Solutions Guide: Please do not present as your own. I sometimes post solutions that are totally mine, from the book’s solutions manual, or a mix of my work and the books solutions manual. But this is only meant as a solutions guide for you to answer the problem on your own. I recommend doing this with any content you buy online whether from me or from someone else.

Case 3-32

1. Traditional approach: Actual total manufacturing overhead cost incurred (assumed to equal the original estimate)...... $2,000,000 Manufacturing overhead applied (80,000 units × $25 per unit)...... 2,000,000 Overhead underapplied or overapplied...... $ 0

TurboDrives, Inc. Income Statement: Traditional Approach Revenue (75,000 units × $70 per unit)...... $5,250,000 Cost of goods sold: Variable manufacturing (75,000 units × $18 per unit)...... $1,350,000 Manufacturing overhead applied (75,000 units × $25 per unit)...... 1,875,000 3,225,000 Gross margin...... 2,025,000 Selling and administrative expenses...... 1,950,000 Net operating income...... $ 75,000

New approach: TurboDrives, Inc. Income Statement: New Approach Revenue (75,000 units × $70 per unit)...... $5,250,000 Cost of goods sold: Variable manufacturing (75,000 units × $18 per unit)...... $1,350,000 Manufacturing overhead applied (75,000 units × $20 per unit)...... 1,500,000 2,850,000 Gross margin...... 2,400,000 Cost of unused capacity [(100,000 units  80,000 units) × $20 per unit]...... 400,000 Selling and administrative expenses...... 1,950,000 Net operating income...... $ 50,000

2. Traditional approach: Under the traditional approach, the reported net operating income can be increased by increasing the production level, which then results in overapplied overhead that is deducted from Cost of Goods Sold.

Additional net operating income required to attain target net operating income ($210,000 - $75,000) (a)...... $135,000 Overhead applied per unit of output (b)...... $25 per unit Additional output required to attain target net operating income (a) ÷ (b)...... 5,400 units Actual total manufacturing overhead cost incurred...... $2,000,000 Manufacturing overhead applied [(80,000 units + 5,400 units) × $25 per unit]...... 2,135,000 Overhead overapplied...... $ 135,000

TurboDrives, Inc. Income Statement: Traditional Approach Revenue (75,000 units × $70 per unit)...... $5,250,000 Cost of goods sold: Variable manufacturing (75,000 units × $18 per unit)...... $1,350,000 Manufacturing overhead applied (75,000 units × $25 per unit)...... 1,875,000 Less: Manufacturing overhead overapplied...... 135,000 3,090,000 Gross margin...... 2,160,000 Selling and administrative expenses...... 1,950,000 Net operating income...... $ 210,000

Note: If the overapplied manufacturing overhead were prorated between ending inventories and Cost of Goods Sold, more units would have to be produced to attain the target net profit of $210,000.

New approach: Under the new approach, the reported net operating income can be increased by increasing the production level which then results in less of a deduction on the income statement for the Cost of Unused Capacity.

Additional net operating income required to attain target net operating income ($210,000 - $50,000) (a)...... $160,000 Overhead applied per unit of output (b)...... $20 per unit Additional output required to attain target net operating income (a) ÷ (b)...... 8,000 units Estimated number of units produced...... 80,000 units Actual number of units to be produced...... 88,000 units

TurboDrives, Inc. Income Statement: New Approach Revenue (75,000 units × $70 per unit)...... $5,250,000 Cost of goods sold: Variable manufacturing (75,000 units × $18 per unit)...... $1,350,000 Manufacturing overhead applied (75,000 units × $20 per unit)...... 1,500,000 2,850,000 Gross margin...... 2,400,000 Cost of unused capacity [(100,000 units - 88,000 units) × $20 per unit]...... 240,000 Selling and administrative expenses...... 1,950,000 Net operating income...... $ 210,000

3. Net operating income is more volatile under the new method than under the old method. The reason for this is that the reported profit per unit sold is higher under the new method by $5, the difference in the predetermined overhead rates. As a consequence, swings in sales in either direction will have a more dramatic impact on reported profits under the new method. 4. As the computations in part (2) above show, the “hat trick” is a bit harder to perform under the new method. Under the old method, the target net operating income can be attained by producing an additional 5,400 units. Under the new method, the production would have to be increased by 8,000 units. This is a consequence of the difference in predetermined overhead rates. The drop in sales has had a more dramatic effect on net operating income under the new method as noted above in part (3). In addition, since the predetermined overhead rate is lower under the new method, producing excess inventories has less of an effect per unit on net operating income than under the traditional method and hence more excess production is required.

5. One can argue that whether the “hat trick” is unethical depends on the level of sophistication of the owners of the company and others who read the financial statements. If they understand the effects of excess production on net operating income and are not misled, it can be argued that the hat trick is ethical. However, if that were the case, there does not seem to be any reason to use the hat trick. Why would the owners want to tie up working capital in inventories just to artificially attain a target net operating income for the period? And increasing the rate of production toward the end of the year is likely to increase overhead costs due to overtime and other costs. Building up inventories all at once is very likely to be much more expensive than increasing the rate of production uniformly throughout the year. In the case, we assumed that there would not be an increase in overhead costs due to the additional production, but that is likely not to be true. In our opinion the hat trick is unethical unless there is a good reason for increasing production other than to artificially boost the current period’s net operating income. It is certainly unethical if the purpose is to fool users of financial reports such as owners and creditors or if the purpose is to meet targets so that bonuses will be paid to top managers.

CASE 5-27

Note to the instructor: This case requires the ability to build on concepts that are introduced only briefly in the text. To some degree, this case anticipates issues that will be covered in more depth in later chapters. 1. In order to estimate the contribution to profit of the charity event, it is first necessary to estimate the variable costs of catering the event. The costs of food and beverages and labor are all apparently variable with respect to the number of guests. However, the situation with respect overhead expenses is less clear. A good first step is to plot the labor hour and overhead expense data in a scattergraph as shown below. $60,000

$50,000 e s

n $40,000 e p x E

d a

e $30,000 h r e v O $20,000

$10,000

$0 0 1,000 2,000 3,000 4,000 5,000 Labor Hours

This scattergraph reveals several interesting points about the behavior of overhead costs: • The relation between overhead expense and labor hours is approximated reasonably well by a straight line. (However, there appears to be a slight downward bend in the plot as the labor hours increase—evidence of increasing returns to scale. This is a common occurrence in practice. See Noreen & Soderstrom, “Are overhead costs strictly proportional to activity?” Journal of Accounting and Economics, vol. 17, 1994, pp. 255-278.) • The data points are all fairly close to the straight line. This indicates that most of the variation in overhead expenses is explained by labor hours. As a consequence, there probably wouldn’t be much benefit to investigating other possible cost drivers for the overhead expenses. • Most of the overhead expense appears to be fixed. Jasmine should ask herself if this is reasonable. Does the company have large fixed expenses such as rent, depreciation, and salaries? The overhead expenses can be decomposed into fixed and variable elements using the high-low method, least-squares regression method, or even the quick-and-dirty method based on the scattergraph. • The high-low method throws away most of the data and bases the estimates of variable and fixed costs on data for only two months. For that reason, it is a decidedly inferior method in this situation. Nevertheless, if the high-low method were used, the estimates would be computed as follows: Labor Overhead Hours Expense High level of activity...... 4,500 $61,600 Low level of activity...... 1,500 44,000 Change...... 3,000 $17,600

Change in cost Variable cost = Change in activity

$17,600 = = $5.87 per labor hour 3,000 labor hours Fixed cost element = Total cost - Variable cost element = $61,600 - ($5.87 × 4,500) = $35,185

• In contrast, the least-squares regression method yields estimates of $5.27 per labor hour for the variable cost and $38,501 per month for the fixed cost using statistical software. (The adjusted R2 is 96%.) To obtain these estimates, use a statistical software package or a spreadsheet application such as Excel.

Using the least-squares regression estimates of the variable overhead cost, the total variable cost per guest is computed as follows: Food and beverages...... $17.00 Labor (0.5 hour @ $10 per hour)...... 5.00 Overhead (0.5 hour @ $5.27 per hour)...... 2.64 Total variable cost per guest...... $24.64 The total contribution from 120 guests paying $45 each is computed as follows: Revenue (120 guests @ $45.00 per guest)...... $5,400.00 Variable cost (120 guests @ $24.64 per guest)...... 2,956.80 Contribution to profit...... $2,443.20 Fixed costs are not included in the above computation because there is no indication that any additional fixed costs would be incurred as a consequence of catering the cocktail party. If additional fixed costs were incurred, they should also be subtracted from revenue.

2. Assuming that no additional fixed costs are incurred as a result of catering the charity event, any price greater than the variable cost per guest of $24.64 would contribute to profits.

3. We would favor bidding slightly less than $42 to get the contract. Any bid above $24.64 would contribute to profits and a bid at the normal price of $45 is unlikely to land the contract. And apart from the contribution to profit, catering the event would show off the company’s capabilities to potential clients. The danger is that a price that is lower than the normal bid of $45 might set a precedent for the future or it might initiate a price war among caterers. However, the price need not be publicized and the lower price could be justified to future clients because this is a charity event. Another possibility would be for Jasmine to maintain her normal price but throw in additional services at no cost to the customer. Whether to compete on price or service is a delicate issue that Jasmine will have to decide after getting to know the personality and preferences of the customer.

Case 6-32

1. The contribution format income statements (in thousands of dollars) for the three alternatives are: 18% Commission 20% Commission Sales...... $30,000 100% $30,000 100% Variable expenses: Variable cost of goods sold...... 17,400 17,400 Commissions...... 5,400 6,000 Total variable expense...... 22,800 76% 23,400 78% Contribution margin...... 7,200 24% 6,600 22% Fixed expenses: Fixed cost of goods sold...... 2,800 2,800 Fixed advertising expense...... 800 800 Fixed marketing staff expense...... Fixed administrative expense...... 3,200 3,200 Total fixed expenses...... 6,800 6,800 Net operating income...... $ 400 ( $ 200) * $800,000 + $500,000 = $1,300,000 ** $700,000 + $400,000 + $200,000 = $1,300,000 2. Given the data above, the break-even points can be determined using total fixed expenses and the CM ratios as follows:

a. Fixed expenses $6,800,000 = = $28,333,333 CM ratio 0.24

b. Fixed expenses $6,800,000 = = $30,909,091 CM ratio 0.22

c. Fixed expenses $8,600,000 = = $26,875,000 CM ratio 0.32

3. Fixed expenses + Target profit Dollar sales to attain= target profit CM ratio $8,600,000 - $200,000 = 0.32 = $26,250,000

4. X = Total sales revenue

Net operating income = 0.32X - $8,600,000 with company sales force

Net operating income = 0.22X - $6,800,000 with the 20% commissions

The two net operating incomes are equal when: 0.32X – $8,600,000 = 0.22X – $6,800,000 0.10X = $1,800,000 X = $1,800,000 ÷ 0.10 X = $18,000,000 Thus, at a sales level of $18,000,000 either plan will yield the same net operating income. This is verified below (in thousands of dollars): 20% Commission Own Sales Force Sales...... $ 18,000 100% $ 18,000 100% Total variable expense...... 14,040 78% 12,240 68% Contribution margin...... 3,960 22% 5,760 32% Total fixed expenses...... 6,800 8,600 Net operating income...... $ (2,840) $ (2,840)

5. A graph showing both alternatives appears below:

$6,000

$4,000

$2,000

$0 $0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000 -$2,000

-$4,000 Hire Own Sales Force Use Sales Agents -$6,000

-$8,000

-$10,000 Sales 6. To:President of Marston Corporation Fm: Student’s name Assuming that a competent sales force can be quickly hired and trained and the new sales force is as effective as the sales agents, this is the better alternative. Using the data provided by the controller, net operating income is higher when the company has its own sales force unless sales fall below $18,000,000. At that level of sales and below the company would be losing money so it is unlikely that this would be the normal situation. The major concern I have with this recommendation is the assumption that the new sales force will be as effective as the sales agents. The sales agents have been selling our product for a number of years, so they are likely to have more field experience than any sales force we hire. And, our own sales force would be selling just our product instead of a variety of products. On the one hand, that will result in a more focused selling effort. On the other hand, that may make it more difficult for a salesperson to get the attention of a hospital’s purchasing agent. The purchasing agents may prefer to deal through a small number of salespersons each of whom sells many products rather than a large number of salespersons each of whom sells only a single product. Even so, we can afford some decrease in sales because of the lower cost of maintaining our own sales force. For example, assuming that the sales agents make the budgeted sales of $30,000,000, we would have a net operating loss of $200,000 for the year. We would do better than this with our own sales force as long as sales are greater than $26,250,000. In other words, we could afford a fall-off in sales of $3,750,000 or 12.5% and still be better off with our own sales force. If we are confident that our own sales force could do at least this well relative to the sales agents, then we should certainly switch to using our own sales force.