

Current Events

In April 2002, Stacy Swampscott, the manager in charge of ETD, was reviewing the results for the division for the first quarter. She realized that this was the second consecutive quarter in which the Aerospace division had reduced the number of components they had sent to ETD for testing. She assigned her assistant manager, Fred Dusseldorf, to find out why aerospace was reducing their use of ETD. Fred had determined that Aerospace was outsourcing testing for some of their components. Furthermore, the division manager of the military department in Weber’s had recently suggested that they might outsource some of their testing because ETD’s costs were getting a little high. The manager of the Aerospace division had complained to Fred that, “I do not know what you all are paying your people over there, but ABC labs came in at 25% of your cost.”

This seemed strange to Susan. Just this quarter, the department had won an external bid for testing components for a defense contractor, Spellman Industries, that does not compete with Weber’s. When her production manager, Hank Kellog, had prepared the estimate for the costs of the new job, he had determined that testing on this product would require that the department purchase another machine, that would cost the department approximately $2,000,000. However, similar to the last two external testing jobs, the testing on this component was almost entirely automated, direct labor costs were estimated to be less than $50,000, handling costs were estimated to be less than $15,000, and other engineering and overhead costs associated with this job were expected to be less than $100,000. He also determined that after the job was completed, the machine could be retooled and used to help test some of the military parts for which testing was currently outsourced. Since the machine could be used to test other products in Weber’s, her assistant prepared the bid by calculating a revised cost estimate using the 2002 budget, and applying a 20% margin to those costs.



WWW.BSSVE.IN

She decided it was time to have a meeting with Fred and Hank to see if she could determine what was happening with the division’s costs. Since the aerospace division manager was complaining about her direct labor costs, she asked Fred to analyze the departments labor costs over the last two years focusing on the direct labor costs for aerospace components (Exhibit 2), and she asked Hank to bring his estimates for the bid the department had recently won (Exhibit 4).

The Meeting

Fred: Well Susan, I talked to Ross Watts, the manager in charge of process flows, and I thought we might be onto something by analyzing the labor costs of testing electronics components of the Aeronautics division. Ross indicated that we were testing about 60,000 units a month for this division, and that the testing of Aeronautics Components is mostly a manual process, done on simple machines, and require relatively more direct labor hours.

So the first thing I did was investigate whether the increase in the union rates was larger than we had anticipated. As you can see from this graph (Exhibit 2), last March the line personnel got a 3% raise, so I don’t think the slight increase in the wage rate is the driving factor in the difference between our costs and our competitors.

I also looked at the direct labor costs for testing the Aeronautics components. In total, the costs look relatively stable at about $10,000 per month until the 4th quarter of 2001. Then they outsourced the Fetzner boards to ABC LABS, and in January they outsourced the splintners circuits. Thus the direct labor costs associated with testing Aeronautics electronic components dropped.

I also checked the Dl$ per unit tested, and compared it to the average DL$ per unit tested for the company. As you can see in this third graph, the Dl$ per unit tested is higher than the average unit tested in the company, but it is very stable and actually decreasing slightly for the products we test in this division. We implemented a slight change in the process flow that allowed laborers to handle more units per hour. I just don’t think our labor costs are the source of the problem. Maybe the costs of our overhead have increased? Or perhaps ABC LABS has figured out a way to do this better?

Susan: I was afraid that it wasn’t the direct labor costs Fred. I went and looked at the direct labor costs for our entire department, and they look like they have are expected to go down this year as we bring on more of these automated testing machines. I also looked at the total overhead for the department, and total cost of the department and I don’t see much of a change (See Exhibit 3). Since I don’t see a large percentage change in costs, our competitors must have made some technological improvement in how they test these electronic components.

Susan: What amazes me is that we seem to be losing some of our divisions as customers but external customers seem to find us to be the low cost bidder. Hank, how did we determine the cost to charge Spellman for their components?



WWW.BSSVE.IN

Hank: Well Susan, let me give you some of the basics. First, we are going to be testing about 1,200,000 components a year for Spellman. The machine can handle 30,000 components a week at full capacity, so I figure that we are going to use 80% of the machines capacity running the Spellman job.

In determining a rate to charge Spellman, I figured that since we were going to use 20% of the machines capacity on internal orders, the best thing to do was to estimate the costs of adding the Spellman business and then revised the budget to include the expected cost of the Spellman job. (See Exhibit 5) I figure Spellman will use $50,000 in direct labor costs. Some of these costs will be from hiring an additional part time worker, and some of these costs will be from using the excess capacity created when we lost our Aerospace’s components. I also estimated additional overhead associated with this job to be $315,000 and the new burden rate is 1.533, so I come out with total costs of about $126,000. I then used a margin of 20%, and I come up with revenues of $151,200. When I divide this by the 1,200,000 units, I get a rate of 12.6 cents per component tested. I rounded up to 13 cents a unit.

I also analyzed how this job will affect the machine hours available for testing. As you can see from this exhibit, we had 33,201 hours in the main room, and 17,203 hours of machine time in the mechanical testing room. The new machine will annually provide an additional 2000 hours of testing time to the Mechanical room, since all the tests on the Spellman components will be done there. This year I expect the Machine will be used exclusively on the Spellman job. In the future we will have 400 hours of excess capacity to take on additional work.

Susan: Hank, that seems reasonable to me. I’m lost as to how we can be beating our competitors in one set of tests and losing in the other. Perhaps we need to bring in an expert to figure this out. Fred, why don’t call that consultant that just graduated from Sloan maybe she/he can help us.



WWW.BSSVE.IN

Exhibit 1

Panel A: Estimates of Direct Labor and Overhead costs for the ETD Division

2002 Budgeted Expenses

Direct Labor $3,260,015

Overhead:

Indirect Labor 859,242

Salary Expense 394,211

Supplies and Expenses 538,029

Services2 245,226

Personnel Allocations3 229,140

Service Allocations 4 2,448,134

Total Overhead Expenses5 4,713,982

Total Budgeted Expenses $7,973,997

Expected profits from servicing external customers 6

$300,000

Burden rate = (4,713,982)/(3,260,015) = 144.6%

2 Includes Tool Repair, Computer expenses, Maintenance Stores, and service cost transfers from other divisions 3 Includes the costs of indirect and salaried employees fringe benefits, the personnel department, security, stores/warehousing, and holidays/vacations. 4 Includes Building occupancy, telephones, depreciation, information systems, and data control. 5 The cost accounting department estimates that $1,426,317 of the overhead costs is variable, $1,288,000 of the costs is related to depreciation, and the remaining $1,999,665 is other fixed costs. Breakouts of these costs are provided in Panel A 6 ETD is a cost center, the transfer price to the other divisions is full cost. Thus for all of the testing done on Electronic components produced by divisions within Weber’s the expected revenues for ETD is equal to expected costs. For ETD’s external customer’s, the division is expected to markup the costs by 15% to determine the selling price of their service. Any profits above the 15% margin are allocated to a profit sharing pool for the senior managers of the division. For Fiscal 2002, the average margin for servicing outside customer is expected to be 20%, expected profits on external customers is $300,000 and $75,000 is expected to be available for profit sharing.



WWW.BSSVE.IN

Exhibit 1

Panel B: Budgeted Overhead Expenses for each of the three rooms in the ETD Division for 2002

Variable Depreciation Other Fixed Costs

Total Costs

Main Test Room 887,379 88,779 1,126,958 2,103,116

Mechanical Test Room 443,833 808,103 674,327 1,926,263

Total for Test rooms 1,331,212 896,882 1,801,285 4,029,379

Engineering, admin and storage 95,105 391,118 198,380 684,603

Total Costs 1,426,317 1,288,000 1,999,665 4,713,982



WWW.BSSVE.IN

Exhibit 2

8

Apr-0

0

Jun-

00

Aug-0

0

Oct-0

0

Dec

-00

Feb-0

1

Apr-0

1

Jun-

01

Aug-0

1

Oct-0

1

Dec

-01

Feb-0

2

Analysis of Average hourly wage rate per direct labor hour for the employees in the Electronics Testing Department.

Wage

7.7

7.8

7.9

8.1

8.2

8.3

8.4

Wage

Analysis of Direct Labor Cost of testing Aeronautics Electronic components

0

Apr-0

0

Jun-

00

Aug-0

0

Oct-0

0

Dec

-00

Feb-0

1

Apr-0

1

Jun-

01

Aug-0

1

Oct-0

1

Dec

-01

Feb-0

2

Dl$

2000

4000

6000

8000

10000

12000

Dl$



WWW.BSSVE.IN

Exhibit 2

Analysis of average direct labor cost per electronic component tested for the Aeronautics Division compared to the average direct labor dollar per unit for the entire ETD department.

Ap

r-0

0

Jun-0

0

Aug-0

0

Oct-

00

Dec-0

0

Feb-0

1

Ap

r-0

1

Jun-0

1

Aug-0

1

Oct-

01

Dec-0

1

Feb-0

2

Direct labor dollars per unit tested

0.08 0.085

0.09 0.095

0.1 0.105

0.11 0.115

0.12 0.125

0.13 0.135

0.14 0.145

0.15 0.155

0.16 0.165

0.17 0.175

0.18

Aerospace

entire department



WWW.BSSVE.IN

Exhibit 3

Comparison of 2001 Actual results and 2002 budget

2001

Actual

2002 Budget Percentage

Change

Direct Labor $3,766,012 $3,260,015 -13.4%

Overhead:

Indirect Labor 811,028 859,242 +5.9%

Salary Expense 320,045 394,211 +23.1%

Supplies and Expenses

602,230 538,029 -10.6%

Services7 246,006 245,226 -0.3%

Personnel Allocations8 243,498 229,140 -5.8%

Service Allocations9

2,275,034 2,448,134 +7.6%

Total Overhead 4,497,891 4,713,982 +4.8%

Total Expenses 8,263,903 $7,973,997 +3.5%

7 Includes Tool Repair, Computer expenses, Maintenance Stores, and service cost transfers from other divisions 8 Includes the costs of indirect and salaried employees fringe benefits, the personnel department, security, stores/warehousing, and holidays/vacations. 9 Includes Building occupancy, telephones, depreciation, information systems, and data control.



WWW.BSSVE.IN

Exhibit 4

Panel A: Cost analysis of Purchasing new machine to test Spellman’s Electronic Components

Cost of Purchasing Unibridge E34r capicitor flux testor

Cost of New Machine $2,000,000

Depreciation Rate10 $200,000

Direct Labor Costs11 $50,000

Handling Costs $15,000

Engineering Salary $25,000

Other Overhead Charges $75,000

Panel B: Effect of purchasing E34r Capacitor Flux Testor on available machine hours for testing

Expected total Machine Hours for

2002

Capacity provided by E34r

Capacitor Flux Testor12

Revised 2002 estimate of machine

hour capacity

Main Test Room 33,201 0 33,201

Mechanical Test Room 17,103 1,500 18,603

Total 50,304 1,500 52,304

10 Depreciation is done over 10 years on a straight-line basis assuming no residual value. 11 Instead of bringing in an additional full time employee, the division will hire a part time employee for approximately $20,000 per year, the rest of this cost will be from the excess capacity that we have from losing the testing of Aerospace products. 12 Since the Machine is being purchase in April, only 75% of the machine’s annual capacity is available. In addition all of the 1500 hours will be used on testing the external product.



WWW.BSSVE.IN

Panel C: Revised Budget including the costs of doing the Spellman job Revised Budget

Additional Costs

of E34r Capacitor

Flux Testor 2002 Budget

Revised

Budget

Direct Labor13 $20,000 $3,260,015 3,280,015

Overhead:

Indirect Labor 0 859,242 859,242

Salary Expense 25,000 394,211 419,211

Supplies and Expenses 0 538,029 538,029

Services14 25,000 245,226 260,226

Personnel Allocations15 15,000 229,140 244,140

Service Allocations16 250,000 2,448,134 2,698,134

Total Overhead 315,000 4,713,982 5,028,982

Total Expenses 335,000 7,973,997 8,308,997

Revised Burden Rate = 5,028,982/3,280,015 = $1.533 per direct labor hour

13 Instead of bringing in an additional full time employee, the division will hire a part time employee for approximately $20,000 per year, the rest of this cost will be from the excess capacity that we have from losing the testing of Aerospace products. 14 Includes Tool Repair, Computer expenses, Maintenance Stores, and service cost transfers from other divisions 15 Includes the costs of indirect and salaried employees fringe benefits, the personnel department, security, stores/warehousing, and holidays/vacations. 16 Includes Building occupancy, telephones, depreciation, information systems, and data control.



WWW.BSSVE.IN

Exhibit 5

Representative data on the costs and machining time for 1 lot of 10,000 components for 5 different components tested at ETD

Machine Hours

Product Direct Labor Dollars

Main Room Mech. Room Total

ICA 917 8.5 10.0 18.5

ICB 2,051 14.0 26.0 40.0

Capacitor 1,094 3.0 4.5 7.5

Amplifier 525 4.0 1.0 5.0

Diode 519 7.0 5.0 12.0



WWW.BSSVE.IN

Questions

Consider yourself to be the consultant that ETD hires to come help them address the problems that the division is facing. Prepare a report to Susan that highlights the problems that Weber’s currently has and proposed solutions. In your report you should address the following questions.

1. What are the important issues in the ETD division of Weber’s Electronic Components? How would you predict the problems in the ETD division would affect the other divisions in Weber’s?

2. What steps would you suggest ETD implement to rectify these problems? What are the advantages and disadvantages of your proposed system? What other information would you need to help in your recommendation?

3. Exhibit 5 provides data on 5 representative products. What are the costs of the 5 representative products in the current system? What will the costs be when the firm takes on the Spellman job? If you have proposed any changes to the cost accounting system, what are those changes, and what are the costs of these products under your system?

4. How profitable do you think the Spellman job will be? What price would have you charged to make a 20 percent margin? Does the excess capacity that the machine provides affect your analysis? How?

5. Susan also asks that you include a section in your report that provides suggestion for changes in ETD and/or in the firm that could be provided to the CEO.

Remember be clear and concise in your write up. If you need to make any additional assumptions, then be explicit in identifying your assumptions. Please provide schedules supporting any calculations you make. If you elect to email me your solution, your entire write up must be contained in a single, printer friendly document.

** This document refers to a case from Harvard Business School.



WWW.BSSVE.IN

1. overview of absorption costing and variable costing · pdf fileabsorption costing -...

Documents