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Managerial Accounting

Topic 1. Job-order costing

Glossary

No Terms Meaning

1 Allocation base A measure of activity such as direct labor-hours or machine-hours

that is used to assign costs to cost objects

3 Bill of materials A document that shows the quantity of each type of direct material

required to make a product

4 Cost driver A factor, such as machine-hours, beds occupied, computer time,

or flight-hours, that causes overhead costs

5 Cost of goods

manufactured

The manufacturing costs associated with the goods that were

finished during the period

6 Finished goods Units of product that have been completed but not yet sold to

customers

7 Job cost sheet A form that records the materials, labor, and manufacturing

overhead costs charged to a job

8 Job-order costing A costing system used in situations where many different

products, jobs, or services are produced each period

9 Materials requisition

form

A document that specifies the type and quantity of materials to be

drawn from the storeroom and that identifies the job that will be

charged for the cost of those materials

10 Multiple

predetermined

overhead rates

A costing system with multiple overhead cost pools and a

different predetermined overhead rate for each cost pool, rather

than a single predetermined overhead rate for the entire company.

Each production department may be treated as a separate overhead

cost pool.

11 Normal cost system A costing system in which overhead costs are applied to a job by

multiplying a predetermined overhead rate by the actual amount

of the allocation base incurred by the job

12 Over-applied

overhead

A credit balance in the Manufacturing Overhead account

that occurs when the amount of overhead cost applied to Work in

Process exceeds the amount of overhead cost actually incurred

during a period

13 Overhead

application

The process of charging manufacturing overhead cost to job cost

sheets and to the Work in Process account

14 Predetermined

overhead rate

A rate used to charge manufacturing overhead cost to jobs that is

established in advance for each period. It is computed by dividing

the estimated total manufacturing overhead cost for the period by

the estimated total amount of the allocation base for the period

15 Raw materials Any materials that go into the final product

16 A schedule that contains three elements of product

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Schedule of cost

of goods

manufactured

costs—direct materials, direct labor, and manufacturing

overhead—and that summarizes the portions of those costs that

remain in ending Work in Process inventory and that are

transferred out of Work in Process into Finished Goods

17 Schedule of cost of

goods sold

A schedule that contains three elements of product costs—direct

materials, direct labor, and manufacturing overhead — and that

summarize the portions of those costs that remain in ending

Finished Goods inventory and that are transferred out of Finished

Goods into Cost of Goods Sold

18 Time ticket A document that is used to record the amount of time an employee

spends on various activities

19 Under-applied

overhead

A debit balance in the Manufacturing Overhead account

that occurs when the amount of overhead cost actually incurred

exceeds the amount of overhead cost applied to Work in Process

during a period

20 Work in process Units of product that are only partially complete and will require

further work before they are ready for sale to the customer

Concepts in Action

1. Read and fill in the blanks with the following words: costing data, project variances,

unique, last-minute, profitable, identified, leverage, budgeted, cost, individually, pricing decisions,

direct labor-hours, completed, success, experience, grand opening, stages, estimated overhead costs,

allocation bases, the percentage

Job Costing on Cowboys Stadium

Over the years, fans of the National Football League have (1) the Dallas

Cowboys as “America’s Team.” Since 2009, however, the team known for winning five Super

Bowls has become just as recognized for its futuristic new home, Stadium in Arlington, Texas.

When the Cowboys take the field, understanding each week’s game plan is critical for

(2) But for Manhattan Construction, the company that managed the development

of the $1.2 billion Cowboys Stadium project, understanding costs is just as critical for making

successful (3) , winning contracts, and ensuring that each project is

(4) . Each job is estimated (5) because the (6) end-

products, whether a new stadium or an office building, demand different quantities of

Manhattan Construction’s resources.

In 2006, the Dallas Cowboys selected Manhattan Construction to lead the construction

of its 73,000 seat, 3 million- square-foot stadium. To be (7) in three years, the

stadium design featured two monumental arches spanning about a quarter-mile in length over

the dome, a retractable roof, the largest retractable glass doors in the world (in each end zone),

canted glass exterior walls, 325 private suites, and a 600-ton JumboTron hovering 90 feet

above the field.

With only 7% of football fans ever setting foot in a professional stadium, “Our main

competition is the home media center,” Cowboys owner Jerry Jones said in unveiling the

stadium design in 2006. “We wanted to offer a real (8) that you can’t have at

home, but to see it with the technology that you do have at home.”

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Generally speaking, the Cowboys Stadium project had five (9) : (1)

conceptualization, (2) design and planning, (3) preconstruction, (4) construction, and (5)

finalization and delivery. During this 40-month process, Manhattan Construction hired

architects and subcontractors, created blueprints, purchased and cleared land, developed the

stadium—ranging from excavation to materials testing to construction—built out and finished

interiors, and completed (10) changes before the stadium’s

(11) in mid-2009.

While most construction projects have distinct stages, compressed timeframes and

scope changes required diligent management by Manhattan Construction. Before the first game

was played, Manhattan Construction successfully navigated nearly 3,000 change requests and a

constantly evolving budget.

To ensure proper allocation and accounting of resources, Manhattan Construction

project managers used (12) . The system first calculated the (13) of

more than 500 line items of direct materials and labor costs. It then allocated (14)

(supervisor salaries, rent, materials handling, and so on) to the job using

direct material costs and (15) as (16) .

Manhattan Construction’s job-costing system allowed managers to track (17) on

a weekly basis. Manhattan Construction continually estimated the profitability of the Cowboys

Stadium project based on (18) of work completed, insight gleaned from

previous stadium projects, and revenue earned. Managers used the job-costing system to

actively manage costs, while the Dallas Cowboys had access to clear, concise, and transparent

(19) .

Just like quarterback Tony Romo navigating opposing defenses, Manhattan

Construction was able to (20) its job-costing system to ensure the successful

construction of a stadium as iconic as the blue star on the Cowboys’ helmets.

2. Listen and fill in the blanks

Making movie

Big Hollywood movies are fraught with costs of story writers, camera, equipment,

studio space, actors, even the right to shoot in a specific location like a famous restaurant has a

cost. (1) is critical to the studio’s success because it helps them to (2)

such as what type of films to produce in the future? How much to charge for

DVD? and even figure out if the director is keeping to a film’s budget while it is being made.

(3) involves the (4) , (5) and (6) of

(7) . From these data, companies can determine both (8) and

(9) of each product. There are two basic types of (10) :

a job-order cost system and a process cost system. Under (11) , a

company like a movie studio or an independent self – financed film maker assigns costs to

each job or in this case each movie produced. And an (12) of job

order costing is that each job or batch has its own (13) , it

measures costs for (14) rather than for set time periods.

Heidi van Leer knows a lot about film costs. She ‘s not only a programmer for the

annual Slamdance Film Festival in Park City Ulta but in independent film maker herself. Heidi

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van Leer:” production costs, especially the studio production they’re really used to spending a

lot of money on everything. In an independent film, I usually just try and feed my crew, pay for

my equipment, pay for stock and that’s about it”

Companies that manufacture large volumes of (15) use a

(16) which accumulates product related costs for (17) such

as a quarter or year and assigns them to (18) or processes. Job order

costing is more precise in assignment of costs to projects than process costing. However

recording the information is (19) . Just the same, it isn’t unusual for a

company to use both systems . For example Jones Soda practices process costing when

manufacturing soda but uses job order costing when producing small custom orders for its my

Jones program.

Studios today must be more budget – conscious than ever that means maintaining a

good job order (20) . The flow of costs (21) , (22) and

(23) in job order cost accounting parallels the physical flow of

the materials as they are converted into finished goods. While a film is produced, the studio

accumulates (24) through accurate record keeping and assigns those costs

to the account for each film as a (25) . When the film is finished, they

transfer the cost to the film to finished good inventory. Later, when the film is sold or

distributed, they transfer the costs for that film to (26) . So that they can

compare costs to the final revenues of the film to determine their profit.

Not all cost can be easily attributed to one section as the flow of material. Overhead

costs like studio executive office space cannot be assigned to specific jobs on the basis of

(27) incurred. Instead companies assign costs to a work - in process into

specific jobs on an estimated basis to the use (28)______________________

In general, company across industries established a predetermined overhead rate

(29)____________________of the year. Small companies often use a single company – wide

predetermined overhead rate. Large companies often use rates that vary from department to

department. The formula for a predetermined overhead rate is as follows:

(30)______________ divided by (31) equals

Predetermined overhead rate. Overhead relates to production operations as a whole. To know

what the whole is, the logical thing is to wait until the end of the years operation. At that time,

the studio know all of its costs for the period. As a practical matter though, managers cannot

wait until (32) . To price product accurately they need information

about product costs of (33) completed during the year. Using a predetermined

overhead rate enables the cost to be determined for the job immediately.

Job order costing can be fairly (34) and (35) manufacturing

situations. But how costs are assigned to a movie is often (36) and may be

subjected to (37) . For example in Hollywood studios often negotiate

producer, director and actors payment based on a percentage of a films (38) .

As a movie has gone to larger box office grosses it is not uncommon to see the various players

fighting over what they perceive to be their fair share.

Filmmaking has changed greatly in the last half century. Before 1917 it was nearly

impossible to do a film outside of a major studio. Technology has changed all that. But even

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with new distribution channels like cable networks and the internet the overwhelming supply

of material has reduced the price, studio can pay for any individual film.

The (39) of film both great and small is dependent upon the practices of a

careful (40) .

Summary

Read and fill in the blanks with the following words: predetermined overhead rate,

labor time tickets, job-order costing, over-applied overhead, manufacturing overhead costs,

the actual overhead cost, materials requisition forms, the estimated total manufacturing

overhead cost, finished goods, the estimated total amount of the allocation base direct labor-

hours machine-hours, under-applied, cost of goods sold, work- in process

(1) is used in situations where the organization offers

many different products or services, such as in furniture manufacturing, hospitals, and legal

firms. (2) and (3) are used to assign direct

materials and direct labor costs to jobs in a job- order costing system. (4)

are assigned to jobs using a (5) . All of the costs

are recorded on a job cost sheet. The predetermined overhead rate is determined before the

period begins by dividing (6) for the period by

(7) for the period. The most frequently

used allocation bases are (8) and (9) .

Overhead is applied to jobs by multiplying the predetermined overhead rate by the actual

amount of the allocation base recorded for the job. Because the predetermined overhead rate is

based on estimates, (10 ) incurred during a period may be more or

less than the amount of overhead cost applied to production. Such a difference is referred to as

(11) or (12) . The under-applied or over-applied

overhead for a period can be either closed out to (13) or allocated

between (14) , (15) , and Cost of Goods Sold.

When overhead is under-applied, manufacturing overhead costs have been understated and

therefore inventories and/or expenses must be adjusted upwards. When overhead is over-

applied, manufacturing overhead costs have been overstated and therefore inventories

and/or expenses must be adjusted downwards.

Questions

1. Why aren’t actual manufacturing overhead costs traced to jobs just as direct materials

and direct labor costs are traced to jobs?

2. Explain the four-step process used to compute a predetermined overhead rate.

3. What is the purpose of the job cost sheet in a job-order costing system?

4. Explain how a sales order, a production order, a materials requisition form, and a labor

time ticket are involved in producing and costing products.

5. Explain why some production costs must be assigned to products through an allocation

process.

6. Why do companies use predetermined overhead rates rather than actual manufacturing

overhead costs to apply overhead to jobs?

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7. What factors should be considered in selecting a base to be used in computing the

predetermined overhead rate?

8. If a company fully allocates all of its overhead costs to jobs, does this guarantee that a

profit will be earned for the period?

9. What account is credited when overhead cost is applied to Work in Process? Would

you expect the amount applied for a period to equal the actual overhead costs of the period?

Why or why not?

10. What is under-applied overhead? Over-applied overhead? What disposition is made of

these amounts at the end of the period?

11. Provide two reasons why overhead might be under-applied in a given year.

12. What adjustment is made for under-applied overhead on the schedule of cost of goods

sold? What adjustment is made for over-applied overhead?

13. What is a plant-wide overhead rate? Why are multiple overhead rates, rather than a

plant - wide overhead rate, used in some companies?

14. What happens to overhead rates based on direct labor when automated equipment

replaces direct labor?

Topic 2. Process costing

Glossary

No Terms Meaning

1 Conversion cost Direct labor cost plus manufacturing overhead cost

2 Equivalent units The product of the number of partially completed units and their

percentage of completion with respect to a particular cost. Equivalent

units are the number of complete whole units that could be obtained

from the materials and effort contained in partially completed units

3 Equivalent units of

production

(weighted-average

method)

The units transferred to the next department (or to finished goods)

during the period plus the equivalent units in the department’s ending

work in process inventory

4 FIFO method A process costing method in which equivalent units and unit costs

relate only to work done during the current period

5 Operation costing A hybrid costing system used when products have some common

characteristics and some individual characteristics

6 Process costing A costing method used when essentially homogeneous products are

produced on a continuous basis

7 Processing

department

An organizational unit where work is performed on a product and

where materials, labor, or overhead costs are added to the product

8 Weighted-average

method

A process costing method that blends together units and costs from

both the current and prior periods

Concepts in Action

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1. Read and fill in the blanks with the following words: combination, customer profile,

production costs, opportunity, job costing, retail stores, a mass-production, hybrid-costing

system, the conversion cost, customized ,three-step, process costing, digitize

Hybrid Costing for Customized Shoes at Adidas

Adidas has been designing and manufacturing athletic footwear for nearly 90 years.

Although shoemakers have long individually crafted shoes for professional athletes like Reggie

Bush of the New Orleans Saints, Adidas took this concept a step further when it initiated the

mi adidas program. Mi adidas gives customers the (1) to create shoes to their

exact personal specifications for function, fit, and aesthetics. Mi adidas is available in

(2 around the world, and in special mi adidas “Performance Stores” in cities

such as New York, Chicago, and San Francisco.

The process works as follows: The customer goes to a mi adidas station, where a

salesperson develops an in-depth (3) , a 3-D computer scanner develops

a scan of the customer’s feet, and the customer selects from among 90 to 100 different styles

and colors for his or her modularly designed shoe. During the (4) , 30-minute

high-tech process, mi adidas experts take customers through the “mi fit,” “mi performance,”

and “mi design” phases, resulting in a customized shoe (5) their needs. The

resulting data are transferred to an Adidas plant, where small, multiskilled teams produce the

(6) shoe. The measuring and fitting process is (7) , but purchasing

your own specially made shoes costs between $40 and $65 on top of the normal retail price,

depending on the style.

Historically, costs associated with individually customized products have fallen into the

domain of job costing. Adidas, however, uses a (8) — (9) for

the material and customizable components that customers choose and (10) to

account for the conversion costs of production. The cost of making each pair of shoes is

calculated by accumulating all (11) and dividing by the number of shoes

made. In other words, even though each pair of shoes is different, (12) of

each pair is assumed to be the same.

The (13) of customization with certain features of mass production is

called mass customization. It is the consequence of being able to (14) information

that individual customers indicate is important to them. Various products that companies are

now able to customize within (15) setting (for example,

personal computers, blue jeans, bicycles) still require job costing of materials and considerable

human intervention. However, as manufacturing systems become flexible, companies are also

using process costing to account for the standardized conversion costs.

____________________________________________________________________________

2. Listen and fill in the blanks

Jones Soda

In a world where soda brands and flavors can be found almost anywhere and often fill

entire aisle supermarkets , John Soda manages (1) from the competition. This

is partly due to quirky label photos which are submitted by customer as well as their fund yet

eccentric line of soda flavors.

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Mike Spear “ it’s kind of a modern terms but I would say that Jones is an

(2) , today we had 1,2 million photos in our gallery,

online photo gallery, so we really let consumers participate in the brand. You know that and

our flavors and colors of our flavors are very unique. There is not a lot of green apples sodas

out there, not a lot of fruits sodas out there”

Fans of Jones Soda are so well fanatic that many create video tributes to their favorite

flavors or feel themselves trying some of the more challenging flavor. There are many

companies today that manufacture sodas, so competition is understandably fears for both

market share and sell space.

(3) is a cost accounting method that works ideally for the soda

industry or any industry where costs are assigned to (4) that are

(5) in a continuous fashion. (6) on the other

hand is better suited for organizations looking to assign costs to (7) such as

advertising agencies, motion picture companies and law firms. (8) between

the two include: both (9) track three manufacturing (10) , the

accumulation of the costs of materials, labor and overhead and (11) is the

same. The (12) between a job order cost and a process cost system are : the

number of (13) accounts used, the documents used (14) costs,

the point at which costs are (15) and unit cost computations

As a general rule, manufacturing of soda normally consists of two processes: blending

and bottling. As the flow of costs indicates companies can add materials labor and

manufacturing overhead in both departments. When the blending Department finishes its work

, they transfer the (16) to the bottling department. The bottling

department finishes the goods and then transfers (17) . Within each

department (18) is performed on (19) .

Since Jones Soda uses a wide variety of labels particularly within the my Jones personal

customization program, they have three major processes: blending, bottling and labeling. The

use of custom labels has a bit of a story history of Jones Soda .When they first incorporated

custom labels ten years ago, the process was quite humble. They used an intern and inkjet

printer

Mike Spear:” Literally it was sort of a (20) as business grew we

decided that we had to outsource it and then the process actually goes through a machine

now where the labels are glued in, the liquid goes through a process of applying to the bottles

so it’s not hands on anymore

Vendors such as this can give Jones a (21) because as suppliers

they have expertise in specialized areas. Alternatively, large (22) like

Coke and Pepsi have the resources and economy of scale to do almost everything internally.

Now let’s look at an example where we’ve generalized to the assignment of cost at

Jones for the previous month. For purposes of this exercise let’s assume Jones does everything

in-house, so there would be three processes. First ,we have a work - in process for raw

materials. Raw materials used were blending 16,000; bottling 3,000 and labeling 7,000 .

Factory labor costs were blending 10,000; bottling 4,000 and labeling 6,000 and

manufacturing overhead costs were blending 5,000; bottling 2,000 and labeling 2500. The

company transfers units completed at a cost of $19,000 in the blending department to the

bottling department . The bottling department transfers units completed at a cost of $10,000 to

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the labeling department and the labeling department transfers units completed at a cost of

$8,000 to finished goods .

Companies often use a combination of a process cost and a job order cost system

called (23) . This (24) is similar to process costing in

its assumption that (25) are used to manufacture the product. The my

Jones program for example with its highly customized small quantity order is a good example

of a manufactured product more suited to a job order cost system.

Jones Soda has a model run with the little guy create some changes. Cost accounting

helps Jones to compete in a cutthroat business against industry mega corporations along the

way they’ve inspired a great loyalty among fans and organizations including NASA who

ordered soda during their space shuttle program.

Mike Spear: ” and I find out that was just neat. They put it in their VIP areas so I would

imagine senators and vice president senior drinking Jones as they watch the space shuttle

launched into space. I think in a model of some other soda brands if another CBG brand that

we make this emotional connection with consumers, and it just makes me feel good that we can

make people feel good so”

Summary

Read and fill in the blanks with the following words: transferred out, the cost reconciliation report,

percentage of completion, equivalent units, process costing, a job-order costing system, specific

cost category, partially completed units, costs flow, completed units, weighted-average method ,

work–in process

(1) is used in situations where homogeneous products or services are

produced on a continuous basis. (2) through the manufacturing accounts in

basically the same way in a process costing system as in (3) .

However, costs are accumulated by department rather than by job in process costing..

In process costing, the (4) of production must be determined for each

cost category in each department. Under the (5) , the equivalent

units of production equals the number of units transferred out to the next department or to

finished goods plus the equivalent units in ending work in process inventory. The

equivalent units in ending inventory equals the product of the number of

(6) in ending work in process inventory and their (7) with respect to

the specific cost category.

Under the weighted-average method, the cost per equivalent unit for a (8) is

computed by adding the cost of beginning work in process inventory and the cost added during

the period and then dividing the result by the equivalent units of production. The cost per

equivalent unit is then used to value the ending (9) inventory and the units

(10) to the next department or to finished goods.

(11) reconciles the cost of beginning inventory and the costs

added to production during the period to the cost of ending inventory and the cost of units

transferred out. Costs are transferred from one department to the next until the last processing

department. At that point, the cost of (12) is transferred to finished goods.

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Questions

1. Under what conditions would it be appropriate to use a process costing system?

2. In what ways are job-order and process costing similar?

3. Why is cost accumulation simpler in a process costing system than it is in a job-order

costing system?

4. How many Work in Process accounts are maintained in a company that uses process

costing?

5. Assume that a company has two processing departments—Mixing followed by Firing.

Prepare a journal entry to show a transfer of work in process from the Mixing Department

to the Firing Department.

6. Assume that a company has two processing departments—Mixing followed by Firing.

Explain what costs might be added to the Firing Department’s Work in Process account

during a period.

7. What is meant by the term equivalent units of production when the weighted-average

method is used?

8. Watkins Trophies, Inc., produces thousands of medallions made of bronze, silver, and

gold. The medallions are identical except for the materials used in their manufacture. What

costing system would you advise the company to use?

Topic 3. CVP analysis

Glossary

No Terms Meaning

1 Break-even point The level of sales at which profit is zero

2 Contribution margin ratio

(CM ratio)

A ratio computed by dividing contribution margin by

dollar sales

3 Cost-volume-profit (CVP)

graph

A graphical representation of the relationships

between an organization’s revenues, costs, and

profits on the one hand and its sales volume on the

other hand

4 Degree of operating

leverage

A measure, at a given level of sales, of how a

percentage change in sales will affect profits. The

degree of operating leverage is computed by dividing

contribution margin by net operating income

5 Incremental analysis An analytical approach that focuses only on those

costs and revenues that change as a result of a decision

6 Margin of safety The excess of budgeted or actual dollar sales over the

break-even dollar sales

7 Operating leverage A measure of how sensitive net operating income is to

a given percentage change in dollar sales

8 Sales mix The relative proportions in which a company’s

products are sold. Sales mix is computed by

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expressing the sales of each product as a percentage of

total sales.

9 Target profit analysis Estimating what sales volume is needed to achieve a

specific target profit.

10 Variable expense ratio A ratio computed by dividing variable expenses by

dollar sales

Concepts in action

1. Read and fill in the blanks with the following words: low, competitive disadvantage,

in contrast, loyal listeners, fixed costs, cost structure , revenue, bankruptcy, the weight of,

lost, variable costs decrease, high operating leverage, profitability, in debt, opposite, cut,

high , renegotiating, fee

Fixed Costs, Variable Costs, and the Future of Radio

Building up too much (1) can be hazardous to a company’s health.

Because fixed costs, unlike (2) , do not automatically (3) as

volume declines, companies with too much fixed costs can lose a considerable amount of

money during lean times. Sirius XM, the satellite radio broadcaster, learned this lesson the

hard way.

To begin broadcasting in 2001, both Sirius Satellite Radio and

XM Satellite Radio—the two companies now comprising Sirius XM—spent billions of dollars

on broadcasting licenses, space satellites, and other technology infrastructure. Once

operational, the companies also spent billions on other fixed items such as programming and

content (including Howard Stern and Major League Baseball), satellite transmission, and

R&D. (4) , variable costs were minimal, consisting mainly of artist-royalty

fees and customer service and billing. In effect, this created a business model with a

(5) —that is, the companies’ (6) had a very

significant proportion of fixed costs. As such, (7) could only be

achieved by amassing millions of paid subscribers and selling advertising.

The (8) of this highly-leveraged business model was nearly

disastrous. Despite amassing more than 14 million subscribers, over the years Sirius and XM

rang up $3 billion (9) and tallied cumulative operating losses in excess of $10 billion.

Operating leverage, and the threat of bankruptcy, forced the merger of Sirius and XM in

2007, and since then the combined entity has struggled to (10) costs, refinance its

sizable debt, and reap the profits from over 18 million monthly subscribers.

While satellite radio has struggled under (11) too much fixed cost,

Internet radio had the (12) problem—too much variable costs. But “How?”

you ask. Don’t variable costs only increase as revenues increase?

Yes, but if the revenue earned is less than the variable cost, an increase in revenue can lead

to (13) This is almost what happened to Pandora, the Internet radio

service.

Pandora launched in 2005 with only $9.3 million in venture capital. Available free over

the Internet, Pandora earned revenue in three ways: advertising on its Web site, subscription

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fees from users who wanted to opt-out of advertising, and affiliate fees from iTunes and

Amazon.com. Pandora had (14) fixed costs but (15) variable costs for

streaming and performance royalties. Over time, as Pandora’s popular service attracted

millions of (16) , its costs for performance royalties––set by the Copyright

Royalty Board on a per song basis––far exceeded its revenues from advertising and

subscriptions. As a result, even though royalty rates were only a fraction of a cent, Pandora

(17) more and more money each time it played another song!

In 2009, Pandora avoided bankruptcy by (18) a lower per-song

royalty rate in exchange for at least 25% of its U.S. revenue annually. Further, Pandora began

charging its most frequent users a small (19) and also started increasing its

advertising (20)__________________

__________________________________________________________________________________

2. Listen and fill in the blanks

Southwest Airlines

Brad Hawkins:” Southwest Airlines is simply the most legendary and successful

company in modern aviation history. Almost everyone has a Southwest story whether you are

an employee working for the company or you are a devoted customer to the product the

Southwest offered for nearly 40 years”

Back then in 1971 southwest was just a scrappy upstart with a cheeky sense of humor.

Today they ‘re still cheeky but they carry more passengers within the US than any other

airlines and they’ve been (1) every single year of their existence even during

(2) when some competitors were losing 10 to 15 million a day.

Managing any business requires an understanding of how costs respond to changes in

(3 and the effective changes in (4) in (5) on (6) .

Within (7) companies classify costs in a (8) of ways.

(9) are costs that vary in total (10) with changes

in the (11) . so for example if an airline paid 10cents a bag for peanuts and a

flight had one passenger the cost for peanuts would be 10cents. If there were 50 passengers the

cost would be $5 and if there were 100 passengers it would be $10. Variables costs may also

be defined as costs that (12) at every level of activity within

(13) . So the per unit cost up a bag of peanut would be the same

regardless of the number of passengers on the plane. (14) are cost that

(15) regardless of changes in the activity level. the salary of the

pilot on that flight for example would be the same regardless if he or she flew 50 passengers or

100. Because total fixed costs (16) as (17) , fixed

costs per unit is very (18) with activity, as volume increases unit costs decrease

and (19) . Thus if we were to calculate the pilot salary per passenger for one

passenger the fixed cost per unit would be $200, for 2 passengers it would be $100 and for

100 passengers it would be just $2.

Today airlines like Southwest are thought of largely as variable cost companies

because fuel often their largest cost can (20) in price. how significant is

this particular variable cost to their (21) , they consume 1,4 billion gallons

of fuel a year so just a 1 cent per gallon increase equals $14 million. it follows then that

(22) would play a key role in their (23) .

13

The most significant relationship in cost volume profit analysis is the

(24) at which total revenues equal total costs or the (25) .

A great way for a company to determine a break – even point is to prepare

(26 also known not surprisingly as (27) .

Let’s examine a typically airline round trip flight. to keep things simple, we assume that

every ticket costs $100 and that the plane has 150 seats. Okay, looking at our graph we’ve got

the unit of sales along the (28) which in this case is seats. The

(29) is labeled $ because we will use it to record both total revenues and

total costs (fixed plus variable). First, we plot our total sales line starting at zero going up to

(30) . So total revenue for a full plane would be $100 x 150 seats or $1500.

The revenue line here is (31) throughout, sets all tickets cost the same.

Next, we plot our total fixed cost which in this case happens to be $4000 and it is the

same at every level of activity. This represents things like the pilot salary overhead in

(32) . A total cost line starts at the fixed cost line at zero activity. For

this flight we assume a variable cost of $ 60 per seat so if the plane were

(33) the variable cost would be$60 x 150 seats or $9,000 and the

total cost would be $9,000 in variable costs plus $4,000 in fixed costs or $13,000.

(34) that total costs from total revenue we get a $2,000 profit round – trip and

where do they break-even? that would be here, at the (35) of the total cost

line and the total sales line where at 100 seats or $10,000 in sales. Southwest covers the costs

but has not yet earn a profit.

Okay, now the interesting part, Southwest flights are not always full, of course , in fact

the average last year was 75% occupancy. On our graph, that translates to just $480 in profit

round-trip or $240 each way. $240 in profit cannot be true. well yes in fact the

(36) for a one-way flight on Southwest last year was just slightly

higher at $290 and if your divide that by the average one-way ticket price of $58 you can see

that just 5 passengers per flight kept the most successful airline in the USA

Why are airline margin so razor thin mostly because ticket prices adjusted for inflation

or half of what they were 25 years ago. Fuel costs have (37) and that explains

why most airlines now charge for checked baggage, most but not Southwest

Brad Hawkins :” the leadership really made a courageous decision. early on this

process the wall street analysts saying “what are you doing ? you’ve leaving hundreds of

millions of dollars in (38) on the table” but people don’t

want feel nickel-and-dime they don’t want to come back to that”

How did Southwest make this decision by analyzing (39) and

(40) . Southwest flights’ re just one type of aircraft and the

resulting efficiencies give them the lowest baggage handling costs in the industry. crunching

the numbers they predicted that the bags fly free program would lead to higher occupancy

rates and more revenue and the profits would outweigh incremental revenue gain from

baggage fees and as Brad’s explain, their prediction was correct.

Brad Hawkins :” our leadership noted a significant share shift more than a 1% which is

about a billion dollars’ worth of customer business shifting over to us for no reason other the

bags fly free strategy”

14

The airline business is complex in few companies today seem to properly manage all

their fixed and variable costs from personnel to fuel contracts to flight schedules. Southwest

does it well, manages customer loyalty and seems to have an awful lot of fun in the process

____________________________________________________________________________

3. Listen and fill in the blanks

Whole foods

Michael Besancon has worked for Whole Foods for most of his adult life. He loves his

job and that has a lot to do with the fact that he feels good about the Whole foods mission.

Michael Besancon:” the number one (1) of Whole Foods market is to

sell the highest quality natural organic foods possible. Every store of Whole Foods market is

different and every store has a feel. You could blindfold me and take me into a Whole Foods

Market anywhere in the country and I would know I was in a Whole Foods. If I didn’t see any

signs because I would know it by the feel”

Whole Foods sells mostly organic groceries with an emphasis on fresh produces. Their

commitment to sustainable agriculture collaboration with suppliers in community wellness

makes them a premium brand that costs a little more than their big box competitors but

maintaining high quality and great value for the customers without compromising their core

values is the true secret to their success.

(2) (CVP) is the study of the effects of changes in

(3) and (4) on the (5) . Is it important to (6) ?

determining (7) ? Maximizing use of (8) ?

setting (9) ? and often reported in a (10) for

(11) . The income statement classifies costs as variable or fixed and compute

a (12) - the amount of revenue remaining after deducting variable

costs.

Let’s start by reviewing some basics about CVP analysis, specifically break-even

analysis, target net income and margin of safety. For sake of simplicity, let’s assume you’re

selling just one product tomatoes at a farmers market. (13) can be

computed by taking fixed costs and dividing by the contribution margin

((14) ). Contribution margin can also be expressed in the form of

the (15) , contribution margin divided by sales providing the

break-even point in dollars versus units. When a company is in its early stages of operation, the

(16) is break even. Failure to do so will lead to (17) .

Once you’ve determined the break-even point, you want to set a sale goal that will

generate a (18) . This will provide you with (19 in

either units or dollars depending on whether you use a contribution margin per unit or

contribution margin ratio. Finally, (20) indicates how much sales

can decline before you’re operating at a loss and again can be expressed in dollar terms or as a

percentage

Ok, that seems easy enough. Now let’s get back to the Whole foods where things are

slightly more complicated because Whole Foods doesn’t just sell tomatoes, they sell thousands

of different products with different costs that fluctuate constantly under a variety of

(21) such as the weather, competition and transportation costs.

15

Michael Besancon:” Produce could be a higher because of lower freight costs in one

area and in another area it could have a lower margin on it. what you have to do is you have to

blend your margin across the full spectrum of products “

Whole foods starts by determining their (22) , the (23) in

which they sell their (24) . Sales mix is important to managers because different

products often have substantially different contribution margin. Managers can compute break-

even sales for a mix of two or more products by determining the (25) unit

contribution margin of all the products. However to avoid having to calculate thousands of

different unique contribution margins they calculate the break-even point in terms of sales

dollars rather than units sold. Using sales information for division of product lines, also they

must compute the (26) rather than contribution margin per unit.

Ultimately, information such as this provided using CVP analysis can help managers better

understand the impact of sales mix on (27) .

Price fluctuation is one thing but what happens when fluctuation strikes whole nations

and industries. during the recent recession, Whole Foods managed to actually maintain

profitability despite opening 16 new stores, they did this by reducing certain premium prices

and reducing the size of each new store allowing for savings in other areas

Michael Besacon “and we have moved into a direction of what we call right – sizing

stores and the savings from that is that the rent obvious utilities and fewer team members

would be needed to start a store”

Companies that have higher fixed costs relative to variable costs have higher

(28) . Operating leverage is calculated as the contribution margin

divided by the (29) . When a company sales revenues are increasing high

operating leverage can mean that profits will increase rapidly. However when sales are

declining too much operating leverage can have quite devastating effects on the company. By

working with suppliers and streamlining store space to control costs lower overhead gives

Whole Foods a way to lower operating leverage. This coupled with an increased

(30) or during trouble times allows Whole Foods to continue as a

competitive alternative for health-conscious grocery shoppers

Summary

Read and fill in the blanks with the following words: the contribution margin ratio,

special case, sales mix, CVP analysis, a CVP graph, net operating income, break-even

analysis, critical questions, fixed expense, exceeds, the degree of operating leverage, constant,

multiproduct, the margin of safety, specified target profit

(1) is based on a simple model of how profits respond to prices,

costs, and volume. This model can be used to answer a variety of (2) such

as what is the company’s breakeven volume, what is its margin of safety, and what is likely to

happen if specific changes are made in prices, costs, and volume.

(3) depicts the relationships between unit sales on the one hand and

fixed expenses, variable expenses, total expenses, total sales, and profits on the other hand. The

profit graph is simpler than the CVP graph and shows how profits depend on sales. The CVP

16

and profit graphs are useful for developing intuition about how costs and profits respond to

changes in sales.

(4) is the ratio of the total contribution margin to total sales.

This ratio can be used to quickly estimate what impact a change in total sales would have on

(5) . The ratio is also useful in (6) .

Target profit analysis is used to estimate how much sales would have to be to attain a

(7) . The unit sales required to attain the target profit can be estimated by

dividing the sum of the target profit and (8) by the unit contribution

margin. Break-even analysis is a (9) of target profit analysis that is used to

estimate how much sales would have to be to just break even. The unit sales required to break

even can be estimated by dividing the fixed expense by the unit contribution margin.

(10) is the amount by which the company’s current sales

(11) break-even sales. (12) allows

quick estimation of what impact a given percentage change in sales would have on the

company’s net operating income. The higher the degree of operating leverage, the greater is the

impact on the company’s profits. The degree of operating leverage is not (13) —it

depends on the company’s current level of sales. The profits of a (14) company

are affected by its (15) . Changes in the sales mix can affect the break-even point,

margin of safety, and other critical factors.

Questions

1. What is meant by a product’s contribution margin ratio? How is this ratio useful in

planning business operations?

2. Often the most direct route to a business decision is an incremental analysis. What is meant

by an incremental analysis?

3. In all respects, Company A and Company B are identical except that Company A’s costs

are mostly variable, whereas Company B’s costs are mostly fixed. When sales increase,

which company will tend to realize the greatest increase in profits? Explain.

4. What is meant by the term operating leverage?

5. What is meant by the term break-even point?

6. In response to a request from your immediate supervisor, you have prepared a CVP graph

portraying the cost and revenue characteristics of your company’s product and operations.

Explain how the lines on the graph and the break-even point would change if (a ) the

selling price per unit decreased, (b ) fixed cost increased throughout the entire range of

activity portrayed on the graph, and (c) variable cost per unit increased.

7. What is meant by the margin of safety?

8. What is meant by the term sales mix? What assumption is usually made concerning sales

mix in CVP analysis?

9. Explain how a shift in the sales mix could result in both a higher break-even point and a

lower net income.

17

Topic 4. Static Budgets

Glossary

No Terms Meaning

1 Budget A detailed plan for the future that is usually expressed

in formal quantitative terms.

2 Budget committee A group of key managers who are responsible for

overall budgeting policy and for coordinating the

preparation of the budget.

3 Cash budget A detailed plan showing how cash resources will be

acquired and used over a specific time period.

4 Continuous budget A 12-month budget that rolls forward one month as

the current month is completed.

5 Control The process of gathering feedback to ensure that a

plan is being properly executed or modified as

circumstances change.

6 Direct labor budget A detailed plan that shows the direct labor-hours

required to fulfill the production budget.

7 Direct materials budget A detailed plan showing the amount of raw materials

that must be purchased to fulfill the production budget

and to provide for adequate inventories.

8 Ending finished goods

inventory budget

A budget showing the dollar amount of unsold

finished goods inventory that will appear on the

ending balance sheet.

9 Manufacturing overhead

budget

A detailed plan showing the production costs, other

than direct materials and direct labor, that will be

incurred over a specified time period.

10 Master budget A number of separate but interdependent budgets that

formally lay out the company’s sales, production, and

financial goals and that culminates in a cash budget,

budgeted income statement, and budgeted balance

sheet.

11 Merchandise purchases

budget

A detailed plan used by a merchandising company that

shows the amount of goods that must be purchased

from suppliers during the period.

12 Participative budget See Self-imposed budget.

13 Perpetual budget See Continuous budget.

14 Planning Developing goals and preparing budgets to achieve

those goals.

15 Production budget A detailed plan showing the number of units that must

be produced during a period in order to satisfy both

sales and inventory needs.

16 Sales budget A detailed schedule showing expected sales expressed

in both dollars and units.

18

17 Self-imposed budget A method of preparing budgets in which managers

prepare their own budgets. These budgets are then

reviewed by higher-level managers, and any issues are

resolved by mutual agreement.

18 Selling and administrative

expense budget

A detailed schedule of planned expenses that will be

incurred in areas other than manufacturing during a

budget period.

Concepts in action

Read and fill in the blanks with the following words: budgeting, value, companies, control, runs,

accounts, managers, experts, expenses, revenue, sensitivity, competitive, users, decision making

Web-Enabled Budgeting and Hendrick Motorsports

In recent years, an increasing number of (1) have implemented

comprehensive software packages that manage budgeting and forecasting functions across the

organization. One such option is Microsoft Forecaster, which was originally designed by FRx

Software for businesses looking to gain (2) over their budgeting and forecasting

process within a fully integrated Web-based environment.

Among the more unique companies implementing Web-enabled budgeting is Hendrick

Motorsports. Featuring champion drivers Jeff Gordon and Jimmie Johnson, Hendrick is the

premier NASCAR Sprint Cup stock car racing organization. According to Forbes magazine,

Hendrick is NASCAR’s most valuable team, with an estimated (3) of $350 million.

Headquartered on a 12 building, 600,000-square-foot campus near Charlotte, North Carolina,

Hendrick operates four full-time teams in the Sprint Cup series, which (4) annually

from February through November and features 36 races at 22 speedways across the United

States. The Hendrick organization has annual (5) of close to $195 million and more

than 500 employees, with tasks ranging from accounting and marketing to engine building and

racecar driving. Such an environment features multiple functional areas and units, varied

worksites, and ever-changing circumstances. Patrick Perkins, director of marketing, noted,

“Racing is a fast business. It’s just as fast off the track as it is on it. With the work that we put

into development of our teams and technologies, and having to respond to change as well as

anticipate change, I like to think of us in this business as change (6) .”

Microsoft Forecaster, Hendrick’s Web-enabled budgeting package, has allowed

Hendrick’s financial managers to seamlessly manage the planning and budgeting process.

Authorized users from each functional area or team sign on to the application through the

corporate intranet. Security on the system is tight: Access is limited to only the (7) that

a manager is authorized to budget. (For example, Jeff Gordon’s crew chief is not able to see

what Jimmie Johnson’s team members are doing.) Forecaster also allows (8) at the

racetrack to access the application remotely, which allows (9) to receive or update real-

time “actuals” from the system. This way, team managers know their allotted (10) for

each race. Forecaster also provides users with additional features, including seamless links

with general ledger accounts and the option to perform what-if ((11) ) analyses. Scott

Lampe, chief financial officer, said, “Forecaster allows us to change our forecasts to respond to

changes, either rule changes [such as changes in the series’ points system] or technology

19

changes [such as pilot testing NASCAR’s new, safer “Car of Tomorrow”] throughout the

racing season.”

Hendrick’s Web-enabled budgeting system frees the finance department so it can work

on strategy, analysis, and (12) . It also allows Hendrick to complete its annual

(13) process in only six weeks, a 50% reduction in the time spent budgeting and

planning, which is critical given NASCAR’s extremely short off-season. Patrick Pearson from

Hendrick Motorsports believes the system gives the organization a (14) advantage:

“In racing, the team that wins is not only the team with the fastest car, but the team that is the

most disciplined and prepared week in and week out. Forecaster allows us to respond to that

changing landscape.”

Budgetary Planning at BabyCakes

Listen and fill in the blanks

OK. So, you are the owner of BabyCakes NYC, the most popular health-conscious

vegan bakery in the city and you just opened a second store but it’s all the way across country

in Los Angeles, and you’re facing your first big holiday rush, so how you can budget for it?

First, let’s go over some basics. Budgeting which is defined as a written statement that

management’s plans for a specific period expressed in (1) is a cornerstone of

planning for any business, large or small.

Erin McKenna: “Aside from doing the baking, the frosting and designing uniforms, I’m

also in charge of all (2) myself. Budgeting definitely makes us more

efficient and helps us judge (3) of the company and it help us be a little bit

more responsible in (4) .”

Once budgets are established, they become important basis for evaluating future

performance. They can motivate (5) to meet objectives, they serve as a

deterrent waste, to promote efficiency and they can serve as (6) .

Erin McKenna: ‘If I didn’t budget I would definitely overspent because there’s so many

things that I want to do for the bakery. It’s like having a baby, and you want to dress it up, and

you want to take it to Disney World, and you want to make it as fun as possible.”

Sometimes people confuse budgeting with planning. Whereas planning focuses on

(7) , budgeting deals with (8) Budgets can be

prepared for any period of time. In the case of Babycakes, Erin prepares (9) budget

which is supplemented by (10) budgets.

Erin McKenna: “From there we know what we can buy, how much we put into certain

items and that way we can look at an extended period of sales trends or weather, holidays...”

Holidays like Valentine’s Day which brings us back to our starting point. With

Valentine’s Day quickly approaching Erin’s need to be sure that she has allocated

(11) to handle the rush, assuming there will be a rush in the new

location. So how did she proceed?

In business, (12) normally contains two classes of budgets.

(13) , which will discuss in this video, and (14) . There

are many different types of (15) but we’ll focus on the two that Erin uses

predominately. Budget goals of course are based on past performance. In larger companies,

data collected from various organizational units beginning several months before the end of

20

current year. Because it is derived from (16) , every other budget depends on it,

the sales budget is the first budget prepared. Normally companies forecast sales by considering

a variety of factors but Erin doesn’t always have all these at her disposal on the new LA

bakery.

Erin McKenna: “It can be challenging to plan for Valentine’s Day because we don’t

have past years that we’ve been at this location.”

In the absence of (17) she’ll refer to data from her New York store for

guidance. One thing she learned over the year is that Valentine’s Day is not a holiday to be

taken lightly.

Erin McKenna: “Our first Valentine’s Day in New York we baked a little bit more than

usual, but right when we open our door, there is a line, you know, sneaking around the block

and we couldn’t take fast enough. So I leant my lesson very quickly that time.”

In terms of marketing, Erin keeps her holiday costs low in the new location by using

her creativity and by making use of online social network.

Erin McKenna: “We will tweet that we have special sweetheart boxes, two cupcakes

and window box and it looks like a little present. And things like heart shaped cookies and that

would usually get the word out enough for us. ”

Because Babycakes appeals to a very specific demographic, people with food allergies

Erin can’t really look to changes like Sprinkles for industry trends. As a general rule, Erin

tends to over-bake rather than under-bake so as not to disappoint our customers. In the end she

doesn’t move all of her product, she can always sell items the following day at

(18)___________________

The bottom line is that for small businesses (19) can be

somewhat informal at times. Erin takes a very hands-on approach to her business which allows

her to spot trends, minimize waste and trust her instincts.

Erin McKenna: “When I’m here and I see the waste then the ideas come. And when I

see their reactions to certain items, the doughnuts, brings a really big emotional reaction from

people. And if I didn’t see that then I wouldn’t know to put more money into doughnut pans

and I will, for example, say, the corn bread isn’t selling, stop making it. You know, like as you

see all the little details.”

OK. Now let’s look at an example in her LA store, let’s say that Erin normally sell

about 1,000 up the red velvet cupcakes a day at $3.5 each. On a Valentine’s Day she expects to

sell an additional 500 or 1,500 red velvet cupcakes in total. So we multiply (20) by

(21) to obtain total sales which in this case is 5,250 for the red velvet

cupcakes. So she knows that she needs to ensure she has enough supplies to handle the

production. Next, let’s look at the production budget which shows the units must be produced

to meet the anticipated sales. This is derived from the sales budget plus the desired change in

(22) . In an ideal world, a bakery wants to end the day by selling all

of its product. However, it needs to maintain supplies to produce the next day’s product. The

required production in units formula is: budgeted sales units plus desire ending finished goods

units minus (23) equals required production units. So, if

they sell 1,000 red velvet cupcakes each day on average and I have to account for an extra 500

red velvet cupcakes on Valentine’s Day, there are only enough raw materials for the holiday

but for the days that follow. This is obviously a very simplified example but you can imagine it

21

gets even more complicated when Erin has to take into account different types of cupcakes and

other products and flavors.

Erin worked hard to budget for Valentine’s Day in her new location despite not having

much history to help guide her decisions. She relied on a combination of

(24) and informal budgeting intuition to help her make

decisions and the results or lack of them speak for themselves.

Erin McKenna: “Looks like it’s a big success! Budgeted perfectly.”

She did extremely well in her playing with respect to cupcakes running out just before closing

time. and best of all she knows that she has enough supplies for tomorrow with the entire

process starts all over again at 4 a.m.

Summary

Read and fill in the blanks with the following words: budget, budgeting, budgeted,

production, produce, manufacturing, sold, relate, master, cash

This chapter describes the (1) process and shows how the various operating

budgets (2) to each other. The sales (3) is the foundation for profit

planning. Once the sales budget has been set, the (4) budget and the selling and

administrative expense budget can be prepared because they depend on how many units are to

be (5) . The production budget determines how many units are to be (6) ,

so after it is prepared, the various (7) cost budgets can be prepared. All

of these budgets feed into the (8) budget and the budgeted income statement and

balance sheet. The parts of the (9) budget are connected in many ways. For

example, the schedule of expected cash collections, which is completed in connection with the

sales budget, provides data for both the cash budget and the (10) balance sheet.

Questions

1. What is a budget? What is budgetary control?

2. Discuss some of the major benefits to be gained from budgeting.

3. What is a master budget? Briefly describe its contents.

4. Why is the sales forecast the starting point in budgeting?

5. “As a practical matter, planning and control mean exactly the same thing.” Do you agree?

Explain.

6. Describe the flow of budget data in an organization. Who are the participants in the

budgeting process, and how do they participate?

7. What is a self-imposed budget? What are the major advantages of self-imposed budgets?

What caution must be exercised in their use?

8. How can budgeting assist a company in planning its workforce staffing levels?

9. “The principal purpose of the cash budget is to see how much cash the company will have

in the bank at the end of the year.” Do you agree? Explain.

22

Topic 5. Flexible Budgets

Glossary

No Terms Meaning

1 Activity variance The difference between a revenue or cost item in the

static planning budget and the same item in the

flexible budget. An activity variance is due solely to

the difference between the level of activity assumed in

the planning budget and the actual level of activity

used in the flexible budget.

2 Flexible budget A report showing estimates of what revenues and costs

should have been, given the actual level of activity for

the period.

3 Ideal standards Standards that assume peak efficiency at all times.

4 Labor efficiency variance The difference between the actual hours taken to

complete a task and the standard hours allowed for the

actual output, multiplied by the standard hourly labor

rate.

5 Labor rate variance The difference between the actual hourly labor rate

and the standard rate, multiplied by the number of

hours worked during the period.

6 Management by exception A management system in which standards are set for

various activities, with actual results compared to

these standards. Significant deviations from standards

are flagged as exceptions.

7 Materials price variance The difference between the actual unit price paid for

an item and the standard price, multiplied by the

quantity purchased.

8 Materials quantity variance The difference between the actual quantity of

materials used in production and the standard quantity

allowed for the actual output, multiplied by the

standard price per unit of materials.

9 Planning budget A budget created at the beginning of the budgeting

period that is valid only for the planned level of

activity.

10 Practical standards Standards that allow for normal machine downtime

and other work interruptions and that can be attained

through reasonable, though highly efficient, efforts by

the average worker.

11 Price variance A variance that is computed by taking the difference

between the actual price and the standard price and

multiplying the result by the actual quantity of the

23

input.

12 Quantity variance A variance that is computed by taking the difference

between the actual quantity of the input used and the

amount of the input that should have been used for the

actual level of output and multiplying the result by the

standard price of the input.

13 Revenue variance The difference between how much the revenue should

have been, given the actual level of activity, and the

actual revenue for the period. A favorable

(unfavorable) revenue variance occurs because the

revenue is higher (lower) than expected, given the

actual level of activity for the period.

14 Spending variance The difference between how much a cost should have

been, given the actual level of activity, and the actual

amount of the cost. A favorable (unfavorable)

spending variance occurs because the cost is lower

(higher) than expected, given the actual level of

activity for the period.

15 Standard cost card A detailed listing of the standard amounts of inputs

and their costs that are required to produce one unit of

a specific product.

16 Standard cost per unit The standard quantity allowed of an input per unit of a

specific product, multiplied by the standard price of

the input.

17 Standard hours allowed The time that should have been taken to complete the

period’s output. It is computed by multiplying the

actual number of units produced by the standard hours

per unit.

18 Standard hours per unit The amount of direct labor time that should be

required to complete a single unit of product,

including allowances for breaks, machine downtime,

cleanup, rejects, and other normal inefficiencies.

19 Standard price per unit The price that should be paid for an input.

20 Standard quantity allowed The amount of an input that should have been used to

complete the period’s actual output. It is computed by

multiplying the actual number of units produced by

the standard quantity per unit.

21 Standard quantity per unit The amount of an input that should be required to

complete a single unit of product, including

allowances for normal waste, spoilage, rejects, and

other normal inefficiencies.

22 Standard rate per hour The labor rate that should be incurred per hour of

labor time, including employment taxes and fringe

24

benefits.

23 Variable overhead

efficiency variance

The difference between the actual level of activity

(direct labor-hours, machine-hours, or some other

base) and the standard activity allowed, multiplied

by the variable part of the predetermined overhead

rate.

24 Variable overhead rate

variance

The difference between the actual variable overhead

cost incurred during a period and the standard cost that

should have been incurred based on the actual activity

of the period.

Concepts in action

Read and fill in the blanks with the following words: direct, labor, materials, waste, spoilage,

increase, reducing, expenses, costs, revenue, profit. variances, analysis.

Starbucks Reduces Direct-cost Variances to Brew a Turnaround

Along with coffee, Starbucks brewed profitable growth for many years. From Seattle

to Singapore, customers lined up to buy $4 lattes and Frappuccinos. Walking around with a

coffee drink from Starbucks became an affordable-luxury status symbol. But when consumers

tightened their purse strings amid the recession, the company was in serious trouble. With

customers cutting back and lower-priced competition—from Dunkin’ Donuts and McDonald’s

among others—increasing, Starbucks’ (1) margins were under attack.

For Starbucks, profitability depends on making each high-quality beverage at the

lowest possible (2) . As a result, an intricate understanding of direct costs is critical.

Variance (3) helps managers assess and maintain profitability at desired levels. In

each Starbucks store, the two key (4) costs are materials and labor.

(5) costs at Starbucks include coffee beans, milk, flavoring syrups,

pastries, paper cups, and lids. To reduce budgeted costs for materials, Starbucks focused on

two key inputs: coffee and milk. For coffee, Starbucks sought to avoid waste and (6) by

no longer brewing decaffeinated and darker coffee blends in the afternoon and evening, when

store traffic is slower. Instead, baristas were instructed to brew a pot only when a customer

ordered it. With milk prices rising (and making up around 10% of Starbucks’ cost of sales), the

company switched to 2% milk, which is healthier and costs less, and redoubled efforts to

reduce milk-related spoilage.

Labor costs at Starbucks, which cost 24% of company (7) annually, were

another area of variance focus. Many stores employed fewer baristas. In other stores, Starbucks

adopted many “lean” production techniques. With 30% of baristas’ time involved in walking

around behind the counter, reaching for items, and blending drinks, Starbucks sought to make

its drink-making processes more efficient. While the changes seem small—keeping bins of

coffee beans on top of the counter so baristas don’t have to bend over, moving bottles of

flavored syrups closer to where drinks are made, and using colored tape to quickly differentiate

25

between pitchers of soy, nonfat, and low-fat milk—some stores experienced a 10%

(8) in transactions using the same number of workers or fewer.

The company took additional steps to align (9) costs with its pricing.

Starbucks cut prices on easier-to-make drinks like drip coffee, while lifting prices by as much

as 30 cents for larger and more complex drinks, such as a venti caramel macchiato.

Starbucks’ focus on (10) year-over-year variances paid off. In fiscal year

2009, the company reduced its store operating (11) by $320 million, or 8.5%.

Continued focus on direct-cost (12) will be critical to the company’s future

success in any economic climate.

Summary

Summary 1

Read and fill in the blanks with the following words: favorable, unfavorable, flexible, static,

actual, budgeted, reasons, spending, level, cost, fixed, variable, variances, behavior, activity,

change, compared, adjusted

Directly comparing (1) planning budget revenues and costs to (2) revenues

and costs can easily lead to erroneous conclusions. Actual revenues and costs differ from

budgeted revenues and costs for a variety of (3) , but one of the biggest is a (4) in

the level of activity. One would expect actual revenues and costs to increase or decrease as the

activity level increases or decreases. (5) budgets enable managers to isolate the

various causes of the differences between budgeted and actual costs.

A flexible budget is a budget that is (6) to the actual level of activity. It is the

best estimate of what revenues and costs should have been, given the actual level of activity

during the period. The flexible budget can be (7) to the budget from the beginning

of the period or to the actual results.

When the flexible budget is compared to the budget from the beginning of the period,

(8) variances are the result. An activity variance shows how a revenue or cost should

have changed in response to the difference between (9) and actual activity.

When the flexible budget is compared to actual results, revenue and (10) variances

are the result. A (11) revenue variance indicates that revenue was larger than

should have been expected, given the actual level of activity. An (12) revenue

variance indicates that revenue was less than it should have been, given the actual level of

activity. A favorable spending variance indicates that the cost was less than expected, given the

actual (13)___________ of activity. An unfavorable spending variance indicates that the

(14) was greater than it should have been, given the actual level of activity.

A flexible budget performance report combines the activity variances and the revenue

and spending variances on one report.

Common errors in comparing budgeted costs to actual costs are to assume all costs are

(15) or to assume all costs are (16) . If all costs are assumed to be fixed,

the (17) for variable and mixed costs will be incorrect. If all costs are assumed to be

variable, the variances for fixed and mixed costs will be incorrect. The variance for a cost will

26

only be correct if the actual (18) of the cost is used to develop the flexible budget

benchmark.

Summary 2

Read and fill in the blanks with the following words and terms: investigated, attained,

emphasized, fixed, quantity standards, cost standards, variance, quantity variances, price

variances, standard cost variances, price, cost, quantity.

A standard is a benchmark, or “norm,” for measuring performance. Standards are set

for both the quantity and the (1)________ of inputs needed to manufacture goods or to provide

services. (2) indicate how much of an input, such as labor time or raw

materials, should be used to make a product or provide a service. (3) indicate

what the cost of the input should be.

Standards are normally set so that they can be (4) by reasonable, though

highly efficient, efforts. Such “practical” standards are believed to positively motivate

employees.

When standards are compared to actual performance, the difference is referred to as a

(5) Variances are computed and reported to management on a regular basis for

both the (6) and the (7) elements of direct materials, direct labor, and

variable overhead. (8) are computed by taking the difference between the

actual amount of the input used and the amount of input that is allowed for the actual output,

and then multiplying the result by the standard price of the input. (9) are

computed by taking the difference between actual and standard prices and multiplying the

result by the amount of input purchased.

Not all variances require management attention. Only unusual or particularly

significant variances should be (10) —otherwise a great deal of time would be spent

investigating unimportant matters. Additionally, it should be (11) that the point

of the investigation should not be to find someone to blame. The point of the investigation is to

pinpoint the problem so that it can be (12) and operations improved.

Traditional standard cost variance reports are often supplemented with other

performance measures. Overemphasis on (13) may lead to problems in

other critical areas such as product quality, inventory levels, and on-time delivery.

Questions

1. What is a static planning budget?

2. What is a flexible budget and how does it differ from a static planning budget?

3. What are some of the possible reasons that actual results may differ from what had been

budgeted at the beginning of a period?

4. Why is it difficult to interpret a difference between how much expense was budgeted and

how much was actually spent?

5. What is an activity variance and what does it mean?

6. What is a revenue variance and what does it mean?

7. What is a spending variance and what does it mean?

8. What does a flexible budget performance report do that a simple comparison of budgeted to

actual results does not do?

27

9. What assumption is implicitly made about cost behavior when a static planning budget is

directly compared to actual results? Why is this assumption questionable?

10. What assumption is implicitly made about cost behavior when all of the items in a static

planning budget are adjusted in proportion to a change in activity? Why is this assumption

questionable?

11. What is a quantity standard? What is a price standard?

12. What is meant by the term management by exception?

13. Why are separate price and quantity variances computed?

14. Who is generally responsible for the materials price variance? The materials quantity

variance? The labor efficiency variance?

15. The materials price variance can be computed at what two different points in time? Which

point is better? Why?

16. If the materials price variance is favorable but the materials quantity variance is

unfavorable, what might this indicate?

17. Should standards be used to identify who to blame for problems?

18. “Our workers are all under labor contracts; therefore, our labor rate variance is bound to be

zero.” Discuss.

19. What effect, if any, would you expect poor-quality materials to have on direct labor

variances?

20. If variable manufacturing overhead is applied to production on the basis of direct

laborhours and the direct labor efficiency variance is unfavorable, will the variable

overhead efficiency variance be favorable or unfavorable, or could it be either? Explain.

21. What is a statistical control chart, and how is it used?

22. Why can undue emphasis on labor efficiency variances lead to excess work in process

inventories?

Topic 6. Managerial Accounting Information for Shorterm Decisions

Glossary

No Terms Meaning

1 Avoidable cost A cost that can be eliminated by choosing one

alternative over another in a decision.

This term is synonymous with relevant cost.

2 Bottleneck A machine or some other part of a process that limits

the total output of the entire system.

3 Constraint A limitation under which a company must operate,

such as limited available machine time or raw

materials that restricts the company’s ability to satisfy

demand.

4 Joint costs Costs that are incurred up to the split-off point in a

process that produces joint products.

5 Joint products Two or more products that are produced from a

common input.

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6 Make or buy decision A decision concerning whether an item should be

produced internally or purchased from an outside

supplier.

7 Relevant benefit A benefit that differs between alternatives in a

decision. Synonyms are differential benefit and

incremental benefit.

8 Relevant cost A cost that differs between alternatives in a decision.

Synonyms are avoidable cost, differential cost, and

incremental cost.

9 Sell or process further

decision

A decision as to whether a joint product should be sold

at the split-off point or sold after further processing.

10 Special order A one-time order that is not considered part of the

company’s normal ongoing business.

11 Split-off point That point in the manufacturing process where some

or all of the joint products can be recognized as

individual products.

12 Sunk cost Any cost that has already been incurred and that

cannot be changed by any decision made now or in the

future.

Concepts in action

1. Read and fill in the blanks with the following words: solutions, resources, savings, costs,

outsourcing, offshoring, scarce, labor, defined, discovered, invented, development, innovation.

Pringles Prints and the Offshoring of Innovation

According to a recent survey, 67% of U.S. companies are engaged in the rapidly-

evolving process of “offshoring,” which is the (1) of business processes and

jobs to other countries. (2) was initially popular with companies because it

yielded immediate labor-cost (3) for activities such as software development, call

centers, and technical support.

While the practice remains popular today, offshoring has transformed from lowering

(4) on back-office processes to accessing global talent for innovation. With global

markets expanding and domestic talent (5) companies are now hiring qualified

engineers, scientists, inventors, and analysts all over the world for research and development

(R&D), new product development (NPD), engineering, and knowledge services.

Innovation Offshoring Services

R&D NPD Engineering Knowlegde services

Programming

Code

development

New technologies

New

Prototype design

Product

development

Systems design

Support services

Testing

Reengineering

Drafting/modeling

Embedded systems

development

Market analysis

Credit analysis

Data mining

Forecasting

Risk

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materials/process

research

management

By utilizing offshoring innovation, companies not only continue to reduce

(6) costs, but cut back-office costs as well. Companies also obtain local market

knowledge and access to global best practices in many important areas.

Some companies are leveraging offshore (7) by creating global innovation

networks. Procter & Gamble (P&G), for instance, established “Connect and Develop,” a multi-

national effort to create and leverage innovative ideas for product (8) When the

company wanted to create a new line of Pringles potato chips with pictures and words—trivia

questions, animal facts, and jokes—printed on each chip, the company turned to offshore

(9) .

Rather than trying to invent the technology required to print images on potato chips in-

house, Procter & Gamble created a technology brief that (10) the problems it needed

to solve, and circulated it throughout the company’s global innovation network for possible

(11)________________

As a result, P&G (12) a small bakery in Bologna, Italy, run by a university

professor who also manufactured baking equipment. He had (13)___________ an ink-jet

method for printing edible images on cakes and cookies, which the company quickly adapted

for potato chips. As a result, Pringles Prints were developed in less than a year—as opposed to

a more traditional two year process—and immediately led to double-digit product growth.

______________________________________________________________________________________________

2. Listen and fill in the blanks

Incremental Analysis at Method

When Adam Lowry and Eric Ryan, friends since high school got tired of Monday

looking cleaning products that were (1) . They have a decision to make:

live with them like everyone else or try to create an entirely new line, eco-friendly cleaning

products even if that meant competing against (2) corporations.

Eric Ryan: “We knew when we started this business that we weren’t going up against

one goliath player, we were actually going up against seven goliath players who arguably had

100 years head start on us. So reinventing soap is no easy task because It’s a very basic product

and our only chance of success was to bring a lot of differentiations. So this tiny bottle does 50

loads of laundry which would be the equivalent to a very large jog and essentially it’s not only

the world’s most efficient laundry detergent but it’s also the world’s greenest laundry

detergent.”

Managers make important decisions all the time and some of those decisions require

(3) in unusual ways. For Adam and Eric, their first was to decide whether to

(4) themselves, (5)_____________ or because of their unique needs,

outsource in a way that gave them (6) . Which of these methods would

cost more? Which would be more environmentally friendly?

Like many managers they followed (7) in their decision-making

process. They identified a basic challenge. How would they manufacture Method soap? They

(8) their options: open a factory, completely outsource production or outsource

production and retain some control. (9) all the costs and benefits, they made a

decision. And, after all the number started to roll in, they (10) the results of that

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decision to make sure they (11) . The process used to identify the financial

data that change under alternative courses of action is called (12) . To make

their decision, Method management analyzed (13) factors,

(14) factors, such as costs that would change depending on which alternative

course of action is chosen. There was a major benefit to opening their own factory. Method

would have (15) but they would have to buy or lease a large

building, purchase tons of equipment and employ a huge staff.

Adam Lowry: “Building a manufacturing infrastructure is really expensive and it

burdens your business with a lot of (16) .”

Eric Ryan: “As I knew as you go up against companies with incredible economies of

scale, it’s really really hard to go into that same cost structure”

By outsourcing they share these costs with all the other clients of vender with whom

they did business.

Adam Lowry: “Contract manufacturers are built for scale and can run them more

efficiently than we would if we scale our online first small business.”

So, from a purely quantitative perspective it made the most sense for Eric and Adam to

outsource production of their soaps to an outside party. But costs aren’t the only consideration

for managers at the company, Method had to also consider (17) . Those

considerations which are (18) but still important in making decisions.

Their main mission to make soap that’s easier to use more attractive to display and better for

the environment sets them apart from other cleaning products. The size of their company also

sets them apart from their competition and to that end, a large expensive factory might hinder

them strategically.

Adam Lowry: “And as the little guy in our category, we need to be very quick to market

and very flexible so that we can be innovative. It’s how we compete.”

Another consideration, of course, was (19) . To stay green, they need

lots of control over their production methods, exactly the kind of control they be giving up

using an outside factory. Ultimately, they chose to outsource manufacturing of their products

but only with vendors that (20) for ecological production methods.

Adam Lowry: “We have a program called Green sourcing and what that program’s

about is working with our contract manufacturers and our suppliers to get greener together and

the reason we do that is the footprint of our manufacturing business is actually the footprint of

our suppliers and venders.”

But executing a plan is not always as simple as it might seem. In the case of one

manufacturer, for example, Method offered to install solar panels on the roof of the factory to

power the forklift.

Adam Lowry: “But because we didn’t own that facility, and actually our vendor didn’t

own that facility, they (21) , we had to get very creative in how we did

the solar installation, so we installed the solar on top of the decommissioned tractor-trailer and

parked it on the side of the building and running the wires in the side door.”

There are many qualitative factors that are important to Adam and Eric, and the loyal

customer base which compete with quantitative factors when making decisions.

Adam Lowry: “They include things like what are the carbon footprint of the products

that we’re using and then on the social side there’s issues of where do we manufacture this

31

product or people being paid a living wage. There are four primary factors that we use to

choose our contract manufacturers and all of the suppliers we use which are

(22) .”

Even though Method’s environmentally friendly manufacturing choices cost more upfront. In

the long-term they usually save money on day-to-day operating costs associated with using

those technologies.

Adam Lowry: “We have a fleet of 8 semi-trailers, 53 foot-trailers that we run

exclusively off of waste vegetable oil biodiesel but now they are cheapest trucks in our fleet

because they get 30 to 50 percent better mileage than any other truck.”

Adam Lowry and Eric Ryan are on a mission to change the way we clean and by

making great (23) that weight different options based on how they

impact (24) like brand identity. They keep Method soap

cleaning up at the cash register and the environment.

Summary

Read and fill in the blanks with the following words and terms: future costs, sunk costs,

differ, constrained, relevant, irrelevant, applications, decisions

Everything in this chapter consists of applications of one simple but powerful idea.

Only those costs and benefits that (1) between alternatives are (2)________ in a

decision. All other costs and benefits are (3) and should be ignored. In particular,

(4) are irrelevant as are (5) that do not differ between alternatives.

This simple idea was applied in a variety of situations including (6) that

involve adding or dropping a product line, making or buying a component, accepting or

rejecting a special order, using a (7) resource, and processing a joint product

further. This list includes only a small sample of the possible (8) of the relevant

cost concept. Indeed, any decision involving costs hinges on the proper identification and

analysis of the costs that are relevant.

Questions

1. What is a relevant cost?

2. Define the following terms: incremental cost, opportunity cost, and sunk cost.

3. Are variable costs always relevant costs? Explain.

4. “Sunk costs are easy to spot—they’re the fixed costs associated with a decision.” Do you

agree? Explain.

5. “Variable costs and differential costs mean the same thing.” Do you agree? Explain.

6. “All future costs are relevant in decision making.” Do you agree? Why?

7. Prentice Company is considering dropping one of its product lines. What costs of the

product line would be relevant to this decision? What costs would be irrelevant?

8. “If a product is generating a loss, then it should be discontinued.” Do you agree? Explain.

9. What is the danger in allocating common fixed costs among products or other segments of

an organization?

10. How does opportunity cost enter into a make or buy decision?

11. Give at least four examples of possible constraints.

32

12. How will relating product contribution margins to the amount of the constrained resource

they consume help a company maximize its profits?

13. Define the following terms: joint products, joint costs, and split-off point.

14. From a decision-making point of view, should joint costs be allocated among joint

products?

15. What guideline should be used in determining whether a joint product should be sold at the

split-off point or processed further?

16. Airlines sometimes offer reduced rates during certain times of the week to members of a

businessperson’s family if they accompany him or her on trips. How does the concept of

relevant costs enter into the decision by the airline to offer reduced rates of this type?

Topic 7. Managerial Accounting Information for Long-term Decisions

Glossary

No Terms Meaning

1 Capital budgeting The process of planning significant investments in

projects that have longterm implications such as the

purchase of new equipment or the introduction of a

new product.

2 Cost of capital The average rate of return a company must pay to its

long-term creditors and shareholders for the use of

their funds.

3 Internal rate of return The discount rate at which the net present value of an

investment project is zero; the rate of return of a

project over its useful life.

4 Net present value The difference between the present value of an

investment project’s cash inflows and the present

value of its cash outflows.

5 Out-of-pocket costs Actual cash outlays for salaries, advertising, repairs,

and similar costs.

6 Payback period The length of time that it takes for a project to fully

recover its initial cost out of the net cash inflows that

it generates.

7 Preference decision A decision in which the alternatives must be ranked.

8 Project profitability index The ratio of the net present value of a project’s cash

flows to the investment required.

9 Screening decision A decision as to whether a proposed investment

project is acceptable.

10 Simple rate of return The rate of return computed by dividing a project’s

annual incremental accounting net operating income

by the initial investment required.

11 Working capital Current assets less current liabilities.

33

Concepts in action

Read and fill in the blank with the following words: NPV, AAR, returns, techniques, ratio,

capital, money, entertainment, revenue, budgeting, project, decision, investment, positive,

evaluated, developed, experienced.

International capital budgeting at Disney

The Walt Disney Company, one of the world’s leading (1) producers,

had more than $36 billion in 2009 (2) through movies, television networks, branded

products, and theme parks and resorts. Within its theme park business, Disney spends around

$1 billion annually in (3) investments for new theme parks, rides and attractions,

and other park construction and improvements. This (4) is divided between its

domestic properties and international parks in Paris, Hong Kong, and Tokyo.

Years ago, Disney (5) a robust capital budgeting approval process.

Project approval relied heavily on projected (6) on capital investment as measured by

net present value (NPV) and internal rate of return (IRR) calculations. While this worked well

for Disney’s investments in its domestic theme park business, the company

(7)___________ challenges when it considered building the DisneySea theme park near

Tokyo, Japan.

While capital (8) in the United States relies on discounted cash flow

analysis, Japanese firms frequently use the average accounting return (AAR) method instead.

AAR is analogous to an accrual accounting rate of return (AARR) measure based on average

investment. However, it focuses on the first few years of a (9) (five years, in the case

of DisneySea) and ignores terminal values.

Disney discovered that the difference in capital budgeting (10) between

U.S. and Japanese firms reflected the difference in corporate governance in the two countries.

The use of NPV and IRR in the United States underlined the perspective of shareholder-value

maximization. On the other hand, the preference for the simple accounting based measure in

Japan reflected the importance of achieving complete consensus among all parties affected by

the investment (11)______________

When the DisneySea project was (12) , it was found to have a positive

(13) , but a negative (14) . To account for the differences in philosophies

and capital budgeting techniques, managers at Disney introduced a third calculation method

called average cash flow return (ACFR). This hybrid method measured the average cash flow

over the first five years, with the asset assumed to be sold for book value at the end of that

period as a fraction of the initial (15) in the project. The resulting (16) was

found to exceed the return on Japanese government bonds, and hence to yield a (17)_______

return for DisneySea. As a result, the DisneySea theme park was constructed next to Tokyo

Disneyland and has since become a profitable addition to Disney’s Japanese operations.

Summary

Read and fill in the blanks with the following words and terms: cash inflows, cash

outflows, projects, funds, initial investment, accounting net operating income, time value of

money, net present value, internal rate of return, minimum required rate of return, project

profitability index, required.

34

Investment decisions should take into account the (1) because

a dollar today is more valuable than a dollar received in the future. The net present value and

(2) methods both reflect this fact. In the net present value method,

future cash flows are discounted to their present value. The difference between the present

value of the (3) and the present value of the cash outflows is called a

project’s net present value. If the (4) of a project is negative, the

project is rejected. The discount rate in the net present value method is usually based on a

minimum required rate of return such as a company’s cost of capital.

The internal rate of return is the rate of return that equates the present value of the cash

inflows and the present value of the (5) , resulting in a zero net present value.

If the internal rate of return is less than a company’s (6) , the

project is rejected.

After rejecting (7) whose net present values are negative or whose

internal rates of return are less than the minimum required rate of return, more projects may

remain than can be supported with available (8) The remaining projects can be

ranked using either the (9) or internal rate of return. The project

profitability index is computed by dividing the net present value of the project by the required

(10)_______________

Some companies prefer to use either the payback method or the simple rate of return to

evaluate investment proposals. The payback period is the number of periods that are

(11) to fully recover the initial investment in a project. The simple rate of return is

determined by dividing a project’s (12) by the initial

investment in the project.

Questions

1. What is the difference between capital budgeting screening decisions and capital budgeting

preference decisions?

2. What is meant by the term time value of money?

3. What is meant by the term discounting?

4. Why isn’t accounting net income used in the net present value and internal rate of return

methods of making capital budgeting decisions?

5. Why are discounted cash flow methods of making capital budgeting decisions superior to

other methods?

6. What is net present value? Can it ever be negative? Explain.

7. Identify two simplifying assumptions associated with discounted cash flow methods of

making capital budgeting decisions.

8. If a company has to pay interest of 14% on long-term debt, then its cost of capital is 14%.

Do you agree? Explain.

9. What is meant by an investment project’s internal rate of return? How is the internal rate of

return computed?

10. Explain how the cost of capital serves as a screening tool when using ( a ) the net present

value method and ( b ) the internal rate of return method.

11. As the discount rate increases, the present value of a given future cash flow also increases.

Do you agree? Explain.

12. How is the project profitability index computed, and what does it measure?

35

13. What is meant by the term payback period? How is the payback period determined?

14. How can the payback method be useful?

15. What is the major criticism of the payback and simple rate of return methods of making

capital budgeting decisions?

Managerial Accounting Today

Listen and fill in the blanks

In 1959 when Pizza Hut began to expand out from its first store in Witchita Kansas, the

idea of pizza chains was still very much a novelty. Half of a century later the competitive

environment for restaurants and fast-food both in the US and worldwide has changed

dramatically. To stay on top, managerial (1) for companies like Pizza Hut and

parent company Yum Brands must be forward-looking. One of the ways managerial

accountants improve productivity and eliminate waste is to analyze the (2) . The

value chain refers to all activities associated with (3) .

Activities include research and development, acquisition of materials, production, sales,

delivery and customer relations. At Pizza Hut, (4) fresh fully cooked pizza for

in-store dining, take-out and delivery requires a team effort. Every link in the chain has to work

together in order to reach the goal of bringing the best value to

(5) Companies focus on (6) through a variety

of techniques. Tools such as these allow companies to respond quicker to make better

decisions and they often provide more insight into (7) . Let’s take a closer

look at Pizza Hut and some of the techniques they use to improve productivity and

(8) in their value chain.

For many companies, often the most difficult part of computing accurate unit costs is

determining the proper (9) , the ongoing operating cost of running a

business to assign to a product. This is especially true with new products. Several years ago,

Pizza Hut introduced its line of Tuscani Pastas which required new ingredients and processes

and a massive marketing campaign directed at the public who previously only associated Pizza

Hut with pizza. (10) helped Pizza Hut to accurately assign overhead

costs during and beyond this transition phase.

When acquiring basic ingredients, Pizza Hut can sometimes find profitability and

workflow constrained by shortages and price fluctuations of basic commodities like flour and

cheese. Using the theory of constraint, they can anticipate such constraints called

(11) and circumvent them through clever strategies and creative hedging.

Chris Fuller: “When dairy costs go up, cheese costs can skyrocket and we can’t

tomorrow charge an additional $5 for a pizza, so we work with our suppliers to hedge against

commodity prices. So a year in advance we may set the price for cheese even though it might

go up on the exchange, we can hedge against to get a lower cost to keep providing a good

value, low cost pizzas to our customers.”

The production of each customer order happens at the store level. Most of which are

franchised out. But even if the supply chain is abundantly supplied, they try to limit space and

budget for inventory or spoilage due to over stocking. Thus Pizza Hut provides

(12) that track the current stock levels of everything

36

from tomatoes to drinking straws, giving managers easy to use tools to reorder supplies online

from central distribution points around the country.

Many companies now employ (13) software systems

which provide a centralized integrated source of information that companies can use to manage

all (14) , from sales to purchasing, to manufacturing, to human

resources. For Pizza Hut, one benefit is that their customers can order at the place that is the

most convenient for them.

Chris Fuller: “Our goal is really to be wherever our customers are. In addition

to the website and other places, we can order picking up the phone, the whole

traditional way. You can order from our iPhone app which was recognized as one of the

most downloaded apps. It’s really fun and you need an interactive way to order your

pizza.”

All this trouble is wasted if the food doesn’t get where it’s going in a timely fashion or

arrive piping hot and tasty, so Pizza Hut employs (15) protocols that

aim to reduce errors in order fulfillment. Even though most stores are independently owned,

each franchisee must learn and adhere to the core company guidelines like methodologies for

assembling, cooking and transporting pizza and other dishes.

Chris Fuller: “The brand has to be the same whether they’re ordering form Amarillo

Texas or from one of our restaurants in Rhode Island. We want to make sure we are fulfilling

that order and creating them the perfect pizza every time. All the way to a smile on her face

when the delivery driver rise at the door or they come to our restaurant to pick up.”

Finally, Pizza Hut seeks customer feedback in order to gauge how it’s doing in their

eyes. For example, customers can use www.tellpizzahut.com and that information goes back to

the individual store to help it improve. Pizza Hut measures both

(16)________________________evaluating all aspects of the company’s performance in an

integrated way, in a balanced scorecard. This helps Pizza Hut understand not only how

customers vote with their wallets but also how well the brand is perceived via community

participation.

Chris Fuller: “We encourage our franchisees to get involve with their communities and

doing philanthropists in their communities as well, so why we have World Hunger Relief Week

and we have the Book it! program. You also see different programs across the country their

causes that are important to our local operators and their communities.”

It isn’t easy to be the largest pizza company in the world and it is even harder to stay on

top in (17) , but the value chain and the various techniques used to

help manage the value chain, all play a key role in helping companies like Pizza Hut stay

number one.

Discussion 1

Use “think-pair-share” to work on this exercise. First, read the following exercise.

Then, take one to two minutes to think of your answers. Pair with another student to discuss

your answers. Finally, be prepared to share your responses with the rest of the class.

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Name a product and a service you have purchased that you believe was accounted for

using job-order costing. Explain why you think so. Then, think how that product and service

can be transformed such that process costing would be appropriate.

Discussion 2

No Free Lunch Hardly a week goes by without a company advertising a free product

with the purchase of another. Examples are a free printer with a digital camera purchase or a

free monitor with a computer purchase. Can these companies break even, let alone earn

profits? We are reminded of the nofree-lunch adage, meaning that companies expect profits

from the companion or add-on purchase to make up for the free product.

Discussion 3

A local movie theater owner explains to you that ticket sales on weekends and evenings

are strong, but attendance during the weekdays, Monday through Thursday, is poor. The owner

proposes to offer a contract to the local grade school to show educational materials at the

theater for a set charge per student during school hours. The owner asks your help to prepare a

CVP analysis listing the cost and sales projections for the proposal. The owner must propose to

the school’s administration a charge per child. At a minimum, the charge per child needs to be

sufficient for the theater to break even.

Prepare a list of questions being answered by the owner of the movie theater that enable

you to complete a reliable CVP analysis of this situation.

Discussion 4

Norton Company, a manufacturer of infant furniture and carriages, is in the initial

stages of preparing the annual budget for 2010. Scott Ford has recently joined Norton’s

accounting staff and is interested in learning as much as possible about the company’s

budgeting process. During a recent lunch with Marge Atkins, sales manager, and Pete Granger,

production manager, Scott initiated the following conversation.

Scott: Since I’m new around here and am going to be involved with the preparation of the

annual budget, I’d be interested in learning how the two of you estimate sales and production

numbers.

Marge: We start out very methodically by looking at recent history, discussing what we know

about current accounts, potential customers, and the general state of consumer spending. Then,

we add that usual dose of intuition to come up with the best forecast we can.

Pete: I usually take the sales projections as the basis for my projections. Of course, we have to

make an estimate of what this year’s closing inventories will be, which is sometimes difficult.

Scott: Why does that present a problem? There must have been an estimate of closing

inventories in the budget for the current year.

Pete: Those numbers aren’t always reliable since Marge makes some adjustments to the sales

numbers before passing them on to me.

Scott: What kind of adjustments?

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Marge: Well, we don’t want to fall short of the sales projections so we generally give

ourselves a little breathing room by lowering the initial sales projection anywhere from 5 to 10

percent.

Pete: So, you can see why this year’s budget is not a very reliable starting point. We always

have to adjust the projected production rates as the year progresses, and of course, this changes

the ending inventory estimates. By the way, we make similar adjustments to expenses by

adding at least 10 percent to the estimates; I think everyone around here does the same thing.

Required:

a. Explain why Marge and Pete behave in this manner, and describe the benefits they expect to

realize from the use of budgetary slack.

b. Explain how the use of budgetary slack can adversely affect Marge and Pete.

Discussion 5

In November 2005, Microsoft introduced its highly anticipated new video game player, the

Xbox 360.

In early July 2007, Microsoft announced it was extending the warranty on its Xbox 360 to

three years for a certain type of malfunction indicated by three flashing red lights on the game

console. The warranty extension would apply to previously sold units; however, the warranty

for any other type of failure would not be extended beyond the original one-year warranty

term. In making this announcement, Microsoft indicated it would take a charge of $1.05–1.15

billion in the quarter ending June 30, 2007, for the costs of the warranty extension. [Source:

Nick Wingfi eld, “Microsoft’s Videogame Eff orts Take a Costly Hit,” Wall Street Journal

(July 6, 2007), p. A3.]

a. What relevant costs were likely considered by Microsoft management in reaching the

decision to extend the warranty on the Xbox 360 and, in so doing, incur in excess of $1 billion

of additional costs?

b. Comment on whether Microsoft was ethically obligated to extend the warranty on the Xbox

360 to three years.

Discussion 6

CXI has formal policies and procedures to screen and approve capital projects. Proposed

capital projects are classified as one of the following types:

1. Expansion requiring new plant and equipment,

2. Expansion by replacement of present equipment with more productive equipment, or

3. Replacement of old equipment with new equipment of similar quality.

All expansion and replacement projects that will cost more than $50,000 must be submitted to

the top management capital investment committee for approval. The investment committee

evaluates proposed projects considering the costs and benefits outlined in the supporting

proposal and the long-range effects on the company. The projected revenue and/or expense

effects of the projects, once operational, are included in the proposal. After a project is

accepted, the committee approves an expenditure budget from the project’s inception until it

becomes operational. The expenditures required each year for the expansions or replacements

are also incorporated into CXI’s annual budget procedure. The budgeted revenue and/or cost

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effects of the projects for the periods in which they become operational are incorporated into

the 5-year forecast.

CXI does not have a procedure for evaluating projects once they have been implemented and

become operational. The vice president of finance has recommended that CXI establish a post-

investment audit program to evaluate its capital expenditure projects.

a. Discuss the benefits a company could derive from a post- investment audit program for

capital expenditure projects.

b. Discuss the practical difficulties in collecting and accumulating information that would be

used to evaluate a capital project once it becomes operational.