Chapter 2

Managerial Accounting and Cost Concepts

Solutions to Questions
2-1 Managers carry out three major activities in an organization: planning, directing and motivating, and controlling. Planning involves establishing a basic strategy, selecting a course of action, and specifying how the action will be implemented. Directing and motivating involves mobilizing people to carry out plans and run routine operations. Controlling involves ensuring that the plan is actually carried out and is appropriately modified as circumstances change. 2-2 he planning and control cycle involves formulating plans, implementing plans, measuring performance, and evaluating differences between planned and actual performance. 2-3 !n contrast to financial accounting, managerial accounting: "#$ focuses on the needs of managers rather than outsiders% "&$ emphasizes decisions affecting the future rather than the financial conse'uences of past actions% "($ emphasizes relevance rather than objectivity and verifiability% ")$ emphasizes timeliness rather than precision% "*$ emphasizes the segments of an organization rather than summary data concerning the entire organization% "+$ is not governed by ,--P% and ".$ is not mandatory. 2-4 he three major elements of product costs in a manufacturing company are direct materials, direct labor, and manufacturing overhead. 2-5 a. Direct materials are an integral part of a finished product and their costs can be conveniently traced to it. b. !ndirect materials are generally small items of material such as glue and nails. hey may be an integral part of a finished product but their costs can be traced to the product only at great cost or inconvenience. c. Direct labor consists of labor costs that can be easily traced to particular products. Direct labor is also called /touch labor.0 d. !ndirect labor consists of the labor costs of janitors, supervisors, materials handlers, and other factory wor1ers that cannot be conveniently traced to particular products. hese labor costs are incurred to support production, but the wor1ers involved do not directly wor1 on the product. e. Manufacturing overhead includes all manufacturing costs e2cept direct materials and direct labor. Conse'uently, manufacturing overhead includes indirect materials and indirect labor as well as other manufacturing costs. 2-6 - product cost is any cost involved in purchasing or manufacturing goods. !n the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. period cost is a cost that is ta1en directly to the income statement as an e2pense in the period in which it is incurred. 2-7 he income statement of a manufacturing company differs from the income statement of a merchandising company in the cost of goods sold

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section. - merchandising company sells finished goods that it has purchased from a supplier. hese goods are listed as /purchases0 in the cost of goods sold section. 9ecause a manufacturing company produces its goods rather than buying them from a supplier, it lists /cost of goods manufactured0 in place of /purchases.0 -lso, the manufacturing company identifies its inventory in this section as :inished ,oods inventory, rather than as Merchandise !nventory. 2he schedule of cost of goods manufactured lists the manufacturing costs that have been incurred during the period. hese costs are organized under the three categories of direct materials, direct labor, and manufacturing overhead. he total costs incurred are adjusted for any change in the ;or1 in Process inventory to determine the cost of goods manufactured "i.e. finished$ during the period. he schedule of cost of goods manufactured ties into the income statement through the cost of goods sold section. he cost of goods manufactured is added to the beginning :inished ,oods inventory to determine the goods available for sale. !n effect, the cost of goods manufactured ta1es the place of the Purchases account in a merchandising firm. 2-! - manufacturing company usually has three inventory accounts: <aw Materials, ;or1 in Process, and :inished ,oods. - merchandising company may have a single inventory account= Merchandise !nventory. 2-1" Product costs are assigned to units as they are processed and hence are included in inventories. he flow is from direct materials, direct labor, and manufacturing overhead to ;or1 in Process inventory. -s goods are completed, their cost is removed from ;or1 in Process inventory and transferred to :inished ,oods inventory. -s goods are sold, their cost is removed from :inished ,oods inventory and transferred to Cost

of ,oods 7old. Cost of ,oods 7old is an e2pense on the income statement. 2-11 >es, costs such as salaries and depreciation can end up as part of assets on the balance sheet if they are manufacturing costs. Manufacturing costs are inventoried until the associated finished goods are sold. hus, if some units are still in inventory, such costs may be part of either ;or1 in Process inventory or :inished ,oods inventory at the end of the period. 2-12 ?o. - variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. he variable cost per unit is constant. - fi2ed cost is fi2ed in total, but the average cost per unit changes with the level of activity. 2-13 - differential cost is a cost that differs between alternatives in a decision. -n opportunity cost is the potential benefit that is given up when one alternative is selected over another. sun1 cost is a cost that has already been incurred and cannot be altered by any decision ta1en now or in the future. 2-14 ?o, differential costs can be either variable or fi2ed. :or e2ample, the alternatives might consist of purchasing one machine rather than another to ma1e a product. he difference between the fi2ed costs of purchasing the two machines is a differential cost.

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#$ercise 2-1 "#6 minutes$ #. Directing and motivating &. 9udgets (. Planning ). Precision% imeliness *. Managerial accounting% :inancial accounting +. Managerial accounting . :inancial accounting% Managerial accounting A. :eedbac1 8. Controller #6. Performance report

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#$ercise 2-2 "#6 minutes$ #. he cost of a hard drive installed in a computer: direct materials. &. he cost of advertising in the Puget Sound Computer User newspaper: selling. (. he wages of employees who assemble computers from components: direct labor. ). 7ales commissions paid to the companyBs salespeople: selling. *. he wages of the assembly shopBs supervisor: manufacturing overhead. +. he wages of the companyBs accountant: administrative. .. Depreciation on e'uipment used to test assembled computers before release to customers: manufacturing overhead. A. <ent on the facility in the industrial par1: a combination of manufacturing overhead, selling, and administrative. he rent would most li1ely be prorated on the basis of the amount of space occupied by manufacturing, selling, and administrative operations.

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#$ercise 2-3 "#* minutes$ Produc t Cost C C Perio d Cost C

#. Depreciation on salespersonsB cars................ &. <ent on e'uipment used in the factory.......... (. Dubricants used for machine maintenance..... ). 7alaries of personnel who wor1 in the finished goods warehouse............................ *. 7oap and paper towels used by factory wor1ers at the end of a shift........................ +. :actory supervisorsB salaries.......................... .. 5eat, water, and power consumed in the factory......................................................... A. Materials used for bo2ing products for shipment overseas "units are not normally bo2ed$......................................................... 8. -dvertising costs............................................ #6. ;or1ersB compensation insurance for factory employees................................................... ##. Depreciation on chairs and tables in the factory lunchroom........................................ #&. he wages of the receptionist in the administrative offices................................... #(. Cost of leasing the corporate jet used by the companyEs e2ecutives.................................. #). he cost of renting rooms at a :lorida resort for the annual sales conference................... #*. he cost of pac1aging the companyBs product

C C C C C C C C C C C C

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#$ercise 2-4 "#* minutes$ Cyber,ames !ncome 7tatement 7ales................................................ Cost of goods sold: 9eginning merchandise inventory.. -dd: Purchases.............................. ,oods available for sale................. Deduct: @nding merchandise inventory..................................... ,ross margin.................................... 7elling and administrative e2penses: 7elling e2pense.............................. -dministrative e2pense................. ?et operating income....................... F &)6,66 6 8*6,666 #,#86,666 #.6,666 F#,)*6,66 6

#,6&6,66 6 )(6,666

&#6,666 #A6,666

(86,66 6 F )6,66 6

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#$ercise 2-5 "#* minutes$ Dompac Products 7chedule of Cost of ,oods Manufactured Direct materials: 9eginning raw materials inventory. . -dd: Purchases of raw materials...... <aw materials available for use....... Deduct: @nding raw materials inventory....................................... <aw materials used in production.... Direct labor........................................ Manufacturing overhead.................... otal manufacturing costs.................. -dd: 9eginning wor1 in process inventory......................................... Deduct: @nding wor1 in process inventory......................................... Cost of goods manufactured.............. F +6,66 6 +86,66 6 .*6,666 )*,66 6

F .6*,66 6 #(*,666 (.6,66 6 #,&#6,666 #&6,66 6 #,((6,666 #(6,66 6 F#,&66,66 6

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#$ercise 2-6 "#* minutes$ - few of these costs may generate debate. :or e2ample, some may argue that the cost of advertising a roc1 concert is a variable cost because the number of people who come to the roc1 concert depends on the amount of advertising. 5owever, one can argue that if the price is within reason, any roc1 concert in ?ew >or1 City will be sold out and the function of advertising is simply to let people 1now the event will be happening. Moreover, while advertising may affect the number of persons who ultimately buy tic1ets, the causation is in one direction. !f more people buy tic1ets, the advertising costs donBt go up. Cost Behavior Variabl i!e e d C C C C C C C C C

Cost (Measure of Activity) #. he cost of C4ray film used in the radiology lab at Girginia Mason 5ospital in 7eattle "?umber of C4rays ta1en$............................................... &. he cost of advertising a roc1 concert in ?ew >or1 City "?umber of roc1 concert tic1ets sold$ (. he cost of renting retail space for a McDonaldBs restaurant in 5ong Hong " otal sales at the restaurant$.................................... ). he electrical cost of running a roller coaster at Magic Mountain "?umber of times the roller coaster is run$.................................................. *.Property ta2es paid by your local cinema theater "?umber of tic1ets sold$...................... +. he cost of sales commissions paid to salespersons at a ?ordstrom store " otal sales at the store$..................................................... ..Property insurance on a Coca Cola bottling plant "?umber of cases of bottles produced$.... A. he costs of synthetic materials used to ma1e a particular model of running shoe "?umber of shoes of that model produced$......................... 8. he costs of shipping Panasonic televisions to retail stores "?umber of televisions sold$.........
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#6. he cost of leasing an ultra4scan diagnostic machine at the -merican 5ospital in Paris "?umber of patients scanned with the machine$..........................................................

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#$ercise 2-7 "#* minutes$ Cost he wages of pediatric nurses Prescription drugs 5eating the hospital he salary of the head of pediatrics he salary of the head of pediatrics 5ospital chaplainBs salary Dab tests by outside contractor Dab tests by outside contractor Cost "b#ect he pediatric department - particular patient he pediatric department he pediatric department - particular pediatric patient - particular patient - particular patient - particular department $irect Cost C C C C C C C C %ndirec t Cost

# . & . ( . ) . * . + . . . A .

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#$ercise 2- "#* minutes$ %tem Cost of the old C4ray machine............................. he salary of the head of the <adiology Department....... he salary of the head of the Pediatrics Department....... Cost of the new color laser printer................................ <ent on the space occupied by <adiology...................... he cost of maintaining the old machine....................... 9enefits from a new D?analyzer............................. Cost of electricity to run the C4ray machines.................. $ifferenti al Cost "pportunit y Cost Sun& Cost C

# . & . ( . ) . * . + . . . A .

C C C

?ote: he costs of the salaries of the head of the <adiology Department and Pediatrics Department and the rent on the space occupied by <adiology are neither differential costs, nor opportunity costs, nor sun1 costs. hese costs do not differ between the alternatives and therefore are irrelevant in the decision, but they are not sun1 costs because they occur in the future.

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#$ercise 2-! "#* minutes$ #. &. (. ). *. +. .. A. 8. #6 . Product cost% variable cost Conversion cost Ipportunity cost Prime cost 7un1 cost Period cost% variable cost Product cost% period cost% fi2ed cost Product cost Period cost :i2ed cost% product cost% conversion cost

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#$ercise 2-1" "#* minutes$ Selling and Administrati ve Cost Produc t Cost C C C C C

Cost %tem #. 5amburger buns at a ;endyBs outlet. . &. -dvertising by a dental office......... (. -pples processed and canned by Del Monte................... ). 7hipping canned apples from a Del Monte plant to customers............ *. !nsurance on a 9ausch J Domb factory producing contact lenses...... +. !nsurance on !9MBs corporate head'uarters........ .. 7alary of a supervisor overseeing production of printers at 5ewlett4Pac1ard... A. Commissions paid to @ncyclopedia 9ritannica salespersons........ 8. Depreciation of factory lunchroom facilities at a ,eneral @lectric plant..................... #6. 7teering wheels
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Cost Behavior Variable i!ed C

C C C

C C

C C
(#

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installed in 9M;s.

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#$ercise 2-11 "(6 minutes$ #. Mason Company 7chedule of Cost of ,oods Manufactured Direct materials: 9eginning raw materials inventory.......... F .,666 -dd: Purchases of raw materials.............. ##A,666 <aw materials available for use............... #&*,666 Deduct: @nding raw materials inventory. . #*,666 <aw materials used in production............ F##6,66 6 Direct labor................................................ .6,666 Manufacturing overhead............................ A6,666 otal manufacturing costs.......................... &+6,666 -dd: 9eginning wor1 in process inventory.. #6,666 &.6,666 Deduct: @nding wor1 in process inventory.. *,666 Cost of goods manufactured...................... F&+*,66 6 &. he cost of goods sold section of Mason CompanyBs income statement: 9eginning finished goods inventory..... FK&6,666 -dd: Cost of goods manufactured........ &+*,666 ,oods available for sale....................... &A*,666 Deduct: @nding finished goods (*,666 inventory........................................... Cost of goods sold................................ F&*6,66 6

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#$ercise 2-12 "(6 minutes$ #. a.9atteries purchased................................................. 9atteries drawn from inventory............................... 9atteries remaining in inventory.............................. Cost per battery....................................................... Cost in <aw Materials !nventory at -pril (6.............. b.9atteries used in production ".,+66 M #66$.............. Motorcycles completed and transferred to :inished ,oods "86N L .,*66$............................................ Motorcycles still in ;or1 in Process at -pril (6......... Cost per battery....................................................... Cost in ;or1 in Process !nventory at -pril (6........... A,666 .,+66 )66 L F#6 F),666 .,*66 +,.*6 .*6 L F#6 F.,*66

c.Motorcycles completed and transferred to :inished ,oods "see above$................................................. +,.*6 Motorcycles sold during the month ".6N L +,.*6$....................................................... ),.&* Motorcycles still in :inished ,oods at -pril (6.......... &,6&* Cost per battery....................................................... L F#6 Cost in :inished ,oods !nventory at -pril (6............ F&6,&*6 d.Motorcycles sold during the month "above$............. ),.&* Cost per battery....................................................... L F#6 Cost in Cost of ,oods 7old at -pril (6...................... F).,&*6 e.9atteries used in salespersonsB motorcycles............ Cost per battery....................................................... Cost in 7elling @2pense at -pril (6........................... &. <aw Materials !nventory=balance sheet ;or1 in Process !nventory=balance sheet :inished ,oods !nventory=balance sheet Cost of ,oods 7old=income statement 7elling @2pense=income statement #66 L F#6 F #,666

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%roble& 2-13 "(6 minutes$ ?ote to the !nstructor: here may be some e2ceptions to the answers below. he purpose of this problem is to get the student to start thin&ing about cost behavior and cost purposes% try to avoid lengthy discussions about how a particular cost is classified. Manufacturin g Administrativ (Product) Selling e Cost $irec Cost Cost t %ndirect C C C C C C C C C C C C

Variable or Cost %tem #. Property ta2es, factory......................... &. 9o2es used for pac1aging detergent produced by the company................. (. 7alespersonsB commissions.................. ). 7upervisorBs salary, factory.................. *. Depreciation, e2ecutive autos.............. +. ;ages of wor1ers assembling computers.......................................... .. !nsurance, finished goods warehouses. A. Dubricants for production e'uipment.... 8. -dvertising costs.................................. #6. Microchips used in producing calculators......................................... ##. 7hipping costs on merchandise sold..... #&. Magazine subscriptions, factory lunchroom.......................................... i!ed : G G : : G : G : G G :

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#(. hread in a garment factory................. #). 9illing costs.......................................... #*. @2ecutive life insurance........................

G G :

C CO C

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%roble& 2-13 "continued$ Manufacturin g Administrativ (Product) Selling e Cost $irec Cost Cost t %ndirect C COO C C

Variable or Cost %tem #+. !n1 used in te2tboo1 production........... #.. :ringe benefits, assembly4line wor1ers. #A. >arn used in sweater production.......... #8. ;ages of receptionist, e2ecutive offices................................................ O Could be administrative cost. OO Could be indirect cost. i!ed G G G :

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%roble& 2-14 "(6 minutes$ Period (Sellin g

'ame of the Cost <ental revenue forgone, F(6,666 per year.................. Direct materials cost, FA6 per unit....................................... <ental cost of warehouse, F*66 per month.................... <ental cost of e'uipment, F),666 per month................. Direct labor cost, F+6 per unit. Depreciation of the anne2 space, FA,666 per year......... -dvertising cost, F*6,666 per year...................................... 7upervisorEs salary, F#,*66 per month............................. @lectricity for machines, F#.&6 per unit................................. 7hipping cost, F8 per unit....... <eturn earned on

Product Cost Manu) "ppor i!e $irect $irec facturing and ) Sun Variabl d Material t "verhea Admin tunity & e Cost Cost s (abor d ) Cost Cost Cost C C C C C C C C C C C C C C C C C C C C C

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investments, F(,666 per year......................................

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%roble& 2-15 "(6 minutes$ Cost Behavior Variable i!ed C C C C C C C C C C C C C C C C C C C C C C C *o Units of Product $irect %ndirect C C C C C C C

Cost %tem #. @lectricity to run production e'uipment............ &. <ent on a factory building................................. (. Cloth used to ma1e drapes............................... ). Production superintendentBs salary................... *. ;ages of laborers assembling a product........... +. Depreciation of air purification e'uipment used to ma1e furniture........................................... .. Panitorial salaries............................................... A. Peaches used in canning fruit........................... 8. Dubricants for production e'uipment................ #6. 7ugar used in soft drin1 production................... ##. Property ta2es on the factory............................ #&. ;ages of wor1ers painting a product................ #(. Depreciation on cafeteria e'uipment................ #). !nsurance on a building used in producing helicopters...................................................... #*. Cost of rotor blades used in producing helicopters......................................................

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%roble& 2-16 ")* minutes$ #. 7wift Company 7chedule of Cost of ,oods Manufactured :or the Month @nded -ugust (# Direct materials: <aw materials inventory, -ugust #......... F A,66 6 -dd: Purchases of raw materials............ #+*,66 6 <aw materials available for use............. #.(,666 Deduct: <aw materials inventory, #(,66 -ugust (#............................................ 6 <aw materials used in production.......... F#+6,666 Direct labor.............................................. .6,666 Manufacturing overhead.......................... A*,666 otal manufacturing costs........................ (#*,666 -dd: ;or1 in process inventory, -ugust # #+,666 ((#,666 Deduct: ;or1 in process inventory, &#,666 -ugust (#.............................................. Cost of goods manufactured..................... F(#6,666 &. 7wift Company !ncome 7tatement :or the Month @nded -ugust (# 7ales........................................................ Cost of goods sold: :inished goods inventory, -ugust #........ F)*6,66 6

FK )6,666 -dd: Cost of goods manufactured.......... (#6,66 6 ,oods available for sale......................... (*6,666 Deduct: :inished goods inventory, +6,66 &86,666 -ugust (#............................................ 6
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,ross margin............................................ 7elling and administrative e2penses........ ?et operating income...............................

#+6,666 #)&,666 FK #A,666

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%roble& 2-16 "continued$ (. !n preparing the income statement for -ugust, 7am failed to distinguish between product costs and period costs, and he also failed to recognize the changes in inventories between the beginning and end of the month. Ince these errors have been corrected, the financial condition of the company loo1s much better and selling the company may not be advisable.

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%roble& 2-17 "#* minutes$ #. he controller is correct that the salary cost should be classified as a selling "mar1eting$ cost. he duties described in the problem have nothing to do with manufacturing a product, but rather deal with moving finished units from the factory to distribution warehouses. 7elling costs include all costs necessary to secure customer orders and to get the finished product into the hands of customers. Coordination of shipments of finished units from the factory to distribution warehouses falls in this category. &. ?o, the president is not correct. he reported net operating income for the year will differ depending on how the salary cost is classified. !f the salary cost is classified as a selling e2pense all of it will appear on the income statement as a period cost. 5owever, if the salary cost is classified as a manufacturing "product$ cost, it will be added to ;or1 in Process inventory along with other manufacturing costs for the period. o the e2tent that goods are still in process at the end of the period, part of the salary cost will remain with these goods in the ;or1 in Process inventory account. Inly that portion of the salary cost that has been assigned to finished units will leave the ;or1 in Process inventory account and be transferred into the :inished ,oods inventory account. !n li1e manner, to the e2tent that goods are unsold at the end of the period, part of the salary cost will remain with these goods in the :inished ,oods inventory account. Inly the portion of the salary that has been assigned to finished units that are sold during the period will appear on the income statement as an e2pense "part of Cost of ,oods 7old$ for the period. he remainder of the salary costs will be on the balance sheet as part of inventories.

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%roble& 2-1 ")* minutes$ #. Meriwell Company 7chedule of Cost of ,oods Manufactured Direct materials: <aw materials inventory, beginning..... -dd: Purchases of raw materials.......... <aw materials available for use........... Deduct: <aw materials inventory, ending............................................... <aw materials used in production........ Direct labor............................................ Manufacturing overhead........................ otal manufacturing costs...................... -dd: ;or1 in process inventory, beginning............................................ Deduct: ;or1 in process inventory, ending................................................. Cost of goods manufactured.................. &. Meriwell Company !ncome 7tatement 7ales...................................................... F*66,666 Cost of goods sold: :inished goods inventory, beginning.... FK&6,666 -dd: Cost of goods manufactured........ &86,666 ,oods available for sale....................... (#6,666 Deduct: :inished goods inventory, ending............................................... )6,666 &.6,666 ,ross margin.......................................... &(6,666 7elling and administrative e2penses: 7elling e2penses.................................. A6,666 -dministrative e2penses...................... ##6,666 #86,666
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F K8,666 #&*,666 #(),666 +,666 F#&A,66 6 .6,666 #6*,666 (6(,666 #.,666 (&6,666 (6,666 F&86,66 6

?et operating income.............................

FK)6,666

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%roble& 2-1 "continued$ (. Direct materials: F#&A,666 Q #6,666 units R F#&.A6 per unit. :i2ed manufacturing overhead: F86,666 Q #6,666 units R F8.66 per unit. ). Direct materials: Snit cost: F#&.A6 "unchanged$ otal cost: #*,666 units L F#&.A6 per unit R F#8&,666. :i2ed manufacturing overhead: Snit cost: F86,666 Q #*,666 units R F+.66 per unit. otal cost: F86,666 "unchanged$ *. Snit cost for fi2ed manufacturing overhead dropped from F8.66 to F+.66, because of the increase in production between the two years. 9ecause fi2ed costs do not change in total as the activity level changes, they will decrease on a unit basis as the activity level rises.

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%roble& 2-1! ")* minutes$ #. Cost Behavior Variabl e i!ed F##A,66 6 F*6,666 )6,666 A6,666 (,*66 &,*66 ),666 +,666 (,666 8),666 &6,66 6 #&,666 #6,666 +6,666 A6,666 ),666 #&,666 +,666 (,666 +6,666 #6,666 8),666 Selling or Administrati ve Cost F*6,666

Cost %tem :actory labor, direct.............. -dvertising............................ :actory supervision............... Property ta2es, factory building............................... 7ales commissions................ !nsurance, factory................. Depreciation, administrative office e'uipment................. Dease cost, factory e'uipment.......................... !ndirect materials, factory..... Depreciation, factory building............................... -dministrative office supplies -dministrative office salaries Direct materials used............ Stilities, factory.....................

Product Cost %ndirec $irect t F##A,66 6 F)6,66 6 (,*66 &,*66

&6,66 6

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otal costs.............................

F(&#,66 6

F#A&,66 6

F#8.,666

F&#&,66 6

F8),66 6

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%roble& 2-1! "continued$ &. Direct............................................. !ndirect.......................................... otal.............................................. F(6+,666 Q &,666 sets R F#*( per set F&#&,66 6 8),66 6 F(6+,66 6

(. he average product cost per set would increase if the production drops. his is because the fi2ed costs would be spread over fewer units, causing the average cost per unit to rise. ). a. >es, the president may e2pect a minimum price of F#*(, which is the average cost to manufacture one set. 5e might e2pect a price even higher than this to cover a portion of the administrative costs as well. he brother4in4law probably is thin1ing of cost as including only direct materials, or, at most, direct materials and direct labor. Direct materials alone would be only F). per set, and direct materials and direct labor would be only F#6+. b. he term is opportunity cost. he full, regular price of a set might be appropriate here, because the company is operating at full capacity, and this is the amount that must be given up "benefit forgone$ to sell a set to the brother4in4 law.

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%roble& 2-2" "(6 minutes$ #. Product Cost $irec $irect t Manuf+ Materia (abo "verhe ls r ad Period (Sellin g and Admin ) Cost "ppor ) Sun tunity & Cost Cost C C C C C C C C C C C C C C C C C

'ame of the Cost 7taciEs current salary, F(,A66 per month........... 9uilding rent, F*66 per month............................. Clay and glaze, F& per pot ;ages of production wor1ers, FA per pot......... -dvertising, F+66 per month............................. 7ales commission, F) per pot.................................. <ent of production e'uipment, F(66 per month............................. Degal and filing fees, F*66 <ent of sales office, F&*6 per month....................... Phone for ta1ing orders,

Variabl e Cost

i!e d Cost C C

C C

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F)6 per month................ !nterest lost on savings account, F#,&66 per year................................

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%roble& 2-2" "continued$ &. he F*66 cost of incorporating the business is not a differential cost. @ven though the cost was incurred to start the business, it is a sun1 cost. ;hether 7taci produces pottery or stays in her present job, she will have incurred this cost.

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%roble& 2-21 "+6 minutes$ #. 7uperior Company 7chedule of Cost of ,oods Manufactured :or the >ear @nded December (# Direct materials: <aw materials inventory, beginning FK)6,666 "given$.............................................. -dd: Purchases of raw materials &86,666 "given$.............................................. <aw materials available for use........... ((6,666 Deduct: <aw materials inventory, #6,666 ending "given$................................... <aw materials used in production........ F(&6,66 6 Direct labor............................................ 8(,666 O Manufacturing overhead "given$............ &.6,666 otal manufacturing costs "given$.......... +A(,666 -dd: ;or1 in process inventory, )&,666 O beginning............................................ .&*,666 Deduct: ;or1 in process inventory, (*,666 ending "given$..................................... Cost of goods manufactured.................. F+86,66 6 he cost of goods sold section of the income statement follows: :inished goods inventory, beginning "given$................................................ -dd: Cost of goods manufactured.......... ,oods available for sale "given$............. Deduct: :inished goods inventory, ending................................................. Cost of goods sold "given$...................... O FK*6,666 +86,666 O .)6,666 A6,666 O F++6,66 6

hese items must be computed by wor1ing bac1wards up through the statements.

&. Direct materials: F(&6,666 Q )6,666 units R FA.66 per unit.

Manufacturing overhead: F&.6,666 Q )6,666 units R F+..* per unit. (. Direct materials: FA.66 per unit. Manufacturing overhead: F&.6,666 Q *6,666 units R F*.)6 per unit.

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%roble& 2-21 'continued( ). he average cost per unit for manufacturing overhead dropped from F+..* to F*.)6 because of the increase in production between the two years. 9ecause fi2ed costs do not change in total as the activity level changes, the average cost per unit will decrease as the activity level rises.

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%roble& 2-22 "(6 minutes$ #. - cost that is classified as a period cost will be recognized on the income statement as an e2pense in the current period. cost that is classified as a product cost will be recognized on the income statement as an e2pense "i.e., cost of goods sold$ only when the associated units of product are sold. !f some units are unsold at the end of the period, the costs of those unsold units are treated as assets. herefore, by reclassifying period costs as product costs, the company is able to carry some costs forward in inventories that would have been treated as current e2penses. &. he discussion below is divided into two parts=,allantBs actions to postpone e2penditures and the actions to reclassify period costs as product costs. he decision to postpone e2penditures is 'uestionable. !t is one thing to postpone e2penditures due to a cash bind% it is 'uite another to postpone e2penditures in order to hit a profit target. Postponing these e2penditures may have the effect of ultimately increasing future costs and reducing future profits. !f orders to the companyBs suppliers are changed, it may disrupt the suppliersB operations. he additional costs may be passed on to ,allantBs company and may create ill will and a feeling of mistrust. Postponing maintenance on e'uipment is particularly 'uestionable. he result may be brea1downs, inefficient andTor unsafe operations, and a shortened life for the machinery. !nterestingly, in a survey of +)8 managers reported in Management Accounting, only #&N stated that it is unethical to defer e2penses and thereby manipulate 'uarterly earnings. he proportion who felt it was unethical increased to &)N when it involved annual earnings. -nother )#N said that deferring e2penses is a 'uestionable practice when it involved 'uarterly reports and (*N said this when annual reports were involved. :inally, ).N said that it is completely ethical to manipulate 'uarterly reports in this way and )#N gave the green light for annual reports. "7ee ;illiam P. 9runs, Pr. and Henneth -. Merchant, / he Dangerous Morality of Managing @arnings,0 Management Accounting, -ugust #886, pp. &&4&*$
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%roble& 2-22 "continued$ ,allantBs decision to reclassify period costs is not ethical= assuming that there is no intention of disclosing in the financial reports this reclassification. 7uch a reclassification would be a violation of the principle of consistency in financial reporting and is a clear attempt to mislead readers of the financial reports. -lthough some may argue that the overall effect of ,allantBs action will be a /wash0=that is, profits gained in this period will simply be ta1en from the ne2t period=the trend of earnings will be affected. 5opefully, the auditors would discover any such attempt to manipulate annual earnings and would refuse to issue an un'ualified opinion due to the lac1 of consistency. 5owever, recent accounting scandals may lead to some s1epticism about how forceful auditors have been in enforcing tight accounting standards.

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%roble& 2-23 "&6 minutes$

$irect or %ndirect Cost of the Meals)"n) ,heels Program %tem a. b. c. d. $escription he cost of leasing the meals4on4wheels van........................................................... he cost of incidental supplies such as salt, pepper, nap1ins, and so on.............. he cost of gasoline consumed by the meals4on4wheels van............................... he rent on the facility that houses Madison 7eniors Care Center, including the meals4on4wheels program................. he salary of the part4time manager of the meals4on4wheels program........................ Depreciation on the 1itchen e'uipment used in the meals4on4wheels program..... he hourly wages of the caregiver who drives the van and delivers the meals..... he costs of complying with health safety regulations in the 1itchen........................ he costs of mailing letters soliciting $irect %ndirect C C C

Variable or i!ed -ith .espect to the 'umber of Seniors Served by the Meals)"n) ,heels Program Variabl e i!ed C

C C C C C C C

CO C C C C C

C C C

e. f. g. h. i.

C C

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donations to the meals4on4wheels program................................................... O hese costs could be direct costs of serving particular seniors.

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%roble& 2-24 "+6 minutes$ #. Gisic Corporation 7chedule of Cost of ,oods Manufactured Direct materials: <aw materials inventory, beginning............. FK &6,666 -dd: Purchases of raw materials.................. )A6,666 <aw materials available for use.................... *66,666 Deduct: <aw materials inventory, ending..... (6,666 <aw materials used in production................. F).6,66 6 Direct labor..................................................... 86,666 Manufacturing overhead................................. (66,666 otal manufacturing costs.............................. A+6,666 -dd: ;or1 in process inventory, beginning..... *6,666 8#6,666 Deduct: ;or1 in process inventory, ending..... )6,666 Cost of goods manufactured........................... FA.6,66 6 &. a. o compute the number of units in the finished goods inventory at the end of the year, we must first compute the number of units sold during the year. otal sales F#,(66,666 R R &+,666 units sold Snit selling price F*6 per unit sold Snits in the finished goods inventory, beginning................................................... Snits produced during the year..................... Snits available for sale.................................. Snits sold during the year "above$ ............... Snits in the finished goods inventory, ending 6 &8,666 &8,666 &+,666 (,666

b. he average production cost per unit during the year is: Cost of goods manufactured FA.6,666 R R F(6 per unit ?umber of units produced &8,666 units
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hus, the cost of the units in the finished goods inventory at the end of the year is: (,666 units L F(6 per unit R F86,666.

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%roble& 2-24 "continued$ (. Gisic Corporation !ncome 7tatement 7ales..................................................... Cost of goods sold: :inished goods inventory, beginning... -dd: Cost of goods manufactured....... ,oods available for sale...................... :inished goods inventory, ending........ ,ross margin......................................... 7elling and administrative e2penses..... ?et operating income............................ F#,(66,666 F 6 A.6,666 A.6,666 86,666

.A6,666 *&6,666 (A6,666 FKK#)6,666

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%roble& 2-25 ")* minutes$ Direct materials................................ Direct labor....................................... Manufacturing overhead................... otal manufacturing costs................ 9eginning wor1 in process inventory @nding wor1 in process inventory..... Cost of goods manufactured............. 7ales................................................ 9eginning finished goods inventory. . Cost of goods manufactured............. ,oods available for sale.................... @nding finished goods inventory....... Cost of goods sold............................ ,ross margin.................................... 7elling and administrative e2penses ?et operating income....................... O Missing data in the problem. Case / Case 0 FK),*66 FK+,666 8,666 O (,666 *,666 ),666 #A,*66 #(,666 O &,*66 &,666 O "(,666$O "#,666$ F#),66 F#A,666 6 F&#,66 F(6,666 6 #,666 &,*66 #A,666 #),666 #8,666 O #+,*66 O "&,666$O "#,*66$ #.,666 #*,666 O #(,666 +,666 O "8,666$O "(,*66$ FK),666 FK&,*66 O Case 1 FK*,666 .,666 A,666 O &6,666 (,666 "),666$ F#8,66 6O F(+,66 6 (,*66 O #8,666 O &&,*66 O "),666$ #A,*66 #.,*66 "#&,*66$O FK*,666 Case 2 FK(,666 ),666 8,666 #+,666 O ),*66 O "(,666$ F#.,*6 6 F)6,66 6 &,666 #.,*66 #8,*66 O "(,*66$ #+,666 O &),666 O "#*,666$ O FK8,666

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Case 2-26 "+6 minutes$ he following cost items are needed before a schedule of cost of goods manufactured can be prepared: Materials used in production: Prime cost............................................. Dess direct labor cost............................ Direct materials cost............................. Manufacturing overhead cost: Direct labor cost F#A6,666 R Percentage of conversion cost (6NO R F+66,666 total conversion cost O#66N M .6N R (6N. Conversion cost.................................... F+66,666 Dess direct labor cost............................ #A6,666 Manufacturing overhead cost............... F)&6,666 Cost of goods manufactured: ,oods available for sale........................ FA#6,666 Dess finished goods inventory, )*,666 beginning........................................... Cost of goods manufactured................. F.+*,666 he easiest way to proceed from this point is to place all 1nown amounts in a partially completed schedule of cost of goods manufactured and a partially completed income statement. hen fill in the missing amounts by analysis of the available data. F)#6,66 6 #A6,666 F&(6,66 6

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Case 2-26 "continued$ Direct materials: <aw materials inventory, beginning............... FK #A,666 &86,66 6 (6A,666 -

-dd: Purchases of raw materials.................... <aw materials available for use...................... Deduct: <aw materials inventory, ending....... <aw materials used in production "see above$......................................................... &(6,666 #A6,66 Direct labor cost............................................... 6 )&6,66 Manufacturing overhead cost "see above$........ 6 otal manufacturing costs................................ A(6,666 +*,66 -dd: ;or1 in process inventory, beginning....... 6 A8*,666 Deduct: ;or1 in process inventory, ending....... 9 F.+*,66 Cost of goods manufactured "see above$.......... 6 herefore, /-0 "<aw materials inventory, ending$ is F.A,666% and /90 ";or1 in process inventory, ending$ is F#(6,666. 7ales.......................................................... Cost of goods sold: :inished goods inventory, beginning....... -dd: Cost of goods manufactured "see above$.................................................. ,oods available for sale.......................... Deduct: :inished goods inventory, ending.................................................. ,ross margin............................................. OF#,&66,666 L "#66N M )6N$ R F.&6,666.
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F#,&66,66 6 FK )*,666 .+*,666 A#6,666 C

.&6,66 6 F )A6,66 6

herefore, /C0 ":inished goods inventory, ending$ is F86,666. he procedure outlined above is just one way in which the solution to the case can be approached. 7ome may wish to start at the bottom of the income statement "with gross margin$ and wor1 upwards from that point. -lso, the solution can be obtained by use of 4accounts.

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Case 2-27 "+6 minutes$ #. ?o distinction has been made between period e2penses and product costs on the income statement filed by the companyBs accountant. Product costs "e.g., direct materials, direct labor, and manufacturing overhead$ should be assigned to inventory accounts and flow through to the income statement as cost of goods sold only when finished products are sold. 9ecause there were ending inventories, some of the product costs should appear on the balance sheet as assets rather than on the income statement as e2penses. &. 7olar echnology, !nc. 7chedule of Cost of ,oods Manufactured :or the Uuarter @nded March (# Direct materials: <aw materials inventory, beginning...... -dd: Purchases of raw materials........... <aw materials available for use............ Deduct: <aw materials inventory, ending................................................ <aw materials used in production......... Direct labor............................................. Manufacturing overhead......................... otal manufacturing costs....................... -dd: ;or1 in process inventory, beginning.............................................. Deduct: ;or1 in process inventory, ending................................................... Cost of goods manufactured.................... F 6 (+6,666 (+6,666 #6,666 F(*6,666 .6,666 )#6,666 A(6,666 6 A(6,666 *6,666 F.A6,666

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Case 2-27 "continued$ (. 9efore an income statement can be prepared, the cost of the A,666 batteries in the ending finished goods inventory must be determined. -ltogether, the company produced )6,666 batteries during the 'uarter% thus, the production cost per battery was: Cost of goods manufactured F.A6,666 R RF#8.*6 per unit 9atteries produced during the 'uarter )6,666 units 9ecause A,666 batteries ")6,666 M (&,666 R A,666$ were in the finished goods inventory at the end of the 'uarter, the total cost of this inventory was: A,666 units L F#8.*6 per unit R F#*+,666. ;ith this and other data from the case, the companyBs income statement for the 'uarter can be prepared as follows: 7olar echnology, !nc. !ncome 7tatement :or the Uuarter @nded March (# 7ales "(&,666 batteries$...................... F8+6,66 6

Cost of goods sold: :inished goods inventory, beginning. F 6 -dd: Cost of goods manufactured .... .A6,66 6 ,oods available for sale.................... .A6,666 Deduct: :inished goods inventory, #*+,66 +&),666 ending............................................ 6 ,ross margin....................................... ((+,666 7elling and administrative e2penses. . . &86,666 ?et operating income.......................... FK)+,666

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Case 2-27 "continued$ ). ?o, the insurance company probably does not owe 7olar echnology F&&+,666. he 1ey 'uestion is how /cost0 was defined in the insurance contract. !t is most li1ely that the insurance contract limits reimbursement for losses to those costs that would normally be considered product costs=in other words, direct materials, direct labor, and manufacturing overhead. he F&&+,666 is overstated because it includes elements of selling and administrative e2penses as well as product costs. he F&&+,666 also does not recognize that some costs incurred during the period are in the ending <aw Materials and ;or1 in Process inventory accounts, as e2plained in part "#$ above. he insurance companyBs liability is probably just F#*+,666, which is the amount of cost associated with the ending :inished ,oods inventory as shown in part "($ above.

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)esearch and Application 2-2 #. Dell succeeds because of its operational e2cellence customer value proposition. Page # of the #64H "under the heading 9usiness 7trategy$ lists the 1ey tenets of DellBs business strategy. he first three tenets focus on operational e2cellence. he first tenet discusses the direct business model, which /eliminates wholesale and retail dealers that add unnecessary time and cost or diminish DellBs understanding of customer e2pectations.0 he second tenet is DellBs build4to4order manufacturing process that /enables Dell to turn over inventory every four days on average, and reduce inventory levels.0 he third tenet is /DellBs relentless focus on reducing its costs VwhichW allows it to consistently provide customers with superior value.0 -lso, the first bullet point on Page A of the #64H says /DellBs success is based on its ability to profitably offer its products at a lower price than its competitors.0 &. Dell faces numerous business ris1s as described in pages .4#6 of the #64H. 7tudents may mention other ris1s beyond those specifically mentioned in the #64H. 5ere are four ris1s faced by Dell with suggested control activities: <is1: Profits may fall short if DellBs product, customer, and geographic mi2 is substantially different than anticipated. Control activities: Maintain a budgeting program that forecasts sales by product line, customer segment, and geographic region. ;hile the budget is not going to be perfectly accurate, a reasonably accurate forecast would help Dell manage investor e2pectations. <is1: Disruptions in component availability from suppliers could reduce DellBs ability to meet customer orders. his is of particular concern for Dell because its lean production practices result in minimal inventory levels and because Dell relies on several single4sourced suppliers. Control activities: Develop a plan with single4sourced suppliers to ensure that they can produce the necessary components at more than one plant location and to ensure that each location has more than one means of delivering the parts to DellBs assembly facilities.
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)esearch and Application 2-2 "continued$ <is1: !nfrastructure failures "e.g., computer viruses, intentional disruptions of ! systems and website outages$ may threaten DellBs ability to boo1 or process orders, manufacture products, or ship products in a timely manner. Control activities: !nstall controls such as physical security, data storage bac1up sites, firewalls and passwords that protect technology assets. <is1: Dosing government contracts could adversely affect the companyBs revenues. Control activities: Develop a formal review process, supervised by legal counsel, to ensure that Dell complies with governmental regulations. (. Pages ()4(* of DellBs :orm #64H contain the audit report issued by PricewaterhouseCoopers "P;C$. he audit report ma1es reference to the role of the Public Company -ccounting Iversight 9oard "PC-I9$ that was created by the 7arbanes4 I2ley -ct of &66& "7IC$. he audit report also contains two opinions dealing with internal control. he first opinion relates to managementBs assessment of its internal controls. he second opinion relates to the auditorBs assessment of the effectiveness of DellBs internal controls. hese two opinions were re'uired by 7IC at the time of this #64H filing. Page *8 includes managementBs report on internal control over financial reporting. his report includes a reference to 7IC. :inally, pages .+4.A contain signed certifications from the C@I "Hevin <ollins$ and the C:I "Pames 7chneider$. 7IC re'uires the C@I and C:I to certify that the #64H and its accompanying financial statements do not contain any untrue statements and are fairly stated in all material respects. ). 9ased solely on the inventories number on the balance sheet, students cannot determine the answer to this 'uestion. :urthermore, given that DellBs total amount of inventories is so small, the company does not report the brea1 down of its inventories between raw materials, wor14in4process, and finished goods. ?onetheless, students should be able to readily ascertain that Dell is a manufacturer. Page & of the #64H says
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/Dell designs, develops, manufactures, mar1ets, sells, and supports a wide range of products that are customized to customer re'uirements.0 Page * states /DellBs manufacturing process consists of assembly,

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)esearch and Application 2-2 "continued$ software installation, functional testing, and 'uality control.0 Page . states that Dell has manufacturing facilities in -ustin, e2as, @ldorado do 7ul, 9razil, ?ashville and Debanon, ennessee, Dimeric1, !reland, Penang, Malaysia, and Ciamen, China. *. @2amples of direct inventoriable costs include the component parts that go into ma1ing DellBs main product families, which include enterprise systems, client systems, printing and imaging systems, software, and peripherals. he /touch0 laborers that wor1 in each of the aforementioned plants would also be a direct inventoriable cost. @2amples of indirect inventoriable costs include the costs to sustain the manufacturing plants that cannot be conveniently traced to specific products. he utility bills, insurance premiums, plant management salaries, and e'uipment4related costs, etc. that are incurred to sustain plant operations would all be indirect inventoriable costs. he gross margin "in dollars$ has steadily increased and the gross margin as a percent of sales has remained fairly steady for two reasons. :irst, the cost of goods sold consists largely of variable costs "e.g., direct materials and direct labor costs$. -s sales grow, these variable costs increase in total, but as a percentage of sales, they remain fairly stable over time. 7ome students may as1 about the fi2ed overhead costs that are incurred to run the plants. 7preading fi2ed overhead costs over a higher volume of sales would increase the gross margin percentage. 5owever, the fi2ed overhead costs are relatively small in relation to the dollar value of raw materials that flows through DellBs plants each year. 7econd, pages &&4&( mention that Dell plans to reduce product costs in four areas: manufacturing costs, warranty costs, design costs, and overhead costs. he company says that its /general practice is to aggressively pass on declines in costs to its customers in order to add customer value while increasing global mar1et share.0 !n other words, rather than holding price
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constant when costs decline, thereby increasing the gross margin percentage, the company lowers prices. Ssing terminology that will be defined in Chapter #&, Dell grows profits by increasing turnover while holding margin reasonably constant.

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)esearch and Application 2-2 "continued$ +. he inventory balance on Panuary &A, &66* is F)*8 million. -s discussed on Page & of the #64H, the balance is low because of DellBs build4to4order "lean$ manufacturing process that enables the company to /turn over inventory every four days on average, and reduce inventory levels.0 ;hen units are built to order rather than built to stoc1, it not only reduces finished goods inventory, it reduces wor14in4process inventory because large batches of partially completed goods do not accumulate in front of wor1stations or in temporary storage areas. !t also reduces raw materials inventory because suppliers provide just4 in4time delivery of the 'uantities needed to satisfy customer orders. -s stated on page &, this offers Dell a competitive advantage because it allows the company to /rapidly introduce the latest relevant technology more 'uic1ly than companies with slow4 moving, indirect distribution channels, and to rapidly pass on component cost savings directly to customers.0 he negative cash conversion cycle is a good sign for Dell. -lthough this term is not defined in the chapter, students can ascertain from page &. of the #64H that it is computed as follows: days sales outstanding X days of supply in inventory M days in accounts payable. -s stated on pages &+4&., the negative cash conversion cycle means that Dell is /collecting amounts due from customers before paying vendors, thus allowing the company to generate annual cash flows from operating activities that typically e2ceed net income.0 .. -s shown on page &(, DellBs two main categories of operating e2penses are selling, general, and administrative "F),&8A million$ and research, development, and engineering "F)+( million$. Page )& e2plains that DellBs selling, general, and administrative e2penses /include items such as sales commissions, mar1eting and advertising costs, and contractor services.0 !t also mentions that advertising costs totaled F*.+ million in fiscal &66*. ,eneral and administrative costs include /:inance, Degal, 5uman <esources and information technology support.0 DellBs website development costs are included in
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<esearch, Development, and @ngineering costs along with payroll, infrastructure, and administrative costs related directly to research and development.

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)esearch and Application 2-2 "continued$ :or financial reporting purposes, costs are classified as either product costs or period costs. Product costs include those costs involved with ma1ing or ac'uiring the product. Period costs include all costs that are not product costs. he e2penses mentioned in the paragraph above are not involved with ma1ing the product so they are e2pensed as incurred. ;hen the focus changes from e2ternal reporting to internal decision ma1ing, the need to comply with ,--P disappears. 7o for e2ample, on page )& it says /<esearch, development, and engineering costs are e2pensed as incurred, in accordance with 7:-7 ?o. &, Accounting for .esearch and $evelopment Costs.0 5owever, for internal reporting purposes it may be entirely appropriate to assign some research and development costs to particular products. A. 5ere are four e2amples of cost objects for Dell including one direct and one indirect cost for each cost object. - product line, such as a particular type of server. - direct cost would be the cost of raw material component parts and an indirect cost would be factory utility costs. - particular product family, such as enterprise systems, which according to page & includes servers, storage, wor1stations, and networ1ing products. - direct cost would be the component parts used to ma1e these products and an indirect cost would be factory insurance costs that are assigned to these products. - particular geographic region, such as -sia Pacific4Papan, which is mentioned on page **. - direct cost would be the salary of ;illiam -melio, 7enior Gice4President, -sia Pacific4 Papan "see page ##$ and an indirect cost would be the salary of Martin P. ,arvin, 7enior Gice President, ;orldwide Procurement and ,lobal Customer @2perience "see page ##$, given that he oversees worldwide procurement operations. - particular customer segment, such as the government segment as mentioned on page ). - direct cost would be a sales representative who is dedicated to serving the government segment and an indirect cost would be research
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and development costs that are e2pended on products purchased by more than one customer segment.

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Appendi$ 2A
*urther Classi+ication o+ ,abor Costs

#$ercise 2A-1 "#6 minutes$ Direct labor "() hours L F#* per hour$. . . Manufacturing overhead "idle time: + hours L F#* per hour$..... otal wages earned................................. F*#6 86 F+66

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#$ercise 2A-2 "#6 minutes$ Direct labor ")* hours L F#) per hour$. . . Manufacturing overhead "overtime: * hours L F. per hour$....... otal wages earned................................. F+(6 (* F++*

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#$ercise 2A-3 "#* minutes$ #. ?o. !t appears that the overtime spent completing the job was simply a matter of how the job happened to be scheduled. Snder these circumstances, an overtime premium probably should not be charged to a customer whose job happens to fall at the end of the dayBs schedule. &. Direct labor "8 hours L F#) per hour$......... ,eneral overhead "# hour L F. per hour$... otal cost.................................................... F#&+ . F#((

(. - charge for an overtime premium might be justified if the customer re'uested a /rush0 order that caused the overtime.

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#$ercise 2A-4 "#* minutes$ #. Direct labor "(# hours L F#) per hour$ Manufacturing overhead "idle time: 8 hours L F#) per hour$... otal cost............................................ &. Direct labor ")A hours L F#) per hour$ Manufacturing overhead "overtime: A hours L F. per hour$.... otal cost............................................ F)() #&+ F*+6 F+.& *+ F.&A

(. - company could treat the cost of fringe benefits relating to direct labor wor1ers as part of manufacturing overhead. his approach spreads the cost of such fringe benefits uniformly over all units of output. -lternatively, the company could treat the cost of fringe benefits relating to direct labor wor1ers as additional direct labor cost. his latter approach charges the costs of fringe benefits to specific jobs rather than to all units of output.

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%roble& 2A-5 "(6 minutes$ #. otal wages for the wee1: <egular time ")6 hours L F&6 per hour$.......... Ivertime "+ hours L F(6 per hour$................. otal wages....................................................... -llocation of total wages: Direct labor ")+ hours L F&6 per hour$........... Manufacturing overhead "Ivertime: + hours L F#6 per hour$.............. otal wages....................................................... &. otal wages for the wee1: <egular time ")6 hours L F&6 per hour$.......... Ivertime "A hours L F(6 per hour$................. otal wages..................................................... -llocation of total wages: Direct labor ")* hours L F&6 per hour$........... Manufacturing overhead: "!dle time: ( hours L F&6 per hour$.............. "Ivertime: A hours L F#6 per hour$.............. otal wages..................................................... (. otal wages and fringe benefits for the wee1: <egular time ")6 hours L F&6 per hour$.......... Ivertime "#6 hours L F(6 per hour$............... :ringe benefits "*6 hours L F+ per hour$........ otal wages and fringe benefits...................... -llocation of wages and fringe benefits: Direct labor ")A hours L F&6 per hour$........... Manufacturing overhead: "!dle time: & hours L F&6 per hour$.............. "Ivertime: #6 hours L F#6 per hour$............ ":ringe benefits: *6 hours L F+ per hour$..... otal wages and fringe benefits...................... FA66 #A6 F8A6 F8&6 +6 F8A6 F A66 &)6 F#,6)6 F 866 F+6 A6 #)6 F#,6)6 F A66 (66 (66 F#,)66 F 8+6 F )6 #66 (66

))6 F#,)66

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%roble& 2A-5 "continued$ ). -llocation of wages and fringe benefits: Direct labor: ;age cost ")A hours L F&6 per hour$........... :ringe benefits ")A hours L F+ per hour$...... Manufacturing overhead: "!dle time: & hours L F&6 per hour$.............. "Ivertime: #6 hours L F#6 per hour$............ ":ringe benefits: & hours L F+ per hour$....... otal wages and fringe benefits......................

F8+6 &AA F#,&)A )6 #66 #&

#*& F#,)66

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Appendi$ 2Cost o+ Qualit.

#$ercise 2--1 "#6 minutes$ #. Uuality of conformance &. Uuality costs (. Uuality circles ). Prevention costs, appraisal costs *. !nternal failure costs, e2ternal failure costs +. @2ternal failure costs .. -ppraisal costs A. Prevention costs 8. !nternal failure costs #6. @2ternal failure costs ##. Prevention costs, appraisal costs #&. Uuality cost report

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#$ercise 2--2 "#* minutes$ #. %nternal 3!ternal Preventio Appraisa ailure ailure n Cost l Cost Cost Cost Product testing............... C Product recalls................ C <ewor1 labor and overhead...................... C Uuality circles................. C Downtime caused by defects......................... C Cost of field servicing..... C !nspection of goods........ C Uuality engineering........ C ;arranty repairs............ C 7tatistical process control......................... C ?et cost of scrap............ C Depreciation of test e'uipment................... C <eturns and allowances arising from poor 'uality.......................... C Disposal of defective products....................... C echnical support to suppliers...................... C 7ystems development.... C ;arranty replacements. . C :ield testing at customer site............................... C Product design............... C

a. b. c. d. e. f. g. h. i. j. 1. l. m. n. o. p. '. r. s.

&. Prevention costs and appraisal costs are incurred in an effort to 1eep poor 'uality of conformance from occurring. !nternal and e2ternal failure costs are incurred because poor 'uality of conformance has occurred.
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%roble& 2--3 "+6 minutes$ #. :lore2 Company Uuality Cost <eport (ast 4ear Amount (in Percen thousand t of s) Sales F )&6 )A6 6 866 .*6 A#6 (6 &#6 #,A66 +(6 #,6*6 .&6 &,)66 #,&66 (,+66 &,#66 +,866 F#&,666 6.*+ 6.+) 6.66 #.&6 #.66 #.6A 6.6) 6.&A &.)6 6.A) #.)6 6.8+ (.&6 #.+6 ).A6 &.A6 8.&6 #+.66

Prevention costs: Uuality engineering.... 7ystems development 7tatistical process control..................... otal prevention costs... -ppraisal costs !nspection................... Product testing........... 7upplies used in testing..................... Depreciation of testing e'uipment.... otal appraisal costs... !nternal failure costs: ?et cost of scrap........ <ewor1 labor.............. Disposal of defective products................... otal internal failure costs........................... @2ternal failure costs: Cost of field servicing. ;arranty repairs........ Product recalls............ otal e2ternal failure costs........................... otal 'uality cost..........

*his 4ear Amount (in Percent thousand of s) Sales F *.6 .*6 #A6 #,*66 866 #,&66 +6 &)6 &,)66 #,#&* #,*66 8.* (,+66 866 #,6*6 .*6 &,.66 F#6,&66 6..+ #.66 6.&) &.66 #.&6 #.+6 6.6A 6.(& (.&6 #.*6 &.66 #.(6 ).A6 #.&6 #.)6 #.66 (.+6 #(.+6

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%roble& 2--3 "continued$ &.

$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 Last Year This Year External Failure Internal Failure Appraisal Prevention

Quality Costs as a Percentage of Sales

18 16 14 12 10 8 6 4 2 0 Last Year This Year External Failure Internal Failure Appraisal Prevention

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%roble& 2--3 "continued$ (. he overall impact of the companyBs increased emphasis on 'uality over the past year has been positive in that total 'uality costs have decreased from #+N of sales to #(.+N of sales. Despite this improvement, the company still has a poor distribution of 'uality costs. he bul1 of the 'uality costs in both years is traceable to internal and e2ternal failure, rather than to prevention and appraisal. -lthough the distribution of these costs is poor, the trend this year is toward more prevention and appraisal as the company has given more emphasis on 'uality. Probably due to the increased spending on prevention and appraisal activities during the past year, internal failure costs have increased by one half, going from F&.) million to F(.+ million. he reason internal failure costs have gone up is that, through increased appraisal activity, defects are being caught and corrected before products are shipped to customers. hus, the company is incurring more cost for scrap, rewor1, and so forth, but it is saving huge amounts in field servicing, warranty repairs, and product recalls. @2ternal failure costs have fallen sharply, decreasing from F+.8 million last year to just F&.. million this year. !f the company continues its emphasis on prevention and appraisal=and particularly on prevention=its total 'uality costs should continue to decrease in future years. -lthough internal failure costs are increasing for the moment, these costs should decrease in time as better 'uality is designed into products. -ppraisal costs should also decrease as the need for inspection, testing, and so forth decreases as a result of better engineering and tighter process control.

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%roble& 2--4 "+6 minutes$ #. -n analysis of the companyBs 'uality cost report is presented below: (ast 4ear Amoun t Percent5 F.6 6 6 .6 #.. 6.6 6.6 #.. #6.) 6.6 6.6 #6.) *his 4ear Amoun t Percent5 F #&6 #6 &6 #*6 &.* &6.( 6.& #.. 6.) (.)

Prevention costs: Machine maintenance........ raining suppliers... Uuality circles......... ............................ otal prevention costs....................... -ppraisal costs: !ncoming inspection............ :inal testing........... otal appraisal costs. !nternal failure costs: <ewor1................... 7crap...................... otal internal failure costs....................... @2ternal failure costs: ;arranty repairs.... Customer returns. . . otal e2ternal failure costs....................... otal 'uality cost...... otal production cost

(.# &*.)

&6 A6 #66 *6 )6 86

6.* #.8 &.) #.& #.6 &.#

(.6 ##.8 #).8 ..* +.6 #(.)

)6 86 #(6 #(6 .6 &66

6.A +.A #.8 #*.( &.. &&.6 &.. &&.6 #.* ##.8 ).& ((.8

86 (&6 )#6 F+.6 F),&6 6

&.# ..+ 8.A #+. 6

#(.) )..A +#.& #66. 6

(6 A6 ##6 F *86 F),A6 6

6.+ *.# #.. #(.+ &.( #A.+ #&. #66. ( 6

O Percentage figures may not add down due to rounding.

%roble& 2--4 "continued$ :rom the above analysis it would appear that Mercury, !nc.Bs program has been successful. otal 'uality costs have declined from #+.6N to #&.(N as a percentage of total production cost. !n dollar amount, total 'uality costs went from F+.6,666 last year to F*86,666 this year.

@2ternal failure costs, those costs signaling customer dissatisfaction, have declined from 8.AN of total production costs to &.(N. hese declines in warranty repairs and customer returns should result in increased sales in the future. -ppraisal costs have increased from &.)N to &..N of total production cost. !nternal failure costs have increased from &.#N to ).&N of production costs. his increase has probably resulted from the increase in appraisal activities. Defective units are now being spotted more fre'uently before they are shipped to customers. Prevention costs have increased from #..N of total production cost to (.#N and from #6.)N of total 'uality costs to &*.)N. he FA6,666 increase is more than offset by decreases in other 'uality costs. &. he initial effect of emphasizing prevention and appraisal was to reduce e2ternal failure costs and increase internal failure costs. he increase in appraisal activities resulted in catching more defective units before they were shipped to customers. -s a conse'uence, rewor1 and scrap costs increased. !n the future, an increased emphasis on prevention should result in a decrease in internal failure costs. -nd as defect rates are reduced, resources devoted to appraisal can be reduced. (. o measure the cost of not implementing the 'uality program, management could assume that sales and mar1et share would continue to decline and then calculate the lost profit. Ir, management might assume that the company will have to cut
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its prices to hang on to its mar1et share. he impact on profits of lowering prices could be estimated.

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