CHAPTER 3: BASIC COST MANAGEMENT CONCEPTS

QUESTIONS

3-1 Cost assignment refers to the general case of assigning costs to cost pools or
cost objects. When there is a direct and traceable link between the cost and the
cost pool or cost object, then the management accountant traces that cost to the
cost pool or cost object. When there is an indirect link between the cost and the
cost pool or cost object, then the management accountant uses cost allocation.
Cost allocation uses cost drivers to assign the indirect cost.

3-2 Direct costs can be physically identified with and/or conveniently traced to the
cost object because there is a direct causal link between them. Indirect costs
cannot be conveniently and easily traced to each cost object. Direct costs for a
manufactured product include the materials (called direct materials) which are
part of the product and the labor (called direct labor) which is used to
manufacture the product. Indirect costs include the machinery, plant and other
labor necessary to manufacture the product, but which is not conveniently and
easily directly traceable to the product, such as labor for inspection and
supervision.

3-3 All direct costs are, by definition, variable since they can be directly traced to the
cost object and thus must vary with the cost driver.

3-4 All fixed costs must be indirect, since the increase in the cost driver or volume of
output does not affect the level of fixed cost. While fixed costs are indirect,
some indirect costs might be variable, but are not considered “direct” because of
the convenience/ease factor.

3-5 A cost driver is any factor that has the effect of changing the level of total cost.

3-6 Variable costs are costs that changes in total, both directionally and
proportionately, in response to changes in one or more cost drivers. A fixed cost
is the portion of the total cost that, within the relevant range, does not change
with a change in the quantity of a designated cost driver

3-7 A step cost varies with the cost driver, but in discrete steps. Costs remain fixed
over narrow ranges of the cost driver. However, total costs increase by a
constant amount at set intervals. Examples of step costs are the costs for certain
clerical tasks, order filling, and other administrative tasks. At specific levels of
the cost driver, an additional clerk must be added. Therefore, total costs
increase by a constant amount at these points.

3-8 The relevant range is that range of activity over which we have knowledge and
experience (or interest). It is the range “of interest,” hence the name “relevant.”
For simplicity, accountants typically (but certainly not always) select a range over
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 which the cost behavior is linear. The relevant range is used to provide a useful
range of activity for the cost driver in which it can be assumed that variable costs
will be constant per unit of the cost driver. This is an assumption since the
behavior of actual costs is likely to be non-linear (see Exhibit 3-6) over the range
of the cost driver. The concept of the relevant range allows the management
accountant to use the concept of constant unit variable cost for a defined range
of operations, even though actual unit variable costs change over the entire
range of the cost driver.

3-9 Conversion costs are the sum of direct labor and overhead costs. Prime costs
are the sum of direct materials and direct labor.

3-10 Unit cost is the additional cost that is incurred as the cost driver increases by one
unit.

3-11 The term average cost can be misleading unless the activity level (denominator)
is known. Because average cost includes a fixed cost component, it will be
different at each possible activity level. The term average cost is meaningless if
the denominator is unknown. An increase in volume does not increase total cost
by the amount of the increase in volume multiplied by total average cost; total
cost increases by the increase in volume multiplied by the unit variable cost
rather than the average cost.

3-12 Total variable costs increase or decrease as the cost driver increases or
decreases. Total fixed costs remain constant as the cost driver changes.
Average variable costs remain constant as the cost driver increases. Average
fixed costs decrease as the cost driver increases and increase as the cost driver
decreases.

3-13 Product costs are costs which are treated as assets, or inventoried. They are
referred to as manufacturing costs in manufacturing firms and merchandise
inventory in merchandising firms. Period costs are expensed as they are
incurred because there is no expectation that they will provide any future benefit
to the firm. Since period costs are not directly or indirectly related to the
production process, they are sometimes called nonproduct costs.

3-14 Cost of goods manufactured is the cost of the units produced during a given
period and transferred into finished good inventory. Cost of goods sold is the
cost of the units sold this period. Cost of goods sold will differ from cost of goods
manufactured because of changes in finished goods inventory. If finished goods
inventory is very nearly the same from the beginning to the end of the period,
then cost of goods sold and cost of goods manufactured will be very nearly the
same.

3-15 The types of inventory in manufacturing firms are Materials Inventory, Work-in-
Process Inventory, and Finished Goods Inventory.
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3-16 Both accuracy and timeliness are important attributes of cost information.
Accuracy is important because effective planning and decision making require
accurate cost information. Cost management information must be available to
the decision maker in a timely manner to facilitate effective decision making. The
cost of delay can be significant in many decisions.

3-17 Executional cost drivers include employee empowerment, design of the

production process or work place, and management of supplier relationships.

3-18 Structural cost drivers include scale, experience, technology, and complexity

3-19 Indirect materials include items used in the production process that are not
included in the product itself, such as rags and small tools, lubricant for the
machines, etc. Indirect materials also include those direct materials which cannot
be conveniently and economically traced to the product, such as nails used in
building a house.

3-20 Indirect labor includes labor that is used in the manufacturing process but cannot
be conveniently and economically traced to each product as it is produced;
indirect labor includes supervision, inspection, training, etc.

BRIEF EXERCISES

3-21 Direct materials are

Manufacturing cost Prime Cost Conversion Cost

a) Yes Yes Yes
b) No Yes No
c) Yes Yes No
d) No No No

Answer C
Feedback: Direct materials are included in a final product as part of the manufacturing
process. Direct materials, along with direct labor, are prime costs, and labor plus
overhead are conversion costs

3-22 Which of the following cost would be included in manufacturing overhead of a

computer manufacturer?

a) The cost of the USB port hardware

b) The wages paid to hardware assemblers
c) The cost of the circuit boards
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d) Depreciation on assembly machinery

Answer D
Feedback: The USB port hardware and circuit boards are both direct materials and the
assembly labor is direct labor.

3-23 Which of the following is true regarding period and product costs?

a) Factory lease is a period cost and sales commissions are a products cost.
b) Factory lease is a product cost and sales commissions are a product cost.
c) Factory lease is a period cost and sales commissions are a period cost.
d) Factory lease is a product cost and sales commissions are a period cost

Answer D
Feedback: Factory lease costs are part of manufacturing overhead and sales
commissions are not part of the production process.

3-24 Which of the following statements is incorrect regarding manufacturing overhead?

a) Manufacturing overhead is an indirect costs to units or products.

b) Manufacturing overhead includes both fixed and variable costs.
c) Actual overhead costs are used in the cost accounting process.
d) Actual Overhead costs tend to remain relatively constant over various output levels

Answer D
Feedback: Because manufacturing overhead can contain both fixed and variable costs,
the total cost of actual overhead would fluctuate with changes in output.

3-25 Direct labor costs are

a) Nonmanufacturing costs
b) Period costs
c) Conversion costs
d) Overhead costs

Answer C
Feedback: Direct labor is a manufacturing cost, and conversion costs are the
combination of direct labor plus overhead.

3-26 $200 + $13,400 -$400 = $13,200

3-27 $2.6 million + $10 million = $12.6 million

3-28 $66,000 + $98,000 +($22,000 - $1,000) - $2,000 = $183,000

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3-29 $400,000 + $1,600,000 - $200,000 = $1,800,000 cost of goods sold

3-30 Period cost includes office support salaries, advertising, and office expense:
$4,000 + $2,500 + $14,000 = $20,500

EXERCISES

3-31 Fares and Fees in the Airline Industry (15 min)

Very much like the consumer products industry (Procter & Gamble as an example)
introduced at the start of the chapter, the airline industry is characterized by a high
degree of complexity in pricing–both fares and fees.

1. It is likely most will argue that the airline industry is a cost leadership industry.
Most passengers look for the lowest price ticket and see very little difference
between airlines in terms of quality, reliability, or service. On the other hand,
airlines would very much like to build a brand loyalty by providing certain free
services and enhanced customer service. Whether this will work is a good
question for class discussion. One point that should arise in the discussion is to
determine whether the airline business is a commodity business. Can a
customer differentiate the different carriers?

Another issue is the airlines’ desire for more control over the purchasing of
tickets. Could this approach help them develop a brand, or simply add to the
complexity and frustration of the consumer? On the other hand, some travel
analysts have questioned the impartiality of the available websites passengers
use to purchase tickets; arguments of this nature could drive the development of
new search engines and divert customers away from airlines that did not
participate in trusted, independent search sites. If the number of websites
increases, as some in the travel industry expect, then it is likely to place more
price pressure on the airlines and reinforce the commodity view of the industry.

2. The complexity of fees and fares presents a challenge for the consumer and an
opportunity for search sites such as Expedia to assist passengers in getting the
flight they want at the lowest price. From the airlines’ point of view, the
complexity presents an opportunity for revenue growth (fees for various services
such as checked baggage, priority seating, etc.). Does the additional complexity
increase the operating costs of the airline?

It is likely that the additional complexity in fares and fees will affect the airlines’
costs for the cost of additional time and administrative effort in processing fee
payments and in assisting customers. Of course, the additional fees are very
likely to cover these additional costs.

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 Source: Jad Mouawad and Claire Cain Miller, “Search for Low Airfares Gets
More Competitive,” The New York Times, February 10, 2011; Gary Stoler, “Fee-
fi-fo-fum, Airline Charges Leave Some Travelers Numb,” USA Today, September
20, 2011, p B1.

Hereacleous and Wirtz offer a contrasting view. They argue that Singapore
Airlines simultaneously competes on cost leadership and differentiation. The
authors further argue that this competition is common in Asian airlines. The
authors call this a “dual strategy.” Source: Loizos Hereacleous and Jochen
Wirtz, “Singapore Airlines Balancing Act,” Harvard Business Review, July-August
2010, pp. 145-149.

3-32 Complexity of Operations and the Effect on Cost (15 min)

The observations made by the consultant show that the manufacturer was incurring
large costs in operations, distribution, and administration due to the high level of
complexity in its products. Maintaining relationships with 10 vendors for a single item
contributed to high purchasing and stocking costs. Similarly, most of the firm’s volume
was made up of products with five color combinations, with the result that
manufacturing, warehousing, shipping, and selling costs were high relative to fewer
color combinations. Also, the high product variety required smaller batch production
and more frequent set-ups, which caused increased manufacturing costs. Additionally,
the variety of different customers, prices, and promotional programs created increased
manufacturing, shipping, and customer service costs as well as increased costs in
accounting for the customers’ invoices and account balances.

The solution was to reduce complexity. This was done by reducing the number of
customers; the low value customers were reviewed and some were not continued.
Also, a process of review was developed for the introduction of new products, or new
variations on existing products, to ensure the likely profitability of the new product.
Further, the complexity of equipment set-ups was reduced so that the firm could meet
the customers’ demands for smaller batch sizes without increasing overall costs. The
result of the program was that overall profit margins improved. The firm had found a
way to deal with the cost consequences of its strategic initiative.

The firm also adopted new cost management practices that included new nonfinancial
measures such as set-up time and frequency, percent of orders shipped on time,
percent of orders on just-in-time, and number of vendors for the top 20 commodity raw
materials items. In addition, the firm began to calculate and regularly review customer
profitability by type of market and customer size.

Based on information in: Barry Berman, “Products, Products Everywhere,” The Wall
Street Journal, August 23, 2010, p. R8; Frank A. J. Gonsalves and Robert G. Eiler,

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“Managing Complexity Through Performance Measurement,” Management Accounting,
August 1996, pp 34-39.

3-33 Classification of Costs (10 min)

Parts 1 and 2:
1. Print machine setup costs: activity; product

2. Cost of complexity; the number and variety of products: structural; product

3. Training costs for new staff: executional; product

4. Ink: volume; product

5. Customer service costs: activity; period

6. Paper: volume; product

7. Redesign of the print process to improve efficiency: executional; product

8. Machine operation labor: volume; product

9. Order taking: activity; period

10 . Purchasing and stocking paper and other supplies – activity: product

3. The ink could have a harmful environmental impact. The company could choose
to use environmentally friendly ink, or dispose of the harmful ink in a proper
manner. All waste paper should be properly recycled. As is the case with the ink,
the company could also choose to use paper that is environmentally friendly,
e.g., recycled paper versus paper that required cutting down additional living
trees.

3-34 Classification of Costs (10 min)

1. Period
2. Product; indirect
3. Product: indirect
4. Product: direct
5. Period
6. Period
7. Product: direct
8. Period
9. Product: indirect
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 10. Period
11. Period
12. Product: indirect
13. Period
14. Period

3-35 Classification of Costs (10 min)

1. Direct: variable
2. Indirect: fixed
3. Indirect: variable
4. Indirect: fixed
5. Direct: variable
6. Indirect: fixed
7. Indirect: variable
8. Direct: variable
9. Indirect: fixed
10. Indirect: fixed

3-36 Classification of Costs (10 min)

1. Direct
2. Indirect
3. Direct
4. Indirect
5. Direct
6. Indirect
7. Indirect
8. Direct
9. Indirect
10. Indirect

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3-37 Activity Levels and Cost Drivers (10 Min)

Cost Object Cost Driver

1 Product line or Directly trace to product line, or each custom order
customer requiring design
2 Product line or Directly trace to product line, or each custom order
customer requiring testing
3 Product line Allocation base: product line
4 Product line Allocation base: number of purchase orders
5 Customer order Directly trace to customer
6 Customer order Directly trace to customer
7 Customer order Directly trace to customer
8 Customer order Directly trace to customer
9 Each customer Directly trace to customer
10 Customer order Directly trace to customer
11 Customer order Allocation base: number of orders
12 Individual products Allocation base: number of units produced

3-38 Application of the Direct Cost Concept in the Fashion Industry (15 min)

It is always possible, by definition, to trace direct materials and direct labor costs to
each unit produced. In some cases, as in this one, the most practical approach is to
trace the materials and labor costs directly to the batch. This is convenient both for
cost management and pricing, since the batch is for a single customer. This is a
preview of job costing, which is the topic of Chapter 4.

3-39 Manufacturing Direct Labor: Fixed or Variable? (10 min)

The effect of the policy of Lincoln Electric is that labor expense, while fixed in total
expenditure, is treated as a variable expense. Labor is flexible and can be moved from
job to job or plant to plant as demand dictates; that is, labor cost at the plant level
fluctuates with demand at each plant, while total labor cost at the firm stays fixed. For
companies like Nestle, instead of incurring a fixed cost for labor, the company’s total
labor costs are flexible and vary with demand, as part-time labor is added when needed.

Source: Clara Asbury, “In the Workplace, Jobs Morph to Suit Rapid Pace of Change,”
The Wall Street Journal, March 22, 2002, p.1.

3-40 Average and Total Costs (15 min)

1. Total cost:

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 $ 1,500 (fixed cost of space rental)
+ 1,500 (variable cost of refreshments = $15 × 100)
$ 3,000

Average cost: $3,000÷100 people = $30.00 per person

2. Total cost:
$ 1,500 (fixed cost of space rental)
+ 3,000 (variable cost of refreshments = $15 × 200)
$ 4,500

Average cost: $4,500÷200 people = $22.50 per person

3. Average costs decrease as attendance increases because the fixed cost

component of total costs is now spread over 100 extra people.

Fixed cost per person: $1,500÷100 people = $15

$1,500÷200 = $ 7.50
Decrease in fixed cost per person $ 7.50

Average cost for 100 people $30.00

- Decrease per person in fixed costs 7.50
Average cost for 200 people $ 22.50

3-41 Classification of Costs (15 min)

1. While a variety of possible cost objects are possible for the dance studio, the
most reasonable choice is the studio since management’s goal is to analyze the
profitability of the studios.

2. Studios as the cost object

1. Direct: variable
2. Direct: variable
3. Direct: variable
4. Direct: variable
5. Direct: variable
6. Indirect: variable
7. Direct: variable
8. Direct: fixed

Or,

Lessons as the cost object

1. Direct: fixed
2. Indirect: fixed
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 3. Indirect: fixed
4. Indirect: fixed
5. Indirect: fixed
6. Indirect: fixed
7. Indirect: fixed
8. Indirect: fixed

3-42 Relevant Range (20 min)

1. The volume-based costs include:

a. administrative costs of management in Austin and Paris and the 16
marketing and customer service locations
b. the royalties paid for the images sold, the cost of computer operations
personnel,
c. the purchase of small servers as needed
d. purchase of larger computer servers as needed when demand increases,
2. The relevant range is applicable for PGI because PGI’s operations centers must
grow as demand increases. This means higher costs due to the cost of adding
small computer servers and the cost of hiring additional staff, etc. Note that the
cost of the additional support staff would increase fixed costs, but the cost of
adding capacity – additional large servers and new administrative staff–would be
a step cost, increasing unit costs. So PGI’s total costs increase in a non-linear,
upward-sloping manner over wide ranges of demand. The relevant range is
used to determine the level of unit variable cost and total fixed cost for a limited
range of activity–a range in which there is no need for additional servers or hiring
costs, etc.

3. The growth of the company globally means that the company will be more
exposed to the effects of foreign currency fluctuations. For example, a rising
dollar relative to the euro will increase the effective cost of PGI’s service to
European customers, thereby potentially decreasing demand in Europe. Also,
the translation of the European earnings in euros to PGI’s financial statement will
mean foreign currency losses, as the euro earnings are worth less with the falling
dollar. The changes in the currency exchange rates can potentially and perhaps
significantly affect the company’s earnings in two ways, decreased sales and
foreign currency exchange losses. The reverse would be true if the dollar were
to depreciate relative to the euro. The same currency issues apply should the
company’s business continue to grow in China. In this case, the currency effect
is likely to be smaller, since the Chinese currency has not changed much relative
to the dollar in recent years.

3-43 Fixed; Variable; and Mixed Costs (10 min)

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 Department A Fixed
Department B Variable
Department C Mixed
Department D Mixed
Department E Variable

3-44 Fixed; Variable; and Mixed Costs (10 min)

Department 1 Mixed
Department 2 Mixed
Department 3 Fixed
Department 4 Variable
Department 5 Variable

3-45 Strategy; Variable and Fixed Costs (20 min)

1. The variable costs for Zipcar would be the same as for any car owner–gasoline
(customers do not pay for gas, but instead use a fuel card, included in the rate, to
replenish gas used and pay an hourly rate) and upkeep. The fixed costs are the
largest part of the total cost and include the cost of the car, insurance, and the
parking spot, among others.

2. The key challenge facing Zipcar is the entrance of competitors such as Hertz and
Enterprise car rental agencies. Zipcar has no “barrier to entry” and is vulnerable to
new competition.

A good question for class discussion is “How will Zipcar be able to compete
effectively against the larger companies?” Does the Zipcar concept represent a
commodity which can be copied and used by the other companies, or are there
some features and services that can make Zipcar unique and differentiated? One
idea would be to stress that the company offers very small cars to achieve both
convenience (in large cities) and a “green” advantage (by Zipcar’s estimate, each
car it adds to its fleet keeps up to 20 cars off the road). Another approach might be
to emphasize its initiative in the business and its environmental contribution over the
last 10 years, ideas that might have traction with those customers who want to make
a statement about their commitment to the environment.

Since fixed costs are a key component of total costs for the company, the ability of
the company to grow at a fast rate is critical. A larger company, with more members
and more usage of its vehicles, would be able to more easily cover those fixed costs.
As shown in Exhibit 3.11, average fixed costs fall as output increases.

Another challenge for Zipcar is the rising cost of gasoline. Because of the short
rental periods, it is not practical to have customers refuel the car, and the flat hourly
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 rate is appropriate and convenient. But this also exposes Zipcar to fluctuations in
gas prices which must be covered by that fixed hourly rate.

Source: “The Business of Sharing,” The Economist, October 14, 2010; Adam Aston,
“Growth Galore, but Profits are Zip,” Bloomberg Businessweek ,September 8, 2008, p
62. Also: Mark Clothier,” In The Race for the Car-less, Can Hertz Outrun Zipcar?”
Bloomberg Businessweek, April 2, 2012, pp. 23-24.

3-46 Interpreting Average Cost (15 min)

This question is based on a report by Paul Raeburn, “Hybrid Cars: Less Fuel but More
Costs,” Bloomberg Businessweek, April 15, 2002, p 107. See also information on the
history of gas prices from January 2000 to the present at the U.S. Department of Energy
website: https://energy.gov/eere/articles/timeline-brief-history-oil-prices-and-vehicle-
technologies

CAFE standards have remained at 27.5 mpg since 2002 but have been increased by
2007 legislation which required 35 mpg by the year 2020. In May 2009, the Obama
admiration pushed the 35MPG target back to 2012, and in August 2011 legislation was
passed that required 54.5 mpg by 2025. The urgency of energy sustainability, oil
independence from non-domestic supplies, and climate change have substantially
increased the efforts to improve vehicle efficiency and reduce vehicle emissions.

The rapid increase of gasoline prices in 2004-2011 should enhance the interest in the
issue discussed. The costs shown for each gallon of gasoline saved look much better
in 2011 than in 2002 when the article was written; in 2002 the price of gas averaged
$1.30, about 30% of the 2011 price. The cost justification for higher fuel efficiency of
the full hybrid would not pass in 2002 (cost of $1.80 per gallon when the price of gas
was $1.30), but would surely pass the test in summer 2011, with the price of gas just
short of $4.00 per gallon.

The main point of this exercise is to have the students understand that the
determination of an average cost, as in this report, requires a specification of the level of
activity, or output, that drives costs. This is the reason the concept of average cost is
often misunderstood and misused in practice.

For example, since in this case total cost per gallon of gas depends on both variable
costs (gasoline) and fixed costs (vehicle cost), the determination of an average cost
requires an assumption of activity level. While variable costs (the price of gasoline) are
constant per unit, for the number of gallons purchased, the average per-gallon fixed
cost of purchasing the vehicle will depend on the number of miles traveled. Car owners
who travel relatively few miles will have large average fixed costs in contrast to “road
warriors” with many miles traveled.

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The Business Week report does a good job in this regard by reporting that the assumed
activity was 12,000 miles per year for 12 years. This gives the reader a way to interpret
the findings; those who drive more than this amount can expect lower “cost for each
gallon of gas saved” from improvements in the vehicle, while those who drive fewer
miles can expect higher costs than those reported.

Instructors can start this exercise by asking the class how average cost is determined in
this case. The key idea to bring out is that average fixed cost is determined by some
pre-determined activity level.

CAFE Standards link:

http://www.nhtsa.gov/fuel-economy

3-47 Interpreting Average Cost (15 min)

This question is based upon the following: Vincent Ryan, “Treasury: Bigger is Better,”
CFO.com, November 9, 2010; “How Does Your Finance Department Measure Up?
“Journal of Accountancy, January 1997, pp50-51.

The main point of this exercise, as for 3-46 above, is to help the student understand the
importance of taking activity levels into account when interpreting average cost
information.

The two articles show, as represented by the information presented in the exercise, that
average fixed costs decline with higher levels of activity. Larger companies, with higher
levels of transaction volume, will have higher total fixed costs, but average fixed costs
should be lower due to economies of scale. Looked at another way, if a given firm
were to grow, and its volume of transactions grew as well, then average fixed costs (or
in this case the ratio of total accounting costs to total revenue) would have to fall.
Average fixed cost would continue to fall with increasing numbers of transactions, until
the firm felt it necessary to increase capacity in the accounting department, thereby
increasing fixed costs.

Thus, the data presented is as we would expect–larger firms will have lower average
costs. We would not expect otherwise. Average fixed costs should be lower for the
larger firms.

The requirement also asks for possible questions to present to the researchers. The
questions will vary based on the background of the students.

3-48 Average Cost (15 min)

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The percentage increase in total variable manufacturing cost, averaging both labor and
fuel costs, is 7.5% for Company A and 6% for Company B. The increase is higher for
Company A because it has a higher percent of fuel costs, which have risen faster than
labor costs.

Calculations:
7.5% = (.5 × 5%) + (.5 × 10%)
6% = (.8 × 5%) + (.2 × 10%)

The calculations for percentage change shown above hold irrespective of the underlying
amounts, as long as the amounts are positive. The example below illustrates:

Variable Original Amounts After Increase

Cost A B Increase A B
Labor $ 40 $ 120 5% $ 42 $ 126
Fuel 40 30 10% 44 33
$ 80 $ 150 $ 86 $ 159

Percentage Increase in total variable cost 7.5% 6%

This example illustrates that two companies that may have the same total variable
costs, and facing the same changes in materials or labor costs, will be affected
differently if the mix of variable costs is not the same for the two companies.

This example is sometimes called the “fallacy of averages.” The take-away is that
averages should be interpreted carefully, and in particular, the management accountant
should always consider the components of cost which make up that average, as in the
example above.

Here is another example. The recession in the early 1980s caused an increase in
unemployment for workers at all educational levels. Also, in the great recession during
2009, the unemployment rates were higher for all educational levels than in 1983.
However, the overall unemployment rate in 2009 (10.2%) was lower than the overall
unemployment rate in 1983(10.8%). Why? The reason for this apparently confusing
result is that the group with the highest educational attainment and lowest
unemployment rates in both recessions was a larger percentage of the total employed
in 2009 relative to 1983. Since more 2009 workers were in the highly-educated group
than in 1983, and this group’s unemployment rate was lower (in both periods), the effect
was to bring down the overall unemployment rate in 2009 relative to 1983.

Source: Carl Bialik, “When Combined Data Reveal the Flaw of Averages,” The Wall
Street Journal, December 9, 2009, p. A21.

3-49 Classification of Costs; Customer Profitability (15 min)

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 1.
Direct (D) or
Indirect(I)
1. Staff salaries I
2. Rent on office and work space used I
by the company
3. Licenses and fees I
4. Supplies; grooming supplies, and D
related items
5. Medications D
6. Legal fees I
7. Accounting services provided part- I
time by practicing accountant
8. Pet food D
9. Utilities for office and work space; I
electricity and water
10. Fire insurance for office and work I
space and its contents
11. Liability insurance for the company I
business

2. Pet Partner could use the information to identify costs that are traceable to each
customer (the direct costs) and determine over a period of a month (or year)
whether the direct costs traced to the customer are less than or greater than the
revenues from the customer, that is, to determine if the customer is profitable. A
much more thorough means of determining customer profitability analysis is
covered in Chapter 5, together with activity-based costing.

3-50 Classification of Costs (15 min)

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Parts 1 and 2
Fixed(F) or Product (P) or
Variable (V) Period (PD)
1. Food costs including pizza V P
dough, olive oil, tomato sauce,
etc.
2. Salaries for drivers N* PD
3. Salaries for telephone N* PD
operators
4. Salaries for cooks N* P
5. Insurance for drivers F PD
6. Utilities; water and electricity V P/PD (allocated to kitchen
and other space)
7. Advertising F PD
8. Discount coupons V PD
9. Food handling licenses, F P
inspections, and fees
10. Accounting and payroll F PD
services
11. Cooking supplies V P
12. Cleaning supplies V P/PD (allocated to kitchen
and other space)
13. Mortgage payments F PD
14. Insurance on facilities F PD

*Note for Class Discussion: these costs are fixed unless Papa’s manager schedules
employees (drivers, operators, and cooks) based on estimated demand so as to
eliminate slack time. In which case the cost of the drivers, operators, and cooks could
be considered variable costs.

3. There are a number of possible answers. Inefficiency and waste in the use of
utilities or food products could be considered an environmental issue. Also,
cleaning supplies should be environmentally-friendly and/or disposed of properly.

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 3-51 Classification of Costs (15 Min)

Parts 1 and 2
Fixed(F) or Product (P)
Variable (V) Period (PD)
1.Technicians F P
2.Parts V P
3.Purchase of oil and tires V P
4.Supplies V P
5.Tools F P
6.Rental of each location F PD
7.Advertising F PD
8. Utilities F PD
9.Licenses and fees F PD
10.Employee training* F P
11.Security service F PD
12. Software for sales and reports F PD
13. Disposal of waste oil and used V P
tires
Employee training is considered a product cost because it is related to direct labor of
the technicians.
Used oil and old tires need to be disposed of as part of the job of changing oil or tires.

3. The disposal of waste oil and used tires is the critical environmental issue for
Speedy Auto Service. Both the waste oil and used tires, which would
accumulate in significant quantities for this type of business, should be disposed
of in an environmentally appropriate manner.

PROBLEMS

3-52 Executional Cost Drivers: Internet Retailer (20 min)

The example of an internet retailer such as Bikes.com is a good example of the

type of firm that must pay close attention to executional cost drivers. The reason
is that its success depends on customer service–prompt response to customer
requests and prompt and accurate filling of customer orders. Customer loyalty is
a key success factor for a firm such as this, and loyalty comes from superior
customer service in all its dimensions. Amazon introduced the successful
internet retailing business model and has built a successful business on the basis
of customer loyalty. This is the approach Bikes.com needs to follow–and this

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Education.
 means execution, execution, execution. The falloff in sales growth could be an
indication of problems in customer satisfaction and loyalty. Bikes.com can
review sales records to investigate.

Specific executional steps that Bikes.com can take include looking for possible
improvements in the purchase and stocking of merchandise and the shipping of
customer orders–the upstream and downstream activities that must work
smoothly to get the orders to the customers quickly and accurately. Also,
Bikes.com should consider the work flow in the company. Can it be streamlined?
Are there non-value-adding activities that can be eliminated? What are the
bottlenecks, if any, that slow the process of accurately filling a customer’s order?
Also, are employees aware of the importance of executional issues? Are the
employees working together to achieve the required speed and accuracy
necessary for the firm’s success?

Executional cost drivers are important to Bikes.com in two ways. First, these are
the executional issues which the firm must achieve in a superior way in order to
compete effectively in internet retailing. And second, effective attention to the
cost drivers and effective cost management can lower the costs of operation and
improve profits.

3-53 Structural Cost Drivers (25 min)

Case A: A key structural issue for Food Fare is complexity. As the menu has
changed, so will costs and service. More complexity means higher food
purchasing costs, higher operating costs, and more complex operations. This
will require new types of training for employees and perhaps additional
employees. Moreover, it will be a challenge for Food Fare to continue to provide
the speed of service that was possible with the shorter menu. The change will
require careful attention to operations and to cost management issues for the
firm to continue to be profitable. Employee training and new uses of technology
to streamline the process of order-taking and order-filling are likely to be
necessary. Scale might also be an important issue in this case–how large must
each restaurant become, and how many restaurants must the chain have in
order to justify the increased purchasing and stocking costs and the new training
and technology costs?

Case B: A key issue in this case is the speed with which Gilman can provide
customer service. The speed of service provides value to the customer and
increases profitability, and technology is likely the key to speed. To increase the
speed of service, Gilman needs effective communication and coordination
among the service teams. This is probably being accomplished now by cell
phone. Gilman can research new and more effective ways to accomplish this,
perhaps using hand-held internet access devices, iPhone, or other modem-
equipped devices. The advantage of computer-based access is that computer-
based tools can be used in the scheduling and assignment of the service teams.
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Education.
 Additionally, the computer can be used by each service team to quickly
determine the availability of parts in the firm’s warehouse or in other service
vehicles, thereby allowing faster service time. Also, the computer can be used to
develop real-time analyses of customer demand and profitability–to better
understand which services and which types of customers are most profitable. Is
it in installation or service, Brand X or Brand Y, residential or commercial, etc.?

Scale is also an important cost driver for Gilman. To serve the large area it now
serves, there should be a careful strategic analysis to get the right balance
between order-getting costs (advertising and promotion to obtain new customers)
plus the costs of maintaining the truck fleet and service teams versus the
opportunity to provide additional services to existing customers.

Given the nature of the products, the experience levels of the service staff are
also likely to have an impact on execution.

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3-54 Cost of Goods Manufactured and Sold (30 min)

Cornelius Company
Statement of Cost of Goods Manufactured
for the Year Ended December 31

Direct Materials
Beginning Materials Inventory $ 25,000
Materials Purchases 555,000
Materials Available 580,000
Ending Materials Inventory 40,000
Materials Used $ 540,000
Direct Labor-Wages 300,000
Factory Overhead
Factory Rent $ 380,000
Utilities for Factory 38,000
Indirect Materials 66,000
Indirect Labor 60,000
Total Factory Overhead 544,000
Total Manufacturing Costs 1,384,000
Beginning Work-in-Process Inventory 45,000
Total Manufacturing Costs 1,429,000
Ending Work-in-Process Inventory 40,000
Cost of Goods Manufactured $ 1,389,000

2. Calculate cost of goods sold.

Beginning Finished Goods Inventory $ 135,000

Plus: Cost of goods manufactured 1,389,000
Less: Ending Finished Goods Inventory 75,000
Cost of goods sold 1,449,000

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Education.
3-55 Cost of Goods Manufactured; Income Statement (30 min)

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Education.
3-56 Cost of Goods Manufactured; Income Statement (30 min)

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Education.
 Huntersville, Inc.
Statement of Cost of Goods Manufactured
For the Year Ended December 31

Direct Materials
Beginning Materials Inventory $ 19,000
Materials Purchases 155,000
Materials Available 174,000
Ending Materials Inventory 26,000
Direct Materials Used $ 148,000
Direct Labor-Wages 487,000
Factory Overhead
Depreciation Expense--Plant & Equip. $ 86,000
Heat, light, & power--Plant 44,000
Indirect Labor--Wages 25,000
Property taxes--Plant 34,000
Supervisor's Salary Plant 66,000
Supplies--Plant 29,000
Total Factory Overhead 284,000
Total Manufacturing Costs 919,000
Beginning Work-in-Process Inventory 23,000
Total Manufacturing Costs 942,000
Ending Work-in-Process Inventory 9,000
Cost of Goods Manufactured $ 933,000

Huntersville, Inc.
Income Statement
For the Year Ended December 31

Sales Revenue $ 1,495,000

Cost of Goods Sold
Beginning Finished Goods Inventory $ 15,000
Cost of Goods Manufactured 933,000
Cost of Goods Available for Sale 948,000
Ending Finished Goods Inventory 38,000

Cost of Goods Sold 910,000

Gross Margin 585,000

Sales Representatives' Salaries $ 145,000
Supplies--Administrative Office 16,000
Depreciation Expense--Admin. Office 32,000
Total Selling & Administrative 193,000

Operating Income $ 392,000 3-57 Cost of

Goods Manufactured; Income Statement (30 min)

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 Fair Wind Yachts
Statement of Cost of Goods Manufactured
For The Year Ended December 31
Direct Materials
Beginning Materials Inventory $ 16,000
Materials Purchases 410,000
Materials Available 426,000
Ending Materials Inventory 18,000
Direct Materials Used $ 408,000
Direct Labor 512,000
Factory Overhead
Insurance on Plant $ 32,000
Supplies--Plant 132,000
Repairs on Plant Building 36,000
Depreciation Expense--Plant and Equip. 320,000
Heat and Light for Plant 22,000
Indirect Labor 269,000
Supervisor's Salary Plant 98,000
Total Factory Overhead 909,000
Total Manufacturing Costs to Account for 1,829,000
Beginning Work-in-Process Inventory 31,000
Total Manufacturing Costs 1,860,000
Ending Work-in-Process Inventory 39,000
Cost of Goods Manufactured $ 1,821,000
Fair Wind Yachts
Income Statement
For the Year Ended December 31,
Sales Revenue $ 2,885,000
Cost of Goods Sold
Beginning Finished Goods Inventory $ 55,000
Cost of Goods Manufactured 1,821,000
Total Goods Available for Sale 1,876,000
Ending Finished Goods Inventory 43,000

Cost of Goods Sold 1,833,000

Gross Margin 1,052,000
Advertising Expenses $ 150,000
Sales Representatives' Salaries 325,000
Supplies--Administrative Office 78,000
Depreciation Expense--Admin. Office 75,000
Depreciation Expense - Delivery Trucks 45,000
Total Selling & Administrative Expenses 673,000
Operating Income $ 379,000

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3-58 Cost of Goods Manufactured; Income Statement (40 min)
Norton Industries
Statement of Cost of Goods Manufactured
For the Month Ended May 31
($000) omitted

Direct Materials
Beginning Materials Inventory $ 28
Materials Purchases 510
Freight-in 15
Materials Available 553
Ending Materials Inventory 23
Direct Materials Used $ 530
Direct Labor-Wages 260
Factory Overhead
Indirect factory labor $ 90
Utilities 108
Property taxes-Plant 60
Insurance 12
Depreciation 50
Total Factory Overhead 320
Total Manufacturing Costs 1,110
Beginning Work-in-Process Inventory 150
Total Manufacturing Costs 1,260
Ending Work-in-Process Inventory 220
Cost of Goods Manufactured $ 1,040

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3-58(continued -1)

Norton Industries
Income Statement
For the Month Ended May 31
($000) omitted

Sales Revenue $ 1,488

Less: Sales Discounts 20
Net Sales 1,468

Cost of Goods Sold:

Beginning Finished Goods Inventory $ 247
Cost of Goods Manufactured 1,040
Cost of Goods Available for Sale 1,287
Ending Finished Goods Inventory 175

Cost of Goods Sold 1,112

Gross Margin $ 356

Selling, General & Administrative Expense:

Office Salaries $ 122
Sales Salaries 42
Insurance 8
Utilities 27
Rent 9
Depreciation 4
Interest 6
Total Selling, General, & Administrative Expense 218
Operating income 138
Other revenue 2
Pre-tax Income $ 140

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