Solman Man Acct

MANAGEMENT ACCOUNTING - Solutions Manual
TABLE OF CONTENTS
Chapter 1 1-1 1-19

MANAGEMENT ACCOUNTING: AN OVERVIEW
2 Management Accounting and the Business Environment 2-1 2-5
3 Understanding of Financial Statements 3-1 3-10
4 Financial Statements Analysis I 4-1 4-9

5 Financial Statements Analysis II 5-1 5-38
6 Cash Flow Analysis 6-1 6-18
7 Gross Profit Valuation Analysis and Earnings Per Share
Determination 7-1 7-7
8 Cost Concepts and Classifications 8-1 8-17
9 Cost Behavior: Analysis and Use 9-1 9-30
10 Systems Design: Job-Order Costing and Process Costing 10-1 10-16
11 Systems Design: Activity-Based Costing and Management 11-1 11-15
12 Variable Costing 12-1 12-21
13 Cost-Volume-Profit Relationships 13-1 13-37
14 Responsibility Accounting and Transfer Pricing 14-1 14-26

15 Functional and Activity-Based Budgeting 15-1 15-22
16 Standard Costs and Operating Performance Measures 16-1 16-17
17 Application of Quantitative Techniques in Planning, Control and
Decision Making - I 17-1 17-2
18 Application of Quantitative Techniques in Planning, Control and
Decision Making II 18-1 18-7
19 Relevant Costs for Decision Making 19-1 19-33
20 Capital Budgeting Decisions 20-1 20-16
21 Decentralized Operations and Segment Reporting 21-1 21-4
22 Business Planning 22-1 22-6
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Chapter 1 Management Accounting: An Overview
23 Strategic Cost Management; Balanced Scorecard 23-1 23-4

24 Advanced Analysis and Appraisal of Performance: Financial
and Nonfinancial 24-1 24-12
25 Managing Productivity and Marketing Effectiveness 25-1 25-19
26 Executive Performance Measures and Compensation 26-1 26-3
27 Managing Accounting in a Changing Environment 27-1 27-22
CHAPTER 1
MANAGEMENT ACCOUNTING: AN OVERVIEW
I. Questions
1. Use of the word need in the quoted passage is pejorative. It implies an

unlimited level of demand for information. However, rational managers
apply a cost-benefit criterion to information and will only want
accounting information if its benefits exceed its costs. Accounting
information provides benefits by improving decision making and
controlling behavior in organizations. In most organizations, accounting
information is very prevalent which implies that its benefits exceed its
costs. Hence, successful managers will find it in their self-interest to
learn how to use accounting information in these organizations.
Clearly, this statement is incurred in those firms where accounting
information has very limited usefulness (e.g., if the accounting
information is often wrong or is not produced in a timely fashion). In
these organizations, managers do not find the accounting information to
have benefits in excess of its costs, will not use it, do not need to know
how to use it, and definitely do not need it.
2. a. Historical costs are of limited use in making planning decisions in a

rapidly changing environment. With changing products, processes
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Management Accounting: An Overview Chapter 1
and prices, the historical costs are inadequate approximations of the

opportunity costs of using resources.
Historical costs may, however, be useful for control purposes, as
they provide information about the activities of managers and can be
used as performance measures to evaluate managers.
b. The purpose of accounting systems is to provide information for
planning purposes and control. Although historical costs are not
generally appropriate for planning purposes, additional measures are
costly to make. An accounting system should include additional
measures if the benefits of improved decision making are greater
than the costs of the additional information.
3. Finance and economics textbooks traditionally state that the goal of a
profit organization is to maximize shareholder wealth. Managers are
frequently presumed to act in the best interest of the shareholder,
although recent finance literature recognizes that appropriate incentives
are necessary to align manager interests with shareholder interests. The
goal, however, are not very clear as to how this is achieved. Most
finance textbooks focus on financing decisions and not on the use of
assets and dealing with customers.
Marketings goal of satisfying customers recognizes that customers are
the source of revenues for the organization, and therefore the means
through which shareholder value is increased. However, customer
satisfaction is only valuable insofar as it creates shareholder wealth. The
further goal of marketing is to ensure that customer satisfaction is
maximized without compromising the organizations profitability.
4. Yes. Planning is really much more vital than control; that is, superior
control is fruitless if faulty plans are being implemented. However,
planning and control are so intertwined that it seems artificial to draw
rigid lines of separation between them.
5. Yes. The controller has line authority over the personnel in his own
department but is a staff executive with respect to the other departments.
6. Line authority is exerted downward over subordinates. Staff authority is

the authority to advise but not command others; it is exercised laterally
or upward. Functional authority is the right to command action laterally
and downward with regard to a specific function or specialty.
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7. Cost accounting is the controllers primary means of implementing the

7-point concept of modern controllership. Cost accounting is
intertwined with all seven duties to some extent, but its major focus is on
the first three.
8. Bettina Company
President
VP, Production VP, Finance VP, Sales
Controller Treasurer
Assistant Assistant
Controller Treasurer
Special Cost Tax Internal General System &

Studies Accounting Manager Audit Accounting EDP
Manager Manager Manager Manager Manager
Cost Budget & Performance

Systems Standard Analyst
Analyst Cost Analyst
Cost Payroll Accounts Accounts Billing General

Clerk Clerk Receivable Payable Clerk Ledger
Clerk Clerk Bookkeeper
9. Management accountants contribute to strategic decisions by providing

information about the sources of competitive advantage and by helping
managers identify and build a companys resources and capabilities.
10. In most organizations, management accountants perform multiple roles:

problem solving (comparative analyses for decision making),
scorekeeping (accumulating data and reporting reliable results), and
attention directing (helping managers properly focus their attention).
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11. Three guidelines that help management accountants increase their value
to managers are (a) employ a cost-benefit approach, (b) recognize
behavioral as well as technical considerations, and (c) identify different
costs for different purposes.
12. Management accounting is an integral part of the controllers function in

an organization. In most organizations, the controller reports to the chief
financial officer, who is a key member of the top management team.
13. Management accountants have ethical responsibilities that are related to

competence, confidentiality, integrity, and objectivity.
14. By reporting and interpreting relevant data, the controller exerts a force
or influence that impels management toward making better-informed
decisions.
The controller of one company described the job as a business advisor

tohelp the team develop strategy and focus the team all the way
through recommendations and implementation.
15.
Financial Accounting
Audience: External: shareholders, creditors, tax
authorities
Purpose: Report on past performance to external
parties; basis of contracts with owners and
lenders
Timeliness: Delayed; historical
Restrictions: Regulated; rules driven by generally accepted
accounting principles and government
authorities
Type of Information: Financial measurements only
Nature of Information: Objective, auditable, reliable, consistent,
precise
Scope: Highly aggregate; report on entire
organization
Managerial Accounting
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Audience: Internal: Workers, managers, executives

Purpose: Inform internal decisions made by employees
and managers; feedback and control on
operating performance
Timeliness: Current, future oriented
Restrictions: No regulations; systems and information
determined by management to meet strategic
and operational needs
Type of Information: Financial, plus operational and physical
measurements on processes, technologies,
suppliers customers, and competitors
Nature of Information: More subjective and judgmental; valid,
relevant, accurate
Scope: Disaggregate; inform local decisions and
actions
16. The competitive environment has changed dramatically. Companies

encountered severe competition from overseas companies that offered
high-quality products at low prices. Activity-based costing systems are
introduced in many manufacturing and service organizations to
overcome the inability of traditional cost systems to accurately assign
overhead costs. Activity-based management is a viable approach for
managers to make decisions based on ABC information. There has been
improvement of operational control systems such that information is
more current and provided more frequently. The nature of work has
changed from controlling to informing. Firms are concerned about
continuous improvement, employee empowerment and total quality.
Nonfinancial information has become a critical feedback measure.
Finally, the focus of many firms is on measuring and managing
activities.
17. As measurements are made on operations and, especially, on individuals

and groups, the behavior of the individuals and groups are affected.
People will react to the measurements being made by focusing on the
variables or behavior being measured. In addition, if managers attempt
to introduce or redesign cost and performance measurement systems,
people familiar with the previous system will resist. Management
accountants must understand and anticipate the reactions of individuals
to information and measurements. The design and introduction of new
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measurements and systems must be accompanied with an analysis of the

likely reactions to the innovations.
II. Exercises
Exercise 1
a. (1) Problem solving

b. (3) Attention-directing
c. (1) Problem solving
d. (2) Scorekeeping
Exercise 2
a. (4) Marketing
b. (3) Production
c. (6) Customer service
d. (5) Distribution
Exercise 3
a. (4) Marketing
b. (3) Production
c. (5) Distribution
d. (4) Marketing
e. (5) Distribution
f. (3) Production
g. (1) Research and development
h. (2) Design
III. Problems
Problem 1 (Problem Solving, Scorekeeping, and Attention Directing)
Because the accountants duties are often not sharply defined, some of these
answers might be challenged:
1. Scorekeeping
2. Attention directing
3. Scorekeeping
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4. Problem solving
7. Problem solving
8. Scorekeeping (depending on the extent of the report) or attention
getting
9. This question is intentionally vague. The give-and-take of the
budgetary process usually encompasses all three functions, but it
emphasizes scorekeeping the least. The main function is attention
directing, but problem solving is also involved.
10. Problem solving
Problem 2 (Management Accounting Information System)
1. Inputs: b, g, i, m
2. Processes: a, d, f, j
3. Outputs: e, k, n
4. System objectives: c, h, l
Problem 3 (Role of Management Accountants)
Planning. The management accountant gains an understanding of the impact

on the organization of planned transactions (i.e., analyzing strengths and
weaknesses) and economic events, both strategic and tactical, and sets
obtainable goals for the organization. The development of budgets is an
example of planning.
Controlling. The management accountant ensures the integrity of financial

information, monitors performance against budgets and goals, and provides
information internally for decision making. Comparing actual performance
against budgeted performance and taking corrective action where necessary
is an example of controlling. Internal auditing is another example.
Evaluating Performance. The management accountant judges and analyzes

the implication of various past and expected events, and then chooses the
optimum course of action. The management accountant also translates data
and communicates the conclusions. Graphical analysis (such as trend, bar
charts, or regression) and reports comparing actual costs with budgeted costs
are examples of evaluating performance.
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Ensuring Accountability of Resources. The management accountant

implements a reporting system closely aligned to organizational goals that
contribute to the measurement of the effective use of resources and
safeguarding of assets. Internal reporting such as comparison of actual to
budget is an example of accountability.
External Reporting. The management accountant prepares reports in

accordance with generally accepted accounting principles and then
disseminates this information to shareholders, creditors, and regulatory tax
agencies. An annual report or a credit application are examples of external
reporting.
Problem 4 (Line Versus Staff)
Jamie Reyes is staff. She is in a support role she prepares reports and
helps explain and interpret them. Her role is to help the line managers more
effectively carry out their responsibilities.
Stephen Santos is a line manager. He has direct responsibility for producing

a garden hose. Clearly, one of the basic objectives for the existence of a
manufacturing firm is to make a product. Thus, Stephen has direct
responsibility for a basic objective and therefore holds a line position.
Problem 5 (Professional Ethics and End-of-Year Games)
Requirement 1
The possible motivations for the snack foods division wanting to play end-
of-year games include:
(a) Management incentives. Yummy Foods may have a division bonus
scheme based on one-year reported division earnings. Efforts to front-
end revenue into the current year or transfer costs into the next year can
increase this bonus.
(b) Promotion opportunities and job security. Top management of Yummy
Foods likely will view those division managers that deliver high reported
earnings growth rates as being the best prospects for promotion.
Division managers who deliver unwelcome surprises may be viewed
as less capable.
(c) Retain division autonomy. If top management of Yummy Foods adopts
a management by exception approach, divisions that report sharp
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reductions in their earnings growth rates may attract a sizable increase in

top management supervision.
Requirement 2
The Standards of Ethical Conduct require management accountants to:
Refrain from either actively or passively subverting the attainment of
the organizations legitimate and ethical objectives, and
Communicate unfavorable as well as favorable information and
professional judgment or opinions.
Several of the end-of-year games clearly are in conflict with these

requirements and should be viewed as unacceptable by Tan:
(a) The fiscal year-end should be closed on midnight of December 31.
Extending the close falsely reports next years sales as this years
sales.
(b) Altering shipping dates is falsification of the accounting reports.
(c) Advertisements run in December should be charged to the current year.
The advertising agency is facilitating falsification of the accounting
records.
The other end-of-year games occur in many organizations and may fall
into the gray to acceptable area. However, much depends on the
circumstances surrounding each one:
(a) If the independent contractor does not do maintenance work in
December, there is no transaction regarding maintenance to record. The
responsibility for ensuring that packaging equipment is well maintained
is that of the plant manager. The division controller probably can do
little more than observe the absence of a December maintenance charge.
(d) In many organizations, sales are heavily concentrated in the final weeks
of the fiscal year-end. If the double bonus is approved by the division
marketing manager, the division controller can do little more than
observe the extra bonus paid in December.
(e) If TV spots are reduced in December, the advertising cost in December
will be reduced. There is no record falsification here.
(g) Much depends on the means of persuading carriers to accept the
merchandise. For example, if an under-the-table payment is involved, it
is clearly unethical. If, however, the carrier receives no extra
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consideration and willingly agrees to accept the assignment, the

transaction appears ethical.
Each of the (a), (d), (e) and (g) end-of-year games may well disadvantage
Yummy Foods in the long run. For example, lack of routine maintenance
may lead to subsequent equipment failure. The divisional controller is well
advised to raise such issues in meetings with the division president.
However, if Yummy Foods has a rigid set of line/staff distinctions, the
division president is the one who bears primary responsibility for justifying
division actions to senior corporate officers.
Requirement 3
If Tan believes that Ryan wants her to engage in unethical behavior, she
should first directly raise her concerns with Ryan. If Ryan is unwilling to
change his request, Tan should discuss her concerns with the Corporate
Controller of Yummy Foods. Tan also may well ask for a transfer from the
snack foods division if she perceives Ryan is unwilling to listen to pressure
brought by the Corporate Controller, CFO, or even President of Yummy
Foods. In the extreme, she may want to resign if the corporate culture of
Yummy Foods is to reward division managers who play end-of-year games
that Tan views as unethical and possibly illegal.
Problem 6
James Torres has come up with a scheme that involves a combination of data
falsification and smoothing! Not only has he made up the revenue numbers,
but also he has had the gall to defer some of them to the next period.
Making up such numbers is clearly illegal. Smoothing, in this example is
also illegal because the numbers are fictitious.
Problem 7
Clearly the vice-president will lose his or her job if you turn him or her in.
Given that this is a major violation of the code of ethics and a violation
patent law, the vice-president could go to jail. Your best course of action is
to check your information and if the vice-president is definitely involved, go
immediately to the VPs superior (who is probably a senior VP or the
company president). The organizations attorneys will take over from there.
Problem 8
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One option is to do nothing and ignore what you saw, however, this may
violate your own code of ethics and your ethical responsibilities under the
organizations code of ethics. Given that you want to do something, it is
probably best to start by talking to employees in your organization whose job
it is to deal with ethical issues. If no such employees exist or are available,
you might start by using a decision model. This model incorporated the
following steps:
1. Determine the Facts What, Who, Where, How
2. Define the Ethical Issue
3. Identify Major Principles, Rule, Values
4. Specify the Alternatives.
5. Compare Values and Alternatives, See if Clear Decision
6. Assess the Consequences.
7. Make Your Decision.
IV. Cases
Case 1 (Financial vs. Managerial Accounting)
Requirement (a)
Other forward looking information desired in addition to the income
statement information are
1. Disclosure of the components of financial performance, i.e., nature
and source of revenues, various activities, transactions, and other
relevant events affecting the company.
2. Nature and function of the components of income and expenses
Requirement (b)
No. GAAP does not allow capitalization of employee training and
advertising costs even if management feels that they increase the value of the
companys brand name. The reasons are uncertainty of the future benefits
that may be derived therefrom and difficulty and reliability of their
measurement.
Requirement (c)
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Detailed information that managers would likely request are analysis of the
significant increases in
1. Sales
2. Cost of sales
3. Payroll
4. Stock and option based compensation
5. Advertising and promotion.
Requirement (d)
Nonmonetary measures:
1. Change in number and profile of customers
2. Share in the market
3. Who, what and how many are the competitors
4. Product lines offered by the entity vs. Product lines of competitors
5. Sales promotion and advertising activities
Requirement (e)
1. Competitors
2. Employees
3. Prospective creditors
Case 2 (You get what you measure!)
Requirement (a)
Increase in sales to new customers to sales
Too much emphasis on this ratio may lead the sales manager to spend more
time developing business with new customers and disregard the needs of
existing customers. It is therefore possible to lose the business of several
key accounts.
Requirement (b)
Decrease in cost of goods sold to sales
This performance measure could create the following problems:
1. Purchasing goods with poor quality at lower cost and selling them
for the same price.
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2. Indiscriminately increasing selling price to widen the profit margin

without regard to competitors current prices.
3. If the entity is manufacturing its own goods, managers could try to
economize on costs, i.e., buying poorer quality of materials,
employing unskilled workers, etc. thereby causing deterioration of
the quality of the finished products.
In all of the above situations, customer patronage could eventually be

adversely affected.
Requirement (c)
Decrease in selling and administrative expense to sales
Cost-cutting is generally advisable for as long as the quality of goods and
services are not compromised. Likewise, certain cost-saving measures could
demotivate sales people and other employees and could lead to counter-
productive activities.
Case 3 (The Roles of Managers and Management Accountants)
1. Managerial accounting, Financial accounting

2. Planning
3. Directing and motivating
4. Feedback
5. Decentralization
6. Line
7. Staff
8. Controller
9. Budgets
10. Performance report
11. Chief Financial Officer
12. Precision; Nonmonetary data
Case 4 (Ethics in Business)
If cashiers routinely short-changed customers whenever the opportunity

presented itself, most of us would be careful to count our change before
leaving the counter. Imagine what effect this would have on the line at your
favorite fast-food restaurant. How would you like to wait in line while each
and every customer laboriously counts out his or her change? Additionally,
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if you cant trust the cashiers to give honest change, can you trust the cooks
to take the time to follow health precautions such as washing their hands? If
you cant trust anyone at the restaurant would you even want to eat out?
Generally, when we buy goods and services in the free market, we assume
we are buying from people who have a certain level of ethical standards. If
we could not trust people to maintain those standards, we would be reluctant
to buy. The net result of widespread dishonesty would be a shrunken
economy with a lower growth rate and fewer goods and services for sale at a
lower overall level of quality.
Case 5 (Ethics and the Manager)
Requirement 1
Failure to report the obsolete nature of the inventory would violate the
Standards of Ethical Conduct as follows:
Competence
Perform duties in accordance with relevant technical standards.
Prepare complete reports using reliable information.
By failing to write down the value of the obsolete inventory, Perez would not
be preparing a complete report using reliable information. In addition,
generally accepted accounting principles (GAAP) require the write-down of
obsolete inventory.
Integrity
Avoid conflicts of interest.
Refrain from activities that prejudice the ability to perform duties
ethically.
Refrain from subverting the legitimate goals of the organization.
Refrain from discrediting the profession.
Members of the management team, of which Perez is a part, are responsible
for both operations and recording the results of operations. Since the team
will benefit from a bonus, increasing earnings by ignoring the obsolete
inventory is clearly a conflict of interest. Perez would also be concealing
unfavorable information and subverting the goals of the organization.
Furthermore, such behavior is a discredit to the profession.
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hObjectivity
Communicate information fairly and objectively.
Disclose all relevant information.
Hiding the obsolete inventory impairs the objectivity and relevance of
financial statements.
Requirement 2
As discussed above, the ethical course of action would be for Perez to insist
on writing down the obsolete inventory. This would not, however, be an
easy thing to do. Apart from adversely affecting her own compensation, the
ethical action may anger her colleagues and make her very unpopular.
Taking the ethical action would require considerable courage and self-
assurance.
Case 6 (Preparing an Organization Chart)
Requirement 1
See the organization chart on page 17.
Requirement 2
Line positions would include the university president, academic vice-
president, the deans of the four colleges, and the dean of the law school. In
addition, the department heads (as well as the faculty) would be in line
positions. The reason is that their positions are directly related to the basic
purpose of the university, which is education. (Line positions are shaded on
the organization chart.)
All other positions on the organization chart are staff positions. The reason
is that these positions are indirectly related to the educational process, and
exist only to provide service or support to the line positions.
Requirement 3
All positions would have need for accounting information of some type. For
example, the manager of central purchasing would need to know the level of
current inventories and budgeted allowances in various areas before doing
any purchasing; the vice president for admissions and records would need to
know the status of scholarship funds as students are admitted to the
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university; the dean of the business college would need to know his/her
budget allowances in various areas, as well as information on cost per
student credit hour; and so forth.
Requirement 1
No, Santos did not act in an ethical manner. In complying with the
presidents instructions to omit liabilities from the companys financial
statements he was in direct violation of the IMAs Standards of Ethical
Conduct for Management Accountants. He violated both the Integrity and
Objectivity guidelines on this code of ethical conduct. The fact that the
president ordered the omission of the liabilities is immaterial.
Requirement 2
No, Santos actions cant be justified. In dealing with similar situations, the
Securities and Exchange Commission (SEC) has consistently ruled that
corporate officerscannot escape culpability by asserting that they acted
as good soldiers and cannot rely upon the fact that the violative conduct
may have been condoned or ordered by their corporate superiors. (Quoted
from: Gerald H. Lander, Michael T. Cronin, and Alan Reinstein, In Defense
of the Management Accountant, Management Accounting, May, 1990, p.
55) Thus, Santos not only acted unethically, but he could be held legally
liable if insolvency occurs and litigation is brought against the company by
creditors or others. It is important that students understand this point early
in the course, since it is widely assumed that good soldiers are justified by
the fact that they are just following orders. In the case at hand, Santos
should have resigned rather than become a party to the fraudulent
misrepresentation of the companys financial statements.
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Case 6
Requirement 1
President
Vice
Vice Vice Vice
Academic Vice President,
President, President, President,
President Financial
Auxiliary Admissions & Physical
Services
Services Records Plant
(Controller)
Manager, Manager, Manager,

Manager, Manager, Manager, Manager, Plant
Central University Grounds &
University Computer Accounting & Maintenance
Purchasing Bookstore Custodial
Press Services & Finance
Services
Dean,
Dean, Business Dean, Dean, Dean,
Engineering &
Humanities Fine Arts Law School
Quantitative
(Departments) (Departments) (Departments) (Departments)
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Requirement 1
Andres Romero has an ethical responsibility to take some action in the
matter of PhilChem, Inc. and the dumping of toxic wastes. The Standards of
Ethical Conduct for Management Accountants specifies that management
accountants should not condone the commission of acts by their organization
that violate the standards of ethical conduct. The specific standards that
apply are as follows.
Competence. Management accountants have a responsibility to
perform their professional duties in accordance with relevant laws
and regulations.
Confidentiality. Management accountants must refrain from
disclosing confidential information unless legally obligated to do so.
However, Andres Romero may have a legal responsibility to take
some action.
Integrity. Management accountants have a responsibility to:
- refrain from either actively or passively subverting the
attainment of the organizations legitimate and ethical
objectives.
- communicate favorable as well as unfavorable information and
professional judgments or opinions.
Objectivity. Management accountants must fully disclose all
relevant information that could reasonably be expected to influence
an intended users understanding of the reports, comments, and
recommendations.
Requirement 2
The Standards of Ethical Conduct for Management Accountants indicates
that the first alternative being considered by Andres Romero, seeking the
advice of his boss, is appropriate. To resolve an ethical conflict, the first
step is to discuss the problem with the immediate superior, unless it appears
that this individual is involved in the conflict. In this case, it does not appear
that Romeros boss is involved.
Communication of confidential information to anyone outside the company

is inappropriate unless there is a legal obligation to do so, in which case
Romero should contact the proper authorities.
Contacting a member of the Board of Directors would be an inappropriate
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Chapter 8 Cost Concepts and Classifications
action at this time. Romero should report the conflict to successively higher
levels within the organization and turn only to the Board of Directors if the
problem is not resolved at lower levels.
Requirement 3
Andres Romero should follow the established policies of the organization
bearing on the resolution of such conflict. If these policies do not resolve
the ethical conflict, Romero should report the problem to successively higher
levels of management up to the Board of Directors until it is satisfactorily
resolved. There is no requirement for Romero to inform his immediate
superior of this action because the superior is involved in the conflict. If the
conflict is not resolved after exhausting all courses of internal review,
Romero may have no other recourse than to resign from the organization and
submit an informative memorandum to an appropriate member of the
organization.
(CMA Unofficial Solution, adapted)
V. Multiple Choice Questions
1. D 11. D 21. B 31. D 41. A 51. B

2. D 12. D 22. B 32. C 42. C 52. B
3. D 13. D 23. A 33. D 43. D 53. A
4. B 14. A 24. A 34. B 44. B 54. C
5. D 15. A 25. B 35. D 45. C 55. D
6. A 16. A 26. C 36. B 46. B 56. C
7. B 17. D 27. B 37. C 47. A 57. C
8. D 18. A 28. D 38. B 48. B 58. C
9. D 19. D 29. B 39. A 49. C 59. A
10. A 20. D 30. C 40. A 50. D 60. B
CHAPTER 2
MANAGEMENT ACCOUNTING
AND THE BUSINESS ENVIRONMENT
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Cost Concepts and Classifications Chapter 8
I. Questions
1. Managerial accounting information often brings to the attention of

managers important issues that need their managerial experience and
skills. In many cases, managerial-accounting information will not
answer the question or solve the problem, but rather make management
aware that the issue or problem exists. In this sense, managerial
accounting sometimes is said to serve an attention-directing role.
2. Non-value-added costs are the costs of activities that can be eliminated

with no deterioration of product quality, performance, or perceived
value.
3. Managers rely on many information systems in addition to managerial-

accounting information. Examples of other information systems include
economic analysis and forecasting, marketing research, legal research
and analysis, and technical information provided by engineers and
production specialists.
4. Becoming the low-cost producer in an industry requires a clear

understanding by management of the costs incurred in its production
process. Reports and analysis of these costs are a primary function of
managerial accounting.
5. Some activities in the value chain of a manufacturer of cotton shirts are

as follows:
(a) Growing and harvesting cotton
(b) Transporting raw materials
(c) Designing shirts
(d) Weaving cotton material
(e) Manufacturing shirts
(f) Transporting shirts to retailers
(g) Advertising cotton shirts
Some activities in the value chain of an airline are as follows:
(a) Making reservations and ticketing
(b) Designing the route network
(c) Scheduling
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(d) Purchasing aircraft

(e) Maintaining aircraft
(f) Running airport operations, including handling baggage
(g) Serving food and beverages in flight
(h) Flying passengers and cargo
6. Strategic cost management is the process of understanding and

managing, to the organizations advantage, the cost relationships among
the activities in an organizations value chain.
7. If customers who provide a company with the most profits are attracted,
satisfied, and retained, profits will increase as a result.
8. A value chain is a sequence of business functions whose objective is to

provide a product to a customer or provide an intermediate good or
service in a larger value chain. These business functions include R&D,
design, production, marketing, distribution, and customer service.
An organization can become more effective by focusing on whether each

link in the chain adds value from the customers perspective and furthers
the organizations objectives.
9. Cost: Organizations are under continuous pressure to reduce the

cost of the products or services they sell to their customers.
Quality: Customers are expecting higher levels of quality and are less
tolerant of low quality than in the past.
Time: Time has many components: the time taken to develop and
bring new products to market; the speed at which an
organization responds to customer requests; and the
reliability with which promised delivery dates are met.
Organizations are under pressure to complete activities
faster and to meet promised delivery dates more reliably
than in the past in order to increase customer satisfaction.
Innovation: There is now heightened recognition that a continuing flow
of innovative products or services is a prerequisite for the
ongoing success of most organizations.
8-22
10. Managers make planning decisions and control decisions. Planning

decisions include deciding on organization goals, predicting results
under various alternative ways of achieving those goals, and then
deciding how to attain the desired goals. Control decisions include
taking actions to implement the planning decisions and deciding on
performance evaluation and feedback that will help future decision
making.
11. Four themes for managers to attain success are customer focus, value-
chain and supply-chain analysis, key success factors, and continuous
improvement and benchmarking.
12. Companies add value through R&D; design of products, services, or

processes; production; marketing; distribution; and customer service.
Managers in all business functions of the value chain are customers of
management accounting information.
13. This phrase means that people will direct their attention to work
primarily on those tasks that management monitors and measures.
Employees may not pay as much attention (or no attention) to tasks that
are not measured. Often management will reward people based on how
well they perform relative to a specific measure. As an example, in a
manufacturing organization, if people are measured and rewarded based
on the number of outputs per hour, regardless of quality, employees will
focus their attention on producing as many units of output as possible. A
negative consequence is that the quality of output may suffer.
14. Some of these new measures are quality, speed to market, cycle time,
flexibility, complexity and productivity.
15. Customer satisfaction is often thought to be a qualitative measure of

performance as one cannot directly observe satisfaction. However,
using attitude surveys and psychological measurements, customer
satisfaction can be measured in quantitative terms. For instance, people
who design surveys often employ attitude scales that ask questions in
which customers respond on a 1 to 5 scale. These values can be summed
and averaged to determine satisfaction scores.
8-23
16.
Stakeholders Contribution Requirements
Employees Effort, skills, Rewards, interesting
information jobs, economic
security, proper
treatment
Partners Goods, services, Financial rewards
information commensurate with
the risk taken
Owners Capital Financial rewards
Community Allows the Conformance to laws,
organization to good corporate
operate and does not citizenship and,
oppose its operation perhaps, leadership
17. Competitive benchmarking is an organizations search for, and

implementation of, the best way to do something as practiced in other
organizations.
Continuous improvement is the relentless search to (1) document,

understand, and improve the activities that the organization undertakes
to meet its customers requirement, (2) eliminate processing activities
that do not add product features that customers value, and (3) improve
the performance of activities that increase customer value or satisfaction.
18. A value-added activity is an activity that, if eliminated, would reduce the

products service to the customer in the long run.
An activity that cannot be classified as value-added is a nonvalue-added

activity:
a. Value-added
b. Nonvalue-added
c. Nonvalue-added
d. Value-added
e. Nonvalue-added
f. Nonvalue-added
g. Value-added
h. Value-added
8-24
i. Nonvalue-added
j. Value-added
19. Just-in-time means making a good or service only when the customer,
internal or external, requires it. Just-in-time requires a product layout
with a continuous flow (no delays) once production starts. It means that
setup costs must be reduced substantially to eliminate the need to
produce in batches, and it means that processing systems must be
reliable. Just-in-time production is based on the elimination of all
nonvalue-added activities to reduce cost and time. It is an approach to
improvement that is continuous and involves employee empowerment
and involvement.
20. Managerial accounting is concerned with providing information to

managers for use within the organization. Financial accounting is con-
cerned with providing information to stockholders, creditors, and others
outside of the organization.
21. A strategy is a game plan that enables a company to attract customers by

distinguishing itself from competitors. The focal point of a companys
strategy should be its target customers.
II. Multiple Choice Questions
11. B 21. A 31. B

12. A 22. B 32. C
13. D 23. C 33. C
14. A 24. D
15. D 25. A
16. A 26. A
17. C 27. B
18. B 28. C
19. D 29. B
20. B 30. A
CHAPTER 3
UNDERSTANDING FINANCIAL STATEMENTS
8-25
I. Questions
1. A financial statement is a means of communicating information about an

enterprise in financial (i.e., peso) terms. It represents information that
the accountant believes is a true and fair representation of the financial
activity of the enterprise.
2. Every financial statement relates to time in one way or another. A

statement of financial position, or balance sheet, represent a picture of
the enterprise at a point in time (e.g., the end of a month or year). An
income statement and a statement of cash flows, on the other hand, cover
activity that took place over a period of time (e.g., a month or year).
3. a. Creditors are interested in financial statements to assist them in

evaluating the ability of a business to repay its debts. No one wants
to extend credit to a company that is unable to meet its obligations as
they come due.
b. Potential investors use financial statements in selecting among
alternative investment opportunities. They are interested in
investing in companies in which the value of their investment will
increase as a result of future profitable operations.
c. Labor unions are interested in financial statements because the
financial position of a company and its profits are important factors
in the companys ability to pay higher wages and to employ more
people.
4. Business transactions affect a companys financial position, and as a

result they change the statement of financial position or balance sheet.
The other financial statements the income statement and the statement
of cash flows are detailed expansions of certain aspects of the
statement of financial position and help explain how the companys
position changed over time.
5. The cost principle indicates that many assets are included in the
financial records, and therefore, in the statement of financial position, at
their original cost to the reporting enterprise. This principle affects
accounting for assets in several ways, one of which is that the amount of
8-26
most assets is not adjusted periodically for changes in the market value
of the assets. Instead, cost is retained as the basic method of accounting,
regardless of changes in the market value of those assets.
6. The going concern assumption states that in the absence of evidence to

the contrary (i.e., bankruptcy proceedings), an enterprise is expected to
continue to operate in the foreseeable future. This means, for example,
that it will continue to use the assets it has in its financial statements for
the purpose for which they were acquired.
7. The three categories and the information included in each are:

Operating activities Cash provided by and used in revenue and expense
transactions.
Investing activities Cash provided by and used as a result of
investments in assets, such as machinery, equipment, land, and
buildings.
Financial activities Cash provided by and used in debt and equity
financing, such as borrowing and repaying loans, and investments from
and dividends paid to the enterprises owners.
8. Adequate disclosure refers to the requirement that financial statements,

including accompanying notes, must include information necessary for
reasonably informed users of financial statements to understand the
companys financial activities. This requirement is often met, in part, by
the addition of notes to the financial statements. Financial statement
notes include both quantitative and qualitative information that is not
included in the body of the financial statements.
9. A strong income statement is one that has significantly more pesos of

revenue than expenses, resulting in net income that is a relatively high
percentage of the revenue figure. A trend of relatively high income
numbers over time signals a particularly strong income situation.
10. A strong statement of cash flows is one that shows significant amounts
of cash generated from operating activities. This means that the
enterprise is generating cash from its ongoing activities and is not
required to rely on continuous debt and equity financing, or the sale of
its major assets.
8-27
11. The purpose of classifications in financial statements is to develop useful

subtotals, which help users analyze the statements. The most commonly
used classifications are:
In a balance sheet: current assets, plant and equipment, other assets,
current liabilities, long-term liabilities and equity.
In a multiple-step income statement: revenue, cost of goods sold,
operating expenses, and nonoperating items. The operating expense
section often includes subclassifications for selling expenses and for
general and administrative expenses.
In a statement of cash flows: operating activities, investing activities,
and financing activities.
12. In classified financial statements, similar items are grouped together to

produce subtotals which may assist users in their analyses. Comparative
financial statements show financial statements for two or more time
periods in side-by-side columns. Consolidated statements include not
only the financial statement amounts for the company itself but also for
any subsidiary companies that it owns. The financial statements of large
corporations often possess all three of these characteristics.
13. In a multiple-step income statement, different categories of expenses are

deducted from revenue in a series of steps, thus resulting in various
subtotals, such as gross profit and operating income. In a single-step
income statement, all expenses are combined and deducted from total
revenue in a single step. Both formats result in the same amount of net
income.
II. Matching Type
1.
1. d 3. a 5. e 7. f 9. c
2. g 4. j 6. h 8. b 10. i
2.
1. d 3. i 5. m 7. h 9. f 11. b 13. e
2. a 4. g 6. c 8. n 10. k 12. j 14. l
3.
8-28
a. F c. F e. I g. F I. I k. F
b. I d. I f. F h. F j. F l. I
III. Problems
Problem 1 (Preparing a Balance Sheet A Second Problem)
Requirement (a)
SM Farms
Balance Sheet
September 30, 2005
Assets Liabilities and Equity

Cash P 16,710
Liabilities:
Accounts receivable 22,365 Notes payable P530,000
Land 550,000 Accounts payable 77,095
Barns and sheds 78,300 Property taxes payable 9,135
Citrus trees 76,650 Wages payable 1,820
Livestock 120,780 Total liabilities P618,050
Irrigation system 20,125 Equity:
Farm machinery 42,970 Share capital 250,000
Fences & gates 33,570 Retained earnings* 93,420
Total P961,470
Total P961,470
* Total assets, P961,470, minus total liabilities, P618,050, less share capital,
P250,000.
Requirement (b)
The loss of an asset, Barns and Sheds, from a typhoon would cause a
decrease in total assets. When total assets are decreased, the balance sheet
total of liabilities and equity must also decrease. Since there is no change in
liabilities as a result of the destruction of an asset, the decrease on the right-
hand side of the balance sheet must be in the retained earnings account. The
amount of the decrease in Barns and Sheds, in the equity, and in both
balance sheet totals, is P23,800.
Problem 2 (Preparing a Balance Sheet and Cash Flow Statement;
Effects of Business Transactions)
Requirement (a)
8-29
The Tasty Bakery

Balance Sheet
August 1, 2005

Cash P 6,940Liabilities:
Accounts receivable 11,260 Notes payable P 74,900
Supplies 7,000 Accounts payable 16,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities P100,000
Equipment and fixtures 44,500 Equity:
Share capital 80,000
Retained earnings 40,700
Total P220,700
Total P220,700
Requirement (b)
The Tasty Bakery
Balance Sheet
August 3, 2005

Cash P 14,490
Liabilities:
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities P 91,000
Equipment and fixtures 51,700 Equity:
Retained earnings 40,700
Total P236,700
Total P236,700
The Tasty Bakery

Statement of Cash Flows
For the Period August 1 - 3, 2005
Cash flows from operating
8-30
activities:
Cash payment of P(16,200)
accounts payable
Cash purchase of (1,250)
supplies
Cash used in P(17,450)
operating activities
Cash flows from investing

activities:
None
Cash flows from financing

activities:
Sale of share capital P25,000
Increase in cash P 7,550

Cash balance, August 1, 6,940
2005
Cash balance, August 3, P14,490
2005
Requirement (c)
The Tasty Bakery is in a stronger financial position on August 3 than it was
on August 1.
On August 1, the highly liquid assets (cash and accounts receivable) total
only P18,200, but the company has P25,100 in debts due in the near future
(accounts payable plus salaries payable).
On August 3, after additional infusion of cash from the sale of stock, the
liquid assets total P25,750, and debts due in the near future amount to
P16,100.
Note to Instructor: The analysis of financial position strength in requirement

(c) is based solely upon the balance sheets at August 1 and August 3.
Hopefully, students will raise many legitimate issues regarding necessity of
information about operations, rate at which cash flows into the business, etc.
In this problem, the improvement in financial position results solely from the
sale of share capital.
8-31
Problem 3 (Preparing Financial Statements; Effects of Business

Transactions)
Requirement (a)
The First Malt Shop
Balance Sheet
September 30, 2005

Accounts receivable 1,250 Notes payable* P 70,000
Land 55,000 Total liabilities P 78,500
Building 45,500 Equity:
Furniture & fixtures 20,000 Retained earnings 4,090
Total P132,590
Total P132,590
* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500, equals
notes payable.
Requirement (b)
The First Malt Shop
Balance Sheet
October 6, 2005

Cash P 29,400
Liabilities:
Land 55,000 Total liabilities P 88,000
Furniture & fixtures 38,000 Retained earnings 5,590
Total P173,590
Total P173,590
8-32
The First Malt Shop

Income Statement
For the Period October 1-6, 2005
Revenues P 5,500
Expenses (4,000)
Net income P 1,500
The First Malt Shop

For the Period October 1-6, 2005

activities:
Cash received from P5,500
revenues
Cash paid for expenses (4,000)
Cash paid for accounts (8,500)
payable
Cash paid for supplies
(1,000)
Cash used in operating P(8,000)
activities
Cash flows from investing
activities:
None
Cash flows from financing
activities:
Cash received from sale of P30,000
share capital
Increase in cash P
22,000
Cash balance, October 1, 2005 7,400
8-33
Cash balance, October 6, 2005 P29,400
Requirement (c)
The First Malt Shop is in a stronger financial position on October 6 than on
September 30. On September 30, the company had highly liquid assets (cash
and accounts receivable) of P8,650, which barely exceeded the P8,500 in
liabilities (accounts payable) due in the near future. On October 6, after the
additional investment of cash by shareholders, the companys cash alone
exceeded its short-term obligations.
Problem 4 (Preparing a Balance Sheet; Discussion of Accounting

Principles)
Requirement (1)
Fil-Cinema Scripts
Balance Sheet
November 30, 2005

Notes receivable 2,200 Notes payable P 73,500
Accounts receivable 2,450 Accounts payable 32,700
Land 39,000 Total liabilities P106,200
Share capital 5,000
Office furniture* 12,825 Retained earnings 3,535
Total P114,735
Total P114,735
* P8,850 + P6,500 P2,525.
Requirement (2)
(1) The cash in Cruzs personal savings account is not an asset of the
business entity Fil-Cinema Scripts and should not appear in the balance
sheet of the business. The money on deposit in the business bank
8-34
account (P3,400) and in the company safe (P540) constitute cash owned
by the business. Thus, the cash owned by the business at November 30
totals P3,940.
(2) The years-old IOU does not qualify as a business asset for two reasons.
First, it does not belong to the business entity. Second, it appears to be
uncollectible. A receivable that cannot be collected is not viewed as an
asset, as it represents no future economic benefit.
(3) The total amount to be included in Office furniture for the rug is
P9,400, the total cost, regardless of whether this amount was paid in
cash. Consequently, Office furniture should be increased by P6,500.
The P6,500 liability arising from the purchase of the rug came into
existence prior to the balance sheet date and must be added to the Notes
payable amount.
(4) The computer is no longer owned by Hollywood Scripts and therefore
cannot be included in the assets. To do so would cause an overstatement
of both assets and equity. The Office furniture amount must be
reduced by P2,525.
(5) The P22,400 described as Other assets is not an asset, because there is
no valid legal claim or any reasonable expectation of recovering the
income taxes paid. Also, the payment of income taxes by Cruz was not a
business transaction by Fil-Cinema Scripts. If a refund were obtained
from the government, it would come to Cruz personally, not to the
business entity.
(6) The proper valuation for the land is its historical cost of P39,000, the
amount established by the transaction in which the land was purchased.
Although the land may have a current fair value in excess of its cost, the
offer by the friend to buy the land if Cruz would move the building
appears to be mere conversation rather than solid, verifiable evidence of
the fair value of the land. The cost principle, although less than
perfect, produces far more reliable financial statements than would result
if owners could pull figures out of the air in recording asset values.
(7) The accounts payable should be limited to the debts of the business,
P32,700, and should not include Cruzs personal liabilities.
8-35
IV. Multiple Choice Questions
21. D 31. B 21. B 31. B

22. D 32. C 22. C 32. D
23. D 33. D 23. A 33. D
24. B 34. A 24. B 34. D
25. A 35. D 25. A 35. C
26. B a. A 26. D 36. A
27. D 17. A 27. B 37. A
28. C 18. B 28. B 38. C
29. B 19. C 29. D
30. C 20. C 30. C
CHAPTER 4
FINANCIAL STATEMENTS ANALYSIS - I
I. Questions
1. The objective of financial statements analysis is to determine the extent

of a firms success in attaining its financial goals, namely:
a. To earn maximum profit
b. To maintain solvency
c. To attain stability
2. Some of the indications of satisfactory short-term solvency or working

capital position of a business firm are:
1. Favorable credit position
2. Satisfactory proportion of cash to the requirements of the current
volume
3. Ability to pay current debts in the regular course of business
4. Ability to extend more credit to customers
5. Ability to replenish inventory promptly
3. These tests are:

1. Improvement in the financial position
8-36
2. Well-balanced financial structure between borrowed funds and

equity
3. Effective employment of borrowed funds and equity
4. Ability to declare satisfactory amount of dividends to
shareholders
5. Ability to withstand adverse business conditions
6. Ability to engage in research and development in an attempt to
provide new products or improve old products, methods or
processes
4. Some indicators of managerial efficiency are:

1. Ability to earn a reasonable return on its investment of borrowed
funds and equity
2. Ability to control operating costs within reasonable limits
3. No overinvestment in fixed assets, receivables and inventories
5. The techniques used in Financial Statement Analysis are:

I. Vertical analysis which shows the relationships of the items in
the same year: also referred to as static measure.
a. Financial ratios
b. Common-size statements
II. Horizontal analysis which shows the changes or tendencies of an

item for 2 or more years; also referred to as dynamic measure.
a. Comparative statements - showing changes in absolute
amount and percentages
b. Trend percentages
III. Use of special reports or statements

a. Statements of Changes in Financial Position
b. Gross Profit / Net Income Variation Analysis
6. Refer to page 133 of the textbook.
7. Horizontal analysis involves the comparison of items on financial

statements between years. Analysis of comparative financial statements
8-37
or the increase/decrease method of analysis and trend percentages are the

two techniques that may be applied under horizontal analysis.
Vertical analysis involves the study of items on a single statement for a

single year, such as the analysis of an income statement for some given
year. Common-size statement and financial ratios are techniques used in
vertical analysis.
8. Trends can indicate whether a situation is improving, remaining the

same or deteriorating. They can also give insight to the probable future
course of events in a firm.
9. Trend percentages represent the expression of several years financial

data in percentage form in terms of a base year.
11. Observation of trends is useful primarily in determining whether a

situation is improving, worsening, or remaining constant. By comparing
current data with similar data of prior periods we gain insight into the
direction in which future results are likely to move.
Some other standards of comparison include comparison with other

similar companies, comparison with industry standards, and comparison
with previous years information. By comparing analytical data for one
company with some independent yardstick, the analyst hopes to
determine how the position of the company in question compares with
some standard of performance.
12. Trend percentages are used to show the increase or decrease in a

financial statement amount over a period of years by comparing the
amount in each year with the base-year amount. A component
percentage is the percentage relationship between some financial amount
and a total of which it is a part.
Measuring the change in sales over a period of several years would call
for use of trend percentages. The sales in the base year are assigned a
weight of 100%. The percentage for each later year is computed by
dividing that years sales by the sales in the base year.
8-38
13. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Premiere is apparently having
difficulty in effectively controlling its expenses.
14. A corporate net income of P1 million would be unreasonably low for a

large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by
investing in insured bank savings accounts or in government bonds
which would be virtually risk-free and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for

a corporation which had sales of only P5 million, assets of, say, P3
million, and equity of perhaps one-half million pesos. In other words,
the net income of a corporation must be judged in relation to the scale of
operations and the amount invested.
II. True or False
1. True 3. True 5. False 7. True 9. True

2. False 4. True 6. False 8. False 10. True
III. Problems
Problem 1 (Percentage Changes)
a. Accounts receivable decreased 16% (P24,000 decrease P150,000 =

16% decrease).
b. Marketable securities decreased 100% (P250,000 decrease P250,000 =
100% decrease).
c. A percentage change cannot be calculated because retained earnings
showed a negative amount (a deficit) in the base year and a positive
amount in the following year.
d. A percentage change cannot be calculated because of the zero amount of
notes receivable in 2005, the base year.
e. Notes payable increased 7 % (P60,000 increase P800,000 = 7 %
increase).
f. Cash increased 3% (P2,400 increase P80,000 = 3% increase).
g. Sales increased 10% (P90,000 increase P900,000 = 10% increase).
8-39
Problem 2 (Computing and Interpreting Rates of Change)
Requirement (a)
Computation of percentage changes:
1. Net sales increased 10% (P200,000 increase P2,000,000 = 10%
increase).
2. Total expenses increased 11% (P198,000 increase P1,800,000 = 11%
increase).
Requirement (b)
1. Total expenses grew faster than net sales. Net income cannot also have
grown faster than net sales, or the sum of the parts would exceed the size
of the whole.
2. Net income must represent a smaller percentage of net sales in 2006 than
it did in 2005. Again, the reason is that the expenses have grown at a
faster rate than net sales. Thus, total expenses represent a larger
percentage of total sales in 2006 than in 2005, and net income must
represent a smaller percentage.
Problem 3 (Financial Statement Analysis using Comparative Statements

or Increase-Decrease Method)
Requirement 1
XYZ Corporation
Balance Sheet
As of December 31
Change
Peso %
2005 2006
Assets
Cash and equivalents 14,000 16,000 2,000 14.29%
Receivables 28,800 55,600 26,800 93.06%
Inventories 54,000 85,600 31,600 58.52%
Prepayments and others 4,800 7,400 2,600 54.17%
Total current assets 101,600 164,600 63,000 62.01%
Property, plant & equipment - net
of dep. 30,200 73,400 43,200 143.05%
Total assets 131,800 238,000 106,200 80.58%
8-40
Liabilities and Equity

Notes payable to banks 10,000 54,000 44,000 440.00%
Accounts payable 31,600 55,400 23,800 73.32%
Accrued liabilities 4,200 6,800 2,600 61.90%
Income taxes payable 5,800 7,000 1,200 20.69%
Total current liabilities 51,600 123,200 71,600 138.76%
Share capital 44,600 44,600 0 0.00%
Retained earnings 35,600 70,200 34,600 97.19%
Total equity 80,200 114,800 34,600 43.14%
Total liabilities and equity 131,800 238,000 106,200 80.58%
XYZ Corporation
Income Statement
Years ended December 31
(P thousands)
Change
Peso %
2005 2006
Net sales 266,400 424,000 157,600 59.16%
Cost of goods sold 191,400 314,600 123,200 64.37%
Gross profit 75,000 109,400 34,400 45.87%
Selling, general and administrative
expenses 35,500 58,400 22,900 64.51%
Income before income taxes 39,500 51,000 11,500 29.11%
Income taxes 12,300 16,400 4,100 33.33%
Net income 27,200 34,600 7,400 27.21%
Requirement 2
Short-term financial position

1. Current Current
increased by 62.01% while increased by 138.76%
Assets Liabilities
Unfavorable
2. Quick Current
Assets Liabilities
Unfavorable
3. Net Accounts
Sales Receivable
Unfavorable
4. Cost of Inventories
Goods Sold
Favorable
Leverage
8-41
5. Total Total
Assets Liabilities
Unfavorable
6. Total Total
Liabilities Equity
Unfavorable
Profitability
7. Net Cost of
Sales Goods Sold
Unfavorable
8. Net Selling,
Sales increased by 59.16% while General & increased by 64.51%
Administrative
Expenses
Unfavorable
9. Net Net
Sales Income
Unfavorable
10. Net Total
Income Assets
Unfavorable
Problem 4 (Trend Percentages)
Requirement (1)
The trend percentages are:
Year 5 Year 4 Year 3 Year 2 Year 1
Sales 125.0 120.0 110.0 105.0 100.0
Cash 80.0 90.0 105.0 110.0 100.0

Accounts receivable 140.0 124.0 108.0 104.0 100.0
Inventory 112.0 110.0 102.0 108.0 100.0
Total current assets 118.8 113.1 104.1 106.9 100.0
Current liabilities 130.0 106.0 108.0 110.0 100.0
Requirement (2)
Sales: The sales are increasing at a steady rate, with a particularly
strong gain in Year 4.
8-42
Assets: Cash declined from Year 3 through Year 5. This may have
been due to the growth in both inventories and accounts
receivable. In particular, the accounts receivable grew far
faster than sales in Year 5. The decline in cash may reflect
delays in collecting receivables. This is a matter for
management to investigate further.
Liabilities: The current liabilities jumped up in Year 5. This was probably

due to the buildup in accounts receivable in that the company
doesnt have the cash needed to pay bills as they come due.
Problem 5 (Use of Trend Percentages)
a. 1. An unfavorable tendency could be observed in Receivables in

relation to Net Sales from 2003 2005 because receivables had been
increasing at a much faster rate than Net Sales. This could indicate
inefficiency in the collection of receivables or simply poor company
credit policy. The situation however, improved in 2006 and 2007
when sales started to move up at a faster rate than accounts
receivable. This would indicate improvement in the credit and
collection policy or more cash sales were being generated.
2. Unfavorable tendency in inventory persisted from 2003 to 2007
because it had been going up at a much faster rate than Net Sales. If
this continues, the company will end up with over-investment in
inventory because the buying rate is faster than the selling price.
3. Favorable tendencies could be noted in Fixed Assets in relation to
Net Sales because inspite of the minimal additions to fixed assets
made by the company from 2003 through 2007, sales had been
increasing at a very encouraging rate.
4. Net Income had likewise been increasing at a much faster rate than
net sales. This is favorable because this would indicate that the
company had been successfully controlling the increases in Cost of
Sales and Operating Expenses.
b. Review computations of the Trend Percentages. It will be noted that the
Trend Percentages in Total Noncurrent Liabilities and Equity from 2005
8-43
to 2007 were interchanged. Correction should be made first before

interpretation is done.
1. The upward tendency in current assets had been accompanied by an
upward trend in current liabilities. It could be noted that current
assets had been moving up at a much faster rate than current
liabilities. This is favorable because the margin of safety of the
short-term creditors is widened.
2. Favorable tendencies could also be observed in noncurrent assets
which had been increasing and which increases had been
accompanied by downward trend in noncurrent liabilities. This
would mean better security on the part of creditors and stronger
financial position.
3. There is an unfavorable tendency in Net Sales in relation to non-
current assets. Sales had not been increasing at the same rate as the
increases in fixed assets. This could indicate that more investments
are made in noncurrent assets without considering whether or not
they could sell the additional units of product they are producing.
c. The unfavorable trend in net income could be attributed to the following
tendencies:
1. Higher rates of increases in cost of sales as compared to sales.
2. Higher rates of increases in selling, general and administrative
expenses in relation to net sales.
3. Higher rates of increases in other financial expenses than the rates of
increases in net sales
31. D 36. A, C, D
32. A 37. B*
33. A 38. D
34. B
35. D
36. C
37. C
38. A
8-44
39. D
40. C
* (P400,000 P160,000) P160,000 = 150%
CHAPTER 5
FINANCIAL STATEMENTS ANALYSIS - II
I. Questions
1. By looking at trends, an analyst hopes to get some idea of whether a

situation is improving, remaining the same, or deteriorating. Such
analyses can provide insight into what is likely to happen in the future.
Rather than looking at trends, an analyst may compare one company to
another or to industry averages using common-size financial statements.
2. Ratios highlight relationships, movements, and trends that are very

difficult to perceive looking at the raw underlying data standing alone.
Also, ratios make financial data easier to grasp by putting the data into
perspective. As to the limitation in the use of ratios, refer to page 129.
3. Price-earnings ratios are determined by how investors see a firms future

prospects. Current reported earnings are generally considered to be
useful only so far as they can assist investors in judging what will
happen in the future. For this reason, two firms might have the same
current earnings, but one might have a much higher price-earnings ratio
if investors view it to have superior future prospects. In some cases,
firms with very small current earnings enjoy very high price-earnings
ratios. This is simply because investors view these firms as having very
favorable prospects for earnings in future years. By definition, a stock
with current earnings of P4 and a price-earnings ratio of 20 would be
selling for P80 per share.
8-45
4. A managers financing responsibilities relate to the acquisition of assets

for use in his or her company. The acquisition of assets can be financed
in a number of ways, including through issue of ordinary shares, through
issue of preference shares, through issue of long-term debt, through
leasing, etc. A managers operating responsibilities relate to how these
assets are used once they have been acquired. The return on total assets
ratio is designed to measure how well a manager is discharging his or
her operating responsibilities. It does this by looking at a companys
income before any consideration is given as to how the income will be
distributed among capital resources, i.e., before interest deductions.
5. Financial leverage, as the term is used in business practice, means

obtaining funds from investment sources that require a fixed annual rate
of return, in the hope of enhancing the well-being of the ordinary
shareholders. If the assets in which these funds are invested earn at a
rate greater that the return required by the suppliers of the funds, then
leverage is positive in the sense that the excess accrues to the benefit of
the ordinary shareholders. If the return on assets is less than the return
required by the suppliers of the funds, then leverage is negative in the
sense that part of the earnings from the assets provided by the ordinary
shareholders will have to go to make up the deficiency.
6. How a shareholder would feel would depend in large part on the stability
of the firm and its industry. If the firm is in an industry that experiences
wide fluctuations in earnings, then shareholders might be very pleased
that no interest-paying debt exists in the firms capital structure. In hard
times, interest payments might be very difficult to meet, or earnings
might be so poor that negative leverage would result.
7. No, the stock is not necessarily overpriced. Book value represents the
cumulative effects on the balance sheet of past activities evaluated using
historical prices. The market value of the stock reflects investors
beliefs about the companys future earning prospects. For most
companies market value exceeds book value because investors anticipate
future growth in earnings.
8. A company in a rapidly growing technological industry probably would

have many opportunities to invest its earnings at a high rate of return;
thus, one would expect it to have a low dividend payout ratio.
8-46
9. It is more difficult to obtain positive financial leverage from preference

shares than from long-term debt due to the fact that interest on long-term
debt is tax deductible, whereas dividends paid on preference shares are
not tax deductible.
10. The current ratio would probably be highest during January, when both
current assets and current liabilities are at a minimum. During peak
operating periods, current liabilities generally include short-term
borrowings that are used to temporarily finance inventories and
receivables. As the peak periods end, these short-term borrowings are
paid off, thereby enhancing the current ratio.
11. A 2-to-1 current ratio might not be adequate for several reasons. First,
the composition of the current assets may be heavily weighted toward
slow-turning inventory, or the inventory may consist of large amounts of
obsolete goods. Second, the receivables may be large and of doubtful
collectibility, or the receivables may be turning very slowly due to poor
collection procedures.
12. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Sunday is apparently having
difficulty in effectively controlling its expenses.
13. If the companys earnings are very low, they may become almost
insignificant in relation to stock price. While this means that the p/e
ratio becomes very high, it does not necessarily mean that investors are
optimistic. In fact, they may be valuing the company at its liquidation
value rather than a value based upon expected future earnings.
14. From the viewpoint of the companys shareholders, this situation

represents a favorable use of leverage. It is probable that little interest, if
any, is paid for the use of funds supplied by current creditors, and only
11% interest is being paid to long-term bondholders. Together these two
sources supply 40% of the total assets. Since the firm earns an average
return of 16% on all assets, the amount by which the return on 40% of
the assets exceeds the fixed-interest requirements on liabilities will
accrue to the residual equity holders the ordinary shareholders
raising the return on equity.
15. The length of operating cycle of the two companies cannot be

determined from the fact the one companys current ratio is higher. The
8-47
operating cycle depends on the relationships between receivables and

sales, and between inventories and cost of goods sold. The company
with the higher current ratio might have either small amounts of
receivables and inventories, or large sales and cost of sales, either of
which would tend to produce a relatively short operating cycle.
16. The investor is calculating the rate of return by dividing the dividend by
the purchase price of the investment (P5 P50 = 10%). A more
meaningful figure for rate of return on investment is determined by
relating dividends to current market price, since the investor at the
present time is faced with the alternative of selling the stock for P100
and investing the proceeds elsewhere or keeping the investment. A
decision to retain the stock constitutes, in effect, a decision to continue
to invest P100 in it, at a return of 5%. It is true that in a historical sense
the investor is earning 10% on the original investment, but this is
interesting history rather than useful decision-making information.
17. A corporate net income of P1 million would be unreasonably low for a
large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by
investing in insured bank savings accounts or in government bonds
which would be virtually risk-free and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for
a corporation which had sales of only P5 million, assets of, say, P3
million, and equity of perhaps one-half million pesos. In other words,
the net income of a corporation must be judged in relation to the scale of
operations and the amount invested.
II. True or False
1. True 3. True 5. True 7. True 9. False

2. True 4. False 6. True 8. True 10. False
III. Problems
Problem 1 (Common Size Income Statements)
Common size income statements for 2005 and 2006:

2006 2005
8-48
Sales .................................................. 100% 100%

Cost of goods sold ............................ 66 67
Gross profit ....................................... 34% 33%
Operating expenses ........................... 28 29
Net income ........................................ 6% 4%
The changes from 2005 to 2006 are all favorable. Sales increased and the
gross profit per peso of sales also increased. These two factors led to a
substantial increase in gross profit. Although operating expenses increased
in peso amount, the operating expenses per peso of sales decreased from 29
cents to 28 cents. The combination of these three favorable factors caused
net income to rise from 4 cents to 6 cents out of each peso of sales.
Problem 2 (Measures of Liquidity)
Requirement (a)
Current assets:
Cash P 47,600
Marketable securities 175,040
Accounts receivable 230,540
Inventory 179,600
Unexpired insurance 4,500
Total current assets P637,280
Current liabilities:
Notes payable P 70,000
Accounts payable 125,430
Salaries payable 7,570
Income taxes payable 14,600
Unearned revenue 10,000
Total current liabilities P227,600
Requirement (b)
The current ratio is 2.8 to 1. It is computed by dividing the current assets of

P637,280 by the current liabilities of P227,600. The amount of working
capital is P409,680, computed by subtracting the current liabilities of
P227,600 from the current assets of P637,280.
8-49
The company appears to be in a strong position as to short-run debt-paying

ability. It has almost three pesos of current assets for each peso of current
liabilities. Even if some losses should be sustained in the sale of the
merchandise on hand or in the collection of the accounts receivable, it
appears probable that the company would still be able to pay its debts as they
fall due in the near future. Of course, additional information, such as the
credit terms on the accounts receivable, would be helpful in a careful
evaluation of the companys current position.
Problem 3 (Common-Size Income Statement)
Requirement 1
2006 2005
Sales 100.0 % 100.0 %
Less cost of goods sold .........................................................................................................
63.2 60.0
Gross margin .........................................................................................................................
36.8 40.0
Selling expenses ....................................................................................................................
18.0 17.5
Administrative expenses .......................................................................................................
13.6 14.6
Total expenses .......................................................................................................................
31.6 32.1
Net operating income ............................................................................................................
5.2 7.9
Interest expense.....................................................................................................................
1.4 1.0
Net income before taxes........................................................................................................
3.8 % 6.9 %
Requirement 2
The companys major problem seems to be the increase in cost of goods

sold, which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006.
This suggests that the company is not passing the increases in costs of its
products on to its customers. As a result, cost of goods sold as a percentage
of sales has increased and gross margin has decreased. Selling expenses and
interest expense have both increased slightly during the year, which suggests
that costs generally are going up in the company. The only exception is the
administrative expenses, which have decreased from 14.6% of sales in 2005
to 13.6% of sales in 2006. This probably is a result of the companys efforts
to reduce administrative expenses during the year.
Problem 4 (Comparing Operating Results with Average Performance in

the Industry)
Requirement (a)
Ms. Freeze,Inc. Industry Average
8-50
Sales (net) 100% 100%

Cost of goods sold 49 57
Gross profit on sales 51% 43%
Operating expenses:
Selling 21% 16%
General and administrative 17 20
Total operating expenses 38% 36%
Operating income 13% 7%
Income taxes 6 3
Net income 7% 4%
Requirement (b)
Ms. Freezes operating results are significantly better than the average
performance within the industry. As a percentage of sales revenue, Ms.
Freezes operating income and net income after nearly twice the average for
the industry. As a percentage of total assets, Ms. Freezes profits amount to
an impressive 23% as compared to 14% for the industry.
The key to Ms. Freezes success seems to be its ability to earn a relatively
high rate of gross profit. Ms. Freezes exceptional gross profit rate (51%)
probably results from a combination of factors, such as an ability to
command a premium price for the companys products and production
efficiencies which lead to lower manufacturing costs.
As a percentage of sales, Ms. Freezes selling expenses are five points higher
than the industry average (21% compared to 16%). However, these higher
expenses may explain Ms. Freezes ability to command a premium price for
its products. Since the companys gross profit rate exceeds the industry
average by 8 percentage points, the higher-than-average selling costs may be
part of a successful marketing strategy. The companys general and
administrative expenses are significantly lower than the industry average,
which indicates that Ms. Freezes management is able to control expenses
effectively.
Problem 5 (Common-Size Statements)
Requirement 1
The income statement in common-size form would be:

2006 2005
Sales ......................................................... 100.0% 100.0%
8-51
Less cost of goods sold ............................ 65.0 60.0

Gross margin ............................................ 35.0 40.0
Less operating expenses .......................... 26.3 30.4
Net operating income ............................... 8.7 9.6
Less interest expense ............................... 1.2 1.6
Net income before taxes .......................... 7.5 8.0
Less income taxes (30%) ......................... 2.3 2.4
Net income ............................................... 5.3% 5.6%
The balance sheet in common-size form would be:
2006 2005
Current assets:
Cash ................................................... 2.0% 5.1%
Accounts receivable, net ................... 15.0 10.1
Inventory ........................................... 30.1 15.2
Prepaid expenses ............................... 1.0 1.3
Total current assets ..................... 48.1 31.6
Plant and equipment ................................ 51.9 68.4
Total assets .............................................. 100.0% 100.0%
Liabilities:
Current liabilities............................... 25.1% 12.7%
Bonds payable, 12% .......................... 20.1 25.3
Total liabilities ............................ 45.1 38.0
Equity:
Preference shares, 8%, P10 par ......... 15.0 19.0
Ordinary shares, P5 par ..................... 10.0 12.7
Retained earnings .............................. 29.8 30.4
Total equity ................................. 54.9 62.0
Total liabilities and equity ....................... 100.0% 100.0%
Note: Columns do not total down in all cases due to rounding differences.
Requirement 2
The companys cost of goods sold has increased from 60 percent of sales in
2005 to 65 percent of sales in 2006. This appears to be the major reason the
companys profits showed so little increase between the two years. Some
benefits were realized from the companys cost-cutting efforts, as evidenced
8-52
by the fact that operating expenses were only 26.3 percent of sales in 2006 as
compared to 30.4 percent in 2005. Unfortunately, this reduction in operating
expenses was not enough to offset the increase in cost of goods sold. As a
result, the companys net income declined from 5.6 percent of sales in 2005
to 5.3 percent of sales in 2006.
Problem 6 (Solvency of Alabang Supermarket)
Requirement (a)
(Pesos in
Millions)
Current assets:
Cash P 74.8
Receivables 152.7
Merchandise inventories 1,191.8
Prepaid expenses 95.5
Total current assets P1,514.8
Quick assets:
Cash P 74.8
Receivables 152.7
Total quick assets P 227.5
Requirement (b)
(1) Current ratio:

Current assets (Req. a) P1,514.8
Current liabilities P1,939.0
Current ratio (P1,514.8 P1,939.0) 0.8 to 1
(2) Quick ratio:

Quick assets (Req. a) P 227.5
Current liabilities P1,939.0
Quick ratio (P227.5 P1,939.0) 0.1 to 1
(3) Working capital:

Current assets (Req. a) P1,514.8
Less: Current liabilities P1,939.0
Working capital P(424.2)
Requirement (c)
8-53
No. It is difficult to draw conclusions from the above ratios. Alabang

Supermarkets current ratio and quick ratio are well below safe levels,
according to traditional rules of thumb. On the other hand, some large
companies with steady ash flows are able to operate successfully with
current ratios lower than Alabang Supermarkets.
Requirement (d)
Due to characteristics of the industry, supermarkets tend to have smaller

amounts of current assets and quick assets than other types of merchandising
companies. An inventory of food has a short shelf life. Therefore, the
inventory of a supermarket usually represents only a few weeks sales.
Other merchandising companies may stock inventories representing several
months sales. Also, supermarkets sell primarily for cash. Thus, they have
relatively few receivables. Although supermarkets may generate large
amounts of cash, it is not profitable for them to hold assets in this form.
Therefore, they are likely to reinvest their cash flows in business operations
as quickly as possible.
Requirement (e)
In evaluating Alabang Supermarkets liquidity, it would be useful to review

the companys financial position in prior years, statements of cash flows, and
the financial ratios of other supermarket chains. One might also ascertain
the companys credit rating from an agency such as Dun & Bradstreet.
Note to Instructor: Prior to the year in which the data for this problem was
collected, Alabang Supermarket had reported a negative retained earnings
balance in its balance sheet for several consecutive periods. The fact that
Alabang Supermarket has only recently removed the deficit from its
financial statements is also worrisome.
Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)
Requirement (a)
(1) Quick assets:

Cash P 47,524
Marketable securities (short-term) 55,926
8-54
Total quick assets P127,003
(2) Current assets:

Cash P 47,524
Marketable securities (short-term) 55,926
Inventories 32,210
Prepaid expenses 5,736
Total current assets P164,949
(3) Current liabilities:

Notes payable to banks (due within one year) P 20,000
Accounts payable 5,912
Dividends payable 1,424
Accrued liabilities (short-term) 21,532
Income taxes payable 6,438
Total current liabilities P 55,306
Requirement (b)
(1) Quick ratio:

Quick assets (Req. a) P127,003
Current liabilities (Req. a) P 55,306
Quick ratio (P127,003 P55,306) 2.3 to 1
(2) Current ratio:

Current assets (Req. a) P164,949
Current liabilities (Req. a) P 55,306
Current ratio (P164,949 P55,306) 3.0 to 1
(3) Working capital:

Current assets (Req. a) P164,949
Less: Current liabilities (Req. a) 55,306
Working capital P109,643
(4) Debt ratio:
8-55
Total liabilities (given) P 81,630

Total assets (given) P353,816
Debt ratio (P81,630 P353,816) 23.1%
Requirement (c)
(1) From the viewpoint of short-term creditors, Bonbon Sweets appear

highly liquid. Its quick and current ratios are well above normal rules of
thumb, and the companys cash and marketable securities alone are
almost twice its current liabilities.
(2) Long-term creditors also have little to worry about. Not only is the
company highly liquid, but creditors claims amount to only 23.1% of
total assets. If Bonbon Sweets were to go out of business and liquidate
its assets, it would have to raise only 23 cents from every peso of assets
for creditors to emerge intact.
(3) From the viewpoint of shareholders, Bonbon Sweets appears overly

liquid. Current assets generally do not generate high rates of return.
Thus, the companys relatively large holdings of current assets dilutes its
return on total assets. This should be of concern to shareholders. If
Bonbon Sweets is unable to invest its highly liquid assets more
productively in its business, shareholders probably would like to see the
money distributed as dividends.
Problem 8 (Selected Financial Measures for Short-term Creditors)
Requirement 1
Current assets (P80,000 + P460,000 + P750,000 +

P10,000) ...............................................................................................................
P1,300,000
Current liabilities (P1,300,000 2.5) ......................................................................
520,000
Working capital ........................................................................................................
P 780,000
Requirement 2
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P80,000 + P0 + P460,000
Acid-test ratio
Requirement 3 = = 1.04 to 1 (rounded)
P520,000
8-56
a. Working capital would not be affected:
Current assets (P1,300,000 P100,000) ..................................................................

P1,200,000
Current liabilities (P520,000 P100,000) ...............................................................
420,000
Working capital ........................................................................................................
P 780,000
b. The current ratio would rise:

Current assets
Current ratio =
Current liabilities
P1,200,000
Current rate = = 2.9 to 1 (rounded)
P420,000
Problem 9 (Selected Financial Ratios)
1. Gross margin percentage:

Gross margin P840,000
= = 40%
Sales P2,100,000
2. Current ratio:
Current assets P490,000
= = 2.45 to 1
Current liabilities P200,000
3. Acid-test ratio:
Quick assets P181,000
= = 0.91 to 1 (rounded)
Current liabilities P200,000
4. Accounts receivable turnover:
Sales P2,100,000
= = 14 times
Average accounts receivables P150,000
365 days
= 26.1 days (rounded)
14 times
5. Inventory turnover:
8-57
Cost of goods sold P1,260,000

= = 4.5 times
Average inventory P280,000
365 days
= 81.1 days to turn (rounded)
4.5 times
6. Debt-to-equity ratio:
Total liabilities P500,000
= = 0.63 to 1 (rounded)
Total equity P800,000
7. Times interest earned:
Earnings before interest

and income taxes P180,000
= = 6.0 times
Interest expense P30,000
8. Book value per share:

Equity P800,000
= = P40 per share
Ordinary shares outstanding 20,000 shares*
* P100,000 total par value P5 par value per share = 20,000 shares
Problem 10 (Selected Financial Ratios for Ordinary Shareholders)
1. Earnings per share:
Net income to ordinary shares P105,000

= = P5.25 per share
Average ordinary shares 20,000 shares
outstanding
2. Dividend payout ratio:

Dividends paid per share P3.15
= = 60%
Earnings per share P5.25
3. Dividend yield ratio:

Dividends paid per share P3.15
= = 5%
Market price per share P63.00
4. Price-earnings ratio:
8-58
Market price per share P63.00

= = 12.0
Earnings per share P5.25
Problem 11 (Selected Financial Ratios for Ordinary Shareholders)
1. Return on total assets:
Return on Net income + [Interest expense x (1 Tax rate)]

=
total assets Average total assets
P105,000 + [P30,000 x (1 0.30)]

=
(P1,100,000 + P1,300,000)
P126,000
= = 10.5%
P1,200,000
2. Return on ordinary shareholders equity:
Return on ordinary Net income preference dividends

=
shareholders equity Average ordinary shareholders equity
P105,000
=
(P725,000 + P800,000)
P105,000
= = 13.8% (rounded)
P762,500
3. Financial leverage was positive, since the rate of return to the ordinary
shareholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the companys
current liabilities, which may carry no interest cost, and to the bonds
payable, which have an after-tax interest cost of only 7%.
10% interest rate (1 0.30) = 7% after-tax cost.
Problem 12 (Selected Financial Measures for Short-Term Creditors)
8-59
Requirement (1)
Current assets
(P80,000 + P460,000 + P750,000 + P10,000) ..................................... P1,300,000
Current liabilities (P1,300,000 2.5)...................................................... 520,000
Working capital .......................................................................................
P 780,000
Requirement (2)
Cash + Marketable securities

Acid-test + Accounts receivable + Short-term notes
=
ratio Current liabilities
P80,000 + P0 + P460,000 + P0
= = 1.04 (rounded)
P520,000
Requirement (3)
a. Working capital would not be affected by a P100,000 payment on

accounts payable:
Current assets (P1,300,000 P100,000) ................................ P1,200,000

Current liabilities (P520,000 P100,000) ............................. 420,000
Working capital ......................................................................
P 780,000
b. The current ratio would increase if the company makes a P100,000

payment on accounts payable:
Current assets
Current ratio =
Current liabilities
P1,200,000
= = 2.9 (rounded)
P420,000
Problem 13 (Effects of Transactions on Various Financial Ratios)
8-60
1. Decrease Sale of inventory at a profit will be reflected in an increase

in retained earnings, which is part of shareholders equity.
An increase in shareholders equity will result in a
decrease in the ratio of assets provided by creditors as
compared to assets provided by owners.
2. No effect Purchasing land for cash has no effect on earnings or on
the number of ordinary shares outstanding. One asset is
exchanged for another.
3. Increase A sale of inventory on account will increase the quick
assets (cash, accounts receivable, marketable securities)
but have no effect on the current liabilities. For this
reason, the acid-test ratio will increase.
4. No effect Payments on account reduce cash and accounts payable by
equal amounts; thus, the net amount of working capital is
not affected.
5. Decrease When a customer pays a bill, the accounts receivable
balance is reduced. This increases the accounts receivable
turnover, which in turn decreases the average collection
period.
6. Decrease Declaring a cash dividend will increase current liabilities,
but have no effect on current assets. Therefore, the current
ratio will decrease.
7. Increase Payment of a previously declared cash dividend will
reduce both current assets and current liabilities by the
same amount. An equal reduction in both current assets
and current liabilities will always result in an increase in
the current ratio, so long as the current assets exceed the
current liabilities.
8. No effect Book value per share is not affected by the current market
price of the companys stock.
9. Decrease The dividend yield ratio is obtained by dividing the
8-61
dividend per share by the market price per share. If the

dividend per share remains unchanged and the market
price goes up, then the yield will decrease.
10. Increase Selling property for a profit would increase net income
and therefore the return on total assets would increase.
11. Increase A write-off of inventory will reduce the inventory
balance, thereby increasing the turnover in relation to a
given level of cost of goods sold.
12. Increase Since the companys assets earn at a rate that is higher
than the rate paid on the bonds, leverage is positive,
increasing the return to the ordinary shareholders.
13. No effect Changes in the market price of a stock have no direct
effect on the dividends paid or on the earnings per share
and therefore have no effect on this ratio.
14. Decrease A decrease in net income would mean less income
available to cover interest payments. Therefore, the
times-interest-earned ratio would decrease.
15. No effect Write-off of an uncollectible account against the
Allowance for Bad Debts will have no effect on total
current assets. For this reason, the current ratio will
remain unchanged.
16. Decrease A purchase of inventory on account will increase current
liabilities, but will not increase the quick assets (cash,
accounts receivable, marketable securities). Therefore,
the ratio of quick assets to current liabilities will
decrease.
17. Increase The price-earnings ratio is obtained by dividing the
market price per share by the earnings per share. If the
earnings per share remains unchanged, and the market
price goes up, then the price-earnings ratio will increase.
18. Decrease Payments to creditors will reduce the total liabilities of a
company, thereby decreasing the ratio of total debt to
total equity.
Problem 14 (Interpretation of Financial Ratios)
8-62
a. The market price is going down. The dividends paid per share over the
three-year period are unchanged, but the dividend yield is going up.
Therefore, the market price per share of stock must be decreasing.
b. The earnings per share is increasing. Again, the dividends paid per share
have remained constant. However, the dividend payout ratio is
decreasing. In order for the dividend payout ratio to be decreasing, the
earnings per share must be increasing.
c. The price-earnings ratio is going down. If the market price of the stock is
going down [see part (a) above], and the earnings per share are going up
[see part (b) above], then the price-earnings ratio must be decreasing.
d. In Year 1, leverage was negative because in that year the return on total
assets exceeded the return on ordinary equity. In Year 2 and in Year 3,
leverage was positive because in those years the return on ordinary
equity exceeded the return on total assets employed.
e. It is becoming more difficult for the company to pay its bills as they
come due. Although the current ratio has improved over the three years,
the acid-test ratio is down. Also note that the accounts receivable and
inventory are both turning more slowly, indicating that an increasing
portion of the current assets is being made up of those items, from which
bills cannot be paid.
f. Customers are paying their bills more slowly in Year 3 than in Year 1.
This is evidenced by the decline in accounts receivable turnover.
g. Accounts receivable is increasing. This is evidenced both by a slowdown

in turnover and in an increase in total sales.
h. The level of inventory undoubtedly is increasing. Notice that the

inventory turnover is decreasing. Even if sales (and cost of goods sold)
just remained constant, this would be evidence of a larger average
inventory on hand. However, sales are not constant but rather are
increasing. With sales increasing (and undoubtedly cost of goods sold
also increasing), the average level of inventory must be increasing as
well in order to service the larger volume of sales.
IV. Cases
8-63
Case 1 (Common-Size Statements and Financial Ratios for Creditors)
Requirement 1
This Year Last Year

a. Current assets ..........................................................................................................
P2,060,000 P1,470,000
Current liabilities .....................................................................................................
1,100,000 600,000
Working capital........................................................................................................
P 960,000 P 870,000
b. Current assets (a) .....................................................................................................

P2,060,000 P1,470,000
Current liabilities (b) ...............................................................................................
P1,100,000 P600,000
Current ratio (a) (b) ..............................................................................................
1.87 to 1 2.45 to 1
c. Quick assets (a)........................................................................................................

P740,000 P650,000
Current liabilities (b) ...............................................................................................
P1,100,000 P600,000
Acid-test ratio (a) (b) ............................................................................................
0.67 to 1 1.08 to 1
d. Sales on account (a) .................................................................................................

P7,000,000 P6,000,000
Average receivables (b) ...........................................................................................
P525,000 P375,000
Turnover of receivables (a) (b).............................................................................
13.3 times 16.0 times
Average age of receivables:

365 turnover .........................................................................................................
27.4 days 22.8 days
e. Cost of goods sold (a) ..............................................................................................

P5,400,000 P4,800,000
Average inventory (b) ..............................................................................................
P1,050,000 P760,000
Inventory turnover (a) (b) .....................................................................................
5.1 times 6.3 times
Turnover in days: 365 turnover ............................................................................

71.6 days 57.9 days
f. Total liabilities (a) ...................................................................................................
P1,850,000 P1,350,000
Equity (b) .................................................................................................................
P2,150,000 P1,950,000
Debt-to-equity ratio (a) (b) ...................................................................................
0.86 to 1 0.69 to 1
g. Net income before interest and taxes (a) .................................................................

P630,000 P490,000
Interest expense (b)..................................................................................................
P90,000 P90,000
Times interest earned (a) (b) ................................................................................
7.0 times 5.4 times
Requirement 2
8-64
a. METRO BUILDING SUPPLY

Common-Size Balance Sheets
This Year Last Year

Current assets:
Cash ......................................................................................................................
2.3 % 6.1 %
Marketable securities ...........................................................................................
0.0 1.5
Accounts receivable, net ......................................................................................
16.3 12.1
Inventory ..............................................................................................................
32.5 24.2
Prepaid expenses ..................................................................................................
0.5 0.6
Total current assets ...................................................................................................
51.5 44.5
Plant and equipment, net ..........................................................................................
48.5 55.5
Total assets ...............................................................................................................
100.0 % 100.0 %
Liabilities:
Current liabilities .................................................................................................
27.5 % 18.2 %
Bonds payable, 12% .............................................................................................
18.8 22.7
Total liabilities .........................................................................................................
46.3 40.9
Equity:
Preference shares, P50 par, 8% ............................................................................
5.0 6.1
Ordinary shares, P10 par ......................................................................................
12.5 15.2
Retained earnings .................................................................................................
36.3 37.9
Total equity ..............................................................................................................
53.8 59.1
Total liabilities and equity........................................................................................
100.0 % 100.0 %
Note: Columns do not total down in all cases due to rounding.
b. METRO BUILDING SUPPLY

Common-Size Income Statements
This Year Last Year

Sales .........................................................................................................................
100.0 % 100.0 %
Less cost of goods sold ............................................................................................
77.1 80.0
Gross margin ............................................................................................................
22.9 20.0
Less operating expenses ...........................................................................................
13.9 11.8
Net operating income ...............................................................................................
9.0 8.2
Less interest expense ................................................................................................
1.3 1.5
8-65
Net income before taxes ...........................................................................................

7.7 6.7
Less income taxes.....................................................................................................
3.1 2.7
Net income ...............................................................................................................
4.6 % 4.0 %
Requirement 3
The following points can be made from the analytical work in parts (1) and
(2) above:
The company has improved its profit margin from last year. This is
attributable to an increase in gross margin, which is offset somewhat by an
increase in operating expenses. In both years the companys net income as a
percentage of sales equals or exceeds the industry average of 4%.
Although the companys working capital has increased, its current position
actually has deteriorated significantly since last year. Both the current ratio
and the acid-test ratio are well below the industry average, and both are
trending downward. (This shows the importance of not just looking at the
working capital in assessing the financial strength of a company.) Given the
present trend, it soon will be impossible for the company to pay its bills as
they come due.
The drain on the cash account seems to be a result mostly of a large buildup
in accounts receivable and inventory. This is evident both from the
common-size balance sheet and from the financial ratios. Notice that the
average age of the receivables has increased by 5 days since last year, and
that it is now 9 days over the industry average. Many of the companys
customers are not taking their discounts, since the average collection period
is 27 days and collection terms are 2/10, n/30. This suggests financial
weakness on the part of these customers, or sales to customers who are poor
credit risks. Perhaps the company has been too aggressive in expanding its
sales.
The inventory turned only 5 times this year as compared to over 6 times last
year. It takes three weeks longer for the company to turn its inventory than
the average for the industry (71 days as compared to 50 days for the
industry). This suggests that inventory stocks are higher than they need to be.
In the authors opinion, the loan should be approved on the condition that the
8-66
company take immediate steps to get its accounts receivable and inventory
back under control. This would mean more rigorous checks of
creditworthiness before sales are made and perhaps paring out of slow
paying customers. It would also mean a sharp reduction of inventory levels
to a more manageable size. If these steps are taken, it appears that sufficient
funds could be generated to repay the loan in a reasonable period of time.
Case 2 (Financial Ratios for Ordinary Shareholders)
Requirement 1
a. This Year Last Year

Net income ...............................................................................................................
P324,000 P240,000
Less preference dividends .......................................................................................
16,000 16,000
Net income remaining for ordinary (a) ....................................................................
P308,000 P224,000
Average number of ordinary shares (b) ...................................................................
50,000 50,000
Earnings per share (a) (b) .....................................................................................
P6.16 P4.48
b. Ordinary dividend per share (a)* .............................................................................

P2.16 P1.20
Market price per share (b) .......................................................................................
P45.00 P36.00
Dividend yield ratio (a) (b) ...................................................................................
4.8% 3.33%
*P108,000 50,000 shares = P2.16;
P60,000 50,000 shares = P1.20
c. Ordinary dividend per share (a) ...............................................................................

P2.16 P1.20
Earnings per share (b) ..............................................................................................
P6.16 P4.48
Dividend payout ratio (a) (b) ................................................................................
35.1% 26.8%
d. Market price per share (a) ........................................................................................

P45.00 P36.00
P6.16 P4.48
Price-earnings ratio (a) (b) ....................................................................................
7.3 8.0
Investors regard Metro Building Supply less favorably than other firms
in the industry. This is evidenced by the fact that they are willing to pay
only 7.3 times current earnings for a share of the companys stock, as
compared to 9 times current earnings for the average of all stocks in the
industry. If investors were willing to pay 9 times current earnings for
Metro Building Supplys stock, then it would be selling for about P55
per share (9 P6.16), rather than for only P45 per share.
e. This Year Last Year
8-67
Equity .......................................................................................................................
P2,150,000 P1,950,000
Less preference shares .............................................................................................
200,000 200,000
Ordinary equity (a)...................................................................................................
P1,950,000 P1,750,000
Number of ordinary shares (b) .................................................................................

50,000 50,000
Book value per share (a) (b) .................................................................................
P39.00 P35.00
A market price in excess of book value does not mean that the price of a
stock is too high. Market value is an indication of investors perceptions
of future earnings and/or dividends, whereas book value is a result of
already completed transactions and is geared to the past.
Requirement 2
a. This Year Last Year

Net income ...............................................................................................................
P 324,000 P 240,000
Add after-tax cost of interest paid:
[P90,000 (1 0.40)] ..........................................................................................
54,000 54,000
Total (a) ....................................................................................................................
P 378,000 P 294,000
Average total assets (b) ............................................................................................

P3,650,000 P3,000,000
Return on total assets (a) (b) .................................................................................
10.4% 9.8%
b. This Year Last Year

Net income ...............................................................................................................
P 324,000 P 240,000
Less preference dividends ........................................................................................
16,000 16,000
Net income remaining for ordinary
shareholders (a) ....................................................................................................
P 308,000 P 224,000
Average total equity* ...............................................................................................

P2,050,000 P1,868,000
Less average preference shares ................................................................................
200,000 200,000
Average ordinary equity (b) .....................................................................................
P1,850,000 P1,668,000
*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000).
Return on ordinary equity (a) (b) ..........................................................................

16.6% 13.4%
c. Financial leverage is positive in both years, since the return on ordinary

equity is greater than the return on total assets. This positive financial
8-68
leverage is due to three factors: the preference shares, which has a

dividend of only 8%; the bonds, which have an after-tax interest cost of
only 7.2% [12% interest rate (1 0.40) = 7.2%]; and the accounts
payable, which may bear no interest cost.
Requirement 3
We would recommend keeping the stock. The stocks downside risk seems
small, since it is selling for only 7.3 times current earnings as compared to 9
times earnings for the average firm in the industry. In addition, its earnings
are strong and trending upward, and its return on ordinary equity (16.6%) is
extremely good. Its return on total assets (10.4%) compares favorably with
that of the industry.
The risk, of course, is whether the company can get its cash problem under
control. Conceivably, the cash problem could worsen, leading to an eventual
reduction in profits through inability to operate, a reduction in dividends,
and a precipitous drop in the market price of the companys stock. This does
not seem likely, however, since the company can easily control its cash
problem through more careful management of accounts receivable and
inventory. If this problem is brought under control, the price of the stock
could rise sharply over the next few years, making it an excellent investment.
Case 3 (Comprehensive Ratio Analysis)
Requirement 1
This Year Last Year
a. Net income ...............................................................................................................
P 280,000 P 168,000
Add after-tax cost of interest:
P120,000 (1 0.30)...........................................................................................
84,000
P100,000 (1 0.30)...........................................................................................
70,000
Total (a) ....................................................................................................................
P 364,000 P 238,000
Average total assets (b) ............................................................................................

P5,330,000 P4,640,000
Return on total assets (a) (b) .................................................................................
6.8% 5.1%
b. Net income ...............................................................................................................

P 280,000 P 168,000
Less preference dividends ........................................................................................
48,000 48,000
8-69
Net income remaining for ordinary (a) ....................................................................

P 232,000 P 120,000
Average total equity .................................................................................................

P3,120,000 P3,028,000
Less average preference shares ................................................................................
600,000 600,000
Average ordinary equity (b) .....................................................................................
P2,520,000 P2,428,000
Return on ordinary equity (a) (b) ..........................................................................

9.2% 4.9%
c. Leverage is positive for this year, since the return on ordinary equity
(9.2%) is greater than the return on total assets (6.8%). For last year,
leverage is negative since the return on the ordinary equity (4.9%) is less
than the return on total assets (5.1%).
Requirement 2
This Year Last Year

a. Net income remaining for ordinary (a) ....................................................................
P 232,000 P 120,000
Average number of ordinary shares (b) ....................................................................
50,000 50,000
Earnings per share (a) (b)......................................................................................
P4.64 P2.40
b. Ordinary dividend per share (a) ...............................................................................

P1.44 P0.72
Market price per share (b) ........................................................................................
P36.00 P20.00
Dividend yield ratio (a) (b) ...................................................................................
4.0% 3.6%
c. Ordinary dividend per share (a) ...............................................................................

P1.44 P0.72
P4.64 P2.40
Dividend payout ratio (a) (b) ................................................................................
31.0% 30.0%
d. Market price per share (a) .............................................................................................

P36.00 P20.00
Earnings per share (b) ...................................................................................................
P4.64 P2.40
Price-earnings ratio (a) (b).........................................................................................
7.8 8.3
Notice from the data given in the problem that the average P/E ratio for
companies in Helixs industry is 10. Since Helix Company presently has
a P/E ratio of only 7.8, investors appear to regard it less well than they
do other companies in the industry. That is, investors are willing to pay
only 7.8 times current earnings for a share of Helix Companys stock, as
compared to 10 times current earnings for a share of stock for the
average company in the industry.
8-70
e. Equity .......................................................................................................................
P3,200,000 P3,040,000
Less preference shares .............................................................................................
600,000 600,000
Ordinary equity (a) ...................................................................................................
P2,600,000 P2,440,000
Number of ordinary shares (b) .................................................................................

50,000 50,000
Book value per share (a) (b) .................................................................................
P52.00 P48.80
Note that the book value of Helix Companys stock is greater than the
market value for both years. This does not necessarily indicate that the
stock is selling at a bargain price. Market value is an indication of
investors perceptions of future earnings and/or dividends, whereas book
value is a result of already completed transactions and is geared to the
past.
f. Gross margin (a) .......................................................................................................

P1,050,000 P860,000
Sales (b) ...................................................................................................................
P5,250,000 P4,160,000
Gross margin percentage (a) (b) ...........................................................................
20.0% 20.7%
Requirement 3
This Year Last Year
a. Current assets ...........................................................................................................
P2,600,000 P1,980,000
Current liabilities .....................................................................................................
1,300,000 920,000
Working capital ........................................................................................................
P1,300,000 P1,060,000
b. Current assets (a) .....................................................................................................

P2,600,000 P1,980,000
Current liabilities (b) ................................................................................................
P1,300,000 P920,000
Current ratio (a) (b)...............................................................................................
2.0 to 1 2.15 to 1
c. Quick assets (a) ........................................................................................................

P1,220,000 P1,120,000
Current liabilities (b) ................................................................................................
P1,300,000 P920,000
Acid-test ratio (a) (b) ............................................................................................
0.94 to 1 1.22 to 1
d. Sales on account (a) .................................................................................................

P5,250,000 P4,160,000
Average receivables (b) ............................................................................................
P750,000 P560,000
Accounts receivable turnover (a) (b) ....................................................................
7.0 times 7.4 times
Average age of receivables,
365 turnover ......................................................................................................
52 days 49 days
e. Cost of goods sold (a) ..............................................................................................
P4,200,000 P3,300,000
Average inventory (b) ..............................................................................................
P1,050,000 P720,000
8-71
Inventory turnover (a) (b) .....................................................................................

4.0 times 4.6 times
Number of days to turn inventory,
365 days turnover (rounded) .............................................................................
91 days 79 days
f. Total liabilities (a) ....................................................................................................

P2,500,000 P1,920,000
Equity (b) .................................................................................................................
P3,200,000 P3,040,000
Debt-to-equity ratio (a) (b) ...................................................................................
0.78 to 1 0.63 to 1
g. Net income before interest and taxes (a) .................................................................

P520,000 P340,000
Interest expense (b) ..................................................................................................
P120,000 P100,000
Times interest earned (a) (b) .................................................................................
4.3 times 3.4 times
Requirement 4
As stated by Meri Ramos, both net income and sales are up from last year.
The return on total assets has improved from 5.1% last year to 6.8% this
year, and the return on ordinary equity is up to 9.2% from 4.9% the year
before. But this appears to be the only bright spot in the companys operating
picture. Virtually all other ratios are below the industry average, and, more
important, they are trending downward. The deterioration in the gross
margin percentage, while not large, is worrisome. Sales and inventories have
increased substantially, which should ordinarily result in an improvement in
the gross margin percentage as fixed costs are spread over more units.
However, the gross margin percentage has declined.
Notice particularly that the average age of receivables has lengthened to 52

daysabout three weeks over the industry averageand that the inventory
turnover is 50% longer than the industry average. One wonders if the
increase in sales was obtained at least in part by extending credit to high-risk
customers. Also notice that the debt-to-equity ratio is rising rapidly. If the
P1,000,000 loan is granted, the ratio will rise further to 1.09 to 1.
In the authors opinion, what the company needs is more equitynot more
debt. Therefore, the loan should not be approved. The company should be
encouraged to make another issue of ordinary stock in order to provide a
broader equity base on which to operate.
Case 4 (Statement Reconstruction Using Ratios)
Bulacan Company
8-72
Income Statement
For the Year Ended December 31, 2005
Sales P140,800
Less: Cost of Sales (4) 84,480
Gross Profit P 56,320
Less: Expenses 46,320
Net Income (1) P 10,000
Bulacan Company
Balance Sheet
December 31, 2005
Assets
Current Assets:
Cash P 27,720
Accounts Receivable (5) 28,160
Merchandise Inventory (3) 21,120
Total Current Assets (2) P 77,000
Fixed Assets (8) 55,000
Total Assets P132,000
Current Liabilities:
Accounts Payable (2) P 44,000
Equity:
Share Capital (issued 20,000 shares) (6) P40,000
Retained Earnings 48,000 88,000
Total Liabilities and Equity P132,000
Supporting Computations:
Net Income
(1) Earnings Per Share =
Ordinary Shares Outstanding
X
P0.50 =
20,000
8-73
X (Net Income) = P10,000
(2) Current Assets Pxx 1.75

Current Liabilities xx 1
Working Capital P33,000 0.75
Current Liabilities = P33,000 0.75
= P44,000
Current Assets
(3) Current Ratio =
Current Liabilities
X
1.27 =
44,000
X (Current Assets) = P77,000
Quick Assets
Quick Ratio =
Current Liabilities
X
1.27 =
44,000
X (Current Assets) = P55,880
Current Assets P77,000

Quick Assets 55,800
Inventory P21,120
Cost of Sales
(4) Inventory turnover = Ave. Inventory
X
4 =
P21,120
X (Cost of Sales) = P84,480
8-74
Quick Assets
(5) Average age of outstanding =
Current Liabilities
Accounts Receivable
365
= 73 days (Average age of
5
receivables)
Net Sales
Average Receivables = 5
P140,800
X = 5
X (Receivables) = P28,160
Another Method:
P140,800
365 = 73 days = P28,160 Accounts receivable
(6) Earnings for the year as a percentage of Share Capital

P10,000
= 25%
Share Capital
Share Capital = P40,000
(7) Current Fixed Current Liabilities +

Assets + Assets = Equity
P77,000 + 0.625X = P44,000 + X
0.375X = P33,000
X = P88,000 Equity
(8) Fixed Assets to Equity
Fixed Assets
= 0.625
Equity
X
= 0.625
P140,800
8-75
X (Fixed Assets) = P55,000
Case 5 (Ethics and the Manager)
Requirement 1
The loan officer stipulated that the current ratio prior to obtaining the loan
must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the
interest on the loan must be no more than four times net operating income.
These ratios are computed below:
Current assets
Current ratio =
Current liabilities
P290,000
Current rate = = 1.8 (rounded)
P164,000
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000
Acid-test ratio = = 0.70 (rounded)
P164,000
Net operating income P20,000
= = 5.0
Interest on the loan P80,000 x 0.10 x (6/12)
The company would fail to qualify for the loan because both its current ratio
and its acid-test ratio are too low.
Requirement 2
By reclassifying the P45 thousand net book value of the old machine as
inventory, the current ratio would improve, but there would be no effect on
the acid-test ratio. This happens because inventory is considered to be a
current asset but is not included in the numerator when computing the acid-
test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
P164,000
Cash + Marketable securities + Current receivables

Acid-test ratio =
Current liabilities
P70,000 + 8-76
P0 + P50,000
P164,000
Even if this tactic had succeeded in qualifying the company for the loan, we
strongly advise against it. Inventories are assets the company has acquired
for the sole purpose of selling them to outsiders in the normal course of
business. Used production equipment is not considered to be inventory
even if there is a clear intention to sell it in the near future. Since the loan
officer would not expect used equipment to be included in inventories, doing
so would be intentionally misleading.
Nevertheless, the old equipment is an asset that could be turned into cash. If
this were done, the company would immediately qualify for the loan since
the P45 thousand in cash would be included in the numerator in both the
current ratio and in the acid-test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
P164,000
Cash + Marketable securities + Current receivables

Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000 + P45,000
P164,000
However, other options may be available. After all, the old machine is being
used to relieve bottlenecks in the plastic injection molding process and it
would be desirable to keep this standby capacity. We would advise Rome to
fully and honestly explain the situation to the loan officer. The loan officer
might insist that the machine be sold before any loan is approved, but he
might instead grant a waiver of the current ratio and acid-test ratio
requirements on the basis that they could be satisfied by selling the old
machine. Or he may approve the loan on the condition that the equipment is
pledged as collateral. In that case, Rome would only have to sell the machine
if he would otherwise be unable to pay back the loan.
Case 6 (Financial Ratios for Ordinary Shareholders)

[pesos in thousands]
Requirement (1)
8-77
Calculation of the gross margin percentage:

Gross margin
Gross margin percentage =
Sales
P23,000
= = 34.8%
P66,000
Requirement (2)
Calculation of the earnings per share:

Net income Preference dividends
Earnings per share =
Average number of ordinary shares outstanding
P1,980 P60
= = P3.20 per share
600 shares
Requirement (3)
Calculation of the price-earnings ratio:

Market price per share
Price-earnings ratio =
Earnings per share
P26
= = 8.1
P3.20
Requirement (4)
Calculation of the dividend payout ratio:

Dividends per share
Dividend payout ratio =
Earnings per share
P0.75
= = 23.4%
P3.20
Requirement (5)
Calculation of the dividend yield ratio:

Dividends per share
Dividend yield ratio =
Market price per share
P0.75
= = 2.9%
P26.00
8-78
Requirement (6)
Calculation of the return on total assets:
Net income + [Interest expense x (1 Tax rate)]

Return on total assets =
Average total assets
P1,980 + [P800 x (1 0.40)]
= = 3.7%
(P65,810 + P68,480) / 2
Requirement (7)
Calculation of the return on ordinary shareholders equity:
Beginning balance, shareholders equity (a) P39,610

Ending balance, shareholders equity (b) 41,080
Average shareholders equity [(a) + (b)]/2 40,345
Average preference shares 1,000
Average ordinary shareholders equity P39,345
Return on ordinary Net income Preference dividends
=
shareholders equity Average ordinary shareholders equity
P1,980 P60
= = 4.9%
P39,345
Requirement (8)
Calculation of the book value per share:

Book value Total shareholders equity Preference shares
=
per share Number of ordinary shares outstanding
P41,080 P1,000
= = P66.80 per share
Case 7 (Financial Ratios for Short-Term
600 shares Creditors)
Requirement (1)
Calculation of working capital:
Working capital = Current assets Current liabilities

= P22,680 P19,400 = P3,280
8-79
Requirement (2)
Calculation of the current ratio:

Current assets
Current ratio =
Current liabilities
P22,680
= = 1.17
P19,400
Requirement (3)
Calculation of the acid-test ratio:

Cash + Marketable securities
+ Accounts receivable + Short-term notes
Acid-test ratio =
Current liabilities
P1,080 + P0 + P9,000 + P0
Acid-test ratio = = 0.52
P19,400
Requirement (4)
Calculation of accounts receivable turnover:
Accounts receivable Sales on account

= Average accounts receivable balance
turnover
P66,000
(P6,500 + P9,000) / 2
Requirement (5)
Calculation of the average collection period:
Average collection 365 days

= Accounts receivable turnover
period
365 days
Acid-test ratio = = 42.9 days
8.5
8-80
Requirement (6)
Calculation of inventory turnover:
Inventory Cost of goods sold

= Average inventory balance
turnover
P43,000
(P10,600 + P12,000) / 2
Requirement (7)
Calculation of the average sale period:
Average sale 365 days

= Inventory turnover
period
365 days
Acid-test ratio = = 96.1 days
3.8
Case 8 (Financial Ratios for Long-Term Creditors)
Requirement (1)
Calculation of the times interest earned ratio:
Times interest Earnings before interest expense

= and income taxes
earned ratio
Inventory expense
P4,100
P800
Requirement (2)
Calculation of the debt-to-equity ratio:
Debt-to-equity Total liabilities

= Shareholders equity
ratio
P27,400
P41,080
8-81
41. A 39. C 34. B 41. C 41. C

42. C 40. A 35. D 42. D
43. D 41. C 36. A 43. C
44. B 42. B 37. C 44. A
45. A 43. D 38. A 45. A
46. D 44. B 39. C 46. C
47. C 45. A 40. D 47. A
48. D 46. C 41. A 48. A
49. A 47. A 42. D 49. C
50. B 48. C 43. A 50. C
CHAPTER 6
CASH FLOW ANALYSIS
I. Questions
1. Purposes of the Statement of Cash Flows

a. To predict future cash flows
b. To evaluate management decisions
c. To determine the ability to pay dividends to shareholders and
interest and principal to creditors
d. To show the relationship of net income to changes in the
businesss cash.
2. Comparative balance sheets present the financial position of the

enterprise at two points in time. The income statement for the period
between the two balance sheets describes how the income-producing
activities affected the financial position. Because cash flows from
operating activities may differ substantially from net income, and
because numerous other financing and investing activities have an
8-82
impact on financial position, the statement of cash flows is necessary.

The statement emphasizes changes in the cash balances that result from
changes in assets, liabilities and equity accounts caused by operating,
investing and financing activities.
3. The most important source of cash for many successful companies is

from operating activities. A large positive operating cash flow is a good
sign because it means funds have been internally generated with no fixed
obligations or commitment to return such to anybody.
4. It is possible for cash to decrease during a year when income is high

because cash may be used not only for operating activities but also for
investing and financing activities.
5. Transactions involving accounts payable are not considered to be

financing activities because such transactions are used to obtain goods
and services rather than to obtain cash. Furthermore, purchases of goods
and services relate to a companys day-to-day operating activities.
6. The loss is added back to net income to avoid double counting since the
entire proceeds from the sale (net book value minus loss on sale) will
appear as a cash inflow from investing activities.
7. Three categories of transactions that may result in increases in cash are

a. Operating activities
b. Investing activities (e.g., sale of investments or other assets).
c. Financing activities (e.g., borrowing or sale of shares).
These activities are sources of cash when cash is increased as a result of

the particular activity.
8. Three categories of transactions that may result in decreases in cash are

a. Operating activities
b. Investing activities (e.g., purchase of investments or other assets).
c. Financing activities (e.g., repayment of debt or retirement of shares).
These activities are uses of cash when cash is decreased as a result of the
particular activity.
8-83
9. Noncash transactions do not provide or consume cash even though they

may result in significant changes in financial position. Examples are the
issuance of share capital for plant assets and the conversion of debt or
preference shares into ordinary shares. Such transactions are not
presented in the body of the statement of cash flows but rather disclosed
in a separate schedule as financing or investing activities.
10. While net loss is usually associated with a decrease in cash, it may be a
source of cash if noncash expenses are greater than the amount of the net
loss. For example, if a net loss of P100,000 included amortization and
depreciation of P125,000 and no noncash revenues existed, cash
provided by operating activities would be P25,000, computed as follows:
Net loss P(100,000)

Add: Expenses not requiring cash depreciation
and amortization 125,000
Net cash provided by operating activities P 25,000
11. The change in cash is the difference between cash at the beginning and
end of the accounting period. The net amount of cash provided by or
used in operating, investing and financing activities must equal this
change in cash. For example, if cash increased by P150,000 during the
year, total sources from operating, investing, and financing activities
must exceed total uses by P150,000. Also, if cash decreased by P25,000
during the year, total uses of cash must exceed total sources by P25,000.
12. (a) The use of cash does not occur until the cash dividend is actually
paid in the next period. The declaration of the dividend does affect
financial position, however, and should be disclosed as a noncash
financing activity in a separate schedule accompanying the statement
of cash flows.
(b) Because the dividend was declared and paid in the same accounting
period, it appears in the statement of cash flows as a cash decrease in
the financing activities category.
13. Disagree. The refunding of 10% debt by the 8% debt represents a

significant financing activity, even though the net impact of the
exchange on the balance sheet or on the amount of cash is not material.
8-84
The issuance of 8% bonds and the retirement of 10% bonds should be

reported as noncash financing transactions in a schedule accompanying
the statement of cash flows.
14. The net income figure includes P150,000 as an expense. Only P112,500
of this amount resulted in a decrease in cash, because P37,500 represents
an increase in the deferred income tax liability account. In determining
cash provided by operating activities, the amount of income tax paid is
P112,500 (direct method). Alternatively, under the indirect method,
P37,500 must be added to net income to determine cash flows from
operating activities.
15. The loss is omitted when listing expenses requiring cash payment (direct
approach) or added back to net income (indirect approach) in
determining cash provided by operating activities. This eliminates the
impact of the transaction from cash provided by operating activities.
Then, the proceeds from the sale are included as a source of cash in the
investing activities category of the statement of cash flows. Any tax
effects of the transaction are included in the tax expense figure and
remain a part of cash flows from operating activities.
16. (1) Operating activities: Transactions that affect current assets, current
liabilities, or net income.
(2) Investing activities: Transactions that involve the acquisition or
disposition of noncurrent assets.
(3) Financing activities: Transactions (other than the payment of
interest) involving borrowing from creditors, and any transactions
(involving the owners of a company.
17. Interest is included as an operating activity since it is part of net income.

Financing activities are narrowly defined to include only the principal
amount borrowed or repaid.
18. Since the entire proceeds from a sale of an asset (including any gain)
appear as a cash inflow from investing activities, the gain must be
deducted from net income to avoid double counting.
19. The direct method reconstructs the income statement on a cash basis by
restating revenues and expenses in terms of cash inflows and outflows.
8-85
The indirect method starts with net income and adjusts it to a cash basis
to determine the cash provided by operating activities.
20. An increase in the Accounts Receivable account must be deducted from

net income under the indirect method because this is an increase in a
noncash asset.
21. A decrease in the Accounts Payable account must be added to cost of

goods sold under the direct method. The cost of goods sold is increased
by the amount of the decrease in accounts payable. Because the cost of
goods sold is increased, the net cash flow provided by operating
activities is decreased. The effect of a decrease in a liability is a decrease
in cash.
22. A sale of equipment for cash would be classified as an investing activity.

Any transaction involving the acquisition or disposition of noncurrent
assets is classified as an investing activity.
II. Exercises
Exercise 1
Net income .....................................................................................................................

P84,000
Adjustments to convert net income to a cash basis:
Depreciation charges for the year ..............................................................................
P50,000
Increase in accounts receivable .................................................................................
(60,000)
Increase in inventory..................................................................................................
(77,000)
Decrease in prepaid expenses ....................................................................................
2,000
Increase in accounts payable .....................................................................................
30,000
Decrease in accrued liabilities ...................................................................................
(4,000)
Increase in deferred income taxes ..............................................................................
6,000 (53,000)
Net cash provided by operating activities ......................................................................P31,000
Exercise 2
Sales..................................................................................................
P1,000,000
Adjustments to a cash basis:
60,000
Less increase in accounts receivable ........................................ P940,000
Cost of goods sold ............................................................................
580,000
8-86
Plus increase in inventory .........................................................

+ 77,000
30,000
Less increase in accounts payable ............................................ 627,000
Selling and administrative expenses.................................................
300,000

Less decrease in prepaid expenses ...........................................
2,000
Plus decrease in accrued liabilities ...........................................
+ 4,000
50,000
Less depreciation charges ......................................................... 252,000
Income taxes .....................................................................................
36,000

Less increase in deferred income taxes .................................... 6,000 30,000
Net cash provided by operating activities ........................................ P 31,000
Note that the P31,000 agrees with the cash provided by operating activities
figure under the indirect method in the previous exercise.
Exercise 3
Item Amount Add Deduct

Accounts Receivable ........................................
P70,000 decrease X
Accrued Interest Receivable ............................ P6,000 increase X
Inventory ..........................................................
P110,000 increase X
Prepaid Expenses .............................................
P3,000 decrease X
Accounts Payable .............................................
P40,000 decrease X
Accrued Liabilities ...........................................
P9,000 increase X
Deferred Income Taxes Liability ..................... P15,000 increase X
Sale of equipment ............................................
P8,000 gain X
Sale of long-term investments.......................... P12,000 loss X
Exercise 4
Requirement (1)
Net income .................................................................................................. P75

Adjustments to convert net income to a cash basis:
Depreciation charges ...............................................................................
P40
Decrease in accounts receivable ............................................................. 10
Increase in inventory ...............................................................................
(30)
8-87
Decrease in prepaid expenses .................................................................5

Increase in accounts payable...................................................................
20
Decrease in accrued liabilities ................................................................
(10)
Increase in taxes payable ........................................................................
10
Increase in deferred taxes .......................................................................
5
Loss on sale of long-term investments.................................................... 5
Gain on sale of land ................................................................................
(40) 15
Net cash provided by operating activities ................................................... P90
Requirement (2)
Swan Company
Operating activities:
Net cash provided by operating activities (see above) .........................................
P 90
Investing activities:
Proceeds from sale of long-term investments ......................................................
P 45
Proceeds from sale of land ...................................................................................
70
Additions to long-term investments .....................................................................
(20)
Additions to plant & equipment ...........................................................................
(150)
Net cash used for investing activities ...................................................................
(55)
Financing activities:
Decrease in bonds payable ...................................................................................
(20)
Increase in ordinary shares ...................................................................................
40
Cash dividends .....................................................................................................
(35)
Net cash used by financing activities ................................................................... (15)
Net increase in cash (net cash flow) ....................................................................20

Cash balance, beginning.......................................................................................
100
Cash balance, ending............................................................................................
P120
While not a requirement, a worksheet may be helpful.
Change Source Cash Adjust- Adjusted Classification
8-88
or Flow ments Effect

Use? Effect
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable ................................................. 10 Source +10 +10 Operating
Inventory ................................................................... +30 Use 30 30 Operating
Prepaid expenses..................................................... 5 Source +5 +5 Operating
Noncurrent assets:
Long-term investments ............................................. 30 Source +30 50 20 Investing

Plant and equipment ................................................ +150 Use 150 150 Investing
Land ......................................................................... 30 Source +30 30 0 Investing
Liabilities, Contra assets, and Shareholders Equity

Contra assets:
Accumulated depreciation ........................................ +40 Source +40 +40 Operating
Accounts payable ..................................................... +20 Source +20 +20 Operating
Accrued liabilities ..................................................... 10 Use 10 10 Operating
Taxes payable .......................................................... +10 Source +10 +10 Operating
Noncurrent liabilities:
Bonds payable.......................................................... 20 Use 20 20 Financing
Deferred income taxes ............................................. +5 Source +5 +5 Operating
Shareholders equity:
Ordinary shares ........................................................ +40 Source +40 +40 Financing
Retained earnings:
Net income .......................................................... +75 Source +75 +75 Operating
Dividends ............................................................ 35 Use 35 35 Financing
Additional entries
Proceeds from sale of investments ............................... +45 +45 Investing
Loss on sale of investments .......................................... +5 +5 Operating
Proceeds from sale of land ............................................ +70 +70 Investing
Gain on sale of land....................................................... 40 40 Operating
Total +20 0 +20
Exercise 5
Sales............................................................................................
P600
Decrease in accounts receivable .........................................+10 P610
Cost of goods sold ......................................................................250
Increase in inventory...........................................................+30
Increase in accounts payable ..............................................20 260
8-89
Selling and administrative expenses...........................................280

Decrease in prepaid expenses ............................................. 5
Decrease in accrued liabilities ............................................+10
Depreciation charges ..........................................................40 245
Income taxes ............................................................................... 30
Increase in taxes payable ....................................................10
Increase in deferred taxes ................................................... 5 15
Net cash provided by operating activities .................................. P 90
Exercise 6
Requirements (1) and (2)
Stephenie Company
Operating activities:
Net income...............................................................................................
P 56
Adjustments to convert net income to cash basis:
Depreciation charges .......................................................................
25
Increase in accounts receivable .......................................................(80)
Decrease in inventory ......................................................................
35
Increase in prepaid expenses ........................................................... (2)
Increase in accounts payable ...........................................................75
Decrease in accrued liabilities .........................................................
(10)
Gain on sale of investments .............................................................(5)
Loss on sale of equipment ............................................................... 2
Increase in deferred income taxes ................................................... 8 48
Net cash provided by operating activities ............................................... 104
Investing activities:
Proceeds from sale of long-term investments..........................................
12
Proceeds from sale of equipment ............................................................
18
Additions to plant and equipment ...........................................................
(110)
Net cash used for investing activities ...................................................... (80)
8-90
Financing activities:
Increase in bonds payable ........................................................................
25
Decrease in ordinary shares .....................................................................
(40)
Cash dividends.........................................................................................
(16)
Net cash used for financing activities ..................................................... (31)
Net decrease in cash ................................................................................ (7)

Cash balance, January 1, 2008 ................................................................ 11
Cash balance, December 31, 2008 .......................................................... P 4
While not a requirement, a worksheet may be helpful.

Source Cash
or Flow Adjust- Adjusted Classi-
Change Use? Effect ments Effect fication
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable ................................................. +80 Use 80 80 Operating
Inventory ................................................................... 35 Source +35 +35 Operating
Prepaid expenses..................................................... +2 Use 2 2 Operating
Noncurrent assets:
Plant and equipment ................................................ +80 Use 80 30 110 Investing
Long-term investments ............................................. 7 Source +7 7 0 Investing
Liabilities, Contra assets, and Shareholders Equity

Contra assets:
Accumulated depreciation ........................................ +15 Source +15 +10 +25 Operating
Accounts payable ..................................................... +75 Source +75 +75 Operating
Accrued liabilities ..................................................... 10 Use 10 10 Operating
Noncurrent liabilities:
Bonds payable.......................................................... +25 Source +25 +25 Financing
Deferred income taxes ............................................. +8 Source +8 +8 Operating
Shareholders equity:
Ordinary shares ........................................................ 40 Use 40 40 Financing
Retained earnings:
Net income .......................................................... +56 Source +56 +56 Operating
Dividends ............................................................ 16 Use 16 16 Financing
Additional entries
Proceeds from sale of equipment ................................... +18 +18 Investing
Loss on sale of equipment.............................................. +2 +2 Operating
Proceeds from sale of long-term investments ................ +12 +12 Investing
Gain on sale of long-term investments ........................... 5 5 Operating
8-91
Total 7 0 7
II. Problems
Problem 1
Transaction Operating Investing Financing Source Use

1. Short-term investment
securities were
purchased .................... X X
2. Equipment was
purchased .................... X X
3. Accounts payable
increased ..................... X X
4. Deferred taxes
decreased..................... X X
5. Long-term bonds were
issued .......................... X X
6. Ordinary shares were
sold.............................. X X
7. Interest was paid to
long-term creditors ...... X X
8. A long-term mortgage
was entirely paid off .... X X
9. A cash dividend was
declared and paid ........ X X
10. Inventories decreased ... X X
11. Accounts receivable
increased ....................... X X
12. Depreciation charges
totaled P200,000 for the
year ............................... X X
Problem 2 (Analysis of Cash Flow Transactions)
Requirement (a)
The eight items should be presented in the statement of cash flows as

follows:
1. Net income is the basis for the calculation of cash flows from operating
activities by starting with that number and adjusting for noncash revenue
and expense transactions (indirect method) or by computing by the direct
8-92
method the positive cash flows from revenues, less the negative cash
flows from expenses. The cash flows from the transaction giving rise to
the extraordinary loss is reclassified as an investing activity.
2. The acquisition of intangibles is a negative cash flow from investing
activities. The amortization is a noncash expense in determining cash
flows from operating activities.
3. The payment of a cash dividend is a negative cash flow that is presented
in the financing activities section of the statement.
4. The purchase of treasury share is a negative cash flow in the financing
activities section of the statement.
5. The depreciation expense recognized during the year is a noncash
expense in determining cash flows from operating activities.
6. The conversion of convertible bonds into ordinary shares is a noncash
financing activity that requires disclosure in a separate schedule.
7. The changes in plant asset accounts land, equipment, and building
represent activities whose cash flow effects are presented in the
investing activities section of the statement.
8. The increase in working capital also represents the change in cash
because all other current assets and current liabilities remained constant.
The net of all cash flows from operating, investing and financing
activities must reconcile with the change in cash in the statement of cash
flows.
Requirement (b)
1. Net cash provided by operating activities

Net income P145,000
Noncash expense adjustments:
Depreciation expense 46,250
Amortization expense 6,000
Reclassification of extraordinary loss 15,000
P212,250
2. Net cash used in investing activities
Purchase of intangible assets P (34,000)
Purchase of land (130,000)
Purchase of equipment (60,000)
Purchase of building (100,000)
Sale of land 165,000
8-93
P(159,000)
3. Net cash used in financing activities
Purchase of treasury shares P(31,000)
Payment of dividends (12,500)
P(43,500)
Computations:
Depreciation expense
Change in accumulated depreciation account P35,000
Accumulated depreciation on fully depreciated
assets disposed 11,250
P46,250
Purchase of land
Change in land account P (50,000)
Cost of land sold in condemnation proceedings 180,000
P130,000
Problem 3 (Cash Flow from Operating Activities)
Cash received from customers:

Total revenues P185,000
Less: Note receivable (15,000) P170,000
Cash disbursed for expenses:
Total expenses (P173,000 + P4,200) P177,200
Less: Income taxes deferred (1,260)
Depreciation (25,000)
Amortization (7,000) (143,940)
Problem 4 (Cash Flow from Operating Activities)
Cash received from customers (1) P5,237,000

Cash paid for expenses:
Cost of goods sold P3,150,000
Selling 246,000
Salaries and wages (2) 394,400
Interest (3) 65,200
Miscellaneous operating 5,000
Incomes taxes (4) 335,000 4,195,600
8-94
Net cash provided by operating activities P1,041,400

Computations:
1. Revenue from sales P5,432,000
Less: Note receivable (120,000)
Land (75,000)
P5,237,000
2. Salaries and wages expense P 400,000

Less: Increase in accrued salaries and wages
(P45,600 P40,000) (5,600)
P 394,400
3. Interest expense P 72,000

Less: Discount amortization (6,800)
P 65,200
4. Income tax expense P 445,000

Less: Deferred portion (110,000)
P 335,000
Problem 5 (Statement of Cash Flows Preparation Indirect)
Green Tea Company


activities
Net income* P8,500
Adjustments to reconcile net
income to net cash flows
provided by operating activities:
Depreciation 1,000
Amortization of intangibles 1,000
Increase in current assets (6,000)
Increase in current liabilities 3,000
*
Increase in retained earnings (P20,000 P13,000) P7,000
Dividends declared 1,500
Net income P8,500
8-95
Net cash provided by operating P7,500

activities
Cash flows from financing activities

Dividends paid (1,500)
Retirement of long-term liabilities (1,000)
Net cash used in financing (2,500)
activities
Net increase in cash P 5,000
Cash, January 1, 2005 10,000
Cash, December 31, 2005 P15,000
Problem 6 (Cash Flow Statement Preparation Direct)
Requirement (a)
Hundred Acre Company


activities
Cash received from customers P74,000
Cash paid for expense 67,000
Net cash provided by P7,000
operating activities
Cash flow from investing activities
Sale of equipment 9,500
Sale of investments 15,000
Acquisition of equipment (53,000)
Net cash used in investing (28,500)
activities
Cash flows from financing activities
Sale of ordinary shares 40,000
Payment of cash dividends (8,500)
Net cash used in financing 31,500
activities
Net increase in cash P10,000
Cash, January 1, 2005 20,000
Cash, December 31, 2005 P30,000
8-96
Reconciliation of net income to net cash

provided by operating activities:
Net income P15,000
Adjustments to reconcile net income to
net cash provided by operating
activities:
Depreciation expense 24,500*
Amortization expense 1,000
Increase in accounts receivable (33,000)
Decrease in accrued expenses (500)
Computations:
Cash received from customers:
Revenues P107,000
Deduct: Increase in accounts receivable
(P78,000 P45,000) 33,000
P 74,000
Cash paid for expenses:
Expenses P 92,000
Add: Decrease in accrued expenses
(P7,500 P7,000) 500
Deduct: Depreciation expense
(P33,600 P27,100 + P18,000) (24,500)
Amortization (1,000)
P 67,000
Cash from sale of equipment:
Cost P 27,500
Deduct: Accumulated depreciation (18,000)
Cash received on sale at book value P 9,500
Cash paid to acquire equipment:
Increase in property, plant and equipment
(P118,100 P92,600) P 25,500
Cost of machinery sold 27,500
*
Net increase during 2005 (P33,600 P27,100) P 6,500
Accumulated depreciation on assets sold 18,000
Depreciation expense for 2005 P24,500
8-97
P 53,000
Cash received on sale of shares:
Increase in ordinary shares amount
(P100,000 P75,000) P 25,000
Increase in additional paid-in capital account
(P55,000 P40,000) 15,000
P 40,000
Cash dividends:
Increase in retained earnings (P21,000 P14,500) P 6,500
Net income (P107,000 P92,000) (15,000)
P 8,500
Requirement (b)
The reconciliation of net income to net cash provided by or used in operating

activities is required to be disclosed in order to show more clearly the
relationship and emphasize the differences between the two. Users of
financial statements are often not as aware of the accrual concepts, which
determine net income, as are preparers of those statements. The
reconciliation of net income to net cash flows from operating activities
clearly demonstrates that the two are different and details those events and
transactions that account for the difference.
Problem 7 (Interpretation of Cash Flow Statement)
Requirement (a)
The two companies are similar in the following respects:

1. Overall size.
2. Industry in which they operate.
3. Current ratio (2.4 to 1).
4. Overall peso amounts of cash provided and used:
Range, 2002-2005
Cash Cash Used
Provided
Ebony P125,000 P115,000
Company P168,000 P170,000
Ivory P135,000 P125,000
8-98
Company P160,000 P165,000
5. Net increase in working capital is identical for each year, 2002

2005.
Requirement (b)
The two companies are dissimilar in the makeup of the sources of cash, as
indicated in the following analysis:
Sources of Cash in Percentages

2002 2003 2004
Ebony Ivory Ebony Ivory Ebony I
Cash
provided:
Operations 80 37 77 21 70 (
Long-term debt 8 56 -- 10 --
Share capital -- -- 16 52 --
Asset disposition 12 7 7 17 30
100 100 100 100 100 1
Ebony Company has relied much more heavily on operations to provide cash
and to a very limited extent on debt and equity financing and asset
disposition. On the other hand, Ivory Company has not been able to provide
cash from operations and has been required to rely on the alternatives of debt
and equity financing and asset disposition.
Requirement (c)
Ebony Company is in a considerably stronger position (as determined by the

data given) and thus should be considered the better investment and credit
risk. The following points are significant:
1. Ebony Company has provided 70%-80% of its cash via operating
activities, supplementing with other means to maintain a current
ratio at the industry average. Ebony has not had to rely consistently
on any alternative source of funding.
2. Ivory Company has apparently been forced to rely continuously on
debt financing except in 2005, perhaps because of the inability to
obtain such financing. The year 2004 is particularly weak for Ivory,
with operations resulting in a P60,000 reduction in cash. The ability
8-99
of Ivory to sustain its present financial position (i.e., current ratio,

etc.) is questionable in light of its history.
III. Multiple Choice Questions
1. D 4. D 7. C 10. B
2. C 5. B 8. B 11. A
3. D 6. D 9. A 12. D
CHAPTER 7
GROSS PROFIT VARIATION ANALYSIS AND

EARNINGS PER SHARE DETERMINATION
I. Problems
Problem I
The Dawn Mining Company

Gross Profit Variation Analysis
For 2006
Increase in Sales:
Quantity Factor [(24,000) x P8] P(192,000)
Price Factor (105,000 x P3) 315,000
Quantity/Price Factor [(24,000) x P3] (72,000) P 51,000
Less: Increase (decrease) in Cost of Sales:
Quantity Factor [(24,000) x P9] P(216,000)
Cost Factor [105,000 x (P.50)] (52,500)
Quantity/Cost Factor [(24,000) x (P.50)] 12,000 (256,500)
Increase in Gross Profit P 307,500
Problem II
1. Selling Price Factor

Sales in 2006 P210,000
8-100
Less: Sales in 2006 at 2005 prices

(P210,000 105%) 200,000
Favorable P 10,000
2. Cost Factor
Cost of Sales in 2006 P164,000
Less: Cost of Sales in 2006 at 2005 costs 176,000
Favorable P(12,000)
3. Quantity Factor
Increase in Sales
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Favorable P 50,000
Less: Increase in Cost of Sales
Cost of Sales in 2006 at 2005 costs
(P132,000 x 133-1/3%) P176,000
Less: Cost of Sales in 2005 132,000
Unfavorable P 44,000
Net favorable quantity factor 6,000*
Increase in Gross Profit P 28,000
* This may also be obtained using the following presentation:

Quantity Factor:
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Increase in Sales P 50,000
Multiplied by: Ave. Gross Profit rate in 2005 12%
Net favorable variance P 6,000
Problem III
Requirement A:
Tony Corporation
Statement Accounting for Gross Profit Variation
For 2006
Increase (Decrease) in Sales accounted for as follows:

Price Factor
8-101
Sales this year P210,210

Less: Sales this year at last years prices 269,500
Favorable (Unfavorable) P(59,290)
Quantity Factor
Sales this year at last years
prices (P210,210 78%) P269,500
Less: Sales last year 192,500
Favorable (Unfavorable) P 77,000
Net Increase (decrease) in sales P 17,710
Increase (decrease) in Cost of Sales accounted for as follows:
Cost Factor
Cost of Sales this year P 165,400
Less: Cost of Sales this year at last
years costs 161,700
(Favorable) Unfavorable P 3,700
Quantity Factor
Cost of Sales this year at last years
costs (115,500 x 140%) P 161,700
Less: Cost of Sales last year 115,500
(Favorable) Unfavorable P 46,200
Net increase (decrease) in Cost of Sales P 49,900

Net increase (decrease) in Gross Profit P (32,190)
Gross Profit, this year P 44,810

Gross Profit, last year 77,000
Increase (Decrease) in Gross Profit P(32,190)
Requirement B:
(1) Change in Quantity = P 77,000 = 40% increase

P192,500
(2) Change in Unit Costs = P 3,700 = 2.38% increase

P161,700
Problem IV
8-102
Quantity Factor
1. Decrease in Sales due to decrease in the number
of customers [(1,000) x 18 MCF x P2.50)] P(45,000)
2. Increase in Sales due to increase in consumption
rate per customer (26,000 x 2 MCF x P2.50) 130,000
Net Increase P 85,000
Price Factor
3. Decrease in Sales due to the decrease in rate per
MCF [P(.05) x 520,000] (26,000)
Increase in operating revenues P 59,000
Average Consumption:
(a) 2006 = 520,000 26,000 = 20 MCF/customer
2005 = 486,000 27,000 = 18 MCF/customer
Increase in Consumption
per customer 2 MCF/customer
(b) 27,000 - 26,000 = 1,000 decrease in number of customers
(c) Price 2006 P2.45

2005 2.50
Decrease in rate or
price per MCF sold P(.05)
Problem V
XYZ Corporation
Gross Profit Variation Analysis
For 2006
Price Factor
Sales in 2006 P 1,750
Less: Sales in 2006 at 2005 prices
A (25 x P10) P 250
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B (75 x P20) 1,500 1,750

Increase (decrease) in gross profit P -
Cost Factor:
Cost of sales in 2006 P 875
Less: Cost of sales in 2006 at 2005 costs:
A (25 X P5) P 125
B (75 x P10) 750 875
Quantity Factor:
Increase (decrease) in total quantity
Multiplied by: Average gross profit
per unit in 2005 (P750 100) P 7.50
Sales Mix Factor:

Average gross profit per unit in 2006 at
2005 prices P8.75 *
Less: Average gross profit per unit in 2005 7.50
Increase (decrease) P1.25
Multiplied by: Total quantity in 2006 100
Increase (decrease) in gross profit P125.00
Increase in Gross Profit P125.00
* Sales in 2006 at 2005 prices P1,750

Less: Cost of sales in 2006 at 2005 prices 875
Gross profit in 2006 at 2005 prices P 875
Average Gross Profit on 2006 at 2005 prices:
P875 = P8.75
100 (volume in 2006)
Problem VI (Computation of Weighted Average Number of Ordinary

Shares)
Number of Shares
Adjustment
for 25%
8-104
stock As Weighted
Date Unadjusted dividend Adjusted Multiplier Shares
1/1/2006 16,000 4,000 20,000 12/12 20,000
2/15/2006 3,200 800 4,000 10.5/12 3,500
4/1/2006 (3,000) (750) (3,750) 9/12 (2,812)
6/1/2006 1,400 350 1,750 7/12 1,020
9/1/2006 6,400 1,600 8,000 4/12 2,667
12/1/2006 6,000 (6,000) - - -
Total 30,000 - 30,000 24,375
Problem VII (Computation of Basic EPS and Diluted EPS)
1. Basic EPS = P 90,000

100,000
= P0.90
2. Diluted EPS = P90,000 + (10% x P500,000 x 65%)

P500,000
100,000 + x 100
P1,000
P90,000 + P32,500
= 150,000
= P0.82 (rounded off)
Problem VIII
Requirements (1) and (2)
Explanation Earnings Shares = Per Share

Basic earnings and shares P122,000 a
33,333 b
= P3.66 Basic
Stock option share increment 293c
Tentative DEPS1 amounts P122,000 33,626 = P3.63 DEPS1
10% bond interest expense savingse 13,300d
Increment in shares 4,400d
Tentative DEPS2 amounts P135,300 38,026 = P3.56 DEPS2
7.5% preference dividend savingse 28,500d
Increment in shares 9,310d
P163,800 47,336 = P3.46 DEPS3
8-105
5.8% bonds 21,924 6,264

Diluted earnings and shares P185,724 53,600 = P3.465 Diluted
a
P122,000 = P150,500 (net income) - P28,500 (preference dividends)
b
Weighted average shares: 25,000 x 1.20 = 30,000 x 7/12 = 17,500
32,000 x 1.20 = 38,400 x 4/12 = 12,800
38,400 - 2,000 = 36,400 x 1/12 = 3,033
Weighted average shares 33,333
c
Increment due to stock options:
Issued 4,000
4,000 x ( P33 + P5 )
Reacquired = (3,707)
P41
Increment in shares 293
d
Impact on diluted earnings per share and ranking:
Impact Ranking
[(0.10 x P200,000) P1,000] x 0.7 P13,300

10% bonds: = 4,400 P3.02 5
200 x 22
(0.058 x P540,000) x 0.7 P21,924

5.8% bonds: 540 x 11.6 = 6,264 P3.50 3
(0.075 x P380,000) P28,500

7.5% preference: 3,800 x 2.45 = 9,310 P3.06 2
e
Dilutive effect on diluted earnings per share:
10% bonds: P3.02 impact < P3.63 (DEPS1), therefore dilutive
7.5% preference: P3.06 impact < P3.56 (DEPS2), therefore dilutive
5.8% bonds: P3.50 impact > P3.46 (DEPS3), therefore exclude from EPS
Requirement 3
Fuego Company would report basic earnings per share of P3.66 and diluted
earnings per share of P3.46 on its 2005 income statement.
1. B 5. A 9. A 13. A 17. A 21. C
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2. B 6. B 10. A 14. D 18. B 22. A

3. C 7. B 11. D * 15. C 19. C 23. B
4. D 8. B 12. C 16. A 20. D
* Supporting computation for no. 11:

P3,500,000 + (P800,000 x 65%)
Diluted EPS for 12/31/2006 =
400,000 + 25,000 + 225,000
P4,020,000
= or P6.18
650,000
CHAPTER 8
COST CONCEPTS AND CLASSIFICATIONS
I. Questions
1. The phrase different costs for different purposes refers to the fact that
the word cost can have different meanings depending on the context in
which it is used. Cost data that are classified and recorded in a
particular way for one purpose may be inappropriate for another use.
2. Fixed costs remain constant in total across changes in activity, whereas

variable costs change in proportion to the level of activity.
3. Examples of direct costs of the food and beverage department in a hotel

include the money spent on the food and beverages served, the wages of
table service personnel, and the costs of entertainment in the dining
room and lounge. Examples of indirect costs of the food and beverage
department include allocations of the costs of advertising for the entire
hotel, of the costs of the grounds and maintenance department, and of
the hotel general managers salary.
4. The cost of idle time is treated as manufacturing overhead because it is a

normal cost of the manufacturing operation that should be spread out
among all of the manufactured products. The alternative to this
treatment would be to charge the cost of idle time to a particular job that
happens to be in process when the idle time occurs. Idle time often
results from a random event, such as a power outage. Charging the cost
8-107
of the idle time resulting from such a random event to only the job that
happened to be in process at the time would overstate the cost of that
job.
5. a. Uncontrollable cost
b. Controllable cost
c. Uncontrollable cost
6. Product costs are costs that are associated with manufactured goods until
the time period during which the products are sold, when the product
costs become expenses. Period costs are expensed during the time
period in which they are incurred.
7. The most important difference between a manufacturing firm and a

service industry firm, with regard to the classification of costs, is that the
goods produced by a manufacturing firm are inventoried, whereas the
services produced by a service industry firm are consumed as they are
produced. Thus, the costs incurred in manufacturing products are
treated as product costs until the period during which the goods are sold.
Most of the costs incurred in a service industry firm to produce services
are operating expenses that are treated as period costs.
8. Product costs are also called inventoriable costs because they are
assigned to manufactured goods that are inventoried until a later period,
when the products are sold. The product costs remain in the finished
goods inventory account until the time period when the goods are sold.
9. A sunk cost is a cost that was incurred in the past and cannot be altered
by any current or future decision. A differential cost is the difference in
a cost item under two decision alternatives.
10. a. Direct cost

b. Direct cost
c. Indirect cost
d. Indirect cost
11. The two properties of a relevant cost are:

1. it differs between the decision options
2. it will be incurred in the future
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12. The three types of product costs are:

1. direct materials the materials used in manufacturing the product,
which become a physical part of the finished product.
2. direct labor the labor used in manufacturing the product.
3. factory overhead the indirect costs for materials, labor, and
facilities used to support the manufacturing process, but not used
directly in manufacturing the product.
13. The three types of manufacturing inventories are:

1. materials inventory the store of materials used in the
manufacturing process or in providing the service.
2. work in process inventory accounts for all costs put into the
manufacturing of products that are started but not complete at the
financial statement date.
3. finished goods inventory the cost of goods that are ready for sale.
14. Direct materials include the materials in the product and a reasonable
allowance for scrap and defective units, while indirect materials are
materials used in manufacturing that are not physically part of the
finished product.
15. The income statement of a manufacturing company differs from the

income statement of a merchandising company in the cost of goods sold
section. A merchandising company sells finished goods that it has
purchased from a supplier. These goods are listed as purchases in the
cost of goods sold section. Since a manufacturing company produces its
goods rather than buying them from a supplier, it lists cost of goods
manufactured in place of purchases. Also, the manufacturing
company identifies its inventory in this section as Finished Goods
inventory, rather than as Merchandise Inventory.
16. Yes, costs such as salaries and depreciation can end up as part of assets
on the balance sheet if these are manufacturing costs. Manufacturing
costs are inventoried until the associated finished goods are sold. Thus,
if some units are still in inventory, such costs may be part of either Work
in Process inventory or Finished Goods inventory at the end of a period.
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17. No. A variable cost is a cost that varies, in total, in direct proportion to
changes in the level of activity. A variable cost is constant per unit of
product. A fixed cost is fixed in total, but the average cost per unit
changes with the level of activity.
18. Manufacturing overhead is an indirect cost since these costs cannot be

easily and conveniently traced to particular units of products.
19.
Direct labor cost (34 hours P15 per hour).......................... P510
Manufacturing overhead cost (6 hours P15 per hour) ....... 90
Total wages earned ................................................................ P600
20.
Direct labor cost (45 hours P14 per hour)......................... P630
Manufacturing overhead cost (5 hours P7 per hour) ........ 35
Total wages earned .............................. P665
II. Exercises
Exercise 1 (Schedule of Cost of Goods Manufactured and Sold; Income

Statement)
Requirement 1
Amazing Aluminum Company

Schedule of Cost of Goods Manufactured
Direct material:
Raw-material inventory, January 1 .................. P 60,000
Add: Purchases of raw material ...................... 250,000
Raw material available for use ......................... P310,000
Deduct: Raw-material inventory, 70,000
December 31 ..............................................
Raw material used ............................................ P240,000
Direct labor ............................................................. 400,000
Manufacturing overhead:
Indirect material ............................................... P 10,000
Indirect labor .................................................... 25,000
Depreciation on plant and equipment .............. 100,000
8-110
Utilities ............................................................ 25,000

Other ................................................................ 30,000
Total manufacturing overhead ......................... 190,000
Total manufacturing costs ...................................... P830,000
Add: Work-in-process inventory, January 1 ......... 120,000
Subtotal................................................................... P950,000
Deduct: Work-in-process inventory, 115,000
December 1 ......................................................
Cost of goods manufactured ................................... P835,000
Requirement 2

Schedule of Cost of Goods Sold
Finished goods inventory, January 1 ........................................ P150,000

Add: Cost of goods manufactured ........................................... 835,000
Cost of goods available for sale ............................................... P985,000
Deduct: Finished goods inventory, December 31 ................... 165,000
Cost of goods sold .................................................................... P820,000
Requirement 3

Income Statement
Sales revenue ............................................................................ P1,105,000

Less: Cost of goods sold.......................................................... 820,000
Gross margin ............................................................................ P 285,000
Selling and administrative expenses ........................................ 110,000
Income before taxes .................................................................. P 175,000
Income tax expense .................................................................. 70,000
Net income ............................................................................... P 105,000
Exercise 2
Fixed (F) Period (P)

Cost Item Variable (V) Product (R)
8-111
a. Transportation-in costs on materials

purchased V R
b. Assembly-line workers wages V R
c. Property taxes on work in process
inventories V R
d. Salaries of top executives in the F P
company
e. Overtime premium for assembly workers V R
f. Sales commissions V P
g. Sales personnel office rental F P
h. Production supervisory salaries F R
i. Controllers office supplies F P
Fixed (F) Period (P)
Cost Item Variable (V) Product (R)
j. Executive office heat and air F P
conditioning
k. Executive office security personnel F P
l. Supplies used in assembly work V R
m. Factory heat and air conditioning F R
n. Power to operate factory equipment V R
o. Depreciation on furniture for sales staff F P
p. Varnish used for finishing product V R
q. Marketing personnel health insurance F P
r. Packaging materials for finished product V R
s. Salary of the quality control manager
who checks work on the assembly line F R
t. Assembly-line workers dental insurance F R
Exercise 3 (Cost Classifications; Manufacturer)
1. a, d, g, i
2. a, d, g, j
3. b, f
4. b, d, g, k
5. a, d, g, k
6. a, d, g, j
7. b, c, f
8. b, d, g, k
8-112
9. b, c and d*, e and f and g*, k*

* The building is used for several purposes.
10. b, c, f
11. b, c, h
12. b, c, f
13. b, c, e
14. b, c and d, e and f and g, k

The building that the furnace heats is used for several purposes.
15. b, d, g, k
Exercise 4 (Economic Characteristics of Costs)
1. marginal cost
2. sunk cost
3. average cost
4. opportunity cost
5. differential cost
6. out-of-pocket cost
Exercise 5 (Cost Classifications; Hotel)
1. a, c, e, k
2. b, d, e, k
3. d, e, i
4. d, e, i
5. a, d, e, k
6. a, d, e, k
7. d, e, k
8. b, d, e, k

Unless the dishwasher has been used improperly.
9. h
10. a, d, e*, j
* The hotel general manager may have some control over the total space
allocated to the kitchen.
8-113
11. i
12. j
13. a, c, e
14. e, k
Exercise 6
Pickup Truck Output
3,000 trucks 6,000 trucks 9,000 trucks

Variable production costs P 29,640,000 P 59,280,000 P 88,920,000
Fixed production costs 39,200,000 39,200,000 39,200,000
Variable selling costs 4,500,000 9,000,000 13,500,000
Fixed selling costs 13,660,000 13,660,000 13,660,000
Total costs P 87,000,000 P121,140,000 P155,280,000
Selling price per truck 46,000 40,100 35,900
Unit cost 29,000 20,190 17,253
Profit per truck 17,000 19,910 18,647
Exercise 7
(see next page)
Exercise 8
1. The wages of employees who build the sailboats: direct labor cost.
2. The cost of advertising in the local newspapers: marketing and selling
cost.
3. The cost of an aluminum mast installed in a sailboat: direct materials
cost.
4. The wages of the assembly shops supervisor: manufacturing overhead
cost.
5. Rent on the boathouse: a combination of manufacturing overhead,
administrative, and marketing and selling cost. The rent would most
likely be prorated on the basis of the amount of space occupied by
8-114
manufacturing, administrative, and marketing operations.

6. The wages of the companys bookkeeper: administrative cost.
7. Sales commissions paid to the companys salespeople: marketing and
selling cost.
8. Depreciation on power tools: manufacturing overhead cost.
8-115
Exercise 7
Period Product Cost

Variable Fixed (Selling and Direct Direct Manufacturing Sunk Opportunity
Cost Cost Administrative) Materials Labor Overhead Cost Cost
Cost
1. Wood used
in a table
X X
(P200 per
table)
2. Labor cost
to
assemble a X X
table (P80
per table)
3. Salary of
the factory
supervisor X X
(P76,000
per year)
4. Cost of
electricity
to produce
tables (P4 X X
per
machine-
hour)
5.
Depr
eciation of
machines
used to X X X*
produce
tables
(P20,000
per year)
8-116
6. Salary of
the
company
X X
president
(P200,000
per year)
7. Advertising
expense
X X
(P500,000
per year)
8.
Com
missions
paid to
X X
salesperso
ns (P60
per table
sold)
9. Rental
income
forgone on X1
factory
space
* This is a sunk cost because the outlay for the equipment was made in a previous period.
1 This is an opportunity cost because it represents the potential benefit that is lost or sacrificed as a result of using the factory space to produce tables.
Opportunity cost is a special category of cost that is not ordinarily recorded in an organizations accounting books. To avoid possible confusion with other
costs, we will not attempt to classify this cost in any other way except as an opportunity cost.
8-117
Exercise 9
Direct Indirect
Cost Cost Object Cost Cost
1. The salary of the head chef The hotels restaurant X
2. The salary of the head chef A particular restaurant X
customer
3. Room cleaning supplies A particular hotel guest X
4. Flowers for the reception desk A particular hotel guest X
5. The wages of the doorman A particular hotel guest X
6. Room cleaning supplies The housecleaning X
department
7. Fire insurance on the hotel The hotels gym X
building
8. Towels used in the gym The hotels gym X
Note: The room cleaning supplies would most likely be considered an

indirect cost of a particular hotel guest because it would not be practical to
djkeep track of exactly how much of each cleaning supply was used in the
guests room.
III. Problems
Problem 1
The relevant costs for this decision are the differential costs. These are:
Opportunity cost or lost wages (take home)

[P1,500 x 70% x 12 months] ........ P12,600
Tuition .................................................... 2,200
Books and supplies ................................. 300
Total differential costs ..................... P15,100
Room and board, clothing, car, and incidentals are not relevant because these
are presumed to be the same whether or not Francis goes to school. The
possibility of part-time work, summer jobs, or scholarship assistance could
be considered as reductions to the cost of school. If students are familiar
with the time value of money, then they should recognize that the analysis
calls for a comparison of the present value of the differential after-tax cash
inflows with the present value of differential costs of getting the education
(including the opportunity costs of lost income).
8-118
Problem 2
Requirement (a)
Only the differential outlay costs need be considered. The travel and other
variable expenses of P22 per hour would be the relevant costs. Any amount
received in excess would be a differential, positive return to Pat.
Requirement (b)
The opportunity cost of the hours given up would be considered in this

situation. Unless Pat receives more than the P100 normal consulting rate,
the contract would not be beneficial.
Requirement (c)
In this situation Pat would have to consider the present value of the contract
and compare that to the present value of the existing consulting business.
The final rate may be more or less than the normal P100 rate depending on
the outcome of Pats analysis.
Problem 3
Utilities for the bakery 2,100

Paper used in packaging product 90
Salaries and wages in the bakery 19,500
Cookie ingredients 35,000
Bakery labor and fringe benefits 1,300
Bakery equipment maintenance 800
Depreciation of bakery plant and equipment 2,000
Uniforms 400
Insurance for the bakery 900
Boxes, bags, and cups used in the bakery 1,100
Bakery overtime premiums 2,600
Bakery idle time 500
Total product costs in pesos 66,290
Problem 4
Administrative costs 1,000
8-119
Rent for administration offices 17,200

Advertising 1,900
Office managers salary 13,000
Total period costs in pesos 33,100
Problem 5
Requirement (a)
Sunk costs not shown could include lost book value on traded assets,
depreciation estimates for new investment, and interest costs on capital
needed during facilities construction.
Requirement (b)
The client might be used to differential cost as a decision tool, and believes
(correctly) that use of differential analyses has several advantages --- it is
quicker, requires less data, and tends to give a better focus to the decision.
The banker might suspect the client of hiding some material data in order to
make the proposal more acceptable to the financing agency.
Problem 6
Requirement (1)
EH Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31
Direct materials:
Raw materials, inventory, January 1 P
45,000
Add: Purchases of raw materials
375,000
Raw materials available for use 420,000
Deduct: Raw materials inventory,
December 31 30,000
Raw materials used in production P
390,000
Direct labor 75,000
8-120
Utilities, factory 18,000
Depreciation, factory 81,000
Insurance, factory 20,000
Supplies, factory 7,500
Indirect labor 150,000
Maintenance, factory
43,500
Total manufacturing overhead cost
320,000
Total manufacturing cost 785,000
Add: Work in process inventory, January
1 90,000
875,000
Deduct: Work in process inventory,
December 31 50,000
Cost of goods manufactured P825,000
Requirement (2)
The cost of goods sold would be computed as follows:
Finished goods inventory, January 1 P130,000

Add: Cost of goods manufactured
825,000
Goods available for sale 955,000
Deduct: Finished goods inventory, December 31
105,000
Cost of goods sold P850,000
Requirement (3)
EH Corporation
Income Statement
For the Year Ended December 31
Sales P1,250,000
Cost of goods sold (above) 850,000
Gross margin 400,000
Selling and administrative expenses:
8-121
Selling expenses P
70,000
Administrative expenses
135,000 205,000
Net operating income P
195,000
8-122
Problem 7
Note to the Instructor: Some of the answers below are debatable.
Adminis- Manufacturing
Variable or Selling trative (Product) Cost
Cost Item Fixed Cost Cost Direct Indirect
1. Depreciation, executive jet ........................................................................... F X
2. Costs of shipping finished goods to customers ............................................ V X
3. Wood used in manufacturing furniture ......................................................... V X
4. Sales managers salary.................................................................................. F X
5. Electricity used in manufacturing furniture .................................................. V X
6. Secretary to the company president .............................................................. F X
7. Aerosol attachment placed on a spray can produced by the company ......... V X
8. Billing costs .................................................................................................. V X*
9. Packing supplies for shipping products overseas ......................................... V X
10. Sand used in manufacturing concrete ........................................................... V X
11. Supervisors salary, factory .......................................................................... F X
12. Executive life insurance ............................................................................... F X
13. Sales commissions ........................................................................................ V X
14. Fringe benefits, assembly line workers ........................................................ V X**
15. Advertising costs .......................................................................................... F X
16. Property taxes on finished goods warehouses .............................................. F X
17. Lubricants for production equipment ........................................................... V X
*Could be an administrative cost.
**Could be an indirect cost.
8-123
Problem 8
Requirement (1)
Period
(Selling
Product Cost and
Variable Fixed Direct Direct Mfg. Admin.) Opportunity Sunk
Name of the Cost Cost Cost Materials Labor Overhead Cost Cost Cost
Lings present salary of P400,000 per
month ........................................................................... X
Rent on the garage, P15,000 per month ............................ X X
Rent of production equipment, P50,000 per
month ........................................................................... X X
Materials for producing flyswatters, at
P30.00 each ..................................................................
X X
Labor cost of producing flyswatters, at
P50.00 each ..................................................................
X X
Rent of room for a sales office, P7,500 per
month ........................................................................... X X
Answering device attachment, P2,000 per
month ........................................................................... X X
Interest lost on savings account, P100,000
per year......................................................................... X
Advertising cost, P40,000 per month ................................ X X
Sales commission, at P10.00 per flyswatter ...................... X X
Legal and filing fees, P60,000 .......................................... X
8-124
Requirement (2)
The P60,000 legal and filing fees are not a differential cost. These legal and
filing fees have already been paid and are a sunk cost. Thus, the cost will not
differ depending on whether Ling decides to produce flyswatters or to stay
with the consulting firm. All other costs listed above are differential costs
since they will be incurred only if Ling leaves the consulting firm and
produces the flyswatters.
Problem 9
Requirement (1)
Ms. Rios first action was to direct that discretionary expenditures be

delayed until the first of the new year. Providing that these discretionary
expenditures can be delayed without hampering operations, this is a good
business decision. By delaying expenditures, the company can keep its cash
a bit longer and thereby earn a bit more interest. There is nothing unethical
about such an action. The second action was to ask that the order for the
parts be cancelled. Since the clerks order was a mistake, there is nothing
unethical about this action either.
The third action was to ask the accounting department to delay recognition
of the delivery until the bill is paid in January. This action is dubious.
Asking the accounting department to ignore transactions strikes at the heart
of the integrity of the accounting system. If the accounting system cannot be
trusted, it is very difficult to run a business or obtain funds from outsiders.
However, in Ms. Rios defense, the purchase of the raw materials really
shouldnt be recorded as an expense. He has been placed in an extremely
awkward position because the companys accounting policy is flawed.
Requirement (2)
The companys accounting policy with respect to raw materials is incorrect.

Raw materials should be recorded as an asset when delivered rather than as
an expense. If the correct accounting policy were followed, there would be
no reason for Ms. Rio to ask the accounting department to delay recognition
of the delivery of the raw materials. This flawed accounting policy creates
incentives for managers to delay deliveries of raw materials until after the
end of the fiscal year. This could lead to raw materials shortages and poor
13-125
Chapter 13 Cost-Volume-Profit Relationships
relations with suppliers who would like to record their sales before the end
of the year.
The companys manage-by-the-numbers approach does not foster ethical

behaviorparticularly when managers are told to do anything so long as
you hit the target profits for the year. Such no excuses pressure from the
top too often leads to unethical behavior when managers have difficulty
meeting target profits.
1. B 7. C 13. D 19. A 25. C

2. D 8. D 14. D 20. A* 26. B
3. B 9. C 15. B 21. B 27. B
4. A 10. C 16. A 22. B 28. A **
5. C 11. A 17. C 23. C 29. A
6. D 12. C 18. C 24. C 30. B
* Controllable costs are those costs that can be influenced by a specified

manager within a given time period.
** The answer assumes absorption costing method is used.

Supporting Computations
14. P60 + P10 + P18 + P4 = P92 16. P60 + P10 + P18 + P32 = P120
15. P32 + P16 = P48 17. P4 + P16 = P20
CHAPTER 9
COST BEHAVIOR: ANALYSIS AND USE
I. Questions
1. a. Variable cost: A variable cost is one that remains constant on a per

unit basis, but which changes in total in direct relationship to
changes in volume.
13-126
Cost-Volume-Profit Relationships Chapter 13
b. Fixed cost: A fixed cost is one that remains constant in total

amount, but which changes, if expressed on a per unit basis,
inversely with changes in volume.
c. Mixed cost: A mixed cost is a cost that contains both variable and
fixed cost elements.
2. a. Unit fixed costs will decrease as volume increases.

b. Unit variable costs will remain constant as volume increases.
c. Total fixed costs will remain constant as volume increases.
d. Total variable costs will increase as volume increases.
3. a. Cost behavior: Cost behavior can be defined as the way in which

costs change or respond to changes in some underlying activity, such
as sales volume, production volume, or orders processed.
b. Relevant range: The relevant range can be defined as that range of
activity within which assumptions relative to variable and fixed cost
behavior are valid.
4. Although the accountant recognizes that many costs are not linear in
relationship to volume at some points, he concentrates on their behavior
within narrow bands of activity known as the relevant range. The
relevant range can be defined as that range of activity within which
assumptions as relative to variable and fixed cost behavior are valid.
Generally, within this range an assumption of strict linearity can be used
with insignificant loss of accuracy.
5. The high-low method, the scattergraph method, and the least-squares
regression method are used to analyze mixed costs. The least-squares
regression method is generally considered to be most accurate, since it
derives the fixed and variable elements of a mixed cost by means of
statistical analysis. The scattergraph method derives these elements by
visual inspection only, and the high-low method utilizes only two points
in doing a cost analysis, making it the least accurate of the three
methods.
6. The fixed cost element is represented by the point where the regression
line intersects the vertical axis on the graph. The variable cost per unit
is represented by the slope of the line.
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7. The two assumptions are:

1. A linear cost function usually approximates cost behavior within the
relevant range of the cost driver.
2. Changes in the total costs of a cost object are traceable to variations
or changes in a single cost driver.
8. No. High correlation merely implies that the two variables move
together in the data examined. Without economic plausibility for a
relationship, it is less likely that a high level of correlation observed in
one set of data will be found similarly in another set of data.
10. The relevant range is the range of the cost driver in which a specific
relationship between cost and cost driver is valid. This concept enables
the use of linear cost functions when examining CVP relationships as
long as the volume levels are within that relevant range.
11. A unit cost is computed by dividing some amount of total costs (the
numerator) by the related number of units (the denominator). In many
cases, the numerator will include a fixed cost that will not change
despite changes in the denominator. It is erroneous in those cases to
multiply the unit cost by activity or volume change to predict changes in
total costs at different activity or volume levels.
12. Cost estimation is the process of developing a well-defined relationship

between a cost object and its cost driver for the purpose of predicting the
cost. The cost predictions are used in each of the management
functions:
Strategic Management: Cost estimation is used to predict costs of
alternative activities, predict financial impacts of alternative strategic
choices, and to predict the costs of alternative implementation strategies.
Planning and Decision Making: Cost estimation is used to predict costs
so that management can determine the desirability of alternative options
and to budget expenditures, profits, and cash flows.
Management and Operational Control: Cost estimation is used to
develop cost standards, as a basis for evaluating performance.
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Product and Service Costing: Cost estimation is used to allocate costs to

products and services or to charge users for jointly incurred costs.
13. The five methods of cost estimation are:

a. Account Classification. Advantages: simplicity and ease of use.
Disadvantages: subjectivity of method and some costs are a mix of
both variable and fixed.
b. Visual fit. The visual fit method is easy to use, and requires only
that the data is graphed. Disadvantages are that the scale of the
graph may limit ability to estimate costs accurately and in both
graphical and tabular form, significant perceptual errors are
common.
c. High-Low. Because of the precision in the development of the
equation, it provides a more consistent estimate than the visual fit
and is not difficult to use. Disadvantages: uses only two selected
data points and is, therefore, subjective.
d. Work Measurement. The advantage is accurate estimates through
detailed study of the different operations in the product process, but
like regression, it is more complex.
e. Regression. Quantitative, objective measures of the precision and
accuracy and reliability of the model are the advantages of this
model; disadvantages are its complexity: the effort, expense, and
expertise necessary to utilize this method.
14. Implementation problems with cost estimation include:

a. cost estimates outside of the relevant range may not be reliable.
b. sufficient and reliable data may not be available.
c. cost drivers may not be matched to dependent variables properly in
each observation.
d. the length of the time period for each observation may be too long,
so that the underlying relationship between the cost driver and the
variable to be estimated is difficult to isolate from the numerous
variables and events occurring in that period of time; alternatively
the period may be too short, so that the data is likely to be affected
by accounting errors in which transactions are not properly posted in
the period in which they occurred.
13-129
e. dependent variables and cost drivers may be affected by trend or

seasonality.
f. when extreme observations (outliers) are used the reliability of the
results will be diminished.
g. when there is a shift in the data, as, for example, a new product is
introduced or when there is a work stoppage, the data will be
unreliable for future estimates.
15. The dependent variable is the cost object of interest in the cost
estimation. An important issue in selecting a dependent variable is the
level of aggregation in the variable. For example, the company, plant, or
department may all be possible levels of data for the cost object. The
choice of aggregation level depends on the objectives for the cost
estimation, data availability, reliability, and cost/benefit considerations.
If a key objective is accuracy, then a detailed level of analysis is often
preferred. The detail cost estimates can then be aggregated if desired.
16. Nonlinear cost relationships are cost relationships that are not
adequately explained by a single linear relationship for the cost driver(s).
In accounting data, a common type of nonlinear relationship is trend and
seasonality. For a trend example, if sales increase by 8% each year, the
plot of the data for sales with not be linear with the driver, the number of
years. Similarly, sales which fluctuate according to a seasonal pattern
will have a nonlinear behavior. A different type of nonlinearity is where
the cost driver and the dependent variable have an inherently nonlinear
relationship. For example, payroll costs as a dependent variable
estimated by hours worked and wage rates is nonlinear, since the
relationship is multiplicative and therefore not the additive linear model
assumed in regression analysis.
17. The advantages of using regression analysis include that it:

a. provides an estimation model with best fit (least squared error) to the
data
b. provides measures of goodness of fit and of the reliability of the
model which can be used to assess the usefulness of the specific
model, in contrast to the other estimation methods which provide no
means of self-evaluation
c. can incorporate multiple independent variables
13-130
d. can be adapted to handle non-linear relationships in the data,

including trends, shifts and other discontinuities, seasonality, etc.
e. results in a model that is unique for a given set of data
18. High correlation exists when the changes in two variables occur
together. It is a measure of the degree of association between the two
variables. Because correlation is determined from a sample of values,
there is no assurance that it measures or describes a cause and effect
relationship between the variables.
19. An activity base is a measure of whatever causes the incurrence of a

variable cost. Examples of activity bases include units produced, units
sold, letters typed, beds in a hospital, meals served in a cafe, service
calls made, etc.
20. (a) Variable cost: A variable cost remains constant on a per unit basis,
but increases or decreases in total in direct relation to changes in
activity.
(b) Mixed cost: A mixed cost is a cost that contains both variable and
fixed cost elements.
(c) Step-variable cost: A step-variable cost is a cost that is incurred in
large chunks, and which increases or decreases only in response to
fairly wide changes in activity.
13-131
Mixed Cost
Variable Cost
Cost
Step-Variable Cost
Activity
21. The linear assumption is reasonably valid providing that the cost formula
is used only within the relevant range.
22. A discretionary fixed cost has a fairly short planning horizonusually a

year. Such costs arise from annual decisions by management to spend on
certain fixed cost items, such as advertising, research, and management
development. A committed fixed cost has a long planning horizon
generally many years. Such costs relate to a companys investment in
facilities, equipment, and basic organization. Once such costs have been
incurred, they are locked in for many years.
23. a. Committed d. Committed

b. Discretionary e. Committed
c. Discretionary f. Discretionary
24. The high-low method uses only two points to determine a cost formula.
These two points are likely to be less than typical since they represent
extremes of activity.
25. The term least-squares regression means that the sum of the squares of
the deviations from the plotted points on a graph to the regression line is
smaller than could be obtained from any other line that could be fitted to
the data.
13-132
26. Ordinary single least-squares regression analysis is used when a variable

cost is a function of only a single factor. If a cost is a function of more
than one factor, multiple regression analysis should be used to analyze
the behavior of the cost.
II. Exercises
Exercise 1 (Cost Classification)
1. b
2. f
3. e
4. i
5. e
6. h
7. l
8. a
9. j
10. k
11. c or d
12. g
Exercise 2 (Cost Estimation; High-Low Method)
Requirement (1)
Cost equation using square fee as the cost driver:
Variable costs:
P4,700 P2,800
= P1.134
4,050 2,375
Fixed costs:
P4,700 = Fixed Cost + P1.134 x 4,050

Fixed Cost = P107
Equation One: Total Cost = P107 + P1.134 x square feet
13-133
There are two choices for the High-Low points when using openings for the
cost driver. At 11 openings there is a cost of P2,800 and at 10 openings
there is a cost of P2,875.
Cost equation using 11 openings as the cost driver:
Variable costs:
P4,700 P2,800
= P237.50
19 11
Fixed costs:
P4,700 = Fixed Cost + P237.50 x 19

Fixed Cost = P187.50
Equation Two: Total Cost = P187.50 + P237.50 x openings
Cost equation using 10 openings as the cost driver:
Variable costs:
P4,700 P2,875
= P202.78
19 10
Fixed costs:
P4,700 = Fixed Cost + P202.78 x 19

Fixed Cost = P847.18
Equation Three: Total Cost = P847.18 + P202.78 x openings
Predicted total cost for a 3,200 square foot house with 14 openings using
equation one:
P107 + P1.134 x 3,200 = P3,735.80
13-134
equation two:
P187.50 + P237.50 x 14 = P3,512.50
equation three:
P847.18 + P202.78 x 14 = P3,686.10
There is no simple method to determine which prediction is best when using

the High-Low method. In contrast, regression provides quantitative
measures (R-squared, standard error, t-values,) to help asses which
regression equation is best.
Predicted cost for a 2,400 square foot house with 8 openings, using equation
one:
P107 + P1.134 x 2,400 = P2,828.60
We cannot predict with equation 2 or equation 3 since 8 openings are outside

the relevant range, the range for which the high-low equation was developed.
Requirement 2
Figure 9-A shows that the relationship between costs and square feet is
relatively linear without outliers, while Figure 9-B shows a similar result for
the relationship between costs and number of openings. From this
perspective, both variables are good cost drivers.
13-135
Figure 9-A
P5,000
P4,500
P4,000
P3,500
P3,000
Cost
P2,500
P2,000
P1,500
P1,000
P500
P0
2,375
2,450
2,600
2,600
2,650
2,700
2,800
2,850
3,010
3,550
3,700
4,050
Square Feet
13-136
Figure 9-B
Cost versus No. of Openings
P5,000
P4,500
P4,000
P3,500
P3,000
Cost
P2,500
P2,000
P1,500
P1,000
P500
P0
10 11 11 12 12 13 13 13 15 16 16 19
Num ber of Openings
Exercise 3 (Cost Estimation; Account Classification)
Requirement 1
Fixed Costs:
Rent P10,250
Depreciation 400
Insurance 750
Advertising 650
Utilities 1,250
Mr. Blacks salary 18,500
Total P31,800
Variable Costs:
Wages P17,800
CD Expense 66,750
Shopping Bags 180
Total P84,730
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Variable Costs Per Unit = P84,730 / 8,900

= P95.20
Cost Function Equation: y = P31,800 + P95.20 x (CDs sold)
Requirement 2
New Sales = 8,900 x 1.25

= 11,125 units
= round to 11,130
Total Costs = P31,800 + P95.20 x (11,130)

= P137,760
Per Unit Total Costs = P137,760 / 11,130

= P123.80
Add P1 profit per disc: P123.80 + P10 = P133.80
Requirement 3
Adjusted New Sales = 8,900 x 11.50

= 10,240 units
Revenue = P133.80 x (10,240)

= P137,010
Total Cost = P31,800 + P95.20 x (10,240)

= P129,280
Cost Per Disc = P129,280 / 10,240 = P126.30
Profit Per Disk = P133.80 P126.30

= P7.50
13-138
Exercise 4 (Cost Estimation Using Graphs; Service)
Requirement 1
Sales and Advertising Expense
P160,000
P140,000
P120,000
P100,000
Sales
P80,000
P60,000
P40,000
P20,000
P0
P2,500
P3,000
P3,500
P4,000
P4,500
P5,000
P5,500
Advertising Expense
Requirement 2
There seems to be a positive linear relationship for the data between P2,500
and P4,000 of advertising expense. Llanes analysis is correct within this
relevant range but not outside of it. Notice that the relationship between
advertising expense and sales changes at P4,000 of expense.
Exercise 5 (Fixed and Variable Cost Behavior)
Requirement (1)
Cups of Coffee Served
in a Week
1,800 1,900 2,000
Fixed cost .................................................................................................................
P11,000 P11,000 P11,000
Variable cost ............................................................................................................
4,680 4,940 5,200
Total cost .................................................................................................................
P15,680 P15,940 P16,200
Cost per cup of coffee served * ...............................................................................
P8.71 P8.39 P8.10
* Total cost cups of coffee served in a week
13-139
Requirement (2)
The average cost of a cup of coffee declines as the number of cups of coffee
served increases because the fixed cost is spread over more cups of coffee.
Exercise 6 (Scattergraph Analysis)
Requirement (1)
The completed scattergraph is presented below:
16,000
14,000
12,000
10,000
Total Cost
8,000
6,000
4,000
2,000
0
0 2,000 4,000 6,000 8,000 10,000
Units Processed
13-140
Requirement (2)
(Students answers will vary considerably due to the inherent imprecision
and subjectivity of the quick-and-dirty scattergraph method of estimating
variable and fixed costs.)
The approximate monthly fixed cost is P6,000the point where the straight
line intersects the cost axis.
The variable cost per unit processed can be estimated as follows using the
8,000-unit level of activity, which falls on the straight line:
Total cost at the 8,000-unit level of activity ............................................ P14,000
Less fixed costs .......................................................................................6,000
Variable costs at the 8,000-unit level of activity ..................................... P 8,000
P8,000 8,000 units = P1 per unit.
Observe from the scattergraph that if the company used the high-low method
to determine the slope of the line, the line would be too steep. This would
result in underestimating the fixed cost and overestimating the variable cost
per unit.
Exercise 7 (High-Low Method)

Requirement (1)
Electrical
Month Occupancy-Days Costs
High activity level (August) ................... 3,608 P8,111
Low activity level (October) .................. 186 1,712
Change .................................................... 3,422 P6,399
Variable cost = Change in cost Change in activity
= P6,399 3,422 occupancy-days
= P1.87 per occupancy-day
Total cost (August) ............................................................................................
P8,111
Variable cost element
(P1.87 per occupancy-day 3,608 occupancy-days) .................................... 6,747
Fixed cost element .............................................................................................
P1,364
13-141
Requirement (2)
Electrical costs may reflect seasonal factors other than just the variation in
occupancy days. For example, common areas such as the reception area must
be lighted for longer periods during the winter. This will result in seasonal
effects on the fixed electrical costs.
Additionally, fixed costs will be affected by how many days are in a month.
In other words, costs like the costs of lighting common areas are variable
with respect to the number of days in the month, but are fixed with respect to
how many rooms are occupied during the month.
Other, less systematic, factors may also affect electrical costs such as the
frugality of individual guests. Some guests will turn off lights when they
leave a room. Others will not.
Exercise 8 (Least-Squares Regression)
The least-squares regression estimates of fixed and variable costs can be

computed using any of a variety of statistical and mathematical software
packages or even by hand.
Month Rental Car Wash

Returns Costs
January ......................... 2,310 P10,113
February ....................... 2,453 P12,691
March ........................... 2,641 P10,905
April ............................. 2,874 P12,949
May............................... 3,540 P15,334
June .............................. 4,861 P21,455
July ............................... 5,432 P21,270
August .......................... 5,268 P19,930
September ..................... 4,628 P21,860
October ......................... 3,720 P18,383
November ..................... 2,106 P 9,830
December ..................... 2,495 P11,081
Intercept P2,296
Slope P3.74
RSQ 0.92
13-142
The intercept provides the estimate of the fixed cost element, P2,296 per
month, and the slope provides the estimate of the variable cost element,
P3.74 per rental return. Expressed as an equation, the relation between car
wash costs and rental returns is
Y = P2,296 + P3.74X
where X is the number of rental returns.
Note that the R2 is 0.92, which is quite high, and indicates a strong linear
relationship between car wash costs and rental returns.
While not a requirement of the exercise, it is always a good to plot the data
on a scattergraph. The scattergraph can help spot nonlinearities or other
problems with the data. In this case, the regression line (shown below) is a
reasonably good approximation to the relationship between car wash costs
and rental returns.
Php25,000
Php20,000
Car Wash Costs
Php15,000
Php10,000
Php5,000
Php0
0 1,000 2,000 3,000 4,000 5,000 6,000
Rental Returns
13-143
III. Problems
Problem 1
Requirement (a) Miles Total Annual

Driven Cost*
High level of activity ......................... 120,000 P13,920
Low level of activity .......................... 80,000 10,880
Difference ..................................... 40,000 P 3,040
* 120,000 miles x P0.116 = P13,920.

80,000 miles x P0.136 = P10,880.
Variable cost per mile:
Change in cost, P3,040
Change in activity,40,000 = P0.076 per mile.
Fixed cost per year:
Total cost at 120,000 miles ................................... P13,920
Less variable cost element: 120,000 x P0.076 ..... 9,120
Fixed cost per year ............................................. P 4,800
Requirement (b)
Y = P4,800 + P0.076X
Requirement (c)
Fixed cost..................................................................... P 4,800

Variable cost: 100,000 miles x P0.076 ....................... 7,600
Total annual cost ................................................... P12,400
Problem 2
Requirement 1
Cost of goods sold ...................................................... Variable

Shipping expense ....................................................... Mixed
Advertising expense ................................................... Fixed
Salaries and commissions .......................................... Mixed
Insurance expense ...................................................... Fixed
Depreciation expense ................................................. Fixed
13-144
Requirement 2
Analysis of the mixed expenses:

Salaries
Shipping and Comm.
Units Expense Expense
High level of activity ............... 4,500 P56,000 P143,000
Low level of activity ................ 3,000 44,000 107,000
Difference .......................... 1,500 P12,000 P 36,000
Variable cost element:

Change in cost
= Variable rate
Change in activity
P12,000
Shipping expense: = P8 per unit.
1,500 units
P36,000
Salaries and comm. expense: 1,500 units = P24 per unit.
Fixed cost element:

Shipping Salaries and
Expense Comm. Expense
Cost at high level of activity ............... P56,000 P143,000
Less variable cost element:
4,500 units x P8 ............................ 36,000
4,500 units x P24 .......................... 108,000
Fixed cost element .............................. P20,000 P 35,000
The cost elements are:

Shipping expense: P20,000 per month plus P8 per unit or Y =
P20,000 + P8X.
Salaries and comm. expense: P35,000 per month plus P24 per unit or
Y = P35,000 + P24X.
13-145
Requirement 3
LILY COMPANY
Income Statement
For the Month Ended June 30
Sales in units................................................... 4,500

Sales revenues ................................................ P630,000
Less variable expenses:
Cost of goods sold (@P56)........................ P252,000
Shipping expense (@P8) ........................... 36,000
Salaries and commission expense
(@P24) ................................................... 108,000 396,000
Contribution margin ....................................... 234,000
Less fixed expense:
Shipping expense ....................................... 20,000
Advertising ................................................ 70,000
Salaries and commissions .......................... 35,000
Insurance.................................................... 9,000
Depreciation .............................................. 42,000 176,000
Net income ..................................................... P 58,000
Problem 3
Requirement 1
Number of Total Cost

Year Leagues (X) (Y) XY X2
2004 5 P13,000 P 65,000 25
2005 2 7,000 14,000 4
2006 4 10,500 42,000 16
2007 6 14,000 84,000 36
2008 3 10,000 30,000 9
20 P54,500 P235,000 90
n (XY) - (X) (Y)

b =
n (X2) - (X)2
5 (235,000) - (20) (54,500)
=
5 (90) - (20)2
= 1,700
13-146
a = (Y) - b(X)
n
(54,500) - 1,700 (20)
=
5
= P4,100
Therefore, the variable cost per league is P1,700 and the fixed cost
is P4,100 per year.
Requirement 2
Y = P4,100 + P1,700X
Requirement 3
The expected value total would be:

Fixed cost .............................................................. P 4,100
Variable cost (7 leagues x P1,700) ....................... 11,900
Total cost .......................................................... P16,000
The problem with using the cost formula from (2) to derive this total cost
figure is that an activity level of 7 sections lies outside the relevant range
from which the cost formula was derived. [The relevant range is represented
by a solid line on the graph in requirement 4 below.]
Although an activity figure may lie outside the relevant range, managers will
often use the cost formula anyway to compute expected total cost as we have
done above. The reason is that the cost formula frequently is the only basis
that the manager has to go on. Using the cost formula as the starting point
should not present a problem so long as the manager is alert for any unusual
problems that the higher activity level might bring about.
Requirement 4
P16,000 Y
P14,000
P12,000
P10,000
13-147
P8,000
P6,000
P4,000
P2,000
X
P-
0 1 2 3 4 5 6 7 8
Problem 4 (Regression Analysis, Service Company)
Requirement 1
Figure 9-C plots the relationship between labor-hours and overhead costs
and shows the regression line.
y = P48,271 + P3.93 X
Economic plausibility. Labor-hours appears to be an economically plausible

driver of overhead cost for a catering company. Overhead costs such as
scheduling, hiring and training of workers, and managing the workforce are
largely incurred to support labor.
Goodness of fit. The vertical differences between actual and predicted costs
are extremely small, indicating a very good fit. The good fit indicates a
strong relationship between the labor-hour cost driver and overhead costs.
Slope of regression line. The regression line has a reasonably steep slope
from left to right. The positive slope indicates that, on average, overhead
costs increase as labor-hours increase.
Requirement 2
The regression analysis indicates that, within the relevant range of 2,500 to
7,500 labor-hours, the variable cost per person for a cocktail party equals:
Food and beverages P15.00
Labor (0.5 hrs. x P10 per hour) 5.00
Variable overhead (0.5 hrs. x P3.93 per labor-hour) 1.97
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Total variable cost per person P21.97
Requirement 3
To earn a positive contribution margin, the minimum bid for a 200-person

cocktail party would be any amount greater than P4,394. This amount is
calculated by multiplying the variable cost per person of P21.97 by the 200
people. At a price above the variable costs of P4,394, Bobby Gonzales will
be earning a contribution margin toward coverage of his fixed costs.
Of course, Bobby Gonzales will consider other factors in developing his bid
including (a) an analysis of the competition vigorous competition will limit
Gonzales ability to obtain a higher price (b) a determination of whether or
not his bid will set a precedent for lower prices overall, the prices Bobby
Gonzales charges should generate enough contribution to cover fixed costs
and earn a reasonable profit, and (c) a judgment of how representative past
historical data (used in the regression analysis) is about future costs.
Figure 9-C
Regression Line of Labor-Hours on Overhead Costs for Bobby Gonzales
Catering Company
P90,000
P80,000
P70,000
Overhead Costs
P60,000
P50,000
P40,000
P30,000
P20,000
P10,000
P0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Cost Driver: Labor-Hours
Problem 5 (Linear Cost Approximation)
13-149
Requirement 1
Difference in cost
Slope coefficient (b) =
Difference in labor-hours
P529,000 P400,000
= = P43.00
7,000 4,000
Constant (a) = P529,000 P43.00 (7,000)

= P228,000
Cost function = P228,000 + P43.00 (professional labor-hours)
The linear cost function is plotted in Figure 9-D.
No, the constant component of the cost function does not represent the fixed
overhead cost of the ABS Group. The relevant range of professional labor-
hours is from 3,000 to 8,000. The constant component provides the best
available starting point for a straight line that approximates how a cost
behaves within the 3,000 to 8,000 relevant range.
Requirement 2
A comparison at various levels of professional labor-hours follows. The

linear cost function is based on formula of P228,000 per month plus P43.00
per professional labor-hours.
Total overhead cost behavior:
Month 1 Month 2 Month 3 Month 4 Month 5

Actual total
overhead P340,000 P400,000 P435,000 P477,000 P529,000
costs
Linear 357,000 400,000 443,000 486,000 529,000
approximat
ion
Actual minus
linear P(17,000) P 0 P (8,000) P (9,000) P 0
approximat
ion
Professional 3,000 4,000 5,000 6,000 7,000
labor-hours
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The data are shown in Figure 9-D. The linear cost function overstates costs
by P8,000 at the 5,000-hour level and understates costs by P15,000 at the
8,000-hour level.
Requirement 3
Based on
Linear
Based on Cost
Actual Function
Contribution before deducting
incremental overhead P38,000 P38,000
Incremental overhead 35,000 43,000
Contribution after incremental P 3,000 P
overhead (5,000)
The total contribution margin actually forgone is P3,000.
Figure 9-D
Linear Cost Function Plot of Professional Labor-Hours
on Total Overhead Costs for ABS Consulting Group
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P700,000
P600,000
Total Overhead Costs
P500,000
P400,000
P300,000
P200,000
P100,000
P0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Professional Labor-Hours Billed
Problem 6 (Cost Behavior)
The variable cost per hour can be computed as follows:
P20,000 / 5,000 hours = P4 per hour
Therefore, the missing amounts are as follows:
Hours of Operating Time

5,000 6,000 7,000
Total
costs:
Variab
le costs
(@ P4
per hour) P 20,000 P24,000 P28,000
Fixed
costs 168,000 168,000 168,000
Total costs P188,000 P192,000 P196,000
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Hours of Operating Time

5,000 6,000 7,000
Cost per
hour:
Variab
le cost P4.00 P4.00 P4.00
Fixed
cost 33.60 28.00 24.00
Total cost
per hour P37.60 P32.00 P28.00
Observe that the total variable costs increase in proportion to the number of
hours of operating time, but that these costs remain constant at P4 if
expressed on a per hour basis.
In contrast, the total fixed costs do not change with changes in the level of
activity. They remain constant at P168,000 within the relevant range. With
increases in activity, however, the fixed cost per hour decreases, dropping
from P33.60 per hour when the boats are operated 5,000 hours a period to
only P21.00 per hour when the boats are operated 8,000 hours a period.
Because of this troublesome aspect of fixed costs, they are most easily (and
most safely) dealt with on a total basis, rather than on a unit basis, in cost
analysis work.
Problem 7 (High-Low Method)
Requirement (1)
The first step in the high-low method is to identify the periods of the lowest
and highest activity. Those periods are November (1,100 patients admitted)
and June (1,900 patients admitted).
The second step is to compute the variable cost per unit using those two data
points:
Number of Admitting
Month Patients Department
Admitted Costs
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High activity level 1,900 P15,200

(June)
Low activity level 1,100 12,800
(November)
Change 800 P 2,400
Change in cost
Variable cost =
Change in activity
P240,000
=
800 patients admitted
= P3 per patient admitted
The third step is to compute the fixed cost element by deducting the variable
cost element from the total cost at either the high or low activity. In the
computation below, the high point of activity is used:
Fixed cost element = Total cost Variable cost element
= P15,200 (P3 per patient admitted
x 1,900 patients admitted)
= P9,500
Requirement (2)
The cost formula is Y = P9,500 + P3X.
Problem 8 (Scattergraph Analysis; Selection of an Activity Base)
Requirement (1)
The completed scattergraph for the number of units produced as the activity
base is presented below:
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5,000
4,500
4,000
Janitorial Labor Cost 3,500
3,000
2,500
2,000
1,500
1,000
500
0
0 20 40 60 80 100 120 140
Units Produced
Requirement (2)
The completed scattergraph for the number of workdays as the activity base
is presented below:
5,000
4,500
4,000
3,500
Janitorial Labor Cost
3,000
2,500
2,000
1,500
1,000
500
0
0 2 4 6 8 10 12 14 16 18 20 22 24
Number of Janitorial Workdays
Requirement (3)
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The number of workdays should be used as the activity base rather than the
number of units produced. There are several reasons for this. First, the
scattergraphs reveal that there is a much stronger relationship (i.e., higher
correlation) between janitorial costs and number of workdays than between
janitorial costs and number of units produced. Second, from the description
of the janitorial costs, one would expect that variations in those costs have
little to do with the number of units produced. Two janitors each work an
eight-hour shiftapparently irrespective of the number of units produced or
how busy the company is. Variations in the janitorial labor costs apparently
occur because of the number of workdays in the month and the number of
days the janitors call in sick. Third, for planning purposes, the company is
likely to be able to predict the number of working days in the month with
much greater accuracy than the number of units that will be produced.
Note that the scattergraph in part (1) seems to suggest that the janitorial
labor costs are variable with respect to the number of units produced. This is
false. Janitorial labor costs do vary, but the number of units produced isnt
the cause of the variation. However, since the number of units produced
tends to go up and down with the number of workdays and since the
janitorial labor costs are driven by the number of workdays, it appears on
the scattergraph that the number of units drives the janitorial labor costs to
some extent. Analysts must be careful not to fall into this trap of using the
wrong measure of activity as the activity base just because it appears there is
some relationship between cost and the measure of activity. Careful thought
and analysis should go into the selection of the activity base.
1. A 11. C* 21. C 31. D 41. B

2. D 12. C* 22. D 32. B 42. D
3. B 13. C 23. C 33. A 43. C
4. A 14. A 24. A 34. B
5. B 15. D 25. D 35. A
6. B 16. C 26. B 36. D
7. C 17. D 27. D 37. B
8. D 18. B 28. B 38. C
9. C 19. C 29. A 39. B
10. A 20. C 30. D 40. D
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* Supporting Computations:
11. (10,000 x 2) (P3,000 x 2) P5,000 = P9,000
12. [(P20 + P3 + P6) x 2,000 units] + (P10 x 1,000 units) = P68,000
CHAPTER 10
SYSTEMS DESIGN: JOB-ORDER COSTING AND

PROCESS COSTING
I. Questions
1. Job-order costing is used in those manufacturing situations where there
are many different products produced each period. Each product or job
is different from all others and requires separate costing. Process
costing is used in those manufacturing situations where a single,
homogeneous product, such as cement, bricks, or gasoline, is produced
for long periods at a time.
2. The job cost sheet is used in accumulating all costs assignable to a
particular job. These costs would include direct materials cost traceable
to the job, and manufacturing overhead cost allocable to the job. When
a job is completed, the job cost sheet is used to compute the cost per
completed unit. The job cost sheet is then used as a control document
for: (1) determining how many units have been sold and determining the
cost of these units; and (2) determining how many units are still in
inventory at the end of a period and determining the cost of these units
on the balance sheet.
3. Many production costs cannot be traced directly to a particular product
or job, but rather are incurred as a result of overall production activities.
Therefore, in order to be assigned to products, such costs must be
allocated to the products in some manner. Examples of such costs would
include utilities, maintenance on machines, and depreciation of the
factory building. These costs are indirect production costs.
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4. A firm will not know its actual manufacturing overhead costs until after
a period is over. Thus, if actual costs were used to cost products, it
would be necessary either (1) to wait until the period was over to add
overhead costs to jobs, or (2) to simply add overhead cost to jobs as the
overhead cost was incurred day by day. If the manager waits until after
the period is over to add overhead cost to jobs, then cost data will not be
available during the period. If the manager simply adds overhead cost
to jobs as the overhead cost is incurred, then unit costs may fluctuate
from month to month. This is because overhead cost tends to be
incurred somewhat evenly from month to month (due to the presence of
fixed costs), whereas production activity often fluctuates. For these
reasons, most firms use predetermined overhead rates, based on
estimates of overhead cost and production activity, to apply overhead
cost to jobs.
5. An allocation base should act as a cost driver in the incurrence of the
overhead cost; that is, the base should cause the overhead cost. If the
allocation base does not really cause the overhead, then costs will be
incorrectly attributed to products and jobs and their costs will be
distorted.
6. A process costing system is appropriate in those situations where a
homogeneous product is produced on a continuous basis.
7. In a process costing system, costs are accumulated by department.
8. First, the activity performed in a department must be performed
uniformly on all units moving through it. Second, the output of the
department must be homogeneous.
9. The reason cost accumulation is simpler is that costs only need to be
identified by department - not by separate job. Usually there will be
only a few departments in a company, whereas there can be hundreds or
even thousands of jobs in a job-order costing system.
10. A quantity schedule shows the physical flow of units through a
department during a period. It serves several purposes. First, it provides
the manager with information relative to activity in his or her department
and also shows the manager the stage of completion of any in-process
units. Second, it serves as an essential guide in computing the
equivalent units and in preparing the other parts of the production report.
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11. By definition, manufacturing overhead consists of costs that cannot be

practically traced to products or jobs. Therefore, if these costs are to be
assigned to products or jobs, they must be allocated rather than traced.
12. Assigning manufacturing overhead costs to jobs does not ensure a profit.
The units produced may not be sold and if they are sold, they may not be
sold at prices sufficient to cover all costs. It is a myth that assigning
costs to products or jobs ensures that those costs will be recovered.
Costs are recovered only by selling to customersnot by allocating
costs.
13. (a) Job-order costing and process costing have the same basic
purposesto assign materials, labor, and overhead cost to products
and to provide a mechanism for computing unit product costs.
(b) Both systems use the same basic manufacturing accounts.
(c) Costs flow through the accounts in basically the same way in both
systems.
14. The company will want to distinguish between the costs of the metals
used to make the medallions, but the medals are otherwise identical and
go through the same production processes. Thus, operation costing is
ideally suited for the companys needs.
II. Exercises
Exercise 1 (Process Costing and Job Order Costing)
a. Job-order costing f. Process costing

b. Process costing g. Process costing
c. Process costing * h. Job-order costing
d. Job-order costing i. Job-order costing
e. Job-order costing j. Job-order costing
* Some of the listed companies might use either a process costing or a job-
order costing system, depending on how operations are carried out and
how homogeneous the final product is. For example, a plywood
manufacturer might use job-order costing if plywoods are constructed of
different woods or come in markedly different sizes.
Exercise 2 (Applying Overhead with Various Bases)
Requirement 1
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Predetermined overhead rates:
Company X:
Predetermined Estimated total manufacturing overhead cost

=
overhead rate Estimated total amount of the allocation base
P432,000
= = P7.20 per DLH
60,000 DLHs
Company Y:

=
P270,000
= = P3.00 per MH
90,000 DLHs
Company Z:

=
P384,000
= = 160% of materials cost
P240,000 materials cost
Requirement 2
Actual overhead costs incurred......................................... P420,000

Overhead cost applied to Work in Process: ......................
58,000* actual hours P7.20 per hour ...................... 417,600
Underapplied overhead cost ............................................. P 2,400
* 7,000 hours + 30,000 hours + 21,000 hours = 58,000 hours
Exercise 3 (Departmental Overhead Rates)
Requirement 1
Milling Department:

=
P510,000
= = P8.50 per machine-hour
60,000 machine-hours
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Assembly Department:

=
P800,000
= = 125% of direct labor cost
P640,000 direct labor cost
Requirement 2
Overhead Applied
Milling Department: 90 MHs P8.50 per MH P765
Assembly Department: P160 125% 200
Total overhead cost applied P965
Requirement 3
Yes; if some jobs required a large amount of machine time and little labor
cost, they would be charged substantially less overhead cost if a plantwide
rate based on direct labor cost were being used. It appears, for example, that
this would be true of job 123 which required considerable machine time to
complete, but required only a small amount of labor cost.
Exercise 4 (Process Costing Journal Entries)
Work in ProcessMixing .......................................................................................

330,000
Raw Materials Inventory..................................................................................
330,000

260,000
Work in ProcessBaking .......................................................................................
120,000
Wages Payable .................................................................................................
380,000

190,000
90,000
Manufacturing Overhead .................................................................................
280,000

760,000
Work in ProcessMixing ...............................................................................
760,000
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Finished Goods ........................................................................................................

980,000
Work in ProcessBaking................................................................................
980,000
Exercise 5 (Quantity Schedule, Equivalent Units, and Cost per

Equivalent Unit Weighted Average Method)
Requirement 1
Weighted-Average Method
Quantity
Schedule
Gallons to be accounted for:
Work in process, May 1 (materials 80%
complete, labor and overhead 75%
complete) ....................................................................................................................................
80,000
Started into production ....................................................................................................................
760,000
Total gallons accounted for ..................................................................................................................
840,000
Equivalent Units
Materials Labor Overhead
Gallons accounted for as follows:
Transferred to the next department............... 790,000 790,000 790,000 790,000
complete) ................................................. 50,000 30,000 10,000 10,000
Total gallons accounted for ............................... 840,000 820,000 800,000 800,000
Requirement 2
Total Costs Materials Labor Overhead Whole Unit

Cost to be accounted for:
Work in process, May 1 ............................................
P 146,600 P 68,600 P 30,000 P 48,000
Cost added during the month ....................................
1,869,200 907,200 370,000 592,000
Total cost to be accounted for (a) ...................................
P2,015,800 P975,800 P400,000 P640,000

Equivalent units (b) ........................................................ 820,000 800,000 800,000
Cost per equivalent unit (a) (b) ................................... P1.19 + P0.50 + P0.80 = P2.49
Exercise 6 (Quantity Schedule, Equivalent Units, and Cost per

Equivalent Unit FIFO Method)
13-162
Requirement 1
FIFO Method
Quantity
Schedule
Gallons to be accounted for:
complete) ....................................................................................................................................
80,000
Started into production ....................................................................................................................
760,000
Total gallons accounted for ..................................................................................................................
840,000
Equivalent Units
Materials Labor Overhead
Gallons accounted for as follows:
Transferred to the next department:
From the beginning inventory ................. 80,000 16,000* 20,000* 20,000*
Started and completed this month**........ 710,000 710,000 710,000 710,000
complete) ................................................. 50,000 30,000 10,000 10,000
Total gallons accounted for ............................... 840,000 756,000 740,000 740,000
* Work required to complete the beginning inventory.

** 760,000 gallons started 50,000 gallons in ending work in process = 710,000 gallons
started and completed.
Requirement 2
Total Costs Materials Labor Overhead Whole Unit

Work in process, May 31 ..........................................
P 146,600
Cost added during the month (a)...............................
1,869,200 P907,200 P370,000 P592,000
Total cost to be accounted for ........................................
P2,015,800
Equivalent units (b) ........................................................ 756,000 740,000 740,000
Cost per equivalent unit (a) (b) ................................... P1.20 + P0.50 + P0.80 = P2.50
Exercise 7
Requirement (1)
The direct materials and direct labor costs listed in the exercise would have
been recorded on four different documents: the materials requisition form for
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Job KC123, the time ticket for Kristine, the time ticket for Clarisse, and the
job cost sheet for Job KC123.
Requirement (2)
The costs for Job KC123 would have been recorded as follows:
Materials requisition form:

Quantity Unit Cost Total Cost
Blanks 40 P80.00 P3,200
Nibs 960 P6.00 5,760
P8,960
Time ticket for Kristine

Time Job
Started Ended Completed Rate Amount Number
9:00 AM 12:15 PM 3.25 P120.00 P390.00 KC123
Time ticket for Clarisse

Time Job
Started Ended Completed Rate Amount Number
2:15 PM 4:30 PM 2.25 P140.00 P315.00 KC123
Job Cost Sheet for Job KC123

Direct materials .............. P8,960.00
Direct labor:
Kristine ..................... 390.00
Clarisse ..................... 315.00
P9,665.00
Exercise 8
The predetermined overhead rate is computed as follows:
Estimated total manufacturing overhead .....................................P586,000

Estimated total direct labor hours (DLHs) ............................... 40,000 DLHs
= Predetermined overhead rate .................................................... P14.65 per DLH
Exercise 9
13-164
Materials Labor Overhead Total
Work in process, May 1 ................................ P 14,550 P23,620 P118,100
Cost added during May .................................88,350 14,330 71,650
Total cost (a) .................................................
P102,900 P37,950 P189,750
Equivalent units of
production (b) ........................................... 1,200 1,100 1,100
Cost per equivalent unit
(a) (b) .....................................................P85.75 P34.50 P172.50 P292.75
Exercise 10
FIFO Method
Materials Conversion
To complete beginning work in process:
Materials: 400 units x (100% 75%) .............................................................
100
Conversion: 400 units x (100% 25%) .......................................................... 300
Units started and completed during the period
(42,600 units started 500 units in ending
inventory) ........................................................................................................
42,100 42,100
Ending work in process
Materials: 500 units x 80% complete ..............................................................
400
Conversion: 500 units x 30% complete .......................................................... 150
Equivalent units of production ...............................................................................
42,600 42,550
III. Problems
Problem 1
Requirement 1
a. Raw Materials Inventory .............................................. 210,000

Accounts Payable ..................................................... 210,000
b. Work in Process ........................................................... 178,000

Manufacturing Overhead ............................................. 12,000
Raw Materials Inventory .......................................... 190,000
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c. Work in Process ........................................................... 90,000

Manufacturing Overhead ............................................. 110,000
Salaries and Wages Payable ..................................... 200,000
d. Manufacturing Overhead ............................................. 40,000

Accumulated Depreciation ....................................... 40,000
e. Manufacturing Overhead ............................................. 70,000

Accounts Payable ..................................................... 70,000
f. Work in Process ........................................................... 240,000

Manufacturing Overhead.......................................... 240,000
30,000 MH x P8 per MH = P240,000.
g. Finished Goods............................................................. 520,000

Work in Process ....................................................... 520,000
h. Cost of Goods Sold ...................................................... 480,000

Finished Goods ......................................................... 480,000
Accounts Receivable .................................................... 600,000

Sales ......................................................................... 600,000
P480,000 1.25 = P600,000
Requirement 2
Manufacturing Overhead Work in Process

(b) 12,000 240,000(f) Bal. 42,000 510,000(g)
(c) 110,000 (b) 178,000
(d) 40,000 (c) 90,000
(e) 70,000 (f) 240,000
8,000 Bal. 30,000
(Overapplied
overhea
d)
13-166
Problem 2
Requirement 1
The costing problem does, indeed, lie with manufacturing overhead cost, as
suggested. Since manufacturing overhead is mostly fixed, the cost per unit
increases as the level of production decreases. The problem can be solved
by use of predetermined overhead rates, which should be based on expected
activity for the entire year. Many students will use units of product in
computing the predetermined overhead rate, as follows:
Estimated manufacturing overhead cost, P840,000 = P4.20 per unit.
Estimated units to be produced, 200,000
The predetermined overhead rate could also be set on the basis of either
direct labor cost or direct materials cost. The computations are:
Estimated manufacturing overhead cost, P840,000 350% of direct
=
Estimated direct labor cost, P240,000 labor cost
Estimated manufacturing overhead cost, P840,000 140% of direct

Estimated direct materials cost, P600,000 = materials cost
Requirement 2
Using a predetermined overhead rate, the unit costs would be:

Quarter
First Second Third Fourth
Direct materials ................... P240,000 P120,000 P 60,000 P180,000
Direct labor ......................... 96,000 48,000 24,000 72,000
Applied at P4.20 per
units; 350% of direct
labor cost, or 140% of
direct materials cost ......... 336,000 168,000 84,000 252,000
Total cost ...................... P672,000 P336,000 P168,000 P504,000
Number of units
produced........................... 80,000 40,000 20,000 60,000
Estimated cost per unit........ P8.40 P8.40 P8.40 P8.40
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Problem 3
Quantity
Schedule
Pounds to be accounted for:
Work in process, May 1
(all materials, 55% labor and
overhead added last month) .......... 30,000
Started into production during
May .............................................. 480,000
Total pounds ........................... 510,000
Equivalent Units
Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to Department 2 ............ 490,000* 490,000 490,000
(all materials, 90% labor and
overhead added this month) .......... 20,000 20,000 18,000
Total pounds ........................... 510,000 510,000 508,000
* 30,000 + 480,000 - 20,000 = 490,000.
Problem 4 (Weighted-Average Method; Interpreting a Production
Report)
Requirement 1
The equivalent units for the month would be:
Quantity Equivalent Units

Schedule Materials Conversion
Units accounted for as follows:
Transferred to next department ... 190,000 190,000 190,000
Work in process, April 30
(75% materials, 60%
conversion cost added this
month) ...................................... 40,000 30,000 24,000
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Total units and equivalent units

of production ............................ 230,000 220,000 214,000
Requirement 2
Total Cost Materials Conversion Whole Unit

Work in process, April 1 ... P 98,000 P 67,800 P 30,200
Cost added during the
month 827,000 579,000 248,000
Total cost (a) .................. P925,000 P646,800 P278,200
Equivalent units of
production (b) .............. 220,000 214,000
Cost per EU (a) (b) ....... P2.94 + =
P P
1 4
. .
3 2
0 4
Requirement 3
Total units transferred ....................................................... 190,000

Less units in the beginning inventory ............................... 30,000
Units started and completed during April ......................... 160,000
Requirement 4
No, the manager should not be rewarded for good cost control. The reason
for the Mixing Departments low unit cost for April is traceable to the fact
that costs of the prior month have been averaged in with Aprils costs in
computing the lower, P2.94 per unit figure. This is a major criticism of the
weighted-average method in that the figures computed for product costing
purposes cant be used to evaluate cost control or measure performance for
the current period.
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Problem 5 (Preparation of Production Report from Analysis of Work in

Process T-account Weighted-Average Method)
Requirement 1
Quantity Schedule and Equivalent Units
Quantity
Schedule
Pounds to be accounted for:
(materials all complete, labor
and overhead 4/5 complete) ..... 35,000
Started into production ................ 280,000
Total pounds to be accounted for .... 315,000
Equivalent Units (EU)

Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to Blending* ............ 270,000 270,000 270,000
(materials all complete, labor
and overhead 2/3 complete) ..... 45,000 45,000 30,000
Total pounds accounted for ............. 315,000 315,000 300,000
* 35,000 + 280,000 45,000 = 270,000.
Cost per Equivalent Unit Labor & Whole

Total Materials Ov Unit
er
he
ad
Work in process, May 1 .... P 63,700 P 43,400 P 20,300
Cost added during the
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month 587,300 397,600 189,700

Total cost to be
accounted for (a) ......... P651,000 P441,000 P210,000
Equivalent units (b) ......... 315,000 300,000

Cost per equivalent unit
(a) (b) P1.40 + =
P P
0 2
. .
7 1
0 0
Cost Reconciliation
Total Equivalent Units (EU)

Cost Materials Conversion
Cost accounted for as follows:
Transferred to Blending:
270,000 pounds x P2.10
per pound.............................. P567,000 270,000 270,000
Work in process, May 31:
Materials, at P1.40 per EU ...... 63,000 45,000
Labor and overhead, at P0.70
per EU ................................... 21,000 30,000
Total work in process, May 31 .... 84,000
Total costs accounted for ................. P651,000
Requirement 2
In computing unit costs, the weighted-average method mixes costs of the

prior period with current period costs. Thus, under the weighted-average
method, unit costs are influenced to some extent by what happened in a prior
period. This problem becomes particularly significant when attempting to
measure performance in the current period. Good (or bad) cost control in the
current period might be concealed to some degree by the costs that have
been brought forward in the beginning inventory.
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1. D 6. D 11. A 16. A
2. D 7. A 12. D 17. D
3. D 8. C 13. B 18. A
4. C 9. C 14. D 19. C
5. D 10. B 15. C 20. D
CHAPTER 11
SYSTEMS DESIGN: ACTIVITY-BASED COSTING

AND MANAGEMENT
I. Questions
1. The three levels available are: Level 1, in which a company uses a
plantwide overhead rate; Level 2, in which a company uses departmental
overhead rates; and Level 3, in which a company uses activity-based
costing.
2. New approaches to costing are needed because events of the last few
decades have made drastic changes in many organizations. Automation
has greatly decreased the amount of direct labor required to manufacture
products; product diversity has increased in that companies are
manufacturing a wider range of products and these products differ
substantially in volume, lot size, and complexity of design; and total
overhead cost has increased to the point in some companies that a
correlation no longer exists between it and direct labor.
3. The departmental approach to assigning overhead cost to products relies
solely on volume as an assignment base. Where diversity exists between
products (that is, where products differ in terms of number of units
produced, lot size, or complexity of production), volume alone is not
adequate for overhead costing. Overhead costing based on volume will
13-172
systematically overcost high-volume products and undercost low-volume

products.
4. Process value analysis (PVA) is a systematic approach to gaining an
understanding of the steps associated with a product or service. It
identifies all resource-consuming activities involved in the production
process and labels these activities as being either value-added or non-
value-added. Thus, it is the beginning point in designing an activity-
based costing system since management must know what activities are
involved with each product before activity centers can be designated and
cost drivers established. Also, PVA helps management to eliminate any
non-value-added activities and thereby streamline operations and
minimize costs.
5. The four general levels of activities are:
1. Unit-level activities, which are performed each time a unit is
produced.
2. Batch-level activities, which are performed each time a batch of
goods is handled or processed.
3. Product-level activities, which are performed as needed to support
specific products.
4. Facility-level activities, which simply sustain a facilitys general
manufacturing process.
6. First, activity-based costing increases the number of cost pools used to
accumulate overhead costs. Second, it changes the base used to assign
overhead costs to products. And third, it changes a managers
perception of many overhead costs in that costs that were formerly
thought to be indirect (such as depreciation or machine setup) are
identified with specific activities and thereby are recognized as being
traceable to individual products.
7. The two chief limitations are: First, the portion of overhead costs that
relate to facility-level activities are still usually allocated to products on
some arbitrary basis, such as machine-hours or direct labor-hours.
Critics of activity-based costing argue that facility-level activities
account for the bulk of all overhead costs in some companies. Second,
high measurement costs are involved in operating an activity-based
costing system. That is, the system requires the tracking of large
amounts of detail and the completion of many separate computations in
order to determine the cost of a unit or product.
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8. Yes, activity-based costing can be used in service organizations. It has

been successfully implemented, for example, in railroads, hospitals,
banks and data service companies.
9. A resource driver is a measure of the quality of resources consumed by
an activity.
10. An activity driver is a measure of frequency and intensity of demands
placed on activities by cost objects.
11. Two-stage allocation is a procedure that first assigns a firms resource
costs, namely factory overhead cost, to cost pools, and then to cost
objects.
12. Two major advantages of ABM are:

a. ABM measures the effectiveness of the key business processes and
activities, and identifies how they can be improved to reduce costs
and improve the customer value.
b. ABM improves the management focus by allocating resources to key
value-added activities, key customers, key products, and continuous
improvement methods to maintain the firms competitive advantage.
13. When direct labor is used as an allocation base for overhead, it is
implicitly assumed that overhead cost is directly proportional to direct
labor. When cost systems were originally developed in the 1800s, this
assumption may have been reasonably accurate. However, direct labor
has declined in importance over the years while overhead has been
increasing. This suggests that there is no longer a direct link between the
level of direct labor and overhead. Indeed, when a company automates,
direct labor is replaced by machines; a decrease in direct labor is
accompanied by an increase in overhead. This violates the assumption
that overhead cost is directly proportional to direct labor. Overhead cost
appears to be driven by factors such as product diversity and complexity
as well as by volume, for which direct labor has served as a convenient
measure.
14. Employees may resist activity-based costing because it changes the
rules of the game. ABC changes some of the key measures, such as
product costs, used in making decisions and may affect how individuals
are evaluated. Without top management support, employees may have
little interest in making these changes. In addition, if top managers
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continue to make decisions based on the numbers generated by the

traditional costing system, subordinates will quickly conclude that the
activity-based costing system can be ignored.
15. Unit-level activities are performed for each unit that is produced. Batch-
level activities are performed for each batch regardless of how many
units are in the batch. Product-level activities must be carried out to
support a product regardless of how many batches are run or units
produced. Customer-level activities must be carried out to support
customers regardless of what products or services they buy.
Organization-sustaining activities are carried out regardless of the
companys precise product mix or mix of customers.
16. Organization-sustaining costs, customer-level costs, and the costs of idle
capacity should not be assigned to products. These costs represent
resources that are not consumed by the products.
II. True or False
1. True 3. False 5. False 7. True

2. True 4. True 6. False 8. True
III. Exercises
Exercise 1
Examples of Examples of
Activity Traceable Cost
Activity Classification Costs Drivers
a. Materials are moved Batch-level Labor cost; Number of
from the receiving depreciation receipts;
dock to product pounds
of equipment;
flow lines by a handled
space cost
material-handling
crew
b. Direct labor workers Unit-level Direct labor Direct labor-
assemble various cost; indirect hours
products labor cost;
labor benefits
c. Ongoing training is Facility-level* Space cost; Hours of
provided to all training costs; training time;
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employees in the administration number trained

company costs
d. A product is Product-level Space cost; Hours of
designed by a supplies used; design time;
specialized design depreciation of number of
team design engineering
equipment change orders
e. Equipment setups Batch-level Labor cost; Number of
are performed on a supplies used; setups; hours
regular basis depreciation of or setup time
equipment
f. Numerical control Unit-level Power; Machine-
(NC) machines are supplies used; hours; number
used to cut and maintenance; of units
shape materials depreciation
* Personnel administration and training costs might be traceable in part to the
facility-level and in part to other activity centers at the unit-level, product-
level, and batch-level.
Exercise 2
1. plantwide overhead rate 6. Batch-level

2. volume 7. Product-level
3. two stage, stage, stage 8. Facility-level
4. Process value analysis 9. high-volume, low-volume, low-volume
5. Unit-level 10. activity centers
Exercise 3
a. Various individuals manage the parts

inventories. Product-level
b. A clerk in the factory issues purchase orders for
a job. Batch-level
c. The personnel department trains new production Organization-
workers. sustaining
d. The factorys general manager meets with other
department heads such as marketing to Organization-
coordinate plans. sustaining
e. Direct labor workers assemble products. Unit-level
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f. Engineers design new products. Product-level

g. The materials storekeeper issues raw materials to
be used in jobs. Batch-level
h. The maintenance department performs periodic
preventative maintenance on general-use Organization-
equipment. sustaining
Note: Some of these classifications are debatable and may depend on the
specific circumstances found in particular companies.
Exercise 4
Sales (P1,650 per standard model glider 10 standard

model gliders + P2,300 per custom designed glider 2
custom designed gliders) .....................................................................................
P21,100
Costs:
Direct materials (P462 per standard model glider 10
standard model gliders + P576 per custom
designed glider 2 custom designed gliders) ..................................................
P5,772
Direct labor (P19 per direct labor-hour 28.5 direct
labor-hours per standard model glider 10 standard
model gliders + P19 per direct labor-hour 32 direct
labor-hours per custom designed glider 2 custom
designed gliders)..............................................................................................
6,631
Supporting manufacturing (P18 per direct labor-hour
28.5 direct labor-hours per standard model glider
10 standard model gliders + P18 per direct labor-hour
32 direct labor-hours per custom designed glider
2 custom designed gliders) ..............................................................................
6,282
Order processing (P192 per order 3 orders) .....................................................576
Custom designing (P261 per custom design 2 custom
designs)............................................................................................................
522
Customer service (P426 per customer
1 customer) ......................................................................................................
426 20,209
Customer margin ......................................................................................................
P 891
Exercise 5
Requirement 1
The predetermined overhead rate is computed as follows:
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Predetermined P290,000
= = P5.80 per DLH
overhead rate 50,000 DLHs
The unit product costs under the companys traditional costing system are
computed as follows:
Special Regular
Direct materials ...............................................................................................................
P60.00 P45.00
Direct labor .....................................................................................................................
9.60 7.20
Manufacturing overhead (0.8 DLH P5.80 per DLH;
0.6 DLH P5.80 per DLH) .......................................................................................
4.64 3.48
Unit product cost .............................................................................................................
P74.24 P55.68
Requirement 2
The activity rates are computed as follows:
(a)
Estimated (b)
Overhead Total (a) (b)
Activities Cost Expected Activity Activity Rate
Supporting direct labor ...............................
P150,000 50,000 DLHs P3 per DLH
Batch setups ................................................
P60,000 250 setups P240 per setup
Safety testing...............................................
P80,000 100 tests P800 per test
Manufacturing overhead is assigned to the two products as follows:
Special Product:
(a) (b) (a) (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor ...................................................... P3 per DLH 8,000 DLHs P24,000
Batch setups .......................................................................
P240 per setup 200 setups 48,000
Safety testing......................................................................
P800 per test 80 tests 64,000
Total P136,000
Regular Product:
(a) (b) (a) (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor ...................................................... P3 per DLH 42,000 DLHs P126,000
Batch setups .......................................................................
P240 per setup 50 setups 12,000
Safety testing......................................................................
P800 per test 20 tests 16,000
Total P154,000
Activity-based costing unit product costs are computed as follows:
Special Regular
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Direct materials ..................................................................................................

P60.00 P45.00
Direct labor ........................................................................................................
9.60 7.20
Manufacturing overhead (P136,000 10,000 units; P154,000
70,000 units)..................................................................................................
13.60 2.20
Unit product cost ................................................................................................
P83.20 P54.40
IV. Problems
Problem 1
Cost Pool Cost Driver Cost

Systems Rate Consumption Assignment
Traditional cost system 350% P10,000 P35,000
ABC system
Labor 10% P10,000 P 1,000
Machining P25/hour 800 hours 20,000
Setup P10/hour 100 hours 1,000
Production order P100/order 12 orders 1,200
Material handling P20/requisition 5 requisitions 100
Parts administration P40/part 18 parts 720
P24,020
Problem 2
Requirement 1
(a)
Total overhead = P200,000 + P32,000 + P100,000 + P120,000
= P452,000
Overhead rate = P452,000 / 50,000 direct labor hours

= P9.04 per direct labor hour
Overhead assigned to proposed job = P9.04 x 1,000 direct labor hours

= P9,040
(b) Total cost of proposed job:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 9,040
Total cost P25,040
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(c) Companys bid = Full manufacturing cost x 120% = P25,040 x 120%

= P30,048
Requirement 2
(a) Maintenance : P200,000 / 20,000 = P10 per machine hour

Materials handling: P32,000 / 1,600 = P20 per move
Setups: P100,000 / 2,500 = P40 per setup
Inspection: P120,000 / 4,000 = P30 per inspection
Overhead assigned to proposed job:

Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspection (P30 x 10) 300
Total overhead assigned to job P5,620
(b) Total cost of proposed project:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 5,620
Total cost P21,620
(c) Companys bid = Full manufacturing cost x 120% = P21,620 x 120%

= P25,944
The bid price of P25,944 was determined as follows:

Direct materials P6,000
Direct labor 10,000
Overhead assigned:
Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspections (P30 x 10) 300
Total overhead assigned to job 5,620
Total cost P21,620
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Markup 120%
Bid price P25,944
Problem 3 (Activity-Based Costing)
Requirement 1
The first-stage allocation of costs to the activity cost pools appears below:
Activity Cost Pools

Assembling Processing Supporting
Units Orders Customers Other Total
Manufacturing
overhead P250,000 P175,000 P25,000 P50,000 P500,000
Selling and
administrative
overhead 30,000 135,000 75,000 60,000 300,000
Total cost P280,000 P310,000 P100,000 P110,000 P800,000
Requirement 2
The activity rates for the cost pools are:
(a) (b) (a) (b)

Total Cost Total Activity Activity Rate
Assembling units P280,000 1,000 units P280 per unit
Processing orders P310,000 250 orders P1,240 per order
Supporting customers P100,000 100 customers P1,000 per customer
Requirement 3
The overhead cost attributable to Lucky Sale would be computed as follows:
(a) (b) (a) x (b)

Activity Cost Pools Activity Rate Activity ABC Cost
Assembling units P280 per unit 80 units P22,400
Processing orders P1,240 per order 4 orders P4,960
Supporting customers P1,000 per customer 1 customer P1,000
Requirement 4
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The customer margin can be computed as follows:
Sales (P595 per unit x 80 units) P47,600

Costs:
Direct materials (P180 per unit x 80 units) P14,400
Direct labor (P50 per unit x 80 units) 4,000
Unit-related overhead (above) 22,400
Order-related overhead (above) 4,960
Customer-related overhead (above) 1,000 46,760
Customer margin P 840
Problem 4 (Activity-Based Costing as an Alternative to Traditional

Product Costing)
Requirement 1
a. When direct labor-hours are used to apply overhead cost to products, the
companys predetermined overhead rate would be:
Predetermined Manufacturing overhead cost
=
overhead rate Direct labor hours
P1,480,000
= = P74 per DLH
20,000 DLHs
b. Model
HY5 AS2
Direct materials ......................................................................
P35.00 P25.00
Direct labor:
P20 per hour 0.2 DLH, 0.4 DLH .................................... 4.00 8.00
P74 per hour 0.2 DLH, 0.4 DLH .................................... 14.80 29.60
Total unit product cost ...........................................................
P53.80 P62.60
Requirement 2
a. Predetermined overhead rates for the activity cost pools:
(a) (b) (a) (b)

Activity Cost Pool Estimated Estimated Activity Rate
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Total Cost Total Activity

Machine setups ................ P180,000 250 setups P720 per setup
Special milling ................ P300,000 1,000 MHs P300 per MH
General factory ................
P1,000,000 20,000 DLHs P50 per DLH
The overhead applied to each product can be determined as follows:
Model HY5
(a) (a) (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups .....................................................................................
P720 per setup 150 setups P108,000
Special milling .....................................................................................
P300 per MH 1,000 MHs 300,000
General factory .....................................................................................
P50 per DLH 4,000 DLHs 200,000
Total manufacturing overhead cost (a) ................................................. P608,000
Number of units produced (b) .............................................................. 20,000
Overhead cost per unit (a) (b) ........................................................... P30.40
Model AS2
(a) (a) (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups .....................................................................................
P720 per setup 100 setups P 72,000
Special milling .....................................................................................
P300 per MH 0 MHs 0
General factory .....................................................................................
P50 per DLH 16,000 DLHs 800,000
Total manufacturing overhead cost (a) ................................................. P872,000
Number of units produced (b) .............................................................. 40,000
Overhead cost per unit (a) (b) ........................................................... P21.80
b. The unit product cost of each model under activity-based costing would
be computed as follows:
Model
HY5 AS2
Direct materials .........................................................................................................
P35.00 P25.00
Direct labor (P20 per DLH 0.2 DLH; P20 per DLH 04.DLH) ............................ 4.00 8.00
Manufacturing overhead (above) ...............................................................................
30.40 21.80
Total unit product cost ...............................................................................................
P69.40 P54.80
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Comparing these unit cost figures with the unit costs in Part 1(b), we find
that the unit product cost for Model HY5 has increased from P53.80 to
P69.40, and the unit product cost for Model AS2 has decreased from
P62.60 to P54.80.
Requirement 3
It is especially important to note that, even under activity-based costing, 68%

of the companys overhead costs continue to be applied to products on the
basis of direct labor-hours:
Machine setups (number of setups) ............................P 180,000 12 %
Special milling (machine-hours) ................................ 300,000 20
General factory (direct labor-hours) ........................... 1,000,000 68
Total overhead cost ....................................................P1,480,000 100 %
Thus, the shift in overhead cost from the high-volume product (Model AS2)
to the low-volume product (Model HY5) occurred as a result of reassigning
only 32% of the companys overhead costs.
The increase in unit product cost for Model HY5 can be explained as
follows: First, where possible, overhead costs have been traced to the
products rather than being lumped together and spread uniformly over
production. Therefore, the special milling costs, which are traceable to
Model HY5, have all been assigned to Model HY5 and none assigned to
Model AS2 under the activity-based costing approach. It is common in
industry to have some products that require special handling or special
milling of some type. This is especially true in modern factories that produce
a variety of products. Activity-based costing provides a vehicle for assigning
these costs to the appropriate products.
Second, the costs associated with the batch-level activity (machine setups)
have also been assigned to the specific products to which they relate. These
costs have been assigned according to the number of setups completed for
each product. However, since a batch-level activity is involved, another
factor affecting unit costs comes into play. That factor is batch size. Some
products are produced in large batches and some are produced in small
batches. The smaller the batch, the higher the cost per unit of the batch
activity. In the case at hand, the data can be analyzed as shown below.
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Model HY5:
Cost to complete one setup [see 2(a)]........................................ P720 (a)
Number of units processed per setup
(20,000 units 150 setups).................................................... 133.33 (b)
Setup cost per unit (a) (b) ....................................................... P5.40
Model AS2:
Cost to complete one setup (above) ........................................... P720 (a)
Number of units processed per setup
(40,000 units 100 setups).................................................... 400 (b)
Setup cost per unit (a) (b) ....................................................... P1.80
Thus, the cost per unit for setups is three times as great for Model HY5, the
low-volume product, as it is for Model AS2, the high-volume product. Such
differences in cost are obscured when direct labor-hours (or any other
volume measure) is used as the basis for applying overhead cost to
products.
In sum, overhead cost has shifted from the high-volume product to the low-
volume product as a result of more appropriately assigning some costs to
the products on the basis of the activities involved, rather than on the basis
of direct labor-hours.
1. A 11. B 21. D
2. D 12. D 22. A
3. C 13. C 23. B
4. B 14. A 24. A
5. A 15. C 25. B
6. D 16. D 26. D
7. A 17. D 27. B
8. B 18. C 28. C
9. D 19. B 29. A
10. C 20. A 30. C
CHAPTER 12
13-185
VARIABLE COSTING
I. Questions
1. The variable costing technique does not consider fixed costs as
unimportant or irrelevant, but it maintains that the distinction between
behaviors of different costs is crucial for certain decisions.
2. The central issue in variable costing is what is the proper timing for
release of fixed manufacturing overhead as expense: at the time of
incurrence, or at the time the finished units to which the fixed overhead
relates are sold.
3. Direct costing would be more accurately called variable or marginal

costing because in substance it is the inventory costing method which
applies only variable production costs to product; fixed factory overhead
is not assigned to product.
4. Marketing and administrative costs are treated as period costs under both
variable costing and absorption costing methods of product costing.
5. Under absorption costing, as a company manufactures units of product,

the fixed manufacturing overhead costs of the period are added to the
units, along with direct materials, direct labor, and variable
manufacturing overhead. If some of these units are not sold by the end
of the period, then they are carried into the next period as inventory.
The fixed manufacturing overhead cost attached to the units in ending
inventory follow the units into the next period as part of their inventory
cost. When the units carried over as inventory are finally sold, the fixed
manufacturing overhead cost that has been carried over with the units is
included as part of that periods cost of goods sold.
6. Many accountants and managers believe absorption costing does a better

job of matching costs with revenues than variable costing. They argue
that all manufacturing costs must be assigned to products to properly
match the costs of producing units of product with the revenues from the
units when they are sold. They believe that the fixed costs of
depreciation, taxes, insurance, supervisory salaries, and so on, are just as
essential to manufacturing products as are the variable costs.
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7. If fixed manufacturing overhead cost is released from inventory, then

inventory levels must have decreased and therefore production must
have been less than sales.
8. Under absorption costing it is possible to increase net operating income

without increasing sales by increasing the level of production. If
production exceeds sales, units of product are added to inventory. These
units carry a portion of the current periods fixed manufacturing
overhead costs into the inventory account, thereby reducing the current
periods reported expenses and causing net operating income to rise.
9. Generally speaking, variable costing cannot be used externally for

financial reporting purposes nor can it be used for tax purposes.
10. If production exceeds sales, absorption costing will show higher net
operating income than variable costing. The reason is that inventories
will increase and therefore part of the fixed manufacturing overhead cost
of the current period will be deferred in inventory to the next period
under absorption costing. By contrast, all of the fixed manufacturing
overhead cost of the current period will be charged immediately against
revenues as a period cost under variable costing.
11. Absorption and variable costing differ in how they handle fixed
manufacturing overhead. Under absorption costing, fixed manufacturing
overhead is treated as a product cost and hence is an asset until products
are sold. Under variable costing, fixed manufacturing overhead is treated
as a period cost and is expensed on the current periods income
statement.
12. Advocates of variable costing argue that fixed manufacturing costs are
not really the cost of any particular unit of product. If a unit is made or
not, the total fixed manufacturing costs will be exactly the same.
Therefore, how can one say that these costs are part of the costs of the
products? These costs are incurred to have the capacity to make products
during a particular period and should be charged against that period as
period costs according to the matching principle.
II. Exercises
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Exercise 1 (Variable and Absorption Costing Unit Product Costs and

Income Statements)
Requirement 1
a. The unit product cost under absorption costing would be:

Direct materials .......................................................................... P18
Direct labor ................................................................................. 7
Variable manufacturing overhead ............................................... 2
Total variable manufacturing costs ............................................. 27
Fixed manufacturing overhead (P160,000 20,000 units) ........ 8
Unit product cost ........................................................................ P35
b. The absorption costing income statement:

Sales (16,000 units P50 per unit) ....................... P800,000
Less cost of goods sold:
Beginning inventory .......................................... P 0
Add cost of goods manufactured
(20,000 units P35 per unit) ......................... 700,000
Goods available for sale .................................... 700,000
Less ending inventory
(4,000 units P35 per unit) ........................... 140,000 560,000
Gross margin.......................................................... 240,000
Less selling and administrative expenses .............. 190,000 *
Net operating income ............................................ P 50,000
*(16,000 units P5 per unit) + P110,000 = P190,000.
Requirement 2
a. The unit product cost under variable costing would be:

Direct materials ............................................................................... P18
Direct labor ...................................................................................... 7
Variable manufacturing overhead .................................................... 2
Unit product cost ............................................................................. P27
b. The variable costing income statement:

Sales (16,000 units P50 per unit) ..................... P800,000
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Variable cost of goods sold:
Beginning inventory .................................... P 0
Add variable manufacturing costs
(20,000 units P27 per unit) ................... 540,000
Goods available for sale .............................. 540,000
(4,000 units P27 per unit) ..................... 108,000
Variable cost of goods sold .............................. 432,000 *
Variable selling expense
(16,000 units P5 per unit) ......................... 80,000 512,000
Contribution margin ............................................ 288,000
Less fixed expenses:
Fixed manufacturing overhead ........................ 160,000
Fixed selling and administrative ...................... 110,000 270,000
Net operating income .......................................... P 18,000
* The variable cost of goods sold could be computed more simply as:
16,000 units P27 per unit = P432,000.
Exercise 2 (Variable and Absorption Costing Unit Product Costs)
Requirement 1
Sales (40,000 units P33.75 per unit) .................................... P1,350,000

Variable cost of goods sold
(40,000 units P16 per unit*) .........................................
P640,000
Variable selling and administrative expenses
(40,000 units P3 per unit) .............................................
120,000 760,000
Contribution margin ................................................................ 590,000
Fixed manufacturing overhead ............................................ 250,000
Fixed selling and administrative expenses .......................... 300,000 550,000
Net operating income .............................................................. P 40,000
* Direct materials ........................................................................................................

P10
Direct labor...............................................................................................................
4
Variable manufacturing overhead ............................................................................
2
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Total variable manufacturing cost ............................................................................

P16
Requirement 2
The difference in net operating income can be explained by the P50,000 in

fixed manufacturing overhead deferred in inventory under the absorption
costing method:
Variable costing net operating income ........................................ P40,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing: 10,000 units P5 per unit in
fixed manufacturing overhead cost .......................................... 50,000
Absorption costing net operating income .................................... P90,000
Exercise 3 (Variable Costing Unit Product Cost and Income Statement;

Break-even)
Requirement 1
Under variable costing, only the variable manufacturing costs are included in
product costs.
Direct materials ............................................................................ P 600

Direct labor .................................................................................. 300
Variable manufacturing overhead ................................................ 100
Unit product cost ......................................................................... P1,000
Note that selling and administrative expenses are not treated as product
costs; that is, they are not included in the costs that are inventoried. These
expenses are always treated as period costs and are charged against the
current periods revenue.
Requirement 2
The variable costing income statement appears below:

Sales ........................................................................ P18,000,000
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Beginning inventory...................................... P 0
(10,000 units P1,000 per unit) ................ 10,000,000
Goods available for sale ................................ 10,000,000
Less ending inventory (1,000 units P1,000
per unit) ................................................... 1,000,000
Variable cost of goods sold* ............................... 9,000,000
Variable selling and administrative (9,000 units
P200 per unit) ................................................. 1,800,000 10,800,000
Contribution margin................................................ 7,200,000
Fixed manufacturing overhead ............................... 3,000,000
Fixed selling and administrative ............................. 4,500,000 7,500,000
Net operating loss ................................................... P (300,000)
* The variable cost of goods sold could be computed more simply as: 9,000 units
sold P1,000 per unit = P9,000,000.
Requirement 3
The break-even point in units sold can be computed using the contribution
margin per unit as follows:
Selling price per unit................................................................................................
P2,000
Variable cost per unit ...............................................................................................
1,200
Contribution margin per unit ...................................................................................
P 800
Fixed expenses
Exercise 4 (Absorption
Break-even unitCosting
sales Unit
= Product Cost and Income Statement)
Unit contribution margin
P7,500,000
=
Requirement 1 P800 per unit
= 9,375 units
Under absorption costing, all manufacturing costs (variable and fixed) are
included in product costs.
Direct materials ................................................................. P 600

Direct labor ........................................................................ 300
Variable manufacturing overhead ...................................... 100
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Fixed manufacturing overhead

(P3,000,000 10,000 units) .......................................... 300
Unit product cost ............................................................... P1,300
Requirement 2
The absorption costing income statement appears below:
Sales (9,000 units P2,000 per unit) ................................... P18,000,000

Cost of goods sold:
Beginning inventory .........................................................P 0
Add cost of goods manufactured
(10,000 units P1,300 per unit) ................................... 13,000,000
Goods available for sale ...................................................
13,000,000
(1,000 units P1,300 per unit) ..................................... 1,300,000 11,700,000
Gross margin ........................................................................ 6,300,000
Selling and administrative expenses:
Variable selling and administrative (9,000
units P200 per unit) ...................................................1,800,000
Fixed selling and administrative ...................................... 4,500,000 6,300,000
Net operating income ........................................................... P 0
Note: The company apparently has exactly zero net operating income even
though its sales are below the break-even point computed in Exercise 3. This
occurs because P300,000 of fixed manufacturing overhead has been deferred
in inventory and does not appear on the income statement prepared using
absorption costing.
Exercise 5 (Variable Costing Income Statement; Explanation of Difference in Net
Operating Income)
Requirement 1
2,000 units P60 per unit fixed manufacturing overhead = P120,000
Requirement 2
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The variable costing income statement appears below:
Sales............................................................................... P4,000,000
Variable expenses:
Beginning inventory ..............................................P 0
(10,000 units P310 per unit) ........................3,100,000
Goods available for sale ........................................3,100,000
(2,000 units P310 per unit) ............................. 620,000
Variable cost of goods sold* ......................................2,480,000
Variable selling and administrative
(8,000 units P20 per unit) ................................... 160,000 2,640,000
Contribution margin ...................................................... 1,360,000
Fixed expenses:
Fixed manufacturing overhead .................................. 600,000
Fixed selling and administrative ................................ 400,000 1,000,000
Net operating income .................................................... P 360,000
* The variable cost of goods sold could be computed more simply as: 8,000
units sold P310 per unit = P2,480,000.
The difference in net operating income between variable and absorption

costing can be explained by the deferral of fixed manufacturing overhead
cost in inventory that has taken place under the absorption costing approach.
Note from part (1) that P120,000 of fixed manufacturing overhead cost has
been deferred in inventory to the next period. Thus, net operating income
under the absorption costing approach is P120,000 higher than it is under
variable costing.
Exercise 6 (Evaluating Absorption and Variable Costing as Alternative
Costing Methods)
Requirement 1
a. By assumption, the unit selling price, unit variable costs, and total fixed
costs are constant from year to year. Consequently, variable costing net
operating income will vary with sales. If sales increase, variable costing
net operating income will increase. If sales decrease, variable costing net
13-193
operating income will decrease. If sales are constant, variable costing net
operating income will be constant. Because variable costing net
operating income was P16,847 each year, unit sales must have been the
same in each year.
The same is not true of absorption costing net operating income. Sales
and absorption costing net operating income do not necessarily move in
the same direction because changes in inventories also affect absorption
costing net operating income.
b. When variable costing net operating income exceeds absorption costing

net operating income, sales exceeds production. Inventories shrink and
fixed manufacturing overhead costs are released from inventories. In
contrast, when variable costing net operating income is less than
absorption costing net operating income, production exceeds sales.
Inventories grow and fixed manufacturing overhead costs are deferred in
inventories. The year-by-year effects are shown below.
Year 1 Year 2 Year 3

Variable costing NOI Variable costing NOI < Variable costing NOI
= Absorption costing Absorption costing > Absorption costing
NOI NOI NOI
Production = Sales Production > Sales Production < Sales
Inventories remain the
same Inventories grow Inventories shrink
Requirement 2
a. As discussed in part (1 a) above, unit sales and variable costing net

operating income move in the same direction when unit selling prices
and the cost structure are constant. Because variable costing net
operating income declined, unit sales must have also declined. This is
true even though the absorption costing net operating income increased.
How can that be? By manipulating production (and inventories) it may
be possible to maintain or increase the level of absorption costing net
operating income even though unit sales decline. However, eventually
inventories will grow to be so large that they cannot be ignored.
b. As stated in part (1 b) above, when variable costing net operating income

is less than absorption costing net operating income, production exceeds
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sales. Inventories grow and fixed manufacturing overhead costs are

deferred in inventories. The year-by-year effects are shown below.

Variable costing NOI = Variable costing NOI < Variable costing NOI
Absorption costing Absorption costing < Absorption costing
NOI NOI NOI
Production = Sales Production > Sales Production > Sales
Inventories remain the
same Inventories grow Inventories grow
Requirement 3
Variable costing appears to provide a much better picture of economic reality

than absorption costing in the examples above. In the first case, absorption
costing net operating income fluctuates wildly even though unit sales are the
same each year and unit selling prices, unit variable costs, and total fixed
costs remain the same. In the second case, absorption costing net operating
income increases from year to year even though unit sales decline.
Absorption costing is much more subject to manipulation than variable
costing. Simply by changing production levels (and thereby deferring or
releasing costs from inventory) absorption costing net operating income can
be manipulated upward or downward.
Note: This exercise is based on the following data:
Common data:
Annual fixed manufacturing costs ............................... P153,153
Contribution margin per unit ...................................... P35,000
Annual fixed SGA costs ............................................... P180,000
Part 1:
Beginning inventory ............................................................. 1 1 2
Production ............................................................................ 10 11 9
Sales ..................................................................................... 10 10 10
Ending .................................................................................. 1 2 1
Variable costing net operating income .................................

P16,847 P16,847 P16,847
Fixed manufacturing overhead in beginning P15,315 P15,315 P27,846
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inventory* .....................................................................
Fixed manufacturing overhead in ending inventory ............ P15,315 P27,846 P17,017
Absorption costing net operating income............................. P16,847 P29,378 P6,018
* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2

for Year 1. A FIFO inventory flow assumption is used.
Part 2:
Beginning inventory .................................................. 1 1 4
Production ................................................................. 10 12 20
Sales .......................................................................... 10 9 8
Ending ....................................................................... 1 4 16
Variable costing net operating income (loss) ............P16,847 (P18,153) (P53,153)
Fixed manufacturing overhead in beginning

inventory* ..........................................................P15,315 P15,315 P51,051
Fixed manufacturing overhead in ending
inventory ............................................................P15,315 P51,051 P122,522
Absorption costing net operating income..................P16,847 P17,583 P18,318
* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2

for Year 1. A FIFO inventory flow assumption is used.
III. Problems
Problem 1
Requirement 1: Variable Costing Method
Romero Parts, Inc.

Income Statement - Manufacturing
Sales P20,700,000
Less: Variable Cost of Sales
Inventory, Jan. 1 P1,155,000
Current Production 7,700,000
Total Available for Sale P8,855,000
Inventory, Dec. 31 805,000 8,050,000
Contribution Margin P12,650,000
Less Fixed Costs and Expenses 6,000,000
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Net Income P 6,650,000
Requirement 2: Absorption Costing Method
Romero Parts, Inc.

For the Year Ending December 31, 2006
Sales P26,100,000
Less Cost of goods sold:
Inventory, Jan. 1 P 1,380,000
Current Production 16,100,000
Inventory, Dec. 31 747,500
Cost of Sales - Standard P16,732,500
Favorable Capacity Variance 900,000 15,832,500
Income from Manufacturing P10,267,500
Requirement 3: Variable Costing Method
Romero Parts, Inc.

For the Year Ending December 31, 2006
Sales P26,100,000
Less Variable Cost of Sales:
Inventory, Jan. 1 P 805,000
Production 9,800,000
Inventory, Dec. 31 455,000 10,150,000
Contribution Margin - Manufacturing P15,950,000
Less Fixed Cost 5,400,000
Income from Manufacturing P10,550,000
Reconciliation
Net Income, absorption costing P10,267,500
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Add Fixed Factory Overhead Inventory, 1/1 575,000

Total P10,842,500
Less Fixed Factory Overhead Inventory, 12/31 292,500
Net Income, direct costing P10,550,000
Problem 2
Requirement 1
Honey Company
Income Statement - Direct Costing
Sales P280,000
Less Variable Cost of Sales:
Finished Goods Inventory, 1/1 P 4,000
Current Production 120,000
Total Available for Sale P124,000
Finished Goods Inventory, 12/31 12,000
Variable Cost of Sale - Standard P112,000
Unfavorable Variance 5,000 117,000
Contribution Margin - Manufacturing P163,000

Less Variable Marketing Expenses 28,000
Contribution Margin - Final P135,000
Less Fixed Costs and Expenses:
Fixed Factory Overhead P 54,000
Fixed Marketing and
Administrative Expenses 20,000 74,000
Net Income P 61,000
Requirement 2
Honey Company
Income Statement - Absorption Costing
Sales P280,000
Less: Cost of Sales
Finished goods inventory, Jan. 1 (1,000 x P5.50) P 5,500
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Current production costs

Variable (30,000 x P4.00) P120,000
Fixed (30,000 x P1.50) 45,000 165,000
P170,500
Less: Finished goods inventory, Dec. 31
(3,000 x P5.50) 16,500
Cost of Sales - at Standard P154,000
Add (Deduct) Variance
Unfavorable variable manufacturing
costs variances 5,000
Underapplied fixed factory overhead
(6,000 x P1.50) 9,000
Cost of Sales - Actual P168,000
Gross Profit P112,000
Less: Selling and administrative expenses
Variable 28,000
Fixed 20,000
P 48,000
Net Income P 64,000
Problem 3 (Variable Costing Income Statement; Reconciliation)
Requirement 1
The unit product cost under the variable costing approach would be
Direct materials ........................................................................................................
P 8
Direct labor...............................................................................................................
10
Variable manufacturing overhead ............................................................................
2
Unit product cost ......................................................................................................
P20
With this figure, the variable costing income statements can be prepared:
Year 1 Year 2
Sales .........................................................................................................................
P1,000,000 P1,500,000
Variable cost of goods sold @ P20 per unit.........................................................
400,000 600,000
@ P3 per unit ...................................................................................................
60,000 90,000
13-199
Total variable expenses............................................................................................

460,000 690,000
Contribution margin.................................................................................................
540,000 810,000
Fixed manufacturing overhead ............................................................................
350,000 350,000
Fixed selling and administrative ..........................................................................
250,000 250,000
Total fixed expenses ................................................................................................
600,000 600,000
Net operating income (loss) .....................................................................................
P (60,000) P 210,000
Requirement 2
Variable costing net operating income (loss) ..............P (60,000) P 210,000

Add: Fixed manufacturing overhead cost
deferred in inventory under absorption costing
(5,000 units P14 per unit) .................................... 70,000
Deduct: Fixed manufacturing overhead cost
released from inventory under absorption
costing (5,000 units P14 per unit) ....................... (70,000)
Absorption costing net operating income ....................P 10,000 P 140,000
Problem 4 (Prepare and Interpret Statements; Changes in Both Sales

and Production; JIT)
Requirement 1

Sales P1,000,000 P 800,000 P1,000,000
@ P4 per unit ...............................................................................................................
200,000 160,000 200,000
@ P2 per unit ...............................................................................................................
100,000 80,000 100,000
Total variable expenses .........................................................................................................
300,000 240,000 300,000
Contribution margin ..............................................................................................................
700,000 560,000 700,000
Fixed manufacturing overhead.......................................................................................
600,000 600,000 600,000
Fixed selling and administrative ....................................................................................
70,000 70,000 70,000
Total fixed expenses..............................................................................................................
670,000 670,000 670,000
Net operating income (loss) ..................................................................................................
P 30,000 P(110,000) P 30,000
Requirement 2
13-200
a.
Variable manufacturing cost ....................................................................................
P 4 P 4 P 4
Fixed manufacturing cost:
P600,000 50,000 units ......................................................................................
12
P600,000 60,000 units ......................................................................................
10
P600,000 40,000 units ......................................................................................
15
Unit product cost .....................................................................................................
P16 P14 P19
b.
Variable costing net operating income
(loss) ...................................................................................................................
P30,000 P(110,000) P 30,000
Add (Deduct): Fixed manufacturing
overhead cost deferred in inventory
from Year 2 to Year 3 under
absorption costing (20,000 units
P10 per unit) .......................................................................................................
200,000 (200,000)
Add: Fixed manufacturing overhead
cost deferred in inventory from Year
3 to the future under absorption
costing (10,000 units P15 per
unit) .....................................................................................................................
150,000
Absorption costing net operating
income (loss) .......................................................................................................
P30,000 P 90,000 P(20,000)
Requirement 3
Production went up sharply in Year 2 thereby reducing the unit product cost,
as shown in (2a). This reduction in cost, combined with the large amount of
fixed manufacturing overhead cost deferred in inventory for the year, more
than offset the loss of revenue. The net result is that the companys net
operating income rose even though sales were down.
Requirement 4
The fixed manufacturing overhead cost deferred in inventory from Year 2

was charged against Year 3 operations, as shown in the reconciliation in (2b).
This added charge against Year 3 operations was offset somewhat by the fact
13-201
that part of Year 3s fixed manufacturing overhead costs was deferred in

inventory to future years [again see (2b)]. Overall, the added costs charged
against Year 3 were greater than the costs deferred to future years, so the
company reported less income for the year even though the same number of
units was sold as in Year 1.
Requirement 5
a. Several things would have been different if the company had been using
JIT inventory methods. First, in each year production would have been
geared to sales so that little or no inventory of finished goods would
have been built up in either Year 2 or Year 3. Second, unit product costs
probably would have been the same in all three years, since these costs
would have been established on the basis of expected sales (50,000
units) for each year. Third, since only 40,000 units were sold in Year 2,
the company would have produced only that number of units and
therefore would have had some underapplied overhead cost for the year.
(See the discussion on underapplied overhead in the following
paragraph.)
b. If JIT had been in use, the net operating income under absorption costing
would have been the same as under variable costing in all three years.
The reason is that with production geared to sales, there would have
been no ending inventory on hand, and therefore there would have been
no fixed manufacturing overhead costs deferred in inventory to other
years. Assuming that the company expected to sell 50,000 units in each
year and that unit product costs were set on the basis of that level of
expected activity, the income statements under absorption costing would
have appeared as follows:
Sales ......................................................................................................................................
P1,000,000 P 800,000 P1,000,000
Less cost of goods sold:
Cost of goods manufactured @ P16 per unit .........................................................................
800,000 640,000 * 800,000
Add underapplied overhead ..................................................................................................
120,000 **
Cost of goods sold .................................................................................................................
800,000 760,000 800,000
Gross margin .........................................................................................................................
200,000 40,000 200,000
Selling and administrative expenses ......................................................................................
170,000 150,000 170,000
Net operating income (loss) ..................................................................................................
P 30,000 P(110,000) P 30,000
* 40,000 units P16 per unit = P640,000.
13-202
** 10,000 units not produced P12 per unit fixed manufacturing overhead cost =
P120,000 fixed manufacturing overhead cost not applied to products.
Problem 5 (Contrasting Variable and Absorption Costing)
Requirement 1 (a)
Under absorption costing, all manufacturing costs, variable and fixed, are
included in unit product costs:
Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6
Variable manufacturing overhead 3 3
Fixed manufacturing overhead
(P120,000 10,000 units) 12
(P120,000 6,000 units) 20
Unit product cost P32 P40
Requirement 1 (b)
The absorption costing income statements follow:
Year 1 Year 2
Sales (8,000
units x P50
per unit) P400,000 P400,000
Cost of goods
sold:
Beginning P P
inventory 0 64,000
Add cost of
goods
manufactur
ed (10,000 320,000 240,000
13-203
units x P32
per unit;
6,000 units
x P40 per
unit)
Goods
available for
sale 320,000 304,000
Less ending
inventory
(2,000 units
x P32 per
unit; 0 units
x P40 per
unit) 64,000 256,000 0 304,000
Gross margin 144,000 96,000
Selling and
administrativ
e expenses
(8,000 units
x P4 per unit
+ P70,000) 102,000 102,000
Net operating P
income 42,000 P (6,000)
Requirement 2 (a)
Under variable costing, only the variable manufacturing costs are included in
unit product costs:
Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6
13-204
Variable manufacturing overhead 3 3

Unit product cost P20 P20
Requirement 2 (b)
The variable costing income statements follow. Notice that the variable cost
of goods sold is computed in a simpler, more direct manner than in the
examples provided earlier. On a variable costing income statement, this
simple approach or the more complex approach illustrated earlier is
acceptable for computing the cost of goods sold.
Year 1 Year 2
Sales (8,000
units x P50
per unit) P400,000 P400,000
Variable
expenses:
Variable cost
of goods sold
(8,000 units
x P20 per
unit) P160,000 P160,000
Variable
selling and
administrati
ve (8,000
units x P4
per unit) 32,000 192,000 32,000 192,000
Contribution
margin 208,000 208,000
Fixed
expenses:
13-205
Fixed
manufacturin
g overhead 120,000 120,000
Fixed selling
and
administrati
ve expenses 70,000 190,000 70,000 190,000
Net operating P P
income 18,000 18,000
Requirement 3
The reconciliation of the variable and absorption costing net operating

incomes follows:
Year 1 Year 2
Variable costing net operating income P18,000 P18,000
Add fixed manufacturing overhead costs
deferred in inventory under absorption
costing (2,000 units x P12 per unit) 24,000
Deduct fixed manufacturing overhead
costs released from inventory under
absorption costing (2,000 units x P12
per unit) (24,000)
Absorption costing net operating income P42,000 P(6,000)
Problem 6 (Variable Costing Income Statement; Reconciliation)
Requirement 1
Sales (40,000 units P33.75 per unit) .......................................... P1,350,000

Variable expenses:
(40,000 units P16 per unit*) ..............................................
P640,000
Variable selling and administrative expenses
(40,000 units P3 per unit) ..................................................
120,000 760,000
Contribution margin ...................................................................... 590,000
13-206
Fixed expenses:
Fixed manufacturing overhead..................................................
250,000
Fixed selling and administrative expenses ................................
300,000 550,000
Net operating income .................................................................... P 40,000
* Direct materials......................................................... P10

Direct labor ............................................................... 4
Variable manufacturing overhead ............................. 2
Total variable manufacturing cost ............................ P16
Requirement 2
The difference in net operating income can be explained by the P50,000 in

fixed manufacturing overhead deferred in inventory under the absorption
costing method:
Variable costing net operating income .................................................................

P40,000
Add: Fixed manufacturing overhead cost deferred in
inventory under absorption costing: 10,000 units P5 per
unit in fixed manufacturing overhead cost .......................................................
50,000
Absorption costing net operating income .............................................................
P90,000
1. D 11. B
2. B 12. A
3. B 13. C
4. B 14. D
5. B 15. B
6. C 16. A
7. A 17. C
8. B 18. C
9. A 19. B
10. A 20. C
CHAPTER 13
13-207
COST-VOLUME-PROFIT RELATIONSHIPS
I. Questions
1. The total contribution margin is the excess of total revenue over total
variable costs. The unit contribution margin is the excess of the unit
price over the unit variable costs.
2. Total contribution margin:
Selling price - manufacturing variable costs expensed -
nonmanufacturing variable costs expensed = Total contribution margin.
Gross margin:
Selling price - variable manufacturing costs expensed - fixed
manufacturing costs expensed = Gross margin.
3. A company operating at break-even is probably not covering costs
which are not recorded in the accounting records. An example of such a
cost is the opportunity cost of owner-invested capital. In some small
businesses, owner-managers may not take a salary as large as the
opportunity cost of forgone alternative employment. Hence, the
opportunity cost of owner labor may be excluded.
4. In the short-run, without considering asset replacement, net operating
cash flows would be expected to exceed net income, because the latter
includes depreciation expense, while the former does not. Thus, the
cash basis break-even would be lower than the accrual break-even if
asset replacement is ignored. However, if asset replacement costs are
taken into account, (i.e., on a cradle to grave basis), the long-run net
cash flows equal long-run accrual net income, and the long-run break-
even points are the same.
5. Both unit price and unit variable costs are expressed on a per product
basis, as:
= (P1 - V1) X1 + (P2 - V2) X2 + + (Pn - Vn) Xn - F,
for all products 1 to n where:
= operating profit,
P = average unit selling price,
13-208
V = average unit variable cost,

X = quantity of units,
F = total fixed costs for the period.
6. If the relative proportions of products (i.e., the product mix) is not
held constant, products may be substituted for each other. Thus, there
may be almost an infinite number of ways to achieve a target operating
profit. As shown from the multiple product profit equation, there are
several unknowns for one equation:
= (P1 - V1) X1 + (P2 - V2) X2 + + (Pn - Vn) Xn - F,
for all products 1 to n.
7. A constant product mix is assumed to simplify the analysis. Otherwise,
there may be no unique solution.
8. Operating leverage measures the impact on net operating income of a
given percentage change in sales. The degree of operating leverage at a
given level of sales is computed by dividing the contribution margin at
that level of sales by the net operating income.
9. Three approaches to break-even analysis are (a) the equation method, (b)
the contribution margin method, and (c) the graphical method. In the
equation method, the equation is: Sales = Variable expenses + Fixed
expenses + Profits, where profits are zero at the break-even point. The
equation is solved to determine the break-even point in units or peso
sales.
10. The margin of safety is the excess of budgeted (or actual) sales over the
break-even volume of sales. It states the amount by which sales can
drop before losses begin to be incurred.
11. The sales mix is the relative proportions in which a companys products
are sold. The usual assumption in cost-volume-profit analysis is that the
sales mix will not change.
12. A higher break-even point and a lower net operating income could result
if the sales mix shifted from high contribution margin products to low
contribution margin products. Such a shift would cause the average
contribution margin ratio in the company to decline, resulting in less
total contribution margin for a given amount of sales. Thus, net
operating income would decline. With a lower contribution margin
ratio, the break-even point would be higher since it would require more
sales to cover the same amount of fixed costs.
13-209
13. The contribution margin (CM) ratio is the ratio of the total contribution
margin to total sales revenue. It can be used in a variety of ways. For
example, the change in total contribution margin from a given change in
total sales revenue can be estimated by multiplying the change in total
sales revenue by the CM ratio. If fixed costs do not change, then a peso
increase in contribution margin will result in a peso increase in net
operating income. The CM ratio can also be used in break-even analysis.
Therefore, knowledge of a products CM ratio is extremely helpful in
forecasting contribution margin and net operating income.
14. Incremental analysis focuses on the changes in revenues and costs that
will result from a particular action.
15. All other things equal, Company B, with its higher fixed costs and lower
variable costs, will have a higher contribution margin ratio than
Company A. Therefore, it will tend to realize a larger increase in
contribution margin and in profits when sales increase.
16. (a) If the selling price decreased, then the total revenue line would rise
less steeply, and the break-even point would occur at a higher unit
volume. (b) If the fixed cost increased, then both the fixed cost line and
the total cost line would shift upward and the break-even point would
occur at a higher unit volume. (c) If the variable cost increased, then the
total cost line would rise more steeply and the break-even point would
occur at a higher unit volume.
II. Exercises
Exercise 1 (Using a Contribution Format Income Statement)
Requirement 1
Total Per Unit
Sales (30,000 units 1.15 = 34,500 units) ..............................................................
P172,500 P5.00
Less variable expenses ............................................................................................
103,500 3.00
Contribution margin ................................................................................................
69,000 P2.00
Less fixed expenses .................................................................................................
50,000
Net operating income ..............................................................................................
P 19,000
Requirement 2
13-210

P162,000 P4.50
108,000 3.00
54,000 P1.50
50,000
P 4,000
Requirement 3

P156,750 P5.50
85,500 3.00
71,250 P2.50
Less fixed expenses (P50,000 + P10,000)...............................................................
60,000
P 11,250
Requirement 4

P151,200 P5.60
86,400 3.20
64,800 P2.40
50,000
P 14,800
Exercise 2 (Break-even Analysis and CVP Graphing)
Requirement 1
The contribution margin per person would be:
Price per ticket .........................................................................................................

P30
Dinner ..................................................................................................................
P7
Favors and program .............................................................................................
3 10
Contribution margin per person .............................................................................. P20
The fixed expenses of the Extravaganza total P8,000; therefore, the break-
even point would be computed as follows:
13-211
Sales = Variable expenses + Fixed expense + Profits
P30Q = P10Q + P8,000 + P0

P20Q = P8,000
Q = P8,000 P20 per person
Q = 400 persons; or, at P30 per person, P12,000
Alternative solution:
Break-even Fixed expenses
point =
in unit sales
P8,000
=
P20 per person
= 400 persons
or, at P30 per person, P12,000.
Requirement 2
Variable cost per person (P7 + P3) ..........................................................................

P10
Fixed cost per person (P8,000 250 persons).........................................................
32
Ticket price per person to break even ......................................................................
P42
Requirement 3
Cost-volume-profit graph:
13-212
P22,000
P20,000
P18,000
P16,000 Total Sales
P14,000
Break-even point: 400 persons,
P12,000 or P12,000 in sales
Pesos
P10,000
P8,000 Total Expenses
P6,000 Fixed Expenses
P4,000
P2,000
P0
0 100 200 300 400 500 600
Number of Persons
Exercise 3 (Break-even and Target Profit Analysis)
Requirement 1
Sales = Variable expenses + Fixed expenses + Profits

P900Q = P630Q + P1,350,000 + P0
P270Q = P1,350,000
Q = P1,350,000 P270 per lantern
Q = 5,000 lanterns, or at P900 per lantern, P4,500,000 in sales
point =
in unit sales
P1,350,000
=
P270 per lantern
=
13-2135,000 lanterns
or at P900 per lantern, P4,500,000 in sales
Requirement 2
An increase in the variable expenses as a percentage of the selling price

would result in a higher break-even point. The reason is that if variable
expenses increase as a percentage of sales, then the contribution margin will
decrease as a percentage of sales. A lower CM ratio would mean that more
lanterns would have to be sold to generate enough contribution margin to
cover the fixed costs.
Requirement 3
Present: Proposed:
8,000 Lanterns 10,000 Lanterns*
Total Per Unit Total Per Unit
Sales ...............................................................................................................................
P7,200,000 P900 P8,100,000 P810 **
Less variable expenses ...................................................................................................
5,040,000 630 6,300,000 630
Contribution margin .......................................................................................................
2,160,000 P270 1,800,000 P180
Less fixed expenses ........................................................................................................
1,350,000 1,350,000
Net operating income .....................................................................................................
P 810,000 P 450,000
* 8,000 lanterns 1.25 = 10,000 lanterns

** P900 per lantern 0.9 = P810 per lantern
As shown above, a 25% increase in volume is not enough to offset a 10%

reduction in the selling price; thus, net operating income decreases.
Requirement 4

P810Q = P630Q + P1,350,000 + P720,000
P180Q = P2,070,000
Q = P2,070,000 P180 per lantern
Q = 11,500 lanterns
Unit sales to Fixed expenses + Target profit
attain target profit =
13-214
P1,350,000 + P720,000
=
P180 per lantern
= 11,500 lanterns
Exercise 4 (Operating Leverage)
Requirement 1
Sales (30,000 doors) ................................................................................................

P18,000,000 P600
Less variable expenses .............................................................................................
12,600,000 420
5,400,000 P180
4,500,000
P 900,000
Degree of Contribution margin
operating =
Net operating income
leverage
P5,400,000
=
P900,000
= 6
Requirement 2
a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%,

over present sales of 30,000 doors. Since the degree of operating
leverage is 6, net operating income should increase by 6 times as much,
or by 150% (6 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income...................................................................................
P 900,000
Expected increase in net operating income next year
(150% P900,000) ..............................................................................................
1,350,000
Total expected net operating income.......................................................................
P2,250,000
Exercise 5 (Multiproduct Break-even Analysis)
Requirement 1
Model E700 Model J1500 Total Company
Amount % Amount % Amount %
Sales P700,000 100 P300,000 100 P1,000,000 100
13-215
Less variable expenses ..........................................................................................................

280,000 40 90,000 30 370,000 37
P420,000 60 P210,000 70 630,000 63 *
Less fixed expenses...............................................................................................................
598,500
P 31,500
* 630,000 P1,000,000 = 63%.
Requirement 2
The break-even point for the company as a whole would be:

Break-even point Fixed expenses
in total peso sales =
Overall CM ratio
P598,500
=
0.63
= P950,000 in sales
Requirement 3
The additional contribution margin from the additional sales can be

P50,000 63% CM ratio = P31,500
Assuming no change in fixed expenses, all of this additional contribution

margin should drop to the bottom line as increased net operating income.
This answer assumes no change in selling prices, variable costs per unit,
fixed expenses, or sales mix.
Exercise 6 (Break-even Analysis; Target Profit; Margin of Safety)
Requirement 1

P40Q = P28Q + P150,000 + P0
P12Q = P150,000
Q = P150,000 P12 per unit
Q = 12,500 units, or at P40 per unit, P500,000
Alternatively:
13-216

point =
in unit sales
P150,000
=
P12 per unit
= 12,500 units
or, at P40 per unit, P500,000.
Requirement 2
The contribution margin at the break-even point is P150,000 since at that

point it must equal the fixed expenses.
Requirement 3
P150,000 + P18,000
=
P12 per unit
= 14,000 units
Total Unit
Sales (14,000 units P40 per unit) .........................................................................
P560,000 P40
Less variable expenses
(14,000 units P28 per unit) ...............................................................................
392,000 28
Contribution margin
(14,000 units P12 per unit) ...............................................................................
168,000 P12
150,000
P 18,000
Requirement 4
Margin of safety in peso terms:
Margin of safety in pesos = Total sales Break-even sales
= P600,000 P500,000 = P100,000
13-217
Margin of safety in percentage terms:

Margin of safety Margin of safety in pesos
percentage =
Total sales
P100,000
=
P600,000
= 16.7% (rounded)
Requirement 5
The CM ratio is 30%.
Expected total contribution margin: P680,000 30% ............................................

P204,000
Present total contribution margin: P600,000 30% ...............................................
180,000
Increased contribution margin .................................................................................
P 24,000
P80,000 incremental sales 30% CM ratio = P24,000
Since in this case the companys fixed expenses will not change, monthly net
operating income will increase by the amount of the increased contribution
margin, P24,000.
Exercise 7 (Changes in Variable Costs, Fixed Costs, Selling Price, and

Volume)
Requirement (1)
The following table shows the effect of the proposed change in monthly
advertising budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales ............................................. P225,000 P240,000 P15,000
13-218
Variable expenses ........................ 135,000 144,000 9,000

Contribution margin ..................... 90,000 96,000 6,000
Fixed expenses ............................. 75,000 83,000 8,000
Net operating income ................... P 15,000 P 13,000 P(2,000)
Assuming that there are no other important factors to be considered, the

increase in the advertising budget should not be approved since it would lead
to a decrease in net operating income of P2,000.
Alternative Solution 1
Expected total contribution margin:

P240,000 40% CM ratio............................................ P96,000
Present total contribution margin:
P225,000 40% CM ratio............................................ 90,000
Incremental contribution margin ...................................... 6,000
Change in fixed expenses:
Less incremental advertising expense .......................... 8,000
Change in net operating income ....................................... P(2,000)
Alternative Solution 2
Incremental contribution margin:

P15,000 40% CM ratio............................................. P 6,000
Less incremental advertising expense .............................. 8,000
Change in net operating income ....................................... P(2,000)
Requirement (2)
The P3 increase in variable costs will cause the unit contribution margin to
decrease from P30 to P27 with the following impact on net operating
income:
Expected total contribution margin with the higher-quality
components:
3,450 units P27 per unit ................................................................P93,150
3,000 units P30 per unit ................................................................ 90,000
Change in total contribution margin ....................................................P 3,150
13-219
Assuming no change in fixed costs and all other factors remain the same, the
higher-quality components should be used.
Exercise 8 (Compute the Margin of Safety)
Requirement (1)
To compute the margin of safety, we must first compute the break-even unit
sales.

P25Q = P15Q + P8,500 + P0
P10Q = P8,500
Q = 850 units
Sales (at the budgeted volume of 1,000 units) ................................. P25,000

Break-even sales (at 850 units) ........................................................ 21,250
Margin of safety (in pesos)............................................................... P 3,750
Requirement (2)
The margin of safety as a percentage of sales is as follows:
Margin of safety (in pesos)...................................................... P3,750

Sales ..................................................................................... P25,000
Margin of safety as a percentage of sales ................................ 15.0%
Exercise 9 (Compute and Use the Degree of Operating Leverage)
Requirement (1)
The companys degree of operating leverage would be computed as follows:
Contribution margin .................................. P36,000

Net operating income ............................. P12,000
Degree of operating leverage .................... 3.0
Requirement (2)
13-220
A 10% increase in sales should result in a 30% increase in net operating

income, computed as follows:
Degree of operating leverage ........................................................................3.0

Percent increase in sales ............................................................................
10%
Estimated percent increase in net operating income ..................................... 30%
Requirement (3)
The new income statement reflecting the change in sales would be:
Percent of
Amount Sales
Sales ............................................. P132,000 100%
Variable expenses ......................... 92,400 70%
Contribution margin ..................... 39,600 30%
Fixed expenses ............................. 24,000
Net operating income ................... P 15,600
Net operating income reflecting change in sales ....................................... P15,600

Original net operating income ....................................................................
P12,000
Percent change in net operating income ....................................................30%
Exercise 10 (Compute the Break-Even Point for a Multiproduct

Company)
Requirement (1)
The overall contribution margin ratio can be computed as follows:

Total contribution margin
Overall CM ratio =
Total sales
P120,000
=
P150,000
= 80%
Requirement (2)
13-221
The overall break-even point in sales pesos can be computed as follows:

Total fixed expenses
Overall break-even =
Overall CM ratio
P90,000
=
80%
= P112,500
Requirement (3)
To construct the required income statement, we must first determine the

relative sales mix for the two products:
Ping Pong Total

Original peso sales ....................... P100,000 P50,000 P150,000
Percent of total ............................. 67% 33% 100%
Sales at break-even ....................... P75,000 P37,500 P112,500
Ping Pong Total

Sales ............................................. P75,000 P37,500 P112,500
Variable expenses* ...................... 18,750 3,750 22,500
Contribution margin ..................... P56,250 P33,750 90,000
Fixed expenses ............................. 90,000
Net operating income ................... P 0
*Ping variable expenses: (P75,000/P100,000) P25,000 = P18,750

Pong variable expenses: (P37,500/P50,000) P5,000 = P3,750
Exercise 11 (Break-Even and Target Profit Analysis)
Requirement (1)
Variable expenses: P60 (100% 40%) = P36.
Requirement (2)
a. Selling price ............................................... P60 100%

Variable expenses ...................................... 36 60%
Contribution margin ................................... P24 40%
13-222
Let Q = Break-even point in units.

P60Q = P36Q + P360,000 + P0
P24Q = P360,000
Q = 15,000 units
In sales pesos: 15,000 units P60 per unit = P900,000
Let X = Break-even point in sales pesos.
X = 0.60X + P360,000 + P0
0.40X = P360,000
X = P360,000 0.40
X = P900,000
In units: P900,000 P60 per unit = 15,000 units
b. P60Q = P36Q + P360,000 + P90,000
P24Q = P450,000
Q = 18,750 units
In sales pesos: 18,750 units P60 per unit = P1,125,000

X = 0.60X + P360,000 + P90,000

0.40X = P450,000
X = P450,000 0.40
X = P1,125,000
In units: P1,125,000 P60 per unit = 18,750 units
c. The companys new cost/revenue relationships will be:
Selling price .................................................................. P60 100%

Variable expenses (P36 P3) ....................................... 33 55%
Contribution margin ...................................................... P27 45%
13-223
P60Q = P33Q + P360,000 + P0

P27Q = P360,000
Q = 13,333 units (rounded).
In sales pesos: 13,333 units P60 per unit = P800,000 (rounded)
X = 0.55X + P360,000 + P0
0.45X = P360,000
X = P360,000 0.45
X = P800,000
In units: P800,000 P60 per unit = 13,333 units (rounded)
Requirement (3)
a. in unit sales =
= P360,000 P24 per unit = 15,000 units
In sales pesos: 15,000 units P60 per unit = P900,000
in sales pesos =
CM ratio
= P360,000 0.40 = P900,000
In units: P900,000 P60 per unit = 15,000 units

b. =
attain target profit Unit contribution margin
= (P360,000 + P90,000) P24 per unit
= 18,750 units
13-224
In sales pesos: 18,750 units P60 per unit = P1,125,000
Peso sales to Fixed expenses + Target profit
CM ratio
= (P360,000 + P90,000) 0.40
= P1,125,000
In units: P1,125,000 P60 per unit = 18,750 units
c. Break-even point Fixed expenses

in unit sales =
= P360,000 P27 per unit
= 13,333 units (rounded)

In sales pesos: 13,333 units P60 per unit = P800,000 (rounded)
in sales pesos =
CM ratio
= P360,000 0.45
= P800,000
In units: P800,000 P60 per unit = 13,333 (rounded)
Exercise 12 (Operating Leverage)
Requirement (1)
Sales (30,000 doors) ............................... P1,800,000 P60
13-225
Variable expenses ................................... 1,260,000 42

Contribution margin ............................... 540,000 P18
Fixed expenses ....................................... 450,000
Net operating income ............................. P 90,000
Degree of Contribution margin
operating =
leverage
= P540,000 P90,000 = 6
Requirement (2)
a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%,

over present sales of 30,000 doors. Since the degree of operating
leverage is 6, net operating income should increase by 6 times as much,
or by 150% (6 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income ................................................................

P 90,000
Expected increase in net operating income next year
(150% P90,000) .............................................................................
135,000
Total expected net operating income ....................................................
P225,000
III. Problems
Problem 1 (CVP Relationships)
Requirement 1
Contribution margin P15
CM ratio = = = 25%
Selling price P60
Variable expense P45
Variable expense ratio = = = 75%
Selling price P60
Requirement 2

P60Q = P45Q + P240,000 + P0
P15Q = P240,000
13-226
Q = 16,000 units, or at P60 per unit, P960,000
X = 0.75X + P240,000 + P0
0.25X = P240,000
X = P240,000 0.25
X = P960,000; or at P60 per unit, 16,000 units
Requirement 3
Increase in sales ................................................... P400,000

Multiply by the CM ratio ..................................... x 25%
Expected increase in contribution margin ........... P100,000
Since the fixed expenses are not expected to change, net operating income
will increase by the entire P100,000 increase in contribution margin
computed above.
Requirement 4

P60Q = P45Q + P240,000 + P90,000
P15Q = P330,000
Q = 22,000 units
Contribution margin method:

Fixed expenses + Target profit P240,000 + P90,000
= = 22,000 units
Contribution margin per unit P15 per unit
Requirement 5
= P1,200,000 P960,000 = P240,000
Margin of safety Margin of safety in pesos P240,000

=
percentage =
Total sales P1,200,000 = 20%
13-227
Requirement 6
Contribution margin P300,000
a. Degree of operating leverage = = 5
Net operating P60,000
=
income
b. Expected increase in sales .......................................... 8%
Degree of operating leverage ...................................... x 5
Expected increase in net operating income ................ 40%
c. If sales increase by 8%, then 21,600 units (20,000 x 1.08 = 21,600) will
be sold next year. The new income statement will be as follows:
Percent of
Total Per Unit Sales
Sales (21,600 units) ............... P1,296,000 P60 100%
Less variable expenses ........... 972,000 45 75%
Contribution margin ............... 324,000 P15 25%
Less fixed expenses................ 240,000
Net operating income ............. P 84,000
Thus, the P84,000 expected net operating income for next year
represents a 40% increase over the P60,000 net operating income earned
during the current year:
P84,000 P60,000 P24,000
= = 40% increase
P60,000 P60,000
Note from the income statement above that the increase in sales from
20,000 to 21,600 units has resulted in increases in both total sales and
total variable expenses. It is a common error to overlook the increase in
variable expense when preparing a projected income statement.
Requirement 7
a. A 20% increase in sales would result in 24,000 units being sold next
year: 20,000 units x 1.20 = 24,000 units.
Percent of
Total Per Unit Sales
13-228
Sales (24,000 units) ............... P1,440,000 P60 100%

Less variable expenses ........... 1,152,000 48* 80%
Contribution margin ............... 288,000 P12 20%
Less fixed expenses................ 210,000
Net operating income ............. P 78,000
* P45 + P3 = P48; P48 P60 = 80%.

P240,000 P30,000 = P210,000.
Note that the change in per unit variable expenses results in a change in
both the per unit contribution margin and the CM ratio.
b. Break-even point Fixed expenses

in unit sales =
Contribution margin per unit
P210,000
=
P12 per unit
= 17,500 units
Break-even
c. Yes, based on these point Fixedshould
data the changes expenses
be made. The changes will
peso sales net =operating
increase theincompanys CMincome
ratio from the present P60,000
to P78,000 per year. Although the changes will also result in a higher
P210,000
break-even point (17,500 units= as compared to the present 16,000 units),
0.20
the companys margin of safety will actually be wider than before:
= P1,050,000
= P1,440,000 P1,050,000 = P390,000
As shown in requirement (5) above, the companys present margin of

safety is only P240,000. Thus, several benefits will result from the
proposed changes.
Problem 2 (Basics of CVP Analysis; Cost Structure)
Requirement 1
The CM ratio is 30%.
Total Per Unit Percentage
Sales (13,500 units) .................................................................................................
P270,000 P20 100 %
189,000 14 70
13-229
P 81,000 P 6 30 %
The break-even point is:

P20Q = P14Q + P90,000 + P0
P 6Q = P90,000
Q = 15,000 units
15,000 units P20 per unit = P300,000 in sales
in unit sales =
P90,000
=
P6 per unit
= 15,000 units
in sales pesos = CM ratio
P90,000
=
0.30
= P300,000 in sales
Requirement 2
Incremental contribution margin:

P70,000 increased sales 30% CM ratio ............................................................
P21,000
Less increased fixed costs:
Increased advertising cost ....................................................................................
8,000
Increase in monthly net operating income ...............................................................
P13,000
13-230
Since the company presently has a loss of P9,000 per month, if the changes
are adopted, the loss will turn into a profit of P4,000 per month.
Requirement 3
Sales (27,000 units P18 per unit*) .......................................................................

P486,000
Less variable expenses
(27,000 units P14 per unit) ...............................................................................
378,000
108,000
Less fixed expenses (P90,000 + P35,000) ...............................................................
125,000
Net operating loss ....................................................................................................
P(17,000)
*P20 (P20 0.10) = P18
Requirement 4

P 20Q = P14.60Q* + P90,000 + P4,500
P5.40Q = P94,500
Q = P94,500 P5.40 per unit
Q = 17,500 units
* P14.00 + P0.60 = P14.60.

CM per unit
P90,000 + P4,500
=
P5.40 per unit**
= 17,500 units
** P6.00 P0.60 = P5.40.
Requirement 5
13-231
a. The new CM ratio would be:

Per Unit Percentage
Sales .........................................................................................................................
P20 100 %
7 35
Contribution margin .................................................................................................
P13 65 %
The new break-even point would be:

in unit sales =
P208,000
=
P13 per unit
= 16,000 units

in sales pesos = CM ratio
P208,000
=
0.65
= P320,000 in sales
b. Comparative income statements follow:
Not Automated Automated

Total Per Unit % Total Per Unit %
Sales (20,000 units) ..............................................................................................................
P400,000 P20 100 P400,000 P20 100
280,000 14 70 140,000 7 35
120,000 P 6 30 260,000 P13 65
Less fixed expenses ..............................................................................................................
90,000 208,000
P 30,000 P 52,000
c. Whether or not one would recommend that the company automate its
operations depends on how much risk he or she is willing to take, and
depends heavily on prospects for future sales. The proposed changes
would increase the companys fixed costs and its break-even point.
However, the changes would also increase the companys CM ratio
(from 30% to 65%). The higher CM ratio means that once the break-
13-232
even point is reached, profits will increase more rapidly than at present.
If 20,000 units are sold next month, for example, the higher CM ratio
will generate P22,000 more in profits than if no changes are made.
The greatest risk of automating is that future sales may drop back down
to present levels (only 13,500 units per month), and as a result, losses
will be even larger than at present due to the companys greater fixed
costs. (Note the problem states that sales are erratic from month to
month.) In sum, the proposed changes will help the company if sales
continue to trend upward in future months; the changes will hurt the
company if sales drop back down to or near present levels.
Note to the Instructor: Although it is not asked for in the problem, if

time permits you may want to compute the point of indifference between
the two alternatives in terms of units sold; i.e., the point where profits
will be the same under either alternative. At this point, total revenue
will be the same; hence, we include only costs in our equation:
Let Q = Point of indifference in units sold

P14Q + P90,000 = P7Q + P208,000
P7Q = P118,000
Q = 16,857 units (rounded)
If more than 16,857 units are sold, the proposed plan will yield the greatest
profit; if less than 16,857 units are sold, the present plan will yield the
greatest profit (or the least loss).
Problem 3 (Sales Mix; Multiproduct Break-even Analysis)
Requirement 1
Products
Sinks Mirrors Vanities Total
Percentage of total sales .......................................................................................................................
32% 40% 28% 100%
Sales ....................................................................................................................................................
P160,000 100 % P200,000 100 % P140,000 100 % P500,000 100 %
Less variable expenses .........................................................................................................................
48,000 30 160,000 80 77,000 55 285,000 57
Contribution margin .............................................................................................................................
P112,000 70 % P 40,000 20 % P 63,000 45 % 215,000 43 %*
Less fixed expenses ..............................................................................................................................
223,600
Net operating income (loss) .................................................................................................................
P ( 8,600)
13-233
* P215,000 P500,000 = 43%.
Requirement 2
Break-even sales:
in total peso sales =
CM ratio
P223,600
=
Requirement 3 0.43
Memo to the president: = P520,000 in sales

Although the company met its sales budget of P500,000 for the month, the
mix of products sold changed substantially from that budgeted. This is the
reason the budgeted net operating income was not met, and the reason the
break-even sales were greater than budgeted. The companys sales mix was
planned at 48% Sinks, 20% Mirrors, and 32% Vanities. The actual sales mix
was 32% Sinks, 40% Mirrors, and 28% Vanities.
As shown by these data, sales shifted away from Sinks, which provides our
greatest contribution per peso of sales, and shifted strongly toward Mirrors,
which provides our least contribution per peso of sales. Consequently,
although the company met its budgeted level of sales, these sales provided
considerably less contribution margin than we had planned, with a resulting
decrease in net operating income. Notice from the attached statements that
the companys overall CM ratio was only 43%, as compared to a planned
CM ratio of 52%. This also explains why the break-even point was higher
than planned. With less average contribution margin per peso of sales, a
greater level of sales had to be achieved to provide sufficient contribution
margin to cover fixed costs.
Problem 4 (Basic CVP Analysis)
Requirement 1
13-234
The CM ratio is 60%:

Selling price .............................................................................................................
P150 100 %
60 40
P 90 60 %
Requirement 2
in total sales =
CM ratio
pesos
P1,800,000
=
0.60
= P3,000,000 in sales
Requirement 3
P450,000 increased sales 60% CM ratio = P270,000 increased contribution

margin. Since fixed costs will not change, net operating income should also
increase by P270,000.
Requirement 4
Contribution margin P2,160,000
a. Degree of operating leverage = = 6
Net operating P360,000
=
income
b. 6 15% = 90% increase in net operating income.
Requirement 5
Last Year: Proposed:
28,000 units 42,000 units*
Total Per Unit Total Per Unit
Sales ......................................................................................................................................
P4,200,000 P150.00 P5,670,000 P135.00 **
1,680,000 60.00 2,520,000 60.00
2,520,000 P 90.00 3,150,000 P 75.00
Less fixed expenses ...............................................................................................................
1,800,000 2,500,000
P 720,000 P 650,000
* 28,000 units 1.5 = 42,000 units

** P150 per unit 0.90 = P135.00 per unit
No, the changes should not be made.
Requirement 6
13-235
Expected total contribution margin:

28,000 units 200% P70 per unit* ..................................................................
P3,920,000
28,000 units P90 per unit ..................................................................................
2,520,000
Incremental contribution margin, and the amount by which
advertising can be increased with net operating income
remaining unchanged ...........................................................................................
P1,400,000
* P150 (P60 + P20) = P70
Problem 5 (Break-Even and Target Profit Analysis)
Requirement 1
The contribution margin per patch would be:
Selling price .............................................................................................................

P30
Purchase cost of the patches ................................................................................
P15
Commissions to the student salespersons ............................................................6 21
P 9
Since there are no fixed costs, the number of unit sales needed to yield the
desired P7,200 in profits can be obtained by dividing the target profit by the
unit contribution margin:
Target profit P7,200
= = 800 patches
Unit contribution margin P9 per patch
800 patches x P30 per patch = P24,000 in total sales
Requirement 2
Since an order has been placed, there is now a fixed cost associated with
the purchase price of the patches (i.e., the patches cant be returned). For
example, an order of 200 patches requires a fixed cost (investment) of
P3,000 (200 patches P15 per patch = P3,000). The variable costs drop to
only P6 per patch, and the new contribution margin per patch becomes:
Selling price .............................................................................................................

P30
13-236
Less variable expenses (commissions only) ............................................................ 6

P24
Since the fixed cost of P3,000 must be recovered before Ms. Morales
shows any profit, the break-even computation would be:
point =
in unit sales
P3,000
= = 125 patches
P24 per patch
125 patches x P30 per patch = P3,750 in total sales
If a quantity other than 200 patches were ordered, the answer would change
accordingly.
Problem 6
Requirement 1: Break-even chart

TR
600,000
500,000
TC
400,000
(P)
Break-even
300,000 point
200,000
FC
100,000
13-237
5,000 10,000 15,000 20,000 25,000 30,000
(units)
Requirement 2: Profit-volume graph
250,000
P 200,000
R
O
F 150,000
I
T
100,000
Break-even
50,000
point
0
5,000 10,000 15,000 20,000 25,000 30,000
50,000
100,000
L
O 150,000
S
S 13-238
200,000
250,000
Problem 7 (Sales Mix; Break-Even Analysis; Margin of Safety)
Requirement (1)
a. Hun Yun Total
Pesos % P % Euros %
Sales ..............................................
P80,000 100 P48,000 100 P128,000 100
Variable expenses ......................... 48,000 60 9,600 20 57,600 45
Contribution margin ...................... P32,000 40 P38,400 80 70,400 55
Fixed expenses .............................. 66,000
Net operating income .................... P 4,400
b. Break-even sales = Fixed expenses CM ratio

= P66,000 0.55 = P120,000
Margin of safety
= Actual sales Break-even sales
in pesos
= P128,000 P120,000
= P8,000
Margin of safety Margin of safety in pesos Actual sales

percentage =
= P8,000 P128,000
= 6.25%
13-239
Requirement (2)
a. Hun Yun HY143 Total

Pesos % Pesos % Pesos % Pesos %
Sales P80,000 100 P48,000 100 P32,000 100 P160,000 100
Variable expenses 48,000 60 9,600 20 2,4000 75 81,600 51
Contribution margin P32,000 40 P38,400 80 P 8,000 25 78,400 49
Fixed expenses 66,000
Net operating income P 12,400
b. Break-even sales = Fixed expenses CM ratio

= P66,000 0.49 = P134,700 (rounded)
Margin of safety
= Actual sales Break-even sales
in pesos
= P160,000 P134,700
= P25,300
Margin of safety Margin of safety in pesos Actual sales

percentage =
= P25,300 P160,000
= 15.81%
Requirement (3)
The reason for the increase in the break-even point can be traced to the
decrease in the companys average contribution margin ratio when the third
product is added. Note from the income statements above that this ratio
drops from 55% to 49% with the addition of the third product. This product,
called HY143, has a CM ratio of only 25%, which causes the average
contribution margin ratio to fall.
This problem shows the somewhat tenuous nature of break-even analysis

when more than one product is involved. The manager must be very careful
of his or her assumptions regarding sales mix when making decisions such as
13-240
adding or deleting products.
It should be pointed out to the president that even though the break-even
point is higher with the addition of the third product, the companys margin
of safety is also greater. Notice that the margin of safety increases from
P8,000 to P25,300 or from 6.25% to 15.81%. Thus, the addition of the new
product shifts the company much further from its break-even point, even
though the break-even point is higher.
13-241
Problem 8 (Break-Even Analysis with Step Fixed Costs)
Requirement (1)
The total annual fixed cost of the Pediatric Ward can be computed as follows:
Annual Supervising Total Other Fixed Total Fixed

Patient-Days Aides Nurses Nurses Personnel Cost Cost
@ P360,000 @ P580,000 @ P760,000
10,000-12,000 P2,520,000 P8,700,000 P2,280,000 P13,500,000 P27,400,000 P40,900,000
12,001-13,750 P2,880,000 P8,700,000 P2,280,000 P13,860,000 P27,400,000 P41,260,000
13,751-16,500 P3,240,000 P9,280,000 P3,040,000 P15,560,000 P27,400,000 P42,960,000
16,501-18,250 P3,600,000 P9,280,000 P3,040,000 P15,920,000 P27,400,000 P43,320,000
18,251-20,750 P3,600,000 P9,860,000 P3,800,000 P17,260,000 P27,400,000 P44,660,000
20,751-23,000 P3,960,000 P10,440,000 P3,800,000 P18,200,000 P27,400,000 P45,600,000
Requirement (2)
The break-even can be computed for each range of activity by dividing the total fixed cost for that range of activity by the contribution
margin per patient-day, which is P3,000 (=P4,800 revenue P1,800 variable cost).
(a) (b)
Annual Total Fixed Contribution Break-Even Within Relevant
Patient-Days Cost Margin (a) (b) Range?
10,000-12,000 P40,900,000 P3,000 13,633 No
12,001-13,750 P41,260,000 P3,000 13,753 No
13,751-16,500 P42,960,000 P3,000 14,320 Yes
16,501-18,250 P43,320,000 P3,000 14,440 No
18,251-20,750 P44,660,000 P3,000 14,887 No
20,751-23,000 P45,600,000 P3,000 15,200 No
13-242
While a break-even can be computed for each range of activity (i.e., relevant range), all but one of these break-evens is bogus. For example,
within the range of 10,000 to 12,000 patient-days, the computed break-even is 13,633 (rounded) patient-days. However, this level of activity
is outside this relevant range. To serve 13,633 patient-days, the fixed costs would have to be increased from P40,900,000 to P41,260,000 by
adding one more aide. The only break-even that occurs within its own relevant range is 14,320. This is the only legitimate break-even.
Requirement (3)
The level of activity required to earn a profit of P7,200,000 can be computed as follows:
Activity to
(a) (b) Attain Target
Annual Total Fixed Total Fixed Cost + Contribution Profit Within Relevant
Patient-Days Cost Target Profit Target Profit Margin (a) (b) Range?
10,000-12,000 P40,900,000 P7,200,000 P48,100,000 P3,000 16,033 No
12,001-13,750 P41,260,000 P7,200,000 P48,460,000 P3,000 16,153 No
13,751-16,500 P42,960,000 P7,200,000 P50,160,000 P3,000 16,720 No
16,501-18,250 P43,320,000 P7,200,000 P50,520,000 P3,000 16,840 Yes
18,251-20,750 P44,660,000 P7,200,000 P51,860,000 P3,000 17,287 No
20,751-23,000 P45,600,000 P7,200,000 P52,800,000 P3,000 17,600 No
In this case, the only solution that is within the appropriate relevant range is 16,840 patient-days.
13-243
1. B 6. B 11. B 16. D 21. A 26. A

2. B 7. D 12. A 17. D 22. D 27. B
3. B 8. B 13. A 18. D 23. C 28. C
4. C 9. A 14. C 19. C 24. B 29. B
5. C 10. D 15. D 20. D 25. C 30. A
CHAPTER 14
RESPONSIBILITY ACCOUNTING AND

TRANSFER PRICING
I. Questions
1. Cost centers are evaluated by means of performance reports. Profit
centers are evaluated by means of contribution income statements
(including cost center performance reports), in terms of meeting sales
and cost objectives. Investment centers are evaluated by means of the
rate of return which they are able to generate on invested assets.
2. Overall profitability can be improved (1) by increasing sales, (2) by
reducing expenses, or (3) by reducing assets.
3. ROI may lead to dysfunctional decisions in that divisional managers may
reject otherwise profitable investment opportunities simply because they
would reduce the divisions overall ROI figure. The residual income
approach overcomes this problem by establishing a minimum rate of
return which the company wants to earn on its operating assets, thereby
motivating the manager to accept all investment opportunities promising
a return in excess of this minimum figure.
4. A cost center manager has control over cost, but not revenue or
investment funds. A profit center manager, by contrast, has control over
both cost and revenue. An investment center manager has control over
cost and revenue and investment funds.
18-244
Application of Quantitative Techniques in Planning, Control and Decision Making II Chapter 18
5. The term transfer price means the price charged for a transfer of goods
or services between units of the same organization, such as two
departments or divisions. Transfer prices are needed for performance
evaluation purposes.
6. The use of market price for transfer purposes will create the actual
conditions under which the transferring and receiving units would be
operating if they were completely separate, autonomous companies. It is
generally felt that the creation of such conditions provides managerial
incentive, and leads to greater overall efficiency in operations.
7. Negotiated transfer prices should be used (1) when the volume involved
is large enough to justify quantity discounts, (2) when selling and/or
administrative expenses are less on intracompany sales, (3) when idle
capacity exists, and (4) when no clear-cut market price exists (such as a
sister division being the only supplier of a good or service).
8. Suboptimization can result if transfer prices are set in a way that benefits
a particular division, but works to the disadvantage of the company as a
whole. An example would be a transfer between divisions when no
transfers should be made (e.g., where a better overall contribution
margin could be generated by selling at an intermediate stage, rather
than transferring to the next division). Suboptimization can also result if
transfer pricing is so inflexible that one division buys from the outside
when there is substantial idle capacity to produce the item internally. If
divisional managers are given full autonomy in setting, accepting, and
rejecting transfer prices, then either of these situations can be created,
through selfishness, desire to look good, pettiness, or bickering.
II. Exercises
Exercise 1 (Evaluation of a Profit Center)
No. Although Department 3 does not cover all of the cost allocated to it. It
contributes P21,000 to the total operations over and above its direct costs.
Without Department 3, the company would earn P21,000 less as compared
with the original over-all income of P47,000.
Department
1 2 4 Total
Revenue P132,000 P168,000 P98,000 P398,000
Direct cost of department 82,000 108,000 61,000 251,000
18-245
Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II
Contribution of the
department P 50,000 P 60,000 P37,000 P147,000
Allocated cost 121,000
Net income P 26,000
With the discontinuance of Department 3, the revenue and direct cost of the
department are eliminated, but there is no reduction in the total allocated
cost.
Exercise 2 (Evaluation of an Investment Center)
Requirement 1
ROI RI
Operating assets P400,000 P400,000
Operating income P100,000 P100,000
ROI (P100,000 P400,000) 25%
Minimum required income
(16% x P400,000) P64,000
RI (P100,000 - P64,000) P36,000
Requirement 2
The manager of the Cling Division would not accept this project under the
ROI approach since the division is already earning 25%. Accepting this
project would reduce the present divisional performance, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000* P112,000
ROI 25% 20% 24.35%
* P60,000 x 20% = P12,000
Under the RI approach, on the other hand, the manager would accept this
project since the new project provides a higher return than the minimum
required rate of return (20 percent vs. 16 percent). The new project would
increase the overall divisional residual income, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
18-246
Operating income P100,000 P12,000 P112,000

Minimum required
return at 16% 64,000 9,600* 73,600
RI P 36,000 P 2,400 P 38,400
* P60,000 x 16% = P9,600
Exercise 3 (ROI, Comparison of Three Divisions)
Requirement 1
Division X Division Y Division Z

ROI: P10,000 P12,600 P 28,800
= 25% = 18% = 16%
P40,000 P70,000 P180,000
Requirement 2
Division X would reject this investment opportunity since the addition

would lower the present divisional ROI. Divisions Y and Z would accept it
because they would look better in terms of their divisional ROI.
Exercise 4 (ROI, RI, Comparisons of Two Divisions)
Requirement 1
Net Operating income X Sales = ROI

Sales Average Operating Assets
P630,000 P9,000,000
Division A : X = ROI
P9,000,000 P3,000,000
7% X 3 = 21%
P1,800,000 P20,000,000
Division B : X = ROI
P20,000,000 P10,000,000
9% X 2 = 18%
18-247
Requirement 2
Division A Division B
Average operating assets (a) ........ P3,000,000 P10,000,000
Net operating income ................... P 630,000 P 1,800,000
Minimum required return on average
operating assets - 16% x (a) .... 480,000 1,600,000
Residual income........................... P 150,000 P 200,000
Requirement 3
No, Division B is simply larger than Division A and for this reason one
would expect that it would have a greater amount of residual income. As
stated in the text, residual income cant be used to compare the performance
of divisions of different sizes. Larger divisions will almost always look
better, not necessarily because of better management but because of the
larger peso figures involved. In fact, in the case above, Division B does not
appear to be as well managed as Division A. Note from Part (2) that
Division B has only an 18 percent ROI as compared to 21 percent for
Division A.
Exercise 5 (Evaluation of a Cost Center)
(1) Controllable Costs by supervisor of Department 10 are as follows:

a. Supplies, Department 10
b. Repairs and Maintenance, Department 10
c. Labor Cost, Department 10
(2) Direct Costs of Department 10 are

a. Salary, supervisor of Department 10
b. Supplies, Department 10
c. Repairs and Maintenance, Department 10
d. Labor Cost, Department 10
(3) Costs allocated to Factory Department are:

a. Factory, heat and light
b. Depreciation, factory
c. Factory insurance
d. Salary of factory superintendent
18-248
(4) Costs which do not pertain to factory operations are:

a. Sales salaries and commissions
b. General office salaries
Exercise 6 (Evaluating New Investments Using Return on Investment

(ROI) and Residual Income)
Requirement 1
Computation of ROI
Division A:
P300,000 P6,000,000
ROI = x = 5% x 4 = 20%
P6,000,000 P1,500,000
Division B:
P900,000 P10,000,000
ROI = x = 9% x 2 = 18%
P10,000,000 P5,000,000
Division C:
P180,000 P8,000,000
ROI = x = 2.25% x 4 = 9%
P8,000,000 P2,000,000
Requirement 2
Division A Division B Division C

Average operating assets .......................................................................................................
P1,500,000 P5,000,000 P2,000,000
Required rate of return ..........................................................................................................
15% 18% 12%
Required operating income ...................................................................................................
P 225,000 P 900,000 P 240,000
Actual operating income .......................................................................................................
P 300,000 P 900,000 P 180,000
Required operating income (above) ......................................................................................
225,000 900,000 240,000
Residual income ....................................................................................................................
P 75,000 P 0 P (60,000)
18-249
Requirement 3
a. and b. Division A Division B Division C

Return on investment (ROI) ....................................................................................
20% 18% 9%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ....................................................................................................
Reject Reject Accept
Minimum required return for
computing residual income ..................................................................................
15% 18% 12%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ....................................................................................................
Accept Reject Accept
If performance is being measured by ROI, both Division A and Division B

probably would reject the 17% investment opportunity. The reason is that
these companies are presently earning a return greater than 17%; thus, the
new investment would reduce the overall rate of return and place the
divisional managers in a less favorable light. Division C probably would
accept the 17% investment opportunity, since its acceptance would increase
the Divisions overall rate of return.
If performance is being measured by residual income, both Division A and

Division C probably would accept the 17% investment opportunity. The
17% rate of return promised by the new investment is greater than their
required rates of return of 15% and 12%, respectively, and would therefore
add to the total amount of their residual income. Division B would reject the
opportunity, since the 17% return on the new investment is less than Bs
18% required rate of return.
Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company)
Requirement 1
Division A Division B Total Company
Sales P3,500,000 1 P2,400,000 2 P5,200,000 3
Less expenses:
Added by the division .......................................................................................................
2,600,000 1,200,000 3,800,000

Transfer price paid ............................................................................................................
700,000
18-250
Total expenses .......................................................................................................................

2,600,000 1,900,000 3,800,000
P 900,000 P 500,000 P1,400,000
1
20,000 units P175 per unit = P3,500,000.
2
4,000 units P600 per unit = P2,400,000.
3
Division A outside sales (16,000 units P175 per unit) .......................................................
P2,800,000
Division B outside sales (4,000 units P600 per unit).........................................................
2,400,000
Total outside sales.................................................................................................................
P5,200,000
Observe that the P700,000 in intracompany sales has been eliminated.

Requirement 2
Division A should transfer the 1,000 additional units to Division B. Note

that Division Bs processing adds P425 to each units selling price (Bs P600
selling price, less As P175 selling price = P425 increase), but it adds only
P300 in cost. Therefore, each tube transferred to Division B ultimately
yields P125 more in contribution margin (P425 P300 = P125) to the
company than can be obtained from selling to outside customers. Thus, the
company as a whole will be better off if Division A transfers the 1,000
additional tubes to Division B.
Exercise 8 (Transfer Pricing Situations)
Requirement 1
The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred
.
There is no idle capacity, so each of the 20,000 units transferred from
Division X to Division Y reduces sales to outsiders by one unit. The
contribution margin per unit on outside sales is P20 (= P50 P30).
P20 x 20,000
Transfer price (P30 P2) +
20,000
Transfer price = P28 + P20 = P48
The buying division, Division Y, can purchase a similar unit from an outside
supplier for P47. Therefore, Division Y would be unwilling to pay more
18-251
than P47 per unit.
Transfer price Cost of buying from outside supplier = P47
The requirements of the two divisions are incompatible and no transfer will
take place.
Requirement 2
In this case, Division X has enough idle capacity to satisfy Division Ys

demand. Therefore, there are no lost sales and the lowest acceptable price as
far as the selling division is concerned is the variable cost of P20 per unit.
P0
Transfer price P20 +
20,000
= P20
The buying division, Division Y, can purchase a similar unit from an outside
supplier for P34. Therefore, Division Y would be unwilling to pay more
than P34 per unit.
Transfer price Cost of buying from outside supplier = P34
In this case, the requirements of the two divisions are compatible and a
transfer will hopefully take place at a transfer price within the range:
P20 Transfer price P34
Exercise 9 (Transfer Pricing: Decision Making)
Requirement 1
Division As purchase decision from the overall firm perspective:
Purchase costs from outside 10,000 x P150 = P1,500,000

Less: Savings of Divisions Bs variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P 100,000
Assuming Division B has no outside sales, Division A should buy inside

from Division B for the benefit of the entire firm.
18-252
Requirement 2
As above, but in addition, if Division A buys outside, Division B saves an

additional P200,000.

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Less: Savings of B material assignment 200,000
Net Cost (Benefit) for A to buy outside P (100,000)
The additional savings in Division B means that now Division A should buy
outside.
Requirement 3
Assuming the outside price drops from P150 to P130:

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P (100,000)
Division A should buy outside.
Exercise 10 (Compute the Return on Investment (ROI))
Requirement (1)

Margin = Sales
P5,400,000
= P18,000,000 = 30%
Requirement (2)
Sales
Turnover = Average operating assets
P18,000,000
= 18-253 = 0.5
P36,000,000
Requirement (3)
ROI = Margin x Turnover

= 30% x 0.5 = 15%
Exercise 11 (Residual Income)
Average operating assets (a) ............................................. P2,200,000

Net operating income ....................................................... P400,000
Minimum required return: 16% (a) ............................... 352,000
Residual income ............................................................... P 48,000
III. Problems
Problem 1 (Evaluation of Profit Centers)
Requirement (a)
Jadlow Manufacturing Corporation

Income Statement
Total Product S Product T

Sales P5,100,000 P2,700,000 P2,400,000
Less: Variable Costs 3,330,000 1,890,000 1,440,000
Contribution Margin P1,770,000 P 810,000 P 960,000
Less: Controllable fixed
expenses 501,000 66,000 435,000
Contribution to the recovery
of non-controllable fixed
expenses P1,269,000 P 744,000 P 525,000
Requirement (b)
18-254
The complaint of the manager of Product T is justified on the ground that his
product line shows a positive contribution margin and therefore, contributes
to the recovery of non-controllable fixed expenses. This observation is, of
course, made under the assumption that the preceding years figures (which
are not given) were less favorable than the current year.
Problem 2 (Evaluation of Profit Centers)
Requirement 1
Product
A B C
Incremental sales P71,000 P46,000 P117,000
Less: Incremental costs 42,000 15,000 96,000
Net income P29,000 P31,000 P 21,000
Product B seems to offer the best profit potential.
Requirement 2
The sunk costs are:
Depreciation of equipment P 6,400
Operating cost of the equipment 4,600
Total P11,000
Requirement 3
Opportunity cost of selling Product B is
From Product A P29,000
From Product C 21,000
Total P50,000
Problem 3 (Evaluation of Performance)
Ranjie Tool Company

Performance Report
For the Year 2005
18-255
Budgeted Labor Hours 4,000

Actual Labor Hours 4,200
Budget
Actual Based on
Cost-Volume 4,200 4,200 Variance
Formula Hours Hours U (F)
Variable Overhead Costs:
Utilities P0.80 per hour P 3,600 P 3,360 P240
Supplies 1.80 7,400 7,560 (160)
Indirect labor 1.20 5,300 5,040 260
Total P3.80 P16,300 P15,960 P340
Fixed Overhead Costs:
Utilities P 1,600 P 1,600 -
Supplies 2,200 2,200 -
Depreciation 6,000 6,000 -
Indirect labor 5,400 5,400 -
Insurance 1,200 1,200 -
Total P16,400 P16,400 -
Total Factory Overhead Costs P32,700 P32,360 P340
Problem 4 (Evaluation of Performance)
Requirement 1
Performance Report for the Production Manager

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Direct material P24,000 P20,000 P4,000 (U)
Direct labor 48,000 50,000 2,000 (F)
Supplies 4,000 6,000 2,000 (F)
Maintenance 3,000 4,000 1,000 (F)
Total P79,000 P80,000 P1,000 (F)
The cost of raw materials rose significantly, possibly because of (1) deficient
machinery due to the cutback in maintenance expenditures and/or (2) to the
lower labor cost, possibly due to the use of less-skilled workers. Supplies
decreased, indicating possible inadequacies for next periods production run.
Requirement 2
18-256
Performance Report for the Vice President

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Marketing division P104,000 P102,000 P2,000 (U)
Production division 79,000 80,000 1,000 (F)
Personnel division 72,000 76,000 4,000 (F)
Other costs 68,800 70,000 1,200 (F)
Total P323,800 P328,000 P4,200 (F)
The marketing division is behind its cost allotment. The personnel division
came in somewhat under its budgeted costs. Perhaps there has been a
cutback in hiring, indicating possible reduction in future production.
Problem 5 (Target Sales Price; Return on Investment)
Requirement 1
Return on investment = Operating income / Investment

20% = X / P800,000
Target Operating Income = P160,000
Target revenues, calculated as follows:
Fixed overhead P200,000

Variable costs 1,500,000 x P300 450,000
Desired operating income 160,000
Revenues P810,000
The selling price per units is P540 = P810,000 / 1,500
Requirement 2
Data are in thousands.
Units 1,500 2,000 1,000

Revenues P810 P1,080 P540
Variable costs 450 600 300

Fixed costs 200 200 200
Total costs 650 800 500
18-257
Operating income P160 P280 P 40

Return on 20% 35% 5%
investment
= P160 / = P280 / = P40 /
P800 P800 P800
Note how the change in income follows the change in revenues, as predicted
by operating leverage. Operating leverage multiplied times the percentage
change in sales gives the percentage change in income. Thus, the greater the
operating leverage ratio, the larger the effect on income and ROI of a given
percentage change in sales. This exercise provides an opportunity to review
the relationship between volume and profit. See the illustration below:
Operating leverage = contribution margin / operating income

= (P810 P450) / P160 = 2.25
% change in income = operating leverage x % change in revenues

= 2.25 x 33.33% = 75%
% change in income
If volume goes to 2,000 units: (P280 P160) / P160 = 75%
If volume goes to 1,000 units: (P160 P40) / P160 = 75%
% change in ROI
If volume goes to 2,000 units: (35% - 20%) / 20% = 75%
If volume goes to 1,000 units: (20% - 5%) / 20% = 75%
Problem 6 (Contrasting Return on Investment (ROI) and Residual

Income)
Requirement 1
ROI computations:
Net operating income Sales

ROI = x
Sales Average operating assets
Pasig: P630,000 P9,000,000

x = 7% x 3 = 21%
P9,000,000 P3,000,000
18-258
P1,800,000 P20,000,000
Quezon: x = 9% x 2 = 18%
P20,000,000 P10,000,000
Requirement 2
Pasig Quezon
Average operating assets (a) ....................................................................................
P3,000,000 P10,000,000
P 630,000 P 1,800,000
Minimum required return on average
operating assets16% (a) ................................................................................
480,000 P 1,600,000
Residual income.......................................................................................................
P 150,000 P 200,000
Requirement 3
No, the Quezon Division is simply larger than the Pasig Division and for this
reason one would expect that it would have a greater amount of residual
income. Residual income cant be used to compare the performance of
divisions of different sizes. Larger divisions will almost always look better,
not necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Quezon does not appear to be as
well managed as Pasig. Note from Part (1) that Quezon has only an 18%
ROI as compared to 21% for Pasig.
Problem 7 (Transfer Pricing)
Requirement 1
Since the Valve Division has idle capacity, it does not have to give up any
outside sales to take on the Pump Divisions business. Applying the formula
for the lowest acceptable transfer price from the viewpoint of the selling
division, we get:
Transfer price cost per unit +
18-259
P0
10,000
= P16
The Pump Division would be unwilling to pay more than P29, the price it is
currently paying an outside supplier for its valves. Therefore, the transfer
price must fall within the range:
Requirement 2
Since the Valve Division is selling all of the valves that it can produce on the
outside market, it would have to give up some of these outside sales to take
on the Pump Divisions business. Thus, the Valve Division has an
opportunity cost, which is the total contribution margin on lost sales:
+
(P30 P16) x 10,000

10,000
= P16 + P14 = P30
Since the Pump Division can purchase valves from an outside supplier at
only P29 per unit, no transfers will be made between the two divisions.
Requirement 3
Applying the formula for the lowest acceptable price from the viewpoint of
the selling division, we get:

+
(P30 P16) x 10,000

Transfer price (P16 P3) +
10,000
= P1318-260
+ P14 = P27
In this case, the transfer price must fall within the range:
Problem 8 (Transfer Pricing)
To produce the 20,000 special valves, the Valve Division will have to give
up sales of 30,000 regular valves to outside customers. Applying the
formula for the lowest acceptable price from the viewpoint of the selling
division, we get:
+
(P30 P16) x 30,000

20,000
= P20 + P21 = P41
Problem 9 (Effects of Changes in Sales, Expenses, and Assets in ROI)
1. Net operating income

Margin = Sales
P800,000
= P8,000,000 = 10%
2. Sales
Turnover = Average operating assets
P8,000,000
= P3,200,000 = 2.5
18-261
3.
ROI = Margin x Turnover
= 10% x 2.5 = 25%
Problem 10 (Transfer Pricing Basics)
Requirement (1)
a. The lowest acceptable transfer price from the perspective of the selling
division, the Electrical Division, is given by the following formula:

Variable cost + on lost sales
Transfer price =
per unit Number of units transferred
Because there is enough idle capacity to fill the entire order from the
Motor Division, there are no lost outside sales. And because the variable
cost per unit is P21, the lowest acceptable transfer price as far as the
selling division is concerned is also P21.

10,000
b. The Motor Division can buy a similar transformer from an outside
supplier for P38. Therefore, the Motor Division would be unwilling to
pay more than P38 per transformer.
Transfer price: Cost from buying from outside supplier = P38
c. Combining the requirements of both the selling division and the buying
division, the acceptable range of transfer prices in this situation is:
P21 : Transfer price : P38
Assuming that the managers understand their own businesses and that
they are cooperative, they should be able to agree on a transfer price
within this range and the transfer should take place.
d. From the standpoint of the entire company, the transfer should take
place. The cost of the transformers transferred is only P21 and the
company saves the P38 cost of the transformers purchased from the
18-262
outside supplier.
Requirement (2)
a. Each of the 10,000 units transferred to the Motor Division must displace
a sale to an outsider at a price of P40. Therefore, the selling division
would demand a transfer price of at least P40. This can also be computed
using the formula for the lowest acceptable transfer price as follows:
Transfer price = P21 + (P40 P21) x 10,000

10,000
= P21 + (P40 P21) = P40
b. As before, the Motor Division would be unwilling to pay more than P38
per transformer.
c. The requirements of the selling and buying divisions in this instance are
incompatible. The selling division must have a price of at least P40
whereas the buying division will not pay more than P38. An agreement
to transfer the transformers is extremely unlikely.
d. From the standpoint of the entire company, the transfer should not take
place. By transferring a transformer internally, the company gives up
revenue of P40 and saves P38, for a loss of P2.
Problem 11 (Transfer Pricing with an Outside Market)
Requirement (1)
The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Transfer price =
The Tuner Division has no idle capacity, so transfers from the Tuner
Division to the Assembly Division would cut directly into normal sales of
tuners to outsiders. The costs are the same whether a tuner is transferred
internally or sold to outsiders, so the only relevant cost is the lost revenue of
P200 per tuner that could be sold to outsiders. This is confirmed below:
Transfer price = P110 + (P200 P110) x 30,000

30,000
18-263
= P110 + (P200 P110) = P200
Therefore, the Tuner Division will refuse to transfer at a price less than P200
per tuner.
The Assembly Division can buy tuners from an outside supplier for P200,
less a 10% quantity discount of P20, or P180 per tuner. Therefore, the
Division would be unwilling to pay more than P180 per tuner.
Transfer price : Cost of buying from outside supplier = P180

The requirements of the two divisions are incompatible. The Assembly
Division wont pay more than P180 and the Tuner Division will not accept
less than P200. Thus, there can be no mutually agreeable transfer price and
no transfer will take place.
Requirement (2)
The price being paid to the outside supplier, net of the quantity discount, is
only P180. If the Tuner Division meets this price, then profits in the Tuner
Division and in the company as a whole will drop by P600,000 per year:
Lost revenue per tuner ....................................................... P200

Outside suppliers price ..................................................... P180
Loss in contribution margin per tuner ............................... P20
Number of tuners per year ................................................. 30,000
Total loss in profits ............................................................ P600,000
Profits in the Assembly Division will remain unchanged, since it will be

paying the same price internally as it is now paying externally.
Requirement (3)
The Tuner Division has idle capacity, so transfers from the Tuner Division
to the Assembly Division do not cut into normal sales of tuners to outsiders.
In this case, the minimum price as far as the Assembly Division is concerned
is the variable cost per tuner of P11. This is confirmed in the following
calculation:
30,000
18-264
The Assembly Division can buy tuners from an outside supplier for P180
each and would be unwilling to pay more than that in an internal transfer. If
the managers understand their own businesses and are cooperative, they
should agree to a transfer and should settle on a transfer price within the
range:
P110 : Transfer price : P180
Requirement (4)
Yes, P160 is a bona fide outside price. Even though P160 is less than the
Tuner Divisions P170 full cost per unit, it is within the range given in Part
3 and therefore will provide some contribution to the Tuner Division.
If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in
potential profits:
Price per tuner.................................................. P160

Variable costs ................................................... 110
Contribution margin per tuner ......................... P 50
30,000 tuners P50 per tuner = P1,500,000 potential increased profits
This P1,500,000 in potential profits applies to the Tuner Division and to the
company as a whole.
Requirement (5)
No, the Assembly Division should probably be free to go outside and get the
best price it can. Even though this would result in lower profits for the
company as a whole, the buying division should probably not be forced to
purchase inside if better prices are available outside.
Requirement (6)
The Tuner Division will have an increase in profits:
18-265
Selling price ..................................................... P200

Variable costs ................................................... 110
Contribution margin per tuner ......................... P 90
30,000 tuners P90 per tuner = P2,700,000 increased profits
The Assembly Division will have a decrease in profits:
Inside purchase price ....................................... P200

Outside purchase price .................................... 160
Increased cost per tuner ................................... P 40
30,000 tuners P40 per tuner = P1,200,000 decreased profits
The company as a whole will have an increase in profits:
Increased contribution margin in the Tuner Division...........................................

P 90
Decreased contribution margin in the Assembly Division ................................... 40
Increased contribution margin per tuner ..............................................................
P 50
30,000 tuners P50 per tuner = P1,500,000 increased profits
So long as the selling division has idle capacity and the transfer price is
greater than the selling divisions variable costs, profits in the company as a
whole will increase if internal transfers are made. However, there is a
question of fairness as to how these profits should be split between the
selling and buying divisions. The inflexibility of management in this
situation damages the profits of the Assembly Division and greatly enhances
the profits of the Tuner Division.
Problem 12 (Transfer Pricing; Divisional Performance)
Requirement (1)
18-266
The Electronics Division is presently operating at capacity; therefore, any

sales of the KK8 circuit board to the Clock Division will require that the
Electronics Division give up an equal number of sales to outside customers.
Using the transfer pricing formula, we get a minimum transfer price of:
Transfer price =
Transfer price = P82.50 + (P125.00 P82.50)
Transfer price = P82.50 + P42.50
Transfer price = P125.00
Thus, the Electronics Division should not supply the circuit board to the
Clock Division for P90 each. The Electronics Division must give up
revenues of P125.00 on each circuit board that it sells internally. Since
management performance in the Electronics Division is measured by ROI
and dollar profits, selling the circuit boards to the Clock Division for P9
would adversely affect these performance measurements.
Requirement (2)
The key is to realize that the P100 in fixed overhead and administrative costs
contained in the Clock Divisions P697.50 cost per timing device is not
relevant. There is no indication that winning this contract would actually
affect any of the fixed costs. If these costs would be incurred regardless of
whether or not the Clock Division gets the oven timing device contract, they
should be ignored when determining the effects of the contract on the
companys profits. Another key is that the variable cost of the Electronics
Division is not relevant either. Whether the circuit boards are used in the
timing devices or sold to outsiders, the production costs of the circuit boards
would be the same. The only difference between the two alternatives is the
revenue on outside sales that is given up when the circuit boards are
transferred within the company.
Selling price of the timing devices ................................................................ P700.00

Less:
The cost of the circuit boards used in the timing devices
(i.e. the lost revenue from sale of circuit boards to
outsiders) ...............................................................................................
P125.00
Variable costs of the Clock Division excluding the circuit 507.50 632.50
18-267
board (P300.00 + P207.50)....................................................................

Net positive effect on the companys profit ..................................................
P 67.50
Therefore, the company as a whole would be better off by P67.50 for each
timing device that is sold to the oven manufacturer.
Requirement (3)
As shown in part (1) above, the Electronics Division would insist on a

transfer price of at least P125.00 for the circuit board. Would the Clock
Division make any money at this price? Again, the fixed costs are not
relevant in this decision since they would not be affected. Once this is
realized, it is evident that the Clock Division would be ahead by P67.50 per
timing device if it accepts the P125.00 transfer price.
Selling price of the timing devices ............................................................... P700.00

Less:
Purchased parts (from outside vendors) ...................................................
P300.00
Circuit board KK8 (assumed transfer price) ............................................
125.00
Other variable costs ..................................................................................
207.50 632.50
Clock Division contribution margin ............................................................. P 67.50
In fact, since the contribution margin is P62.50, any transfer price within the
range of P125.00 to P192.50 (= P125.00 + P67.50) will improve the profits
of both divisions. So yes, the managers should be able to agree on a transfer
price.
Requirement (4)
It is in the best interests of the company and of the divisions to come to an

agreement concerning the transfer price. As demonstrated in part (3) above,
any transfer price within the range P125.00 to P192.50 would improve the
profits of both divisions. What happens if the two managers do not come to
an agreement?
In this case, top management knows that there should be a transfer and could
step in and force a transfer at some price within the acceptable range.
However, such an action, if done on a frequent basis, would undermine the
autonomy of the managers and turn decentralization into a sham.
18-268
Our advice to top management would be to ask the two managers to meet to
discuss the transfer pricing decision. Top management should not dictate a
course of action or what is to happen in the meeting, but should carefully
observe what happens in the meeting. If there is no agreement, it is important
to know why. There are at least three possible reasons. First, the managers
may have better information than the top managers and refuse to transfer for
very good reasons. Second, the managers may be uncooperative and
unwilling to deal with each other even if it results in lower profits for the
company and for themselves. Third, the managers may not be able to
correctly analyze the situation and may not understand what is actually in
their own best interests. For example, the manager of the Clock Division
may believe that the fixed overhead and administrative cost of P100 per
timing device really does have to be covered in order to avoid a loss.
If the refusal to come to an agreement is the result of uncooperative attitudes
or an inability to correctly analyze the situation, top management can take
some positive steps that are completely consistent with decentralization. If
the problem is uncooperative attitudes, there are many training companies
that would be happy to put on a short course in team building for the
company. If the problem is that the managers are unable to correctly analyze
the alternatives, they can be sent to executive training courses that
emphasize economics and managerial accounting.
1. C 11. E 21. C 31. B

2. D 12. D 22. B 32. D
3. A 13. C 23. A 33. D
4. A 14. C 24. D 34. D
5. C 15. B 25. B 35. C
6. A 16. C 26. A 36. D
7. D 17. B 27. A 37. B
8. A 18. A 28. B 38. D
9. C 19. B 29. D 39. B
10. A 20. A 30. A 40. D
CHAPTER 15
18-269
FUNCTIONAL AND ACTIVITY-BASED BUDGETING
I. Questions
1. No. Planning and control are different, although related, concepts.
Planning involves developing objectives and formulating steps to
achieve those objectives. Control, by contrast, involves the means by
which management ensures that the objectives set down at the planning
stage are attained.
2. Budgets have a dual purpose, for planning and for following up the
implementation of the plan. The great benefits from budgeting lie in the
quick investigation of deviations and in the subsequent corrective action.
Budgets should not be prepared in the first place if they are ignored,
buried in files, or improperly interpreted.
3. Two major features of a budgetary program are (1) the accounting
techniques which developed it and (2) the human factors which
administer it. The human factors are far more important. The success of
a budgetary system depends upon its acceptance by the company
members who are affected by the budget. Without a thoroughly
educated and cooperative management group at all levels of
responsibility, budgets are a drain on the funds of the business and are a
hindrance instead of help to efficient operations.
4. Manufacturing overhead costs are budgeted at normal operating
capacity, and the costs are applied to the products using a predetermined
rate. The predetermined rate is computed by dividing a factor that can
be identified with both the products and the overhead into the overhead
budgeted at the normal operating capacity. Budgets may also be used in
costing products in a standard cost accounting system.
5. The production division operates to produce the products that are sold.
Production and sales must be coordinated. Products must be
manufactured so that they will be available to meet sales delivery dates.
Activity of the production division will depend upon the sales that can
be made. Also, the sales division is limited by the capabilities of the
production department in manufacturing products. Successful
operations depend upon a coordination of sales and production.
18-270
6. Labor hour required for production can be translated into labor pesos by
multiplying the number of hours budgeted by the appropriate labor rates.
The rates to be used will depend upon the rates established for job
classifications and the policy with respect to premium pay for overtime
or shift differences.
7. A long-range plan for the acquisition of plant assets is broken down and
entered in the current budget as the plan unfolds. The portion of the plan
which is to be executed in the next year is included in the budget for that
year.
8. A budget period is not limited to any particular unit of time. At a
minimum, a budget should cover at least one operating cycle. For
example, a budget should not cover a period when purchasing activity is
high and omit the period when sales volume and cash collection are
relatively high. The budget period should encompass the entire cycle
extending from the purchasing operation to the subsequent sale of the
products and the realization of the sales in cash. Ordinarily, a budget of
operations is prepared for a year which in turn is divided into quarters
and months. Long-term budgets, such as budgets for projects or capital
investments, may extend five to ten years or more into the future.
9. A rolling budget or a progressive budget or sometimes called continuous
budget, is a budget which is prepared throughout the year. As one
month elapses, a budget is prepared for one more month in the future.
At any one time for example, the company will have a budget for one
year into the future, when July of one year is over, a budget for the
following July will be added at the other end of the budget. This process
of adding a new month as a month expires is continuous.
10. Variances that are revealed by a comparison of actual results with a
budget are investigated if it appears that an investigation is warranted.
The investigation may show that stricter control measures are needed or
that some weaknesses in the operation should be corrected. It may also
reveal that the budget plan should be revised. The comparison is one
step in the control and direction of business operations.
11. A comparison of actual results with a budget can contribute information
that can be applied in the preparation of better budgets in the future.
Subsequent investigation of variances provides management with a
better knowledge of operations. This knowledge can be applied in the
preparation of more realistic budgets for subsequent fiscal periods.
18-271
12. A self-imposed budget is one in which persons with responsibility over

cost control prepare their own budgets, i.e., the budget is not imposed
from above. The major advantages are: (1) the views and judgments of
persons from all levels of an organization are represented in the final
budget document; (2) budget estimates generally are more accurate and
reliable, since they are prepared by those who are closest to the
problems; (3) managers generally are more motivated to meet budgets
which they have participated in setting; (4) self-imposed budgets reduce
the amount of upward blaming resulting from inability to meet budget
goals. One caution must be exercised in the use of self-imposed budgets.
The budgets prepared by lower-level managers should be carefully
reviewed to prevent too much slack.
13. No, although this is clearly one of the purposes of the cash budget. The
principal purpose is to provide information on probable cash needs
during the budget period, so that bank loans and other sources of
financing can be anticipated and arranged well in advance of the actual
time of need.
14. Zero-based budgeting requires that managers start at zero levels every
year and justify all costs as if all programs were being proposed for the
first time. In traditional budgeting, by contrast, budget data are usually
generated on an incremental basis, with last years budget being the
starting point.
15. A budget is a detailed quantitative plan for the acquisition and use of
financial and other resources over a given time period. Budgetary control
involves the use of budgets to control the actual activities of a firm.
16. 1. Budgets communicate managements plans throughout the
organization.
2. Budgets force managers to think about and plan for the future.
3. The budgeting process provides a means of allocating resources to
those parts of the organization where they can be used most
effectively.
4. The budgeting process can uncover potential bottlenecks before they
occur.
5. Budgets coordinate the activities of the entire organization by
integrating the plans of its various parts. Budgeting helps to ensure
that everyone in the organization is pulling in the same direction.
6. Budgets define goals and objectives that can serve as benchmarks
for evaluating subsequent performance.
18-272
17. A master budget represents a summary of all of managements plans and

goals for the future, and outlines the way in which these plans are to be
accomplished. The master budget is composed of a number of smaller,
specific budgets encompassing sales, production, raw materials, direct
labor, manufacturing overhead, selling and administrative expenses, and
inventories. The master budget generally also contains a budgeted
income statement, budgeted balance sheet, and cash budget.
18. The flow of budgeting information moves in two directionsupward
and downward. The initial flow should be from the bottom of the
organization upward. Each person having responsibility over revenues or
costs should prepare the budget data against which his or her subsequent
performance will be measured. As the budget data are communicated
upward, higher-level managers should review the budgets for
consistency with the overall goals of the organization and the plans of
other units in the organization. Any issues should be resolved in
discussions between the individuals who prepared the budgets and their
managers.
All levels of an organization should participate in the budgeting

processnot just top management or the accounting department.
Generally, the lower levels will be more familiar with detailed, day-to-
day operating data, and for this reason will have primary responsibility
for developing the specifics in the budget. Top levels of management
should have a better perspective concerning the companys strategy.
19. Budgeting can assist a company forecast its workforce staffing needs
through direct labor and other budgets. By careful planning through the
budget process, a company can often smooth out its activities and avoid
erratic hiring and laying off employees.
II. Matching Type
1. C 6. A
2. H 7. B
3. E 8. J
4. F 9. D
5. I 10. G
III. Exercises
18-273
Exercises 1 (Schedule of Expected Cash Collections)
Requirement 1
July August September Total

May sales:
P430,000 10% .........................................................................................................
P 43,000 P 43,000
June sales:
P540,000 70%, 10% ...............................................................................................
378,000 P54,000 432,000
July sales:
P600,000 20%,
70%, 10% ...............................................................................................................
120,000 420,000 P 60,000 600,000
August sales:
P900,000 20%, 70% ...............................................................................................
180,000 630,000 810,000
September sales:
P500,000 20% .........................................................................................................
100,000 100,000
Total cash collections .....................................................................................................
P541,000 P654,000 P790,000 P1,985,000
Notice that even though sales peak in August, cash collections peak in
September. This occurs because the bulk of the companys customers pay in
the month following sale. The lag in collections that this creates is even
more pronounced in some companies. Indeed, it is not unusual for a
company to have the least cash available in the months when sales are
greatest.
Requirement 2
Accounts receivable at September 30:
From August sales: P900,000 10%.......................................................................

P 90,000
From September sales: P500,000 (70% + 10%) ..................................................
400,000
Total accounts receivable ........................................................................................
P490,000
Exercise 2 (Production Budget)
18-274
July August September Quarter

Budgeted sales in units ..........................................................................................................
30,000 45,000 60,000 135,000
Add desired ending inventory* .............................................................................................
4,500 6,000 5,000 5,000
Total needs ............................................................................................................................
34,500 51,000 65,000 140,000
Less beginning inventory ......................................................................................................
3,000 4,500 6,000 3,000
Required production..............................................................................................................
31,500 46,500 59,000 137,000
* 10% of the following months sales
Exercise 3 (Materials Purchase Budget)
Quarter Year 2 Year 3

First Second Third Fourth First
Required production of calculators ......................................................................................................
60,000 90,000 150,000 100,000 80,000
Number of chips per calculator ............................................................................................................
3 3 3 3 3
Total production needschips.............................................................................................................
180,000 270,000 450,000 300,000 240,000
Year 2
First Second Third Fourth Year
Production needschips .....................................................................................................................
180,000 270,000 450,000 300,000 1,200,000
Add desired ending inventory
chips ................................................................................................................................................
54,000 90,000 60,000 48,000 48,000
Total needschips ...............................................................................................................................
234,000 360,000 510,000 348,000 1,248,000
Less beginning inventorychips .........................................................................................................
36,000 54,000 90,000 60,000 36,000
Required purchaseschips ..................................................................................................................
198,000 306,000 420,000 288,000 1,212,000
Cost of purchases at P2 per chip ..........................................................................................................
P396,000 P612,000 P840,000 P576,000 P2,424,000
Exercise 4 (Direct Labor Budget)
Requirement 1
Assuming that the direct labor workforce is adjusted each quarter, the direct
labor budget would be:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter Year
Units to be produced ............................................................................................................
5,000 4,400 4,500 4,900 18,800
Direct labor time per unit (hours) .........................................................................................
0.40 0.40 0.40 0.40 0.40
Total direct labor hours needed ............................................................................................
2,000 1,760 1,800 1,960 7,520
Direct labor cost per hour .....................................................................................................
P11.00 P11.00 P11.00 P11.00 P11.00
Total direct labor cost ..........................................................................................................
P 22,000 P 19,360 P 19,800 P 21,560 P 82,720
Requirement 2
18-275
Assuming that the direct labor workforce is not adjusted each quarter and
that overtime wages are paid, the direct labor budget would be:
1st 2nd 3rd 4th

Units to be produced ............................................................................................................................
5,000 4,400 4,500 4,900 18,800
Direct labor time per unit (hours) ........................................................................................................
0.40 0.40 0.40 0.40 0.40
Total direct labor hours needed............................................................................................................
2,000 1,760 1,800 1,960 7,520
Regular hours paid ...............................................................................................................................
1,800 1,800 1,800 1,800 7,200
Overtime hours paid .............................................................................................................................
200 - - 160 360
Wages for regular hours
(@ P11.00 per hour) .......................................................................................................................
P19,800 P19,800 P19,800 P19,800 P79,200
Overtime wages
(@ P11.00 per hour 1.5) ..............................................................................................................
3,300 - - 2,640 5,940
Total direct labor cost ..........................................................................................................................
P23,100 P19,800 P19,800 P22,440 P85,140
Exercise 5 (Manufacturing Overhead Budget)
Requirement 1
Kiko Corporation
Manufacturing Overhead Budget
1st 2nd 3rd 4th

Budgeted direct labor-hours .................................................................................................................
5,000 4,800 5,200 5,400 20,400
Variable overhead rate .........................................................................................................................
x P1.75 x P1.75 x P1.75 x P1.75 x P1.75
Variable manufacturing overhead ........................................................................................................
P 8,750 P 8,400 P 9,100 P 9,450 P 35,700
Fixed manufacturing overhead .............................................................................................................
35,000 35,000 35,000 35,000 140,000
Total manufacturing overhead..............................................................................................................
43,750 43,400 44,100 44,450 175,700
Less depreciation..................................................................................................................................
15,000 15,000 15,000 15,000 60,000
Cash disbursements for
manufacturing overhead ..................................................................................................................
P28,750 P28,400 P29,100 P29,450 P115,700
Requirement 2
Total budgeted manufacturing overhead for the year (a) ................................................................................

P175,700
Total budgeted direct labor-hours for the year (b) ..........................................................................................
20,400
Predetermined overhead rate for the year (a) (b) .........................................................................................
P 8.61
Exercise 6 (Selling and Administrative Budget)
18-276
Helene Company
Selling and Administrative Expense Budget
1st 2nd 3rd 4th

Budgeted unit sales ..............................................................................................................................
12,000 14,000 11,000 10,000 47,000
Variable selling and
administrative expense per
unit ..................................................................................................................................................
x P2.75 x P2.75 x P2.75 x P2.75 x P2.75
Variable expense ..................................................................................................................................
P33,000 P 38,500 P 30,250 P 27,500 P129,250
Fixed selling and administrative
expenses:
Advertising ......................................................................................................................................
12,000 12,000 12,000 12,000 48,000
Executive salaries ............................................................................................................................
40,000 40,000 40,000 40,000 160,000
Insurance .........................................................................................................................................
6,000 6,000 12,000
Property taxes ..................................................................................................................................
6,000 6,000
Depreciation ....................................................................................................................................
16,000 16,000 16,000 16,000 64,000
Total fixed selling and
administrative expenses...................................................................................................................
68,000 74,000 74,000 74,000 290,000
Total selling and administrative
expenses ..........................................................................................................................................
101,000 112,500 104,250 101,500 419,250
Less depreciation .................................................................................................................................
16,000 16,000 16,000 16,000 64,000
Cash disbursements for selling
and administrative expenses ............................................................................................................
P 85,000 P 96,500 P 88,250 P 85,500 P355,250
Exercise 7 (Cash Budget Analysis)
Quarter (000 omitted)

1 2 3 4 Year
Cash balance, beginning ........................................................................................................
P 9 * P 5 P 5 P 5 P 9
Add collections from customers ............................................................................................
76 90 125 * 100 391 *
Total cash available ...............................................................................................................
85 * 95 130 105 400
Less disbursements:
Purchase of inventory .......................................................................................................
40 * 58 * 36 32 * 166
Operating expenses ...........................................................................................................
36 42 * 54 * 48 180 *
Equipment purchases ........................................................................................................
10 * 8 * 8 * 10 36 *
Dividends ..........................................................................................................................
2 * 2 * 2 * 2 * 8
Total disbursements ...............................................................................................................
88 110 * 100 92 390
Excess (deficiency) of cash
available over disbursements ............................................................................................
(3) * (15) 30 * 13 10
Financing:
20 *
Borrowings .......................................................................................................................
8 28
18-277
Repayments (including interest)........................................................................................

0 0 (25) (7) * (32)
Total financing ......................................................................................................................
8 20 (25) (7) (4)
Cash balance, ending .............................................................................................................
P5 P 5 P 5 P 6 P 6
*Given.
IV. Problems
Problem 1 (Schedule of Expected Cash Collections and Disbursements)
Requirement 1
September cash sales ................................................................................................

P 7,400
September collections on account:
July sales: P20,000 18%....................................................................................
3,600
August sales: P30,000 70% ...............................................................................
21,000
September sales: P40,000 10% .........................................................................
4,000
Total cash collections ...............................................................................................
P36,000
Requirement 2
Payments to suppliers:
August purchases (accounts payable)...................................................................
P16,000
September purchases: P25,000 20% .................................................................
5,000
Total cash payments .................................................................................................
P21,000
Requirement 3
COOKIE PRODUCTS
Cash Budget
For the Month of September
Cash balance, September 1.......................................................................................

P 9,000
Add cash receipts:
Collections from customers ..................................................................................
36,000
Total cash available before current financing ..........................................................
45,000
Less disbursements:
Payments to suppliers for inventory .....................................................................
P21,000
Selling and administrative expenses.....................................................................
9,000 *
18-278
Equipment purchases ............................................................................................

18,000
Dividends paid ......................................................................................................
3,000
Total disbursements ..................................................................................................
51,000
Excess (deficiency) of cash available over
disbursements .......................................................................................................
(6,000)
Financing:
Borrowings ...........................................................................................................
11,000
Repayments ..........................................................................................................
0
Interest ..................................................................................................................
0
Total financing..........................................................................................................
11,000
Cash balance, September 30.....................................................................................
P 5,000
* P13,000 P4,000 = P9,000.
Problem 2 (Production and Purchases Budget)
Requirement 1
Production budget:
July August September October
Budgeted sales (units) ...........................................................................................................
40,000 50,000 70,000 35,000
Add desired ending inventory ...............................................................................................
20,000 26,000 15,500 11,000
Total needs ............................................................................................................................
60,000 76,000 85,500 46,000
Less beginning inventory ......................................................................................................
17,000 20,000 26,000 15,500
Required production .............................................................................................................
43,000 56,000 59,500 30,500
Requirement 2
During July and August the company is building inventories in anticipation

of peak sales in September. Therefore, production exceeds sales during
these months. In September and October inventories are being reduced in
anticipation of a decrease in sales during the last months of the year.
Therefore, production is less than sales during these months to cut back on
inventory levels.
Requirement 3
18-279
Raw materials purchases budget:

Third
July August September Quarter
Required production (units) ..................................................................................................
43,000 56,000 59,500 158,500
Material P214 needed per unit ..............................................................................................
3 lbs. 3 lbs. 3 lbs. 3 lbs.
Production needs (lbs.) ..........................................................................................................
129,000 168,000 178,500 475,500
Add desired ending inventory (lbs.) ......................................................................................
84,000 89,250 45,750 * 45,750
Total Material P214 needs.....................................................................................................
213,000 257,250 224,250 521,250
Less beginning inventory (lbs.) .............................................................................................
64,500 84,000 89,250 64,500
Material P214 purchases (lbs.) ..............................................................................................
148,500 173,250 135,000 456,750
* 30,500 units (October production) 3 lbs. per unit= 91,500 lbs.; 91,500 lbs.
0.5 = 45,750 lbs.
As shown in requirement (1), production is greatest in September. However,

as shown in the raw material purchases budget, the purchases of materials is
greatest a month earlier because materials must be on hand to support the
heavy production scheduled for September.
Problem 3 (Cash Budget; Income Statement; Balance Sheet)
Requirement 1
Schedule of cash receipts:
Cash salesJune .....................................................................................................

P 60,000
Collections on accounts receivable:
May 31 balance ....................................................................................................
72,000
June (50% 190,000) ..........................................................................................
95,000
Total cash receipts ...................................................................................................
P227,000
Schedule of cash payments for purchases:
May 31 accounts payable balance ...........................................................................

P 90,000
June purchases (40% 200,000) .............................................................................
80,000
Total cash payments.................................................................................................
P170,000
PICTURE THIS, INC.

Cash Budget
18-280
For the Month of June
Cash balance, beginning ..........................................................................................

P 8,000
Add receipts from customers (above) ......................................................................
227,000
Total cash available .................................................................................................
235,000
Less disbursements:
Purchase of inventory (above) .............................................................................
170,000
Operating expenses ..............................................................................................
51,000
Purchases of equipment .......................................................................................
9,000
Total cash disbursements .........................................................................................
230,000
Excess of receipts over disbursements ....................................................................5,000
Financing:
Borrowingsnote................................................................................................
18,000
Repaymentsnote ...............................................................................................
(15,000)
Interest .................................................................................................................
(500)
Total financing .........................................................................................................
2,500
Cash balance, ending ...............................................................................................
P 7,500
Requirement 2
PICTURE THIS, INC.

Budgeted Income Statement
For the Month of June
Sales .........................................................................................................................
P250,000
Cost of goods sold:
Beginning inventory .............................................................................................
P 30,000
Add purchases ......................................................................................................
200,000
Goods available for sale .......................................................................................
230,000
Ending inventory ..................................................................................................
40,000
Cost of goods sold ................................................................................................
190,000
Gross margin ............................................................................................................
60,000
Operating expenses (P51,000 + P2,000) .................................................................. 53,000
7,000
Interest expense ........................................................................................................
500
Net income ...............................................................................................................
P 6,500
Requirement 3
18-281
PICTURE THIS, INC.

Budgeted Balance Sheet
June 30
Assets
Cash ..........................................................................................................................
P 7,500
Accounts receivable (50% 190,000) ..................................................................... 95,000
Inventory...................................................................................................................
40,000
Buildings and equipment, net of depreciation
(P500,000 + P9,000 P2,000) .............................................................................
507,000
Total assets ...............................................................................................................
P649,500

Accounts payable (60% 200,000) .........................................................................
P120,000
Note payable .............................................................................................................
18,000
Share capital .............................................................................................................
420,000
Retained earnings (P85,000 + P6,500) .....................................................................
91,500
Total liabilities and equity ........................................................................................
P649,500
Problem 4 (Sales, Production and Materials Purchases Budget)
Requirement 1
Nikko Manufacturing Company

Sales Budget
For the year ending December 31, 2005
Units Amount
First quarter 16,000 P 480,000
Second quarter 20,000 600,000
Third quarter 22,000 660,000
Fourth quarter 22,000 660,000
Total 80,000 P2,400,000
Requirement 2
18-282

Statement of Production Required
For 2005
Quarter
1st 2nd 3rd 4th Total
Units to be sold 16,000 20,000 22,000 22,000 80,000
Add: Desired ending inventory (20%) 4,000 4,400 4,400 5,000 5,000
Total units required 20,000 24,400 26,400 27,000 85,000
Less: Beginning inventory 3,000 4,000 4,400 4,400 3,000
Units to be produced 17,000 20,400 22,000 22,600 82,000
Requirement 3

Statement of Raw Materials Purchase Requirements
For 2005
Quarter
1st 2nd 3rd 4th Total
Units required for production 51,000 61,200 66,000 67,800 246,000
Add: Desired ending inventory 12,240 13,200 13,560 15,000 15,000
Total units 63,240 74,400 79,560 82,800 261,000
Less: Beginning inventory 12,500 12,240 13,200 13,560 12,500
Raw Materials to be Purchased 50,740 62,160 66,360 69,240 248,500
Problem 5 (Schedule of Expected Cash Collections; Cash Budget)
Requirement 1
Schedule of expected cash collections:
Month
April May June Quarter
From accounts receivable .........................................................................................
P141,000 P 7,200 P148,200
From April sales:
20% 200,000 .....................................................................................................
40,000 40,000
75% 200,000 .....................................................................................................
150,000 150,000
4% 200,000 .......................................................................................................
P 8,000 8,000
From May sales:

20% 300,000 .....................................................................................................
60,000 60,000
18-283
75% 300,000 .....................................................................................................

225,000 225,000
From June sales:
20% 250,000 .....................................................................................................
50,000 50,000
Total cash collections ...............................................................................................
P181,000 P217,200 P283,000 P681,200
Requirement 2
Cash budget:
Month
April May June Quarter
Cash balance, beginning ...........................................................................................
P 26,000 P 27,000 P 20,200 P 26,000
Add receipts:
Collections from
customers ..........................................................................................................
181,000 217,200 283,000 681,200
Total available ..........................................................................................................
207,000 244,200 303,200 707,200
Less disbursements:
Merchandise purchases ........................................................................................
108,000 120,000 180,000 408,000
Payroll ..................................................................................................................
9,000 9,000 8,000 26,000
Lease payments ....................................................................................................
15,000 15,000 15,000 45,000
Advertising ...........................................................................................................
70,000 80,000 60,000 210,000

Equipment purchases ............................................................................................
8,000 8,000
Total disbursements ..................................................................................................
210,000 224,000 263,000 697,000
Excess (deficiency) of
receipts over
disbursements .......................................................................................................
(3,000) 20,200 40,200 10,200
Financing:

Borrowings ...........................................................................................................
30,000 30,000

Repayments ..........................................................................................................
(30,000) (30,000)

Interest ..................................................................................................................
(1,200) (1,200)
30,000
Total financing..........................................................................................................
(31,200) (1,200)
Cash balance, ending P 27,000 P 20,200 P 9,000 P 9,000
Requirement 3
18-284
If the company needs a minimum cash balance of P20,000 to start each

month, the loan cannot be repaid in full by June 30. If the loan is repaid in
full, the cash balance will drop to only P9,000 on June 30, as shown above.
Some portion of the loan balance will have to be carried over to July, at
which time the cash inflow should be sufficient to complete repayment.
Problem 6 (Flexible Budget)
Summer Machine Company

Flexible Overhead Budget
Department 1
Capacity
100% 90% 80% 70% 60%
Machine Hours 200,000 180,000 160,000 140,000 120,000
Variable Overhead P1,300,000 P1,170,000 P1,040,000 P 910,000 P 780,000
Fixed Overhead 300,000 300,000 300,000 300,000 300,000
Total P1,600,000 P1,470,000 P1,340,000 P1,210,000 P1,080,000
Manufacturing Overhead rate per machine hour P8.00
Summer Machine Company

Flexible Overhead Budget
Department 2
Capacity
100% 90% 80% 70% 60%
Direct Labor Hours 200,000 180,000 160,000 140,000 120,000
Machine Hours 400,000 360,000 320,000 280,000 240,000
Variable Overhead P1,400,000 P1,260,000 P1,120,000 P 980,000 P 840,000
Fixed Overhead 500,000 500,000 500,000 500,000 500,000
Total P1,900,000 P1,760,000 P1,620,000 P1,480,000 P1,340,000
Manufacturing Overhead rate per machine hour P4.75
Problem 7 (Cash Budget with Supporting Schedules)
1. Collections on sales: July August Sept. Quarter

Cash sales ......................................................
P 8,000 P14,000 P10,000 P 32,000
Credit sales:
May: P30,000 80% 20% .....................
4,800 4,800
June: P36,000 80% 70%,
20% ........................................................
20,160 5,760 25,920
18-285
July: P40,000 80% 10%,

70%, 20% ..............................................
3,200 22,400 6,400 32,000
Aug.: P70,000 80% 10%,
70% ........................................................ 5,600 39,200 44,800
Sept.: P50,000 80% 10% .................... 4,000 4,000
Total cash collections ....................................
P36,160 P47,760 P59,600 P143,520
2. a. Merchandise purchases budget:

July August Sept. Oct.
Budgeted cost of goods sold.........................
P24,000 P42,000 P30,000 P27,000
Add desired ending inventory* ....................
31,500 22,500 20,250
Total needs ...................................................
55,500 64,500 50,250
Less beginning inventory .............................
18,000 31,500 22,500
Required inventory purchases ......................
P37,500 P33,000 P27,750
*75% of the next months budgeted cost of goods sold.
b. Schedule of expected cash disbursements for merchandise purchases:

Quarte
July August Sept. r
Accounts payable, June 30 ...........................
P11,700 P11,700
July purchases ..............................................18,750 P18,750 37,500
August purchases.......................................... 16,500 P16,500 33,000
September purchases .................................... 13,875 13,875
Total cash disbursements..............................
P30,450 P35,250 P30,375 P96,075
3. Ju Products, Inc.
Cash Budget
For the Quarter Ended September 30
July
August Sept. Quarter
P P P
Cash balance, beginning ............................8,000 8,410 8,020 P 8,000
Add collections from sales ........................
36,160 47,760 59,600 143,520
18-286
Total cash available ...............................

44,160 56,170 67,620 151,520
Less disbursements:
For inventory purchases ........................
30,450 35,250 30,375 96,075
For selling expenses ..............................7,200 11,700 8,500 27,400
For administrative expenses ..................3,600 5,200 4,100 12,900
For land..................................................4,500 0 0 4,500
For dividends ......................................... 0 0 1,000 1,000
Total disbursements ...................................
45,750 52,150 43,975 141,875
Excess (deficiency) of cash available
over disbursements ................................(1,590) 4,020 23,645 9,645
Financing:
Borrowings ............................................
10,000 4,000 14,000
Repayment ............................................. 0 0 (14,000) (14,000)
Interest ................................................... 0 0 (380) (380)
Total financing...........................................
10,000 4,000 (14,380) (380)
P P P
Cash balance, ending .................................8,410 8,020 9,265 P 9,265
* P10,000 1% 3 = P300
P4,000 1% 2 = 80
P380
1. B 11. C 21. C
2. B 12. B 22. C
3. C 13. C 23. D
4. E 14. B 24. C
5. C 15. D 25. C
6. C 16. C 26. C
7. D 17. A 27. D
8. C 18. B 28. A
9. A 19. E 29. C
18-287
10. D 20. B 30. D
Supporting computations:
Questions 16 to 20:
January February
Cost of sales P1,400,000 P1,640,000
Add: Desired Minimum Inventory 492,000 456,000
Total 1,892,000 2,096,000
Less: Beginning Inventory (1,400,000 x 0.3) (17) 420,000 492,000
Gross Purchases (16) 1,472,000 1,604,000
Less: Cash discount 14,720 16,040
Net cost of purchases P1,457,280 P1,587,960
Payments of Purchases
60% - month of purchase P874,368 P 952,776
40% - following month 582,912
Total (18) P1,535,688
(19)
February
Cash
Gross Discount Net
Current months sales (with
discount) 35% P595,000 P11,900 P583,100
Current months sales (without
discount) 15% 255,000 0 255,000
Previous months sales (with

discount) 4.5% 67,500 1,350 66,150
Previous months sales (without
discount) 40.5% 607,500 607,500
P1,525,000 P13,250 P1,511,750
(20)Total Collections in February P1,511,750

Add: Cash sales 350,000
Total P1,861,750
(21)Estimated cash receipts
18-288
Collections from customers P1,350,000

Proceeds from issuance of common stock 500,000
Proceeds from short-term borrowing 100,000
Total P1,950,000
Less: Estimated cash disbursements
For cost and expenses P1,200,000
For income taxes 90,000
Purchase of fixed asset 400,000
Payment on short-term borrowings 50,000
Total 1,740,000
Cash balance, Dec. 31 P 210,000
(22)Net income P120,000

Add: Depreciation 65,000
Working capital provided from operations P185,000
Add: Increase in income taxes payable P 80,000
Increase in provision for doubtful
accounts receivable 45,000 125,000
Total P310,000
Less: Increase in accounts receivable P 35,000
Decrease in accounts payable 25,000 60,000
Increase in cash P250,000
(23)Cash Receipts for February 2005

From February sales (60% x 110,000) P 66,000
From January sales 38,000
Total P104,000
(24)Pro-forma Income Statement, February 2005

Sales P110,000
Cost of sales (75%) 82,500
Gross profit P 27,500
Less: Operating expenses 16,500
Depreciation 5,000
Bad debts 2,200 23,700
Net operating income P 3,800
(25)Accounts Payable on February 28, 2005 will be the unpaid purchases in

February - (75% x P120,000) = P90,000.
18-289
Questions 26 to 29:
Net sales P2,000,000

Less: Cost of sales
Finished goods inventory, Jan. 1 P 350,000
Add: Cost of goods manufactured (Sch. I) 1,350,000 *
Total available for sale P1,700,000
Less: Finished goods inventory, Dec. 31 400,000 1,300,000 (26)
Gross Profit P 700,000
Less: Operating and financial expenses
Selling P 300,000
Administrative 180,000
Finance 20,000 500,000
Net income before taxes P 200,000
* Determined by working back from net income to sales.
Schedule I
Raw materials used

Raw materials inventory, Jan. 1 P 250,000
Add: Purchases 491,000 (29)
Total available 741,000
Less: Raw materials inventory, Dec. 31 300,000
Raw materials used P 441,000
Direct labor 588,000
Manufacturing overhead 441,000 (28)
Total Manufacturing Cost P1,470,000 (27)
Add: Work-in-process inventory, Jan. 1 200,000
Total P1,670,000
Less: Work-in-process inventory, Dec. 31 320,000
Cost of goods manufactured P1,350,000
(30)Variable factory overhead

P150,000
48,000 P3.125
Fixed factory overhead

P240,000
48,000
18-290
5.000
Total factory overhead P8.125
CHAPTER 16
STANDARD COSTS AND OPERATING

PERFORMANCE MEASURES
I. Questions
1. Standard costs are superior to past data for comparison with actual costs
because they ask the question Is present performance better than the
past?.
2. No. Cost control and cost reduction are not the same, but cost reduction
does affect the standards which are used as basis for cost control. Cost
reduction means finding ways to achieve a given result through
improved design, better methods, new layouts and so forth. Cost
reduction results in setting new standards. On the other hand, cost
control is a process of maintaining performance at or as new existing
standards as is possible.
3. Managerial judgment is the basis for deciding whether a given variance
is large enough to warrant investigation. For some items, a small
amount of variance may spark scrutiny. For some items, 5%, 10% or
25% variances from standard may call for follow-up. Management may
also derive the standard deviation based on past cost data.
4. The techniques for overhead control differ because
1) The size of individual overhead costs usually does not justify
elaborate individual control systems;
2) The behavior of individual overhead item is either impossible or
difficult to trace to specific lots or operations; and
3) Various overhead items are the responsibility of different people.
5. In the year-to-year planning of fixed costs, managers must consider:
18-291
1) the projected maximum and minimum levels of activity,

2) prices of cost factors, and
3) changes in facilities and organization.
6. Four criteria for selecting a volume base are:

1) Cause of cost variability.
2) Adequacy of control over the base.
3) Independence of activity unit.
4) Ease of understanding.
7. Non-volume factors which cause costs to vary are:
1) Changes in plant and equipment.
2) Changes in products made, materials used, or methods of
manufacturing.
3) Changes in prices paid for cost factors.
4) Changes in managerial policy toward costs.
5) Lag between cost incurrence and measurement of volume.
8. A budget is usually expressed in terms of total pesos, whereas a standard
is expressed on a per unit basis. A standard might be viewed as the
budgeted cost for one unit.
9. Under management by exception, managers focus their attention on
operating results that deviate from expectations. It is assumed that
results that meet expectations do not require investigation.
10. Separating an overall variance into a price variance and a quantity
variance provides more information. Moreover, prices and quantities are
usually the responsibilities of different managers.
11. The materials price variance is usually the responsibility of the
purchasing manager. The materials quantity variance is usually the
responsibility of the production managers and supervisors. The labor
efficiency variance generally is also the responsibility of the production
managers and supervisors.
12. If used as punitive tools, standards can breed resentment in an
organization and undermine morale. Standards must never be used as an
excuse to conduct witch-hunts, or as a means of finding someone to
blame for problems.
18-292
13. Several factors other than the contractual rate paid to workers can cause
a labor rate variance. For example, skilled workers with high hourly
rates of pay can be given duties that require little skill and that call for
low hourly rates of pay, resulting in an unfavorable rate variance. Or
unskilled or untrained workers can be assigned to tasks that should be
filled by more skilled workers with higher rates of pay, resulting in a
favorable rate variance. Unfavorable rate variances can also arise from
overtime work at premium rates.
14. Poor quality materials can unfavorably affect the labor efficiency
variance. If the materials create production problems, a result could be
excessive labor time and therefore an unfavorable labor efficiency
variance. Poor quality materials would not ordinarily affect the labor
rate variance.
15. If labor is a fixed cost and standards are tight, then the only way to
generate favorable labor efficiency variances is for every workstation to
produce at capacity. However, the output of the entire system is limited
by the capacity of the bottleneck. If workstations before the bottleneck
in the production process produce at capacity, the bottleneck will be
unable to process all of the work in process. In general, if every
workstation is attempting to produce at capacity, then work in process
inventory will build up in front of the workstations with the least
capacity.
16. A quantity standard indicates how much of an input should be used to
make a unit of output. A price standard indicates how much the input
should cost.
17. Chronic inability to meet a standard is likely to be demoralizing and may
result in decreased productivity.
18. A variance is the difference between what was planned or expected and
what was actually accomplished. A standard cost system has at least two
types of variances. A price variance focuses on the difference between
the standard price and the actual price of an input. A quantity variance is
concerned with the difference between the standard quantity of the input
allowed for the actual output and the actual amount of the input used.
II. Matching Type
1. E 3. C 5. A 7. J 9. I
2. G 4. H 6. D 8. B 10. F
18-293
III. Exercises
Exercise 1 (Setting Standards; Preparing a Standard Cost Card)
Requirement 1
Cost per 2 kilogram container ..................................................................................

P6,000.00
Less: 2% cash discount ............................................................................................
120.00
Net cost .....................................................................................................................
P5,880.00
Add freight cost per 2 kilogram container
(P1,000 10 containers) ......................................................................................
100.00
Total cost per 2 kilogram container (a) ....................................................................
P5,980.00
Number of grams per container
(2 kilograms 1000 grams per kilogram) (b) ...................................................... 2,000
Standard cost per gram purchased (a) (b) .............................................................P 2.99
Requirement 2
Beta ML12 required per capsule as per bill of materials ......................................... 6.00 grams
Add allowance for material rejected as unsuitable
(6 grams 0.96 = 6.25 grams;
6.25 grams 6.00 grams = 0.25 grams) ...............................................................
0.25 grams
Total ..........................................................................................................................
6.25 grams
Add allowance for rejected capsules
(6.25 grams 25 capsules) ...................................................................................
0.25 grams
Standard quantity of Beta ML12 per salable capsule ............................................... 6.50 grams
Requirement 3
Standard Quantity Standard Price Standard Cost

Item per Capsule per Gram per Capsule
Beta ML12 6.50 grams P2.99 P19.435
Exercise 2 (Material Variances)
Requirement 1
18-294
Number of chopping blocks .....................................................................................

4,000
Number of board feet per chopping block................................................................ 2.5
Standard board feet allowed .....................................................................................
10,000
Standard cost per board foot.....................................................................................
P1.80
Total standard cost ....................................................................................................
P18,000
Actual cost incurred .................................................................................................

P18,700
Standard cost above ..................................................................................................
18,000
Total varianceunfavorable ....................................................................................
P 700
Requirement 2
Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed for
Actual Price Standard Price Output, at Standard Price
(AQ AP) (AQ SP) (SQ SP)
P18,700 11,000 board feet 10,000 board feet
P1.80 per board foot P1.80 per board foot
= P19,800 = P18,000
Price Variance, Quantity Variance,
P1,100 F P1,800 U
Total Variance, P700 U
Alternatively:
Materials Price Variance = AQ (AP SP)
11,000 board feet (P1.70 per board foot* P1.80 per board foot) =
P1,100 F
* P18,700 11,000 board feet = P1.70 per board foot.
Materials Quantity Variance = SP (AQ SQ)

P1.80 per board foot (11,000 board feet 10,000 board feet) = P1,800 U
Exercise 3 (Labor and Variable Overhead Variances)
Requirement 1
Number of units manufactured .................................................................................

20,000
Standard labor time per unit .....................................................................................
0.4*
18-295
Total standard hours of labor time allowed ..............................................................

8,000
Standard direct labor rate per hour ...........................................................................
P6
Total standard direct labor cost ................................................................................
P48,000
*24 minutes 60 minutes per hour = 0.4 hour
Actual direct labor cost ............................................................................................

P49,300
Standard direct labor cost .........................................................................................
48,000
Total varianceunfavorable ....................................................................................
P 1,300
Requirement 2
Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
(AH AR) (AH SR) (SH SR)
P49,300 8,500 hours P6 per hour 8,000 hours* P6 per hour
= P51,000 = P48,000
Rate Variance, Efficiency Variance,
P1,700 F P3,000 U
Total Variance, P1,300 U
*20,000 units 0.4 hour per unit = 8,000 hours
Alternative Solution:
Labor Rate Variance = AH (AR SR)

8,500 hours (P5.80 per hour* P6.00 per hour) = P1,700 F
*P49,300 8,500 hours = P5.80 per hour
Labor Efficiency Variance = SR (AH SH)

P6 per hour (8,500 hours 8,000 hours) = P3,000 U
Requirement 3
Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
P39,100 8,500 hours P4 per hour 8,000 hours P4 per hour
= P34,000 = P32,000
18-296
Spending Variance, Efficiency Variance,

P5,100 U P2,000 U
Variable Overhead Spending Variance = AH (AR SR)

8,500 hours (P4.60 per hour* P4.00 per hour) = P5,100 U
*P39,100 8,500 hours = P4.60 per hour
Variable Overhead Efficiency Variance = SR (AH SH)
P4 per hour (8,500 hours 8,000 hours) = P2,000 U
Exercise 4 (Working Backwards from Labor Variances)
Requirement 1
If the total variance is P330 unfavorable, and if the rate variance is P150
favorable, then the efficiency variance must be P480 unfavorable, since the
rate and efficiency variances taken together always equal the total variance.
Knowing that the efficiency variance is P480 unfavorable, one approach to

the solution would be:
Efficiency Variance = SR (AH SH)
P6 per hour (AH 420 hours*) = P480 U
P6 per hour AH P2,520 = P480**
P6 per hour AH = P3,000
AH = 500 hours
* 168 batches 2.5 hours per batch = 420 hours
** When used with the formula, unfavorable variances are positive and
favorable variances are negative.
Requirement 2
Knowing that 500 hours of labor time were used during the week, the actual
rate of pay per hour can be computed as follows:
Rate Variance = AH (AR SR)
500 hours (AR P6 per hour) = P150 F
18-297
500 hours AR P3,000 = P150*

500 hours AR = P2,850
AR = P5.70 per hour
* When used with the formula, unfavorable variances are positive and
favorable variances are negative.
Exercise 5 (Direct Labor Variances)
1. Number of meals prepared ................................................... 6,000

Standard direct labor-hours per meal ................................... 0.20
Total direct labor-hours allowed .......................................... 1,200
Standard direct labor cost per hour ...................................... P9.50
Total standard direct labor cost ............................................ P11,400
Actual cost incurred ............................................................. P11,500

Total standard direct labor cost (above) .............................. 11,400
Total direct labor variance ................................................... P 100 Unfavorable
2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
1,150 hours 1,150 hours 1,200 hours
P10.00 per hour P9.50 per hour P9.50 per hour
= P11,500 = P10,925 = P11,400

P575 U P475 F
Alternatively, the variances can be computed using the formulas:
Labor rate variance = AH(AR SR)

= 1,150 hours (P10.00 per hour P9.50 per hour)
= P575 U
Labor efficiency variance = SR(AH SH)
18-298
= P9.50 per hour (1,150 hours 1,200 hours)

= P475 F
Exercise 6 (Variable Overhead Variances)
1. Number of items shipped .................................................................. 140,000

Standard direct labor-hours per item................................................. 0.04
Total direct labor-hours allowed ....................................................... 5,600
Standard variable overhead cost per hour ......................................... P2.80
Total standard variable overhead cost............................................... P15,680
Actual variable overhead cost incurred............................................. P15,950

Total standard variable overhead cost (above) ................................. 15,680
Total variable overhead variance ...................................................... P 270 Unfavorable
2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
5,800 hours 5,800 hours 5,600 hours
P2.75 per hour* P2.80 per hour P2.80 per hour
= P15,950 = P16,240 = P15,680

Variable overhead spending Variable overhead
variance, P290 F efficiency variance, P560 U
Total variance, P270 U
*P15,950 5,800 hours =P2.75 per hour
Alternatively, the variances can be computed using the formulas:
Variable overhead spending variance:

AH(AR SR) = 5,800 hours (P2.75 per hour P2.80 per hour)
= P290 F
Variable overhead efficiency variance:
18-299
SR(AH SH) = P2.80 per hour (5,800 hours 5,600 hours)

= P560 U
IV. Problems
Problem 1 (Comprehensive Variance Analysis)
Requirement 1
a.
the Actual Price Standard Price Output, at the Standard Price
25,000 pounds x 25,000 pounds x 20,000 pounds* x
P2.95 per pound P2.50 per pound P2.50 per pound
= P73,750 = P62,500 = P50,000
Price Variance,
P11,250 U
19,800 pounds x P2.50 per pound
= P49,500
Quantity Variance,
P500 F
* 5,000 metal molds 4.0 pounds per metal mold = 20,000 pounds
Alternatively:
25,000 pounds (P2.95 per pound P2.50 per pound) = P11,250 U
P2.50 per pound (19,800 pounds 20,000 pounds) = P500 F
b.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
3,600 hours x 3,600 hours x 3,000 hours* x
= P31,320 = P32,400 = P27,000
18-300

P1,080 F P5,400 U

* 5,000 metal molds 0.6 hour per metal mold = 3,000 hours
Alternatively:
3,600 hours (P8.70 per hour P9.00 per hour) = P1,080 F
P9.00 per hour (3,600 hours 3,000 hours) = P5,400 U
c.
P4,320 1,800 hours P2 per hour 1,500 hours* P2 per hour
= P3,600 = P3,000
P720 U P600 U
*5,000 metal molds 0.3 hours per metal mold = 1,500 hours
Alternatively:
1,800 hours (P2.40 per hour* P2.00 per hour) = P720 U
* P4,320 1,800 hours = P2.40 per hour
P2.00 per hour (1,800 hours 1,500 hours) = P600 U
Requirement 2
Summary of variances:
Material price variance ............................................................................................

P11,250 U
Material quantity variance .......................................................................................
500 F
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Labor rate variance ..................................................................................................

1,080 F
Labor efficiency variance ........................................................................................
5,400 U
Variable overhead spending variance ......................................................................
720 U
Variable overhead efficiency variance .....................................................................
600 U
Net variance .............................................................................................................
P16,390 U
The net unfavorable variance of P16,390 for the month caused the plants
variable cost of goods sold to increase from the budgeted level of P80,000 to
P96,390:
Budgeted cost of goods sold at P16 per metal mold ................................................

P80,000
Add the net unfavorable variance (as above) ..........................................................
16,390
Actual cost of goods sold .........................................................................................
P96,390
This P16,390 net unfavorable variance also accounts for the difference
between the budgeted net operating income and the actual net loss for the
month.
Budgeted net operating income ...............................................................................

P15,000
Deduct the net unfavorable variance added to cost of goods
sold for the month ................................................................................................
16,390
Net operating loss ....................................................................................................
P(1,390)
Requirement 3
The two most significant variances are the materials price variance and the
labor efficiency variance. Possible causes of the variances include:
Materials Price Outdated standards, uneconomical quantity

Variance: purchased, higher quality materials, high-
cost method of transport.
Labor Efficiency Poorly trained workers, poor quality

Variance: materials, faulty equipment, work
interruptions, inaccurate standards,
insufficient demand.
Problem 2
18-302
1. 1,000 units 4. 14,900 lbs.

2. 25,000 lbs. 5. 3,100 hours
3. P2.01 per lb. 6. P3.98 per hour
Problem 3
Material mix variance:

Actual quantity x Standard price
Material A (8,000 x P0.30) P2,400
Material B (2,400 x P0.20) 480
Material C (2,800 x P0.425) 1,190 P4,070
Less: Total actual input x Average
Standard price (13,200 x 0.30*) 3,960
Unfavorable Mix Variance P 110
P 720
* Average Standard price = 2,400 = P0.30
Material yield variance:

Total actual input at Average Standard price P3,960
Less: Total actual output at Standard raw material cost
(10,000 x 0.36**) 3,600
Unfavorable yield variance P 360
P 720
** Standard Material Cost = = P0.36
2,000
Problem 4 (Comprehensive Variance Analysis; Journal Entries)
Requirement 1
a.
Actual Price Standard Price Output, at Standard Price
21,120 yards x 21,120 yards x 19,200 yards* x
P3.35 per yard P3.60 per yard P3.60 per yard
= P70,752 = P76,032 = P69,120
Price Variance, Quantity Variance,
P5,280 F P6,912 U

18-303
* 4,800 units 4.0 yards per unit = 19,200 yards
Alternatively:
21,120 yards (P3.35 per yard P3.60 per yard) = P5,280 F
P3.60 per yard (21,120 yards 19,200 yards) = P6,912 U
b. Raw Materials (21,120 yards @ P3.60 per yard) .....................................................

76,032
Materials Price Variance
(21,120 yards @ P0.25 per yard F) ..............................................................
5,280
Accounts Payable
(21,120 yards @ P3.35 per yard) ..................................................................
70,752
Work in Process (19,200 yards @ P3.60 per

yard)......................................................................................................................
69,120
Materials Quantity Variance
(1,920 yards U @ P3.60 per yard) ........................................................................
6,912
Raw Materials (21,120 yards @ P3.60 per
yard) ..............................................................................................................
76,032
Requirement 2
a.
6,720 hours* x 6,720 hours x 7,680 hours** x
= P32,592 = P30,240 = P34,560
P2,352 U P4,320 F
Total Variance, P1,968 F
* 4,800 units 1.4 hours per unit = 6,720 hours
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** 4,800 units 1.6 hours per unit = 7,680 hours
Alternatively:
6,720 hours (P4.85 per hour P4.50 per hour) = P2,352 U
P4.50 per hour (6,720 hours 7,680 hours) = P4,320 F
b. Work in Process (7,680 hours @ P4.50 per hour) ....................................................

34,560
Labor Rate Variance
(6,720 hours @ P0.35 per hour U) .......................................................................
2,352
Labor Efficiency Variance
(960 hours F @ P4.50 per hour) ...................................................................
4,320
Wages Payable (6,720 hours @ P4.85 per
hour) .............................................................................................................
32,592
Requirement 3
6,720 hours x 6,720 hours x 7,680 hours x
P14,448 = P12,096 = P13,824
P2,352 U P1,728 F
Alternatively:
6,720 hours (P2.15 per hour P1.80 per hour) = P2,352 U
P1.80 per hour (6,720 hours 7,680 hours) = P1,728 F
Requirement 4
No. This total variance is made up of several quite large individual
18-305
variances, some of which may warrant investigation. A summary of

variances is shown on the next page.
Materials:
Price variance ......................................................................................................
P5,280 F
Quantity variance .................................................................................................
6,912 U P1,632 U
Labor:
Rate variance .......................................................................................................
2,352 U
Efficiency variance ..............................................................................................
4,320 F 1,968 F
Variable overhead:
Spending variance ................................................................................................
2,352 U
Efficiency variance ..............................................................................................
1,728 F 624 U
Net unfavorable variance .........................................................................................
P 288 U
Requirement 5
The variances have many possible causes. Some of the more likely causes
include:
Materials variances:
Favorable price variance: Fortunate buy, inaccurate standards, inferior

quality materials, unusual discount due to quantity purchased, drop in market
price.
Unfavorable quantity variance: Carelessness, poorly adjusted machines,

unskilled workers, inferior quality materials, inaccurate standards.
Labor variances:
Unfavorable rate variance: Use of highly skilled workers, change in wage

rates, inaccurate standards, overtime.
Favorable efficiency variance: Use of highly skilled workers, high quality

materials, new equipment, inaccurate standards.
Variable overhead variances:
Unfavorable spending variance: Increase in costs, inaccurate standards,
18-306
waste, theft, spillage, purchases in uneconomical lots.
Favorable efficiency variance: Same as for labor efficiency variance.
1. C 11. B 21. A 31. A 41. B

2. C 12. A 22. C 32. B 42. C
3. A 13. B 23. C 33. B 43. D
4. B 14. C 24. C 34. D 44. A
5. A 15. A 25. C 35. B 45. B
6. B 16. D 26. D 36. B
7. C 17. D 27. E 37. C
8. C 18. A 28. B 38. D
9. B 19. D 29. B 39. D
10. B 20. B 30. A 40. A
CHAPTER 17
APPLICATION OF QUANTITATIVE TECHNIQUES IN

PLANNING, CONTROL AND DECISION MAKING - I
I. Questions
1. a. Decision tree analysis provides a systematic framework for
analyzing a sequence of interrelated decisions which may be made
over time. Decision making is formulated in terms of the
consequence of acts, events and consequences because it is believed
that present decisions affect future profitability. The study and
understanding of alternative scenarios is encouraged with the use of
decision tree analysis.
b. Advantages of Decision Tree Analysis
1. Clarifies the choices, risks, and monetary gains involved in an
investment problem.
2. Presents the relevant information more clearly.
18-307
3. Combines action choices with different possible events or results

of action which are partially affected by chance or other
uncontrollable circumstances.
4. Encourages the focus on the relationship between current and
future decisions.
5. Utilizes such analytical techniques as present value and
discounted cash flow.
6. Considers various alternatives with greater ease.
Weaknesses of Decision Tree Analysis
1. Not all events that can happen can be/are identified.
2. Not all the decisions that must be made on a subject under
analysis are listed because choices are usually not restricted to
two or three.
3. If a large number of choices is involved, decision tree analysis
by hand becomes complicated.
4. Uncertain alternatives are generally treated as if they were
discrete, well-defined possibilities.
6. A 6. C 31. B 41. B 46. B

7. A 7. B 32. D 42. C 47. D
8. B 8. D 33. C 43. D 48. B
9. B 9. A 34. B 44. D 49. B
10. B 10. D 35. A 45. A 50. D
CHAPTER 18
APPLICATION OF QUANTITATIVE TECHNIQUES IN

PLANNING, CONTROL AND DECISION MAKING - II
I. Questions
1. PERT is superior to Gantt Charts in complex projects because:
18-308
a. PERT charts are flexible and can reflect slippage or changes in

plans, but Gantt charts simply plot a bar chart against a calendar
scale.
b. PERT charts reflect interdependencies among activities; Gantt charts
do not.
c. PERT charts reflect uncertainties or tolerances in the time estimates
for various activities; Gantt charts do not.
2. The use of PERT provides a structured foundation for planning complex
projects in sufficient detail to facilitate effective control.
A workable sequence of events that comprise the project are first
identified. Each key event should represent a task; then the
interdependent relationships between the events are structured.
After the network of events is constructed, cost and time parameters are
established for each package. Staffing plans are reviewed and analyzed.
The critical path computation identifies sequence of key events with
total time equal to the time allotted for the projects completion. Jobs
which are not on the critical path can be slowed down and the slack
resources available on these activities reallocated to activities on the
critical path.
Use of PERT permits sufficient scheduling of effort by functional areas
and by geographic location. It also allows for restructuring scheduling
efforts and redeployment of workers as necessary to compensate for
delays or bottlenecks. The probability of completing this complex
project on time and within the allotted budget is increased.
3. Time slippage in noncritical activities may not warrant extensive
managerial analysis because of available slack, but activity cost usually
increases with time and should be monitored.
4. The critical path is the network path with the longest cumulative
expected activity time. It is critical because a slowdown along this path
delays the entire project.
5. Crashing the network means finding the minimum cost for completing
the project in minimum time in order to achieve an optimum tradeoff
between cost and time. The differential crash cost of an activity is the
additional cost of that activity for each period of time saved.
18-309
6. Slack is the amount of time an event can be delayed without affecting

the projects completion date. Slack can be utilized by management as a
buffer against bottlenecks that may occur on the critical path.
7. Unit gross margin are typically computed with an allocation of fixed
costs. Total fixed costs generally will not change with a change in
volume within the relevant range. Unitizing the fixed costs results in
treating them as though they are variable costs when, in fact, they are
not. Moreover, when multiple products are manufactured, the relative
contribution becomes the criterion for selecting the optimal product mix.
Fixed costs allocations can distort the relative contributions and result in
a suboptimal decision.
8. This approach will maximize profits only if there are no constraints on
production or sales, or if both products use all scarce resources at an
equal rate. Otherwise management would want to maximize the
contribution per unit of scarce resource.
9. The opportunity cost of a constraint is the cost of not having additional
availability of the constrained resources. This is also called a shadow
price.
10. The feasible production region is the area which contains all possible
combinations of production outputs. It is bounded by the constraints
imposed on production possibilities. The production schedule which
management chooses must come from the feasible production region.
11. The accountant usually supplies the contribution margin data that is used
in formulating a profit-maximizing objective function. In addition, the
accountant participates in the analysis of linear programming outputs by
assessing the costs of additional capacity or of changes in product mix.
12. a. Hourly fee for inventory audit (C)
b. Salary of purchasing supervisor (N)
c. Costs to audit purchase orders and invoices (P)
d. Taxes on inventory (C)
e. Stockout costs (P)
f. Storage costs charged per unit in inventory (C)
g. Fire insurance on inventory (C)
h. Fire insurance on warehouse (N)
i. Obsolescence costs on inventory (C)
j. Shipping costs per shipment (P)
18-310
13. Although the inventory models are developed by operations researchers,

statisticians and computer specialists, their areas of expertise do not
extend to the evaluation of the differential costs for the inventory
models. Generally, discussions of inventory models take the costs as
given. It is the role of the accountant to determine which costs are
appropriate for inclusion in an inventory model.
14. Cost of capital represents the interest expense on funds if they were
borrowed or opportunity cost if funds were provided internally or by
owners. It is included as carrying cost of inventory because funds are
tied up in inventory.
15. Costs that vary with the average number of units in inventory:
Inventory insurance P 2.80
Inventory tax 2.05 (P102.25 x 2%)
Total P 4.85
Costs that vary with the number of units purchased:
Purchase price P102.25
Insurance on shipment 1.50
Total P103.75
Total carrying cost = (25% x P103.75) cost of capital + P4.85 = P25.94
+ P4.85 = P30.79
Order costs:
Shipping permit P201.65
Costs to arrange for the shipment 21.45
Unloading 80.20
Stockout costs 122.00
Total P425.30
II. Problems
Problem 1 (Solution is found on the next page.)
Problem 2
Requirement (a)
18-311
The critical path through each of the three alternative paths calculated as the
longest is 0 - 1 - 6- 7- 8.
0-1-2-5-8 2 + 8 + 10 + 14 = 34
0-1-3-4-7-8 2+8+7+5+3 = 25
0-1-6-7-8 2 + 26 + 9 + 3 = 40*
________
* critical
Requirement (b)
40 - 3 - 5 = 32
Requirement (c)
If path 4 - 7 has an unfavorable time variance of 10, this means it takes a

total time of 15 to finish this activity rather than 5. This gives the path 0 - 1
- 3 - 4 - 7 - 8 a total time of 35, but since this is less than the critical path of
40, it has no effect.
Requirement (d)
The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the
expected times.
Problem 3
No, they didnt make a right decision, since they included fixed costs which
do not differ in the short run. If they had used contribution margin instead of
gross margin, they would have had P5 for G1 and P6.50 for G2, therefore
they would have decided to produce G2 exclusively.
18-312
Problem 1
Requirement (a)
TASKS 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
H Order 1 Order 3 Order 4 Order 2

o
b
b
i
n
g
M X X X
X Order 1 X X Order 3 X X X Order 4 Order 2
a
c
h
i
n
i
n
g
___________
X Dead Time
Requirement (b)
28 days are required for the four orders.
18-313
Problem 4
Order costs = Insurance + Other order costs
P = P860 + P18 = P878
Carrying costs = Out-of-pocket Cost of capital

+
costs on inventory
S = P65 + 20% x P222 = P119.40
a. Carrying costs:
QS 250 x P109.40
= = P13,675.00
2 2
Order costs:
AP 1,500 x P878
= = P 5,268.00
Q 250
Total P18,943.00
b. Economic order quantity:

2 x 1,500 x P878
Q* = = 24,077 = 155 units
P109.40
Carrying costs:
QS 155 x P109.40
= = P 8,478.50
2 2
Order costs:
AP 1,500 x P878
= = P 8,496.77
Q 155
Total P16,975.27
Problem 5
18-314
It is necessary to evaluate the annual carrying costs and expected stockout

costs at each safety-stock level. The carrying cost will be P24.40 for each
unit in safety stock. With the given order size, there are 15 orders placed a
year (i.e., 39,000/2,600 = 15). Based on these computations, we prepare the
following schedule:
Safety Carrying Costs Expected Stockout Total

Stock of Safety Stock Costs Costs
0 0 0.50 x 15a x P1,650 = P12,375 P12,375
150 150 x P24.40 = P3,660 0.20 x 15a x P1,650 = P 4,950 8,610
175 175 x P24.40 = P4,270 0.05 x 15a x P1,650 = P 1,273.5 5,507.5 (optional)
250 250 x P24.40 = P6,100b 0.01 x 15a x P1,650 = P 247.5 6,347.5
Additional computations:
a
15 is the number of orders per year.
b
It should be evident that at this level the carrying costs alone exceed the total costs
at a safety stock of 175 units. Therefore, it is not possible for this or any safety-
stock level larger than 250 to be less costly than 175 units. Indeed, given a total
cost at 175 units of P5,507.5, stockout costs would have to occur with probability
zero for any safety stock greater than 225.72 units (i.e., P5,507.5 / P24.40 =
P225.72).
1. C 11. D 21. D 31. C

2. B 12. C 22. C 32. D
3. D 13. A 23. C 33. A
4. B 14. A 24. D 34. C
5. D 15. A 25. D 35. D
6. C 16. C 26. B 36. C
7. A 17. C 27. D 37. D
8. A 18. D 28. E 38. D
9. A 19. C 29. B
10. C 20. D 30. A
CHAPTER 19
RELEVANT COSTS FOR DECISION MAKING
18-315
I. Questions
1. Quantitative factors are those which may more easily be reduced in
terms of pesos such as projected costs of materials, labor and overhead.
Qualitative factors are those whose measurement in pesos is difficult and
imprecise; yet a qualitative factor may be easily given more weight than
the measurable cost savings. It can be seen that the accountants role in
making decisions deals with the quantitative factors.
2. Relevant costs are expected future costs that will differ between
alternatives. In view of the definition of relevant costs, historical costs
are always irrelevant because they are not future costs. They may be
helpful in predicting relevant costs but they are always irrelevant costs
per se.
3. The differential costs in any given situation is commonly defined as the
change in total cost under each alternative. It is not relevant cost, but it
is the algebraic difference between the relevant costs for the alternatives
under consideration.
4. Analysis:
Future costs: Replace Rebuild

New Truck P10,200
Less: Proceeds from
disposal, net 1,000
P 9,200 P8,500
Advantage of rebuilding P700
The original cost of the old truck is irrelevant but its disposal value is
relevant. It is recommended that the truck should be rebuilt because it
will involve lesser cash outlay.
5. No. Variable costs are relevant costs only if they differ in total between
the alternatives under consideration.
6. Only those costs that would be avoided as a result of dropping the

product line are relevant in the decision. Costs that will not differ
regardless of whether the product line is retained or discontinued are
irrelevant.
18-316
7. Not necessarily. An apparent loss may be the result of allocated common

costs or of sunk costs that cannot be avoided if the product line is
dropped. A product line should be discontinued only if the contribution
margin that will be lost as a result of dropping the line is less than the
fixed costs that would be avoided. Even in that situation the product line
may be retained if its presence promotes the sale of other products.
8. Allocations of common fixed costs can make a product line (or other
segment) appear to be unprofitable, whereas in fact it may be profitable.
9. In cost-plus pricing, prices are set by applying a markup percentage to a

products cost.
10. The price elasticity of demand measures the degree to which a change in
price affects unit sales. The unit sales of a product with inelastic demand
are relatively insensitive to the price charged for the product. In contrast,
the unit sales of a product with elastic demand are sensitive to the price
charged for the product.
11. The profit-maximizing price should depend only on the variable

(marginal) cost per unit and on the price elasticity of demand. Fixed
costs do not enter into the pricing decision at all. Fixed costs are relevant
in a decision of whether to offer a product or service, but are not relevant
in deciding what to charge for the product or service. Because price
affects unit sales, total variable costs are affected by the pricing decision
and therefore are relevant.
12. The markup over variable cost depends on the price elasticity of
demand. A product whose demand is elastic should have a lower markup
over cost than a product whose demand is inelastic. If demand for a
product is inelastic, the price can be increased without cutting as
drastically into unit sales.
II. Exercises
Exercise 1 (Identifying Relevant Costs)
18-317
Case 1 Case 2
Not Not
Item Relevant Relevant Relevant Relevant
a. Sales revenue ..................................
X X
b. Direct materials ...............................
X X
c. Direct labor .....................................
X X
d. Variable manufacturing
overhead ..........................................
X X
e. Book value Model E7000
machine ...........................................
X X
f. Disposal value Model E7000
machine ...........................................
X X
g. Depreciation Model E7000
machine ...........................................
X X
h. Market value Model F5000
machine (cost) .................................

X X
i. Fixed manufacturing
overhead ..........................................
X X
j. Variable selling expense .................
X X
k. Fixed selling expense ......................
X X
18-318
l. General administrative
overhead ..........................................
X X
Exercise 2 (Identification of Relevant Costs)
Requirement 1
Fixed cost per mile (P3,500* 10,000 miles) .........................................................

P0.35
Variable operating cost per mile ..............................................................................
0.08
Average cost per mile ..............................................................................................
P0.43
* Depreciation .............................................................................................................
P2,000
Insurance ..................................................................................................................
960
Garage rent ...............................................................................................................
480
Automobile tax and license......................................................................................
60
Total .........................................................................................................................
P3,500
Requirement 2
The variable operating costs would be relevant in this situation. The

depreciation would not be relevant since it relates to a sunk cost. However,
any decrease in the resale value of the car due to its use would be relevant.
The automobile tax and license costs would be incurred whether Ingrid
decides to drive her own car or rent a car for the trip during summer break
and are therefore irrelevant. It is unlikely that her insurance costs would
increase as a result of the trip, so they are irrelevant as well. The garage rent
is relevant only if she could avoid paying part of it if she drives her own car.
Requirement 3
When figuring the incremental cost of the more expensive car, the relevant
costs would be the purchase price of the new car (net of the resale value of
the old car) and the increases in the fixed costs of insurance and automobile
tax and license. The original purchase price of the old car is a sunk cost and
is therefore irrelevant. The variable operating costs would be the same and
18-319
therefore are irrelevant. (Students are inclined to think that variable costs
are always relevant and fixed costs are always irrelevant in decisions. This
requirement helps to dispel that notion.)
Exercise 3 (Make or Buy a Component)
Requirement 1
Per Unit
Differential
Costs 15,000 units
Make Buy Make Buy
Cost of purchasing.................................................................................................................
P200 P3,000,000
Direct materials .....................................................................................................................
P 60 P 900,000
Direct labor ...........................................................................................................................
80 1,200,000
Variable manufacturing overhead ..........................................................................................
10 150,000
Fixed manufacturing overhead, traceable1 ............................................................................
20 300,000
Fixed manufacturing overhead, common ..............................................................................
0 0 0 0
Total costs .............................................................................................................................
P170 P200 P2,550,000 P3,000,000
Difference in favor of continuing to make

the parts.............................................................................................................................
P30 P450,000
1
Only the supervisory salaries can be avoided if the parts are purchased. The
remaining book value of the special equipment is a sunk cost; hence, the P3 per unit
depreciation expense is not relevant to this decision. Based on these data, the
company should reject the offer and should continue to produce the parts internally.
Requirement 2
Make Buy
Cost of purchasing (part 1) ..................................................................................................
P3,000,000
Cost of making (part 1) ........................................................................................................
P2,550,000
Opportunity costsegment margin forgone on a
potential new product line ...............................................................................................
650,000
Total cost .............................................................................................................................
P3,200,000 P3,000,000
Difference in favor of purchasing from the outside

supplier .............................................................................................................................
P200,000
Thus, the company should accept the offer and purchase the parts from the outside
supplier.
18-320
Exercise 4 (Evaluating Special Order)
Only the incremental costs and benefits are relevant. In particular, only the
variable manufacturing overhead and the cost of the special tool are relevant
overhead costs in this situation. The other manufacturing overhead costs are
fixed and are not affected by the decision.
Per Total
Unit 10 bracelets
Incremental revenue .................................................................................................
P3,499.50 P34,995.00
Incremental costs:
Variable costs:
Direct materials ................................................................................................
1,430.00 14,300.00
Direct labor .......................................................................................................
860.00 8,600.00
Variable manufacturing overhead ....................................................................
70.00 700.00
Special filigree ..................................................................................................
60.00 600.00
Total variable cost ................................................................................................
P2,420.00 24,200.00
Fixed costs:
Purchase of special tool ....................................................................................
4,650.00
Total incremental cost ..............................................................................................
28.850.00
Incremental net operating income ............................................................................
P 6.145.00
Even though the price for the special order is below the companys regular
price for such an item, the special order would add to the companys net
operating income and should be accepted. This conclusion would not
necessarily follow if the special order affected the regular selling price of
bracelets or if it required the use of a constrained resource.
Exercise 5 (Utilization of a Constrained Resource)
Requirement 1
X Y Z
(1) Contribution margin per unit.................................................................................................
P18 P36 P20
(2) Direct labor cost per unit ......................................................................................................
P12 P32 P16
(3) Direct labor rate per hour ......................................................................................................
8 8 8
(4) Direct labor-hours required per unit (2) (3) .......................................................................
1.5 4.0 2.0
Contribution margin per direct labor-hour (1) (4) .............................................................
P12 P 9 P10
Requirement 2
18-321
The company should concentrate its labor time on producing product X:
X Y Z
Contribution margin per direct labor-hour ............................................................................
P12 P9 P10
Direct labor-hours available ..................................................................................................
3,000 3,000 3,000
Total contribution margin ......................................................................................................
P36,000 P27,000 P30,000
Although product X has the lowest contribution margin per unit and the
second lowest contribution margin ratio, it has the highest contribution
margin per direct labor-hour. Since labor time seems to be the companys
constraint, this measure should guide management in its production
decisions.
Requirement 3
The amount Jaycee Company should be willing to pay in overtime wages for
additional direct labor time depends on how the time would be used. If there
are unfilled orders for all of the products, Jaycee would presumably use the
additional time to make more of product X. Each hour of direct labor time
generates P12 of contribution margin over and above the usual direct labor
cost. Therefore, Jaycee should be willing to pay up to P20 per hour (the P8
usual wage plus the contribution margin per hour of P12) for additional labor
time, but would of course prefer to pay far less. The upper limit of P20 per
direct labor hour signals to managers how valuable additional labor hours are
to the company.
If all the demand for product X has been satisfied, Jaycee Company would
then use any additional direct labor-hours to manufacture product Z. In that
case, the company should be willing to pay up to P18 per hour (the P8 usual
wage plus the P10 contribution margin per hour for product Z) to
manufacture more product Z.
Likewise, if all the demand for both products X and Z has been satisfied,
additional labor hours would be used to make product Y. In that case, the
company should be willing to pay up to P17 per hour to manufacture more
product Y.
Exercise 6 (Sell or Process Further)
18-322
Product A Product B Product C

Sales value after further processing .......................................................................................
P80,000 P150,000 P75,000
Sales value at split-off point ..................................................................................................
50,000 90,000 60,000
Incremental revenue ..............................................................................................................
30,000 60,000 15,000
Cost of further processing .....................................................................................................
35,000 40,000 12,000
Incremental profit (loss) ........................................................................................................
P(5,000) 20,000 3,000
Products B and C should be processed further, but not Product A.
Exercise 7 (Identification of Relevant Costs)
Requirement 1
The relevant costs of a fishing trip would be:
Fuel and upkeep on boat per trip ............................. P25

Junk food consumed during trip* ............................ 8
Snagged fishing lures .............................................. 7
Total ......................................................................... P40
* The junk food consumed during the trip may not be completely relevant. Even
if Shin were not going on the trip, he would still have to eat. The amount by
which the cost of the junk food exceeds the cost of the food he would
otherwise consume would be the relevant amount.
The other costs are sunk at the point at which the decision is made to go on
another fishing trip.
Requirement 2
If he fishes for the same amount of time as he did on his last trip, all of his
costs are likely to be about the same as they were on his last trip. Therefore,
it really doesnt cost him anything to catch the last fish. The costs are really
incurred in order to be able to catch fish and would be the same whether one,
two, three, or a dozen fish were actually caught. Fishing, not catching fish,
costs money. All of the costs are basically fixed with respect to how many
fish are actually caught during any one fishing trip, except possibly the cost
of snagged lures.
18-323
Requirement 3
In a decision of whether to give up fishing altogether, nearly all of the costs

listed by Shins wife are relevant. If he did not fish, he would not need to pay
for boat moorage, new fishing gear, a fishing license, fuel and upkeep, junk
food, or snagged lures. In addition, he would be able to sell his boat, the
proceeds of which would be considered relevant in this decision. The
original cost of the boat, which is a sunk cost, would not be relevant.
These three requirements illustrate the slippery nature of costs. A cost that is
relevant in one situation can be irrelevant in the next. None of the costs are
relevant when we compute the cost of catching a particular fish; some of
them are relevant when we compute the cost of a fishing trip; and nearly all
of them are relevant when we consider the cost of not giving up fishing.
What is even more confusing is that CG is correct; the average cost of a
salmon is P167, even though the cost of actually catching any one fish is
essentially zero. It may not make sense from an economic standpoint to have
salmon fishing as a hobby, but as long as Shin is out in the boat fishing, he
might as well catch as many fish as he can.
Exercise 8 (Dropping or Retaining a Segment)
Requirement 1
No, the housekeeping program should not be discontinued. It is actually

generating a positive program segment margin and is, of course, providing a
valuable service to seniors. Computations to support this conclusion follow:
Contribution margin lost if the housekeeping program

is dropped ............................................................................................
P(80,000)
Fixed costs that can be avoided:
Liability insurance ..............................................................................
P15,000
Program administrators salary ...........................................................
37,000 52,000
Decrease in net operating income for the organization
as a whole............................................................................................
P(28,000)
Depreciation on the van is a sunk cost and the van has no salvage value since
it would be donated to another organization. The general administrative
18-324
overhead is allocated and none of it would be avoided if the program were

dropped; thus it is not relevant to the decision.
The same result can be obtained with the alternative analysis below:
Difference:
Total If Net Operating
House- Income
Current keeping Is Increase or
Total Dropped (Decrease)
Revenues .....................................................................
P900,000 P660,000 P(240,000)
Variable expenses ........................................................
490,000 330,000 160,000
Contribution margin ....................................................
410,000 330,000 (80,000)
Fixed expenses:
Depreciation* ..........................................................
68,000 68,000 0
Liability insurance ...................................................
42,000 27,000 15,000
Program administrators salaries ............................. 115,000 78,000 37,000
General administrative overhead ............................. 180,000 180,000 0
Total fixed expenses ....................................................
405,000 353,000 52,000
Net operating income (loss) .........................................
P 5,000 P(23,000) P (28,000)
*Includes pro-rated loss on disposal of the van if it is donated to a charity.
Requirement 2
To give the administrator of the entire organization a clearer picture of the

financial viability of each of the organizations programs, the general
administrative overhead should not be allocated. It is a common cost that
should be deducted from the total program segment margin. Following the
format for a segmented income statement, a better income statement would
be:
Home Meals on House-
Total Nursing Wheels keeping
Revenues.......................................................
P900,000 P260,000 P400,000 P240,000
Variable expenses .........................................
490,000 120,000 210,000 160,000
Contribution margin ......................................
410,000 140,000 190,000 80,000
Traceable fixed expenses:
Depreciation .............................................
68,000 8,000 40,000 20,000
Liability insurance ....................................
42,000 20,000 7,000 15,000
Program administrators salaries............... 115,000 40,000 38,000 37,000
Total traceable fixed expenses ...................... 225,000 68,000 85,000 72,000
18-325
Program segment margins .............................

185,000 P 72,000 P105,000 P 8,000
General administrative overhead ..................
180,000
Net operating income (loss) ..........................
P 5,000
Exercise 9 (Special Order)
Requirement 1
Monthly profits would be increased by P9,000:
Total for
Per 2,000
Unit Units
Incremental revenue ........................................................................
P12.00 P24,000
Incremental costs:
Variable costs:
Direct materials........................................................................2.50 5,000
Direct labor ..............................................................................
3.00 6,000
Variable manufacturing overhead ............................................ 0.50 1,000
Variable selling and administrative ......................................... 1.50 3,000
Total variable cost........................................................................
P 7.50 15,000
Fixed costs:
None affected by the special order .......................................... 0
Total incremental cost ..................................................................... 15,000
P
Incremental net operating income ................................................... 9,000
Requirement 2
The relevant cost is P1.50 (the variable selling and administrative costs). All
other variable costs are sunk, since the units have already been produced.
The fixed costs would not be relevant, since they would not be affected by
the sale of leftover units.
Exercise 10 (Make or Buy a Component)
The costs that are relevant in a make-or-buy decision are those costs that can
be avoided as a result of purchasing from the outside. The analysis for this
exercise is:
18-326
Per Unit
Differential
Costs 20,000 Units
Make Buy Make Buy
Cost of purchasing ....................................................... P23.50 P470,000
Cost of making:
Direct materials .......................................................
P 4.80 P 96,000
Direct labor .............................................................
7.00 140,000
Variable manufacturing overhead ............................ 3.20 64,000
Fixed manufacturing overhead ................................ 4.00 * 80,000
Total cost .................................................................
P19.00 P23.50 P380,000 P470,000
* The remaining P6 of fixed manufacturing overhead cost would not be relevant, since
it will continue regardless of whether the company makes or buys the parts.
The P150,000 rental value of the space being used to produce part R-3
represents an opportunity cost of continuing to produce the part internally.
Thus, the completed analysis would be:
Make Buy
Total cost, as above .........................................................................................
P380,000 P470,000
Rental value of the space (opportunity cost) ...................................................
150,000
Total cost, including opportunity cost .............................................................
P530,000 P470,000
Net advantage in favor of buying ....................................................................

P60,000
Profits would increase by P60,000 if the outside suppliers offer is accepted.

Exercise 11 (The Economists Approach to Pricing)
Requirement (1)
Cecile makes more money selling the ice cream cones at the lower price, as
shown below:
P17.90 Price P13.90 Price

Unit sales ........................................................ 860 1,340
Sales ............................................................... P15,394.00 P18,626.00

Cost of goods sold @ P4.10 ........................... 3,526.00 5,494.00
Contribution margin ....................................... 11,868.00 13,132.00
Fixed expenses ............................................... 425.00 425.00
18-327
Net operating income ..................................... P11,443.00 P12,707.00
Requirement (2)
The price elasticity of demand is computed as follows:
d =
In(1 + % change in quantity sold)
In(1 + % change in price)
1,340 860
In(1 + )
860
=
13.90 17.90
In(1 + )
17.90
In(1 + 0.55814)
=
In(1 0.22346)
In(1.55814)
=
In(0.77654)
0.44349
= = 1.75
0.25291
Requirement (3)
The profit-maximizing price can be estimated using the following formulas:
Profit-maximizing 1
=
markup on variable cost 1 + d
1
= = 1.333
1 + (1.75)
Profit-maximizing Profit-maximizing Variable cost
= 1 + x
price markup on variable cost per unit
= (1 + 1.3333) x P4.10 = P9.60
18-328
This price is much lower than the prices Cecile has been charging in the
past. Rather than immediately dropping the price to P9.60, it would be
prudent to drop the price a bit and see what happens to unit sales and to
profits. The formula assumes that the price elasticity is constant, which may
not be the case.
Exercise 12 (Target Costing)
Sales (50,000 batteries P65 per battery)..................................... P3,250,000

Less desired profit (20% P2,500,000) ........................................ 500,000
Target cost for 50,000 batteries ..................................................... P2,750,000
Target cost per battery = (P2,750,000 50,000 batteries)

= P55 per battery
Exercise 13 (Pricing a New Product)
The selling price of the new amaretto cappuccino product should at least
cover its variable cost and its opportunity cost. The variable cost of the new
product is P4.60 and its opportunity cost can be computed by multiplying the
opportunity cost of P34 per minute of order filling time by the amount of
time required to fill an order for the new product:
Selling price of Variable cost of

+
the new product the new product
Opportunity cost Amounts of the constrained

per unit of the x resource required by a unit
constrained resource of the new product
Selling price of 45 seconds

P4.60 + P34 per minute +
the new product 60 seconds per minute
Selling price of
P4.60 + P34 per minute + 0.75 minute
the new product
Selling price of
P4.60 + P25.50
18-329 = P30.10
the new product
Hence, the selling price of the new product should at least cover both its variable
cost of P4.60 and its opportunity cost of P25.50, for a total of P30.10.
III. Problems
Problem 1 (Accept or Reject an Order)
Product A Product B
Selling price per unit P1.20 P1.40
Less Variable costs/unit:
Materials 0.50 0.70
Labor 0.20 0.24
Factory overhead (25%) 0.10 0.14
0.80 1.08
Contribution margin/unit P0.40 P0.32
Multiplied by number of units to be sold 21,000 units 30,000 units
Total contribution margin P8,400 P9,600
Product B should be accepted because its total contribution margin is higher

than that of Product A.
Problem 2 (Eliminate or Retain a Product Line)
Requirement 1
No, production and sale of the round trampolines should not be

discontinued. Computations to support this answer follow:
Contribution margin lost if the round trampolines

are discontinued ............................................ P(80,000)
Less fixed costs that can be avoided:
Advertising traceable ................................. P41,000
Line supervisors salaries .............................. 6,000 47,000
Decrease in net operating income for the
18-330
company as a whole ...................................... P(33,000)
The depreciation of the special equipment represents a sunk cost, and

therefore it is not relevant to the decision. The general factory overhead is
allocated and will presumably continue regardless of whether or not the
round trampolines are discontinued; thus, it is not relevant.
Requirement 2
If management wants a clear picture of the profitability of the segments, the

general factory overhead should not be allocated. It is a common cost and
therefore should be deducted from the total product-line segment margin. A
more useful income statement format would be as follows:
Trampoline
Total Round Rectangular Octagonal
Sales ..................................... P1,000,000 P140,000 P500,000 P360,000
Less variable expenses ......... 410,000 60,000 200,000 150,000
Contribution margin ............. 590,000 80,000 300,000 210,000
Advertising traceable ..... 216,000 41,000 110,000 65,000
Depreciation of special
equipment...................... 95,000 20,000 40,000 35,000
Line supervisors
salaries .......................... 19,000 6,000 7,000 6,000
Total traceable fixed
expenses............................ 330,000 67,000 157,000 106,000
Product-line segment
margin ............................... 260,000 P 13,000 P143,000 P104,000
Less common fixed
expenses............................ 200,000
(loss) ................................. P 60,000
Problem 3 (Product Mix)
Requirement 1
Product Line
A B C D
Selling price per unit P30 P25 P10 P8
Variable cost per unit 25 10 5 4
Contribution margin / unit P5 P15 P 5 P4
18-331
Divided by no. of hours required

for each unit 5 hrs. 10 hrs. 4 hrs. 1 hr.
Contribution per hour P1 P1.5 P1.25 P4
Product ranking:
1. D 2. B 3. C 4. A
Based on the above analysis, first priority should be given to Product D. The
company should use 4,000 out of the available 96,000 hrs. to produce 4,000
units of product D. The remaining 92,000 hrs. should be used to produce
9,200 units of Product B. Hence, the best product combination is 4,000 units
of Product D and 9,200 units of Product B.
Requirement 2
If there were no market limitations on any of the products, the company

should use all the available 96,000 hours in producing 96,000 units of
product D only.
The difference in profit between the two alternatives is computed as follows:
Contribution margin of combination (1)

Product D (4,000 x P 4.00) P 16,000
Product B (9,200 x P15.00) 138,000
Total contribution margin of D and B P154,000
Less contribution margin of D only
(96,000 x P4) 384,000
Difference, excess over profit in combination (1) P230,000
Problem 4 (Accept or Reject a Special Order)
Requirement 1
The company should accept the special order of 4,000 @ P10 each because
this selling price is still higher than the additional variable cost to be
incurred. Whether or not variable marketing expenses will be incurred, the
decision is still to accept the order.
Supporting computations:
(a) Assume no additional variable marketing cost will be incurred.
Selling price per unit P10.00
18-332
Less variable manufacturing costs:

Direct materials P5.00
Direct labor 3.00
Variable overhead 0.75 8.75
Contribution margin/unit P 1.25
Multiplied by number of units of order 4,000 units
Total increase in profit P5,000
(b) Assume additional variable marketing cost will be incurred.
Selling price per unit P10.00
Less variable costs (P8.75 + P0.25) 9.00
Contribution margin / unit P 1.00
Multiplied by number of units of order 4,000 units
Total increase in contribution margin P4,000
Requirement 2
P8.75, the total variable manufacturing cost.
Requirement 3
Direct materials P5.00

Direct labor 3.00
Variable factory overhead 0.75
Total cost of inventory under direct costing P8.75
Requirement 4
Present contribution margin

[10,000 units x (P15 - P9)] P60,000
Less proposed contribution margin
[(P14 - P9) x 11,000 units] 55,000
Decrease in contribution margin P 5,000
The company should not reduce the selling price from P15 to P14 even if
volume will go up because total contribution margin will decrease.
Problem 5 (CVP Analysis used for Decision Making)
Requirement (a)
Units sold per month No. of months Probability
18-333
4,000 6 20%
5,000 15 50%
6,000 9 30%
30 100%
Requirement (b)
Production
4,000 units 5,000 units 6,000 units
Sales (4,000 x P40) P160,000 P160,000 P160,000
Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 - - -
Total P100,000 P125,000 P150,000
Contribution margin P 60,000 P 35,000 P 10,000
Sales (5,000 x P40) P200,000 P200,000 P200,000
Less variable costs
Purchase cost @ P45 45,000 - -
Total P145,000 P125,000 P150,000
Sales (6,000 x P40) P240,000 P240,000 P240,000

Less variable costs
Purchase cost @ P45 90,000 45,000 0
Total P190,000 P170,000 P150,000
Requirement (c)
Sales Order Contribution Margin Probability Expected Value

4,000 P35,000 0.20 P 7,000
5,000 75,000 0.50 37,500
6,000 70,000 0.30 21,000
Average Contribution Margin P65,500
18-334
Problem 6 (Pricing)
Requirement A:
Operating
Result at Full
2005 2006 Capacity
Sales P 100,000 P 400,000 P 480,000
Less Variable cost 130,000 520,000 624,000
Contribution margin (P 30,000) (P120,000) (P144,000)
Less Fixed cost 40,000 40,000 40,000
Net income (loss) (P 70,000) (P160,000) (P184,000)
The company had been operating at a loss because the product had been
selling with a negative contribution margin. Hence, the more units are sold,
the higher the loss will be.
Requirement B: P60.14
Requirement C: P74.29
Requirement D: P56.58
Problem 7 (Make or Buy)
Cost of Making Cost of Buying

Outside purchase P90,000
Direct labor 30,000
Variable manufacturing overhead 10,000
Fixed manufacturing overhead* 15,000
Total cost P70,000 P90,000
* 1/3 x P45,000 = P15,000
Therefore, the annual advantage to make the parts is P20,000.
Problem 8 (Close or Retain a Store)
18-335
Requirement 1
The simplest approach to the solution is:
Gross margin lost if the store is closed .............................................. P(228,000)

Less costs that can be avoided:
Direct advertising .......................................................................... P36,000
Sales salaries .................................................................................45,000
Delivery salaries............................................................................ 7,000
Store rent .......................................................................................65,000
Store management salaries (new employee would not be
hired to fill vacant position at another store) ............................15,000
General office salaries ................................................................... 8,000
Utilities..........................................................................................27,200
Insurance on inventories (2/3 P9,000) ....................................... 6,000
Employment taxes* ....................................................................... 9,000 218,200
Decrease in company net operating income if the Ortigas
Store is closed ............................................................................... P( 9,800)
*Salaries avoided by closing the store:

Sales salaries .........................................................................................................
P45,000
Delivery salaries ................................................................................................... 7,000
Store management salaries ....................................................................................15,000
General office salaries........................................................................................... 8,000
Total salaries .........................................................................................................75,000
Employment tax rate ............................................................................................. 12%
Employment taxes avoided ................................................................................... P 9,000
Requirement 2
The Ortigas Store should not be closed. If the store is closed, overall
company net operating income will decrease by P9,800 per quarter.
Requirement 3
The Ortigas Store should be closed if P200,000 of its sales are picked up by
the Makati Store. The net effect of the closure will be an increase in overall
company net operating income by P76,200 per quarter:
Gross margin lost if the Ortigas Store is closed ........................................................................

P(228,000)
18-336
Gross margin gained at the Makati Store:

P200,000 43% ..................................................................................................................
86,000
Net loss in gross margin ...........................................................................................................
(142,000)
Costs that can be avoided if the Ortigas Store is closed (part 1) .............................................. 218,200
Net advantage of closing the Ortigas Store ..............................................................................
P 76,200
Problem 9 (Shutting Down or Continuing to Operate a Plant)
Requirement 1
Product KK-8 yields a contribution margin of P14 per gallon (P35 P21 =
P14). If the plant closes, this contribution margin will be lost on the 22,000
gallons (11,000 gallons per month 2 = 22,000 gallons) that could have
been sold during the two-month period. However, the company will be able
to avoid certain fixed costs as a result of closing down. The analysis is:
Contribution margin lost by closing the plant for two

months (P14 per gallon 22,000 gallons) .................................................P(308,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost
(P60,000 2 months = P120,000) .........................................................
P120,000
Fixed selling costs
(P310,000 10% 2 months) ...............................................................
62,000 182,000
Net disadvantage of closing, before start-up costs.......................................... (126,000)
Add start-up costs ........................................................................................... (14,000)
Disadvantage of closing the plant ...................................................................P(140,000)
No, the company should not close the plant; it should continue to operate at
the reduced level of 11,000 gallons produced and sold each month. Closing
will result in a P140,000 greater loss over the two-month period than if the
company continues to operate. Additional factors are the potential loss of
goodwill among the customers who need the 11,000 gallons of KK-8 each
month and the adverse effect on employee morale. By closing down, the
needs of customers will not be met (no inventories are on hand), and their
business may be permanently lost to another supplier.
Difference
Net
Operating
Income
Plant Kept Increase
Open Plant Closed (Decrease)
18-337
Sales (11,000 gallons P35 per gallon 2) ............................ P 770,000 P 0 P(770,000)

Less variable expenses (11,000
gallons P21 per gallon 2) .............................................. 462,000 0 462,000
Contribution margin ................................................................. 308,000 0 (308,000)
Less fixed costs:
Fixed manufacturing overhead cost
(P230,000 2;
P170,000 2) ................................................................ 460,000 340,000 120,000
Fixed selling cost (P310,000 2; P310,000
90% 2) .........................................................................
620,000 558,000 62,000
Total fixed cost .........................................................................
1,080,000 898,000 182,000
Net operating loss before start-up costs ................................... (772,000) (898,000) (126,000)
Start-up costs............................................................................ (14,000) (14,000)
Net operating loss ....................................................................
P (772,000) P(912,000) P(140,000)
Requirement 2
Ignoring the additional factors cited in part (1) above, Kristin Company
should be indifferent between closing down or continuing to operate if the
level of sales drops to 12,000 gallons (6,000 gallons per month) over the
two-month period. The computations are:
Cost avoided by closing the plant for two months (see above) ............................... P182,000
Less start-up costs ...................................................................................................
14,000
Net avoidable costs .................................................................................................
P168,000
Net avoidable costs P168,000

=
Contribution margin per gallon P14 per gallon
= 12,000 gallons
Verification: Operate at
12,000 Close for
Gallons for Two
Two Months Months
Sales (12,000 gallons P35 per gallon) ............................................... P 420,000 P 0
Less variable expenses (12,000 gallons P21 per gallon) ................... 252,000 0
Contribution margin .............................................................................168,000 0
Manufacturing overhead (P230,000 and P170,000 2
months) ........................................................................................
460,000 340,000
Selling (P310,000 and P279,000 2 months) ................................. 620,000 558,000
18-338
Total fixed expenses .............................................................................

1,080,000 898,000
Start-up costs ........................................................................................ 0 14,000
Total costs ............................................................................................
1,080,000 912,000
Net operating loss .................................................................................
P (912,000) P(912,000)
Problem 10 (The Economists Approach to Pricing)
Requirement (1)
The postal service makes more money selling the souvenir sheets at the
lower price, as shown below:
P500 Price P600 Price
Unit sales ................................................... 50,000 40,000
Sales........................................................... P25,000,000 P24,000,000

Cost of goods sold @ P60 per unit ............ 3,000,000 2,400,000
Contribution margin .................................. P22,000,000 P21,600,000
Requirement (2)
The price elasticity of demand, as defined in the text, is computed as

follows:
d =
In(1 + % change in quantity sold)
In(1 + % change in price)
40,000 50,000
In(1 + )
50,000
=
600.00 500.00
In(1 + )
500.00
In(1 0.2000)
=
In(1 + 0.2000)
In(0.8000)
=
In(1.2000)
0.2231
=
0.1823
18-339
= 1.2239
Requirement (3)
The profit-maximizing price can be estimated using the following formulas:
Profit-maximizing 1
=
markup on variable cost 1 + d
1
= = 4.4663
1 + (1.2239)
Profit-maximizing Profit-maximizing Variable cost
= 1 + x
price markup on variable cost per unit
= (1 + 4.4663) x P60 = P328

This price is much lower than the price the postal service has been charging
in the past. Rather than immediately dropping the price to P328, it would be
prudent for the postal service to drop the price a bit and observe what
happens to unit sales and to profits. The formula assumes that the price
elasticity of demand is constant, which may not be true.
The critical assumption in the calculation of the profit-maximizing price is

that the percentage increase (decrease) in quantity sold is always the same
for a given percentage decrease (increase) in price. If this is true, we can
estimate the demand schedule for souvenir sheets as follows:
Price* Quantity Sold
P600 40,000
P500 50,000
P417 62,500
P348 78,125
P290 97,656
P242 122,070
P202 152,588
P168 190,735
P140 238,419
P117 298,024
*
The price in each cell in the table is computed by taking 5/6 of the price just
above it in the table. For example, P500 is 5/6 of P600 and P417 is 5/6 of
18-340
P500.

The quantity sold in each cell of the table is computed by multiplying the
quantity sold just above it in the table by 50,000/40,000. For example,
62,500 is computed by multiplying 50,000 by the fraction 50,000/40,000.
The profit at each price in the above demand schedule can be computed as
follows:
Price Quantity Sales Cost of Sales Contribution

(a) Sold (b) (a) (b) P60 (b) Margin
P600 40,000 P24,000,000 P2,400,000 P21,600,000
P500 50,000 P250,00,000 P3,000,000 P22,000,000
P417 62,500 P26,062,500 P3,750,000 P22,312,500
P348 78,125 P27,187,500 P4,687,500 P22,500,000
P290 97,656 P28,320,200 P5,859,400 P22,460,800
P242 122,070 P29,540,900 P7,324,200 P22,216,700
P202 152,588 P30,822,800 P9,155,300 P21,667,500
P168 190,735 P32,043,500 P11,444,100 P20,599,400
P140 238,419 P33,378,700 P14,305,100 P19,073,600
P117 298,024 P34,868,800 P17,881,400 P16,987,400
18-341
The contribution margin is plotted below as a function of the selling price:
23,000,000
22,000,000
Contribution Margin
21,000,000
20,000,000
19,000,000
18,000,000
17,000,000
100.00 200.00 300.00 400.00 500.00 600.00
Selling Price
The plot confirms that the profit-maximizing price is about P328.
Requirement (4)
If the postal service wants to maximize the contribution margin and profit
from sales of souvenir sheets, the new price should be:
Profit-maximizing price = 5.4663 P70 = P383
Note that a P100 increase in cost has led to a P55 (P383 P328) increase in
the profit-maximizing price. This is because the profit-maximizing price is
computed by multiplying the variable cost by 5.4663. Since the variable cost
has increased by P100, the profit-maximizing price has increased by P100
5.4663, or P55.
18-342
Some people may object to such a large increase in price as unfair and
some may even suggest that only the P10 increase in cost should be passed
on to the consumer. The enduring popularity of full-cost pricing may be
explained to some degree by the notion that prices should be fair rather
than calculated to maximize profits.
Problem 11 (Ranking Alternatives and Managing with a Constraint)
Requirement (1)
This problem can be solved by first computing the profitability index of each
customer and then ranking the customers based on that profitability index:
Ji Euns
Incremental Time Profitability
Profit Required Index
Customer (A) (B) (A) (B)
Lalaine ..........................
P1,400 4 P350
Emily ............................
1,240 4 P310
Anna .............................
1,600 5 P320
Catherine ......................
960 3 P320
Gee Ann ........................
1,900 5 P380
Lily 2,880 8 P360
Lourdes .........................
930 3 P310
Ma. Cecilia.....................
1,360 4 P340
Sheila Raya ...................
2,340 6 P390
Jane .............................
2,040 6 P340
Cumulative
Ji Euns Amount of Ji
Profitability Time Euns Time
Customer Index Required Required
Sheila Raya ..... P390 6 6
Gee Ann .......... P380 5 11
Lily P360 8 19
Lalaine ............ P350 4 23
Jane P340 6 29
18-343
Ma. Cecilia ...... P340 4 27

Anna ................ P320 5 38
Catherine ......... P320 3 41
Emily ............... P310 4 45
Lourdes ........... P310 3 48
Given that Ji Eun should not be asked to work more than 33 hours, the four
customers below the line in the above table should be told that their
reservations have to be cancelled.
Requirement (2)
The total profit on wedding cakes for the weekend after canceling the four
reservations would be:
Sheila Raya ...... P 2,34

0
Gee Ann ........... 1,900
Lily 2,880
Lalaine ............. 1,400
Jane 2,040
Ma. Cecilia .......
1,360
Total ................. P11,92
0
Notes:
Both Ji Euns time and the cakes would have to be very carefully
scheduled to make sure that all cakes are completed on time. We have
assumed that the 33 hours of Ji Euns time that are available for cake
decorating do not include hours that have been set aside as a buffer to
provide protection from inevitable disruptions in the schedule.
If the cumulative amount of Ji Euns time required did not exactly
consume the total amount of time available, some adjustment might be
required in which reservations are cancelled to ensure that the most
profitable plan is selected.
Requirement (3)
18-344
To avoid disappointing customers, reservations should probably not be

accepted for any particular weekend after 33 hours of Ji Euns time have
been committed for that weekends cakes. To ensure that only the most
profitable cake reservations are accepted, a reservation for any cake with a
profitability index of less than P340 should probably not be accepted. This
was the cutoff point for the cakes in the first weekend in June. This cutoff
may need to be adjusted upward or downward over timethe cakes that
were reserved for the first weekend in June may not be representative of the
cakes that would be reserved for other weekends. If too many reservations
are turned down and Ji Euns time is not fully utilized, then the cutoff should
be adjusted downward. If too few reservations are turned down and Ji Euns
time is once again overbooked or profitable cake orders are turned away,
then the cutoff should be adjusted upward.
Requirement (4)
Ms. Hye Young should consider changing the way prices are set so that they
include a charge for Ji Euns time. On average, the prices may be the same,
but they should be based not only on the size of the cakes, but also on the
amount of cake decorating that the customer desires. The charge for Ji Euns
time should be her hourly rate of pay (including any fringe benefits) plus the
opportunity cost of at least P340 per hour. Because Ji Eun will not be
working more than 33 hours per week, if another cake reservation is
accepted, some other cake reservation will have to be cancelled. Ms. Hye
Young would have to give up at least P34 profit per hour to accept another
cake reservation.
Requirement (5)
Making Ji Eun happy involves not asking her to work more than 33 hours per
week decorating cakes. Making customers happy involves not canceling their
reservations, not raising prices, and providing top quality wedding cakes.
Ms. Hye Young can accomplish both of these objectives and increase her
profits by clever management of the constraintJi Euns time. The
possibilities include:
Ms. Hye Young should make sure that none of Ji Euns time is wasted on
unnecessary tasks. For example, Ji Eun should not be asked to cream
butter by hand for frostings if a machine could do the job as well with
less labor time.
18-345
Ms. Hye Young should make sure that none of Ji Euns time is wasted on
tasks that can be done by other persons. For example, an assistant can be
assigned to prepare frosting and to clean up, relieving Ji Eun of those
tasks. As long as the cost of the assistants time is less than P34 per hour,
the result will be higher profits and more pleased customers.
Ms. Hye Young should consider assigning an apprentice to Ji Eun. The
apprentice could relieve Ji Eun of some of her workload while learning
the skills to eventually expand the companys cake decorating capacity.
Ms. Hye Young might consider subcontracting some of the less
demanding cake decorating to another baker. This would be profitable as
long as the charge is less than P340 per hour.
1. C 11. D 21. D 31. A

2. C 12. A 22. A 32. D
3. B 13. D 23. D 33. C
4. B 14. A 24. E 34. A
5. A 15. D 25. B 35. C
6. B 16. C 26. D
7. C 17. A 27. D
8. B 18. C 28. C
9. A 19. B 29. A
10. B 20. C 30. A
Supporting computations for nos. 16 - 29:
16. Sales [(100,000 x 90%) x (P5.00 x 120%)] P540,000

Less: Variable costs (P300,000 x 90%) 270,000
Less: Fixed costs 150,000
Operating income P120,000
17. Direct materials P 4

Direct labor 5
Overhead 2
Selling cost 3
Minimum selling price per unit P14
18. Relevant cost to make (10,000 x P24) P240,000
18-346
Purchase cost P300,000

Less: Savings in manufacturing cost P45,000
Avoidable fixed overhead 50,000 95,000
Net purchase price P205,000
Difference in favor of buy alternative P 35,000
19. Increase in sales (60,000 x P3) P180,000

Less: Increase in variable cost (60,000 x P2.50) 150,000
Net increase in income P 30,000
20. R S T
Sales (10,000 x P20) P200,000 P200,000 P200,000
Less: Variable costs
R (P12 x 10,000) 120,000
S (P 8 x 10,000) 80,000
T (P 4 x 10,000) 40,000
Contribution margin P 80,000 P120,000 P160,000
21. R S T
Sales (P16 x 15,000) P240,000 P240,000 P240,000
R (P12 x 15,000) 180,000
S (P 8 x 15,000) 120,000
T (P 4 x 15,000) 60,000
Contribution margin P 60,000 P120,000 P180,000
Less: Fixed costs 40,000 80,000 120,000
Operating income P 20,000 P 40,000 P 60,000
22. Old operating income:

Less: Fixed cost 40,000
P40,000
New operating income 20,000
Difference - decrease P20,000
23. Sales P1,200,000

Factory overhead 80,000
Marketing expenses 70,000
18-347
Administrative expenses 50,000 900,000

Contribution margin P 300,000
Less: Fixed costs
Factory overhead P 50,000
Administrative expenses 20,000
Increase in fixed costs 10,000 110,000
Profit P 190,000
24. Sales P1,200,000

Factory overhead 80,000
Administrative expenses 50,000 850,000
Less: Fixed costs
Factory overhead P 50,000
Administrative expenses 20,000
Decrease in fixed costs
(P25,000 4) (6,250) 93,750
Profit P 256,250
25. Direct materials (P2 x 5,000) P10,000

Direct labor (P8 x 5,000) 40,000
Variable overhead (P4 x 5,000) 20,000
Total variable costs P70,000
Add: Avoidable fixed overhead 10,000
Total P80,000
26. Avoidable fixed overhead P 4
Direct materials 4
Direct labor 16
Variable overhead 18
Total P42
Multiplied by: Number of units to be produced 20,000
Total relevant costs to make the part P840,000
27. Purchase cost (P1.25 x 10,000) P12,500
18-348
Variable costs to make 10,000

Savings of making the blade P 2,500
28. Selling price per unit P17

Less: Variable costs of goods sold per unit
([P320,000 - P80,000] 20,000 units) 12
Contribution margin per unit P 5
Multiplied by units to be sold under Special Order 2,000
Increase in operating income P10,000
29. Budgeted operating income:
Contribution margin (P2,000,000 x 30%) P600,000
Less fixed costs 400,000
Net operating income P200,000
Operating income under the proposal:
Sales P2,000,000
Less Variable costs
([70% x P2,000,000] x 80%) 1,120,000
Less fixed costs 520,000 360,000
Increase in budgeted operating profit P160,000
CHAPTER 20
CAPITAL BUDGETING DECISIONS
I. Questions
1. A capital investment involves a current commitment of funds with the
expectation of generating a satisfactory return on these funds over a
relatively extended period of time in the future.
2. Cost of capital is the weighted minimum desired average rate that a
company must pay for long-term capital while discounted rate of return
is the maximum rate of interest that could be paid for the capital
employed over the life of an investment without loss on the project.
3. The basic principles in capital budgeting are:
18-349
1. Capital investment models are focused on the future cash inflows

and outflows - rather than on net income.
2. Investment proposals should be evaluated according to their
differential effects on the companys cash flows as a whole.
3. Financing costs associated with the project are excluded in the
analysis of incremental cash flows in order to avoid the double-
counting of the cost of money.
4. The concept of the time value of money recognizes that a peso of
present return is worth more than a peso of future return.
5. Choose the investments that will maximize the total net present
value of the projects subject to the capital availability constraint.
4. The major classifications as to purpose are:
1. Replacement projects
- those involving replacements of worn-out assets to avoid
disruption of normal operations, or to improve efficiency.
2. Product or process improvement
- projects that aim to produce additional revenue or to realize cost
savings.
3. Expansion
- projects that enhance long-term returns due to increased
profitable volume.
5. Greater amounts of capital may be used in projects whose combined
returns will exceed any alternate combination of total investment.
6. No. This implies that any equity funds are cost free and this is a
dangerous position because it ignores the opportunity cost or alternative
earnings that could be had from the fund.
7. Yes, if there are alternative earnings foregone by stockholders.
8. Capital budgeting screening decisions concern whether a proposed
investment project passes a preset hurdle, such as a 15% rate of return.
Capital budgeting preference decisions are concerned with choosing
from among two or more alternative investment projects, each of which
has passed the hurdle.
9. The time value of money refers to the fact that a peso received today is
more valuable than a peso received in the future. A peso received today
can be invested to yield more than a peso in the future.
18-350
10. Discounting is the process of computing the present value of a future

cash flow. Discounting gives recognition to the time value of money and
makes it possible to meaningfully add together cash flows that occur at
different times.
11. Accounting net income is based on accruals rather than on cash flows.
Both the net present value and internal rate of return methods focus on
cash flows.
12. One simplifying assumption is that all cash flows occur at the end of a
period. Another is that all cash flows generated by an investment project
are immediately reinvested at a rate of return equal to the discount rate.
13. No. The cost of capital is not simply the interest paid on long-term debt.
The cost of capital is a weighted average of the individual costs of all
sources of financing, both debt and equity.
14. The internal rate of return is the rate of return on an investment project
over its life. It is computed by finding that discount rate that results in a
zero net present value for the project.
15. The project profitability index is computed by dividing the net present
value of the cash flows from an investment project by the investment
required. The index measures the profit (in terms of net present value)
provided by each peso of investment in a project. The higher the project
profitability index, the more desirable is the investment project.
16. Neither the payback method nor the simple rate of return method
considers the time value of money. Under both methods, a peso received
in the future is weighed the same as a peso received today. Furthermore,
the payback method ignores all cash flows that occur after the initial
investment has been recovered.
II. Matching Type
1. A 6. H
2. C 7. D
3. F 8. G
4. B 9. J
5. I 10. E
III. Exercises
18-351
Exercise 1 (Simple Rate of Return Method)
The annual incremental net operating income is determined by comparing

the operating cost of the old machine to the operating cost of the new
machine and the depreciation that would be taken on the new machine:
Operating cost of old machine ..................................................... P33,000

Less operating cost of new machine ............................................ 10,000
Less annual depreciation on the new machine (P80,000
10 years) ............................................................................... 8,000
Annual incremental net operating income................................... P15,000
Cost of the new machine ............................................................. P80,000

Less scrap value of old machine .................................................. 5,000
Initial investment ......................................................................... P75,000
Simple rate Annual incremental net operating income

of return =
Initial investment
P15,000
= = 20%
P75,000
Exercise 2 (Basic Present Value Concepts)
1. a. P400,000 0.794 = P317,600.

b. P400,000 0.712 = P284,800.
2. a. P5,000 4.355 = P21,775.

b. P5,000 3.685 = P18,425.
3. The factor for 10% for 20 years is 8.514. Thus, the present value of
Toms winnings would be:
P50,000 8.514 = P425,700.
Whether or not Tom really won a million pesos depends on your point of
view. She will receive a million pesos over the next 20 years; however,
in terms of its value right now she won much less than a million pesos as
shown by the present value computation above.
18-352
Exercise 3 (After-Tax Costs)
a. Management consulting fee ............................ P100,000

Multiply by 1 0.30 ........................................ 0.70
After-tax cost ................................................... P 70,000
b. Increased revenues .......................................... P40,000

Multiply by 1 0.30 ........................................ 0.70
After-tax cash flow (benefit) ........................... P28,000
c. The depreciation deduction is P210,000 7 years = P30,000 per year,

which has the effect of reducing taxes by 30% of that amount, or P9,000
per year.
Exercise 4 (Basic Net Present Value Analysis)
Amount of 12% Present Value

Year(s) Cash Flows Factor of Cash Flows
Purchase of the stock ....................
Now P(18,000) 1.000 P(18,000)
Annual dividends*........................ 1-4 P720 3.037 2,187
Sale of the stock ...........................4 P22,500 0.636 14,310
Net present value .......................... P( 1,503)
*900 shares P0.80 per share per year = P720 per year.
No, Ms. Cruz did not earn a 12% return on the share. The negative net
present value indicates that the rate of return on the investment is less than
the discount rate of 12%.
Exercise 5 (Internal Rate of Return and Net Present Value)
Factor of the internal Required investment

1. rate of return =
Annual cash inflow
P136,700
= = 5.468
P25,000
A factor of 5.468 represents an internal rate of return of 16%.
2. Item Year(s) Amount of 16% Present Value
18-353
Cash Flows Factor of Cash Flows

Initial investment..........................
Now P(136,700) 1.000 P(136,700)
Net annual cash inflows ...............1-14 P25,000 5.468 136,700
Net present value .......................... P 0
The reason for the zero net present value is that 16% (the discount rate)
represents the machines internal rate of return. The internal rate of return is
the rate that causes the present value of a projects cash inflows to just equal
the present value of the investment required.
3. Factor of the internal Required investment

rate of return =
Annual cash inflow
P136,700
= = 6.835
P20,000
The 6.835 factor is closest to 6.982, the factor for the 11% rate of return.
Thus, to the nearest whole percent, the internal rate of return is 11%.
Exercise 6 (Basic Net Present Value and Internal Rate of Return

Analysis)
1. Amount of 15% Present Value of

Item Year(s) Cash Flows Factor Cash Flows
Initial investment ...................
Now P(40,350) 1.000 P(40,350)
Annual cash inflows ..............1-4 P15,000 2.855 42,825
Net present value ................... P 2,475
Yes, this is an acceptable investment. Its net present value is positive, which
indicates that its rate of return exceeds the minimum 15% rate of return
required by the company.
2. Factor of the internal Investment required

rate of return =
Net annual cash inflow
P111,500
= = 5.575
P20,000
18-354
A factor of 5.575 represents an internal rate of return of 16%.
3. Factor of the internal Investment required

rate of return =
P14,125
= = 5.650
P2,500
A factor of 5.650 represents an internal rate of return of 12%. The

company did not make a wise investment because the return promised by
the machine is less than the required rate of return
IV. Problems
Problem 1 (Equipment Replacement Sensitivity Analysis)
Requirement 1
Total Present Value
A. New Situation:
Recurring cash operating costs (P26,500 x 2.69) P 71,285
Cost of new equipment 44,000
Disposal value of old equipment now (5,000)
Present value of net cash outflows P110,285
B. Present Situation:
Recurring cash operating costs (P45,000 x 2.69) P121,050
Disposal value of old equipment four years
hence (1,342)
(P2,600 x 0.516)
Present value of net cash inflows P119,708
Difference in favor of replacement P 9,423
Requirement 2
P44,000 P5,000
Payback period for the new equipment =
P18,500
18-355
= 2.1 years
Requirement 3
Let X = annual cash savings

Let O = net present value
X (2.69) + P5,000 - P44,000 - P1,342 = O

2.69X = P40,342
X = P14,997
If the annual cash savings decrease from P18,850 to P14,997 or by P3,503,

the point of indifference will be reached.
Another alternative way to get the same answer would be to divide the net
present value of P9,423 by 2.690.
Problem 2
Annual cash expenses of the manual bookkeeping

machine system, P9,800 x 12 P117,600
Annual cash expenses of computerized data processing 53,600
Annual cash savings before taxes P 64,000

Annual cash savings (a) P64,000 P64,000 P64,000
Depreciation 20,000 16,000 12,800
Inflow before tax P44,000 P48,000 P51,200
Income tax (50%) (b) 22,000 24,000 25,600
Cash inflow after tax (a - b) P42,000 P40,000 P38,400
After Tax
Cash Inflows PV Factor PV
Year 1 P42,000 x 0.909 P 38,178
Year 2 40,000 x 0.826 33,040
Year 3 38,400 x 0.750 28,800
Year 3 Salvage 20,000 x 0.750 15,000
Year 3 Tax loss 15,600* x 0.750 11,700
P126,718
Investment (I) 100,000
Net present value (NPV) P 26,718
18-356
_________________
* The P15,600 tax benefit of the loss on the disposal of the computer at the end of
year 3 is computed as follows:
Estimated salvage value P 20,000
Estimated book value:
Historical cost P100,000
Accumulated depreciation 48,800 51,200
Estimated loss P(31,200)
Tax rate 50%

Tax effect of estimated loss P(15,600)
Since the net present value is positive, the computer should be purchased
replacing the manual bookkeeping system.
Problem 3
Requirement 1
(a) Purchase price of new equipment P(300,000)

Disposal of existing equipment:
Selling price P 0
Book value 60,000
Loss on disposal P60,000
Tax rate 0.4
Tax benefit of loss on disposal 24,000
Required investment (I) P(276,000)
(b) Increased cash flows resulting from

change in contribution margin:
Using new equipment [18,000 (P20 - P7)] * P234,000
Using existing equipment [11,000 (P20 - P9)] 121,000
Increased cash flows 113,000
Less: Taxes (0.40 x P113,000) 45,200
Increased cash flows after taxes P 67,800
Depreciation tax shield:
Depreciation on new equipment
(P300,000 5) P60,000
Depreciation on existing equipment
18-357
(P60,000 5) 12,000
Increased depreciation charge P48,000
Tax rate 0.40
Depreciation tax shield 19,200
Recurring annual cash flows P 87,000
_________________
* The new equipment is capable of producing 20,000 units, but ETC Products can
sell only 18,000 units annually.
The sales manager made several errors in his calculations of required investment
and annual cash flows. The errors are as follows:
Required investment:
- The cost of the market research study (P44,000) is a sunk cost because it
was incurred last year and will not change regardless of whether the
investment is made or not.
- The loss on the disposal of the existing equipment does not result in an
actual cash cost as shown by the sales manager. The loss on disposal results
in a reduction of taxes, which reduces the cost of the new equipment.
Annual cash flows:
- The sales manager considered only the depreciation on the new equipment
rather than just the additional depreciation which would result from the
acquisition of the new equipment.
- The sales manager also failed to consider that the depreciation is a noncash
expenditure which provides a tax shield.
- The sales managers use of the discount rate (i.e., cost of capital) was
incorrect. The discount rate should be used to reduce the value of future
cash flows to their current equivalent at time period zero.
Requirement 2
Present value of future cash flows (P87,000 x 3.36) P292,320

Required investment (I) 276,000
Net present value P 16,320
Problem 4
Requirement 1: P(507,000)
18-358
Problem 5
1. The net annual cost savings is computed as follows:
Reduction in labor costs ........................................................................

P240,000
Reduction in material costs ...................................................................96,000
Total cost reductions .............................................................................
336,000
Less increased maintenance costs (P4,250 12) ..................................51,000
Net annual cost savings .........................................................................
P285,000
2. Using this cost savings figure, and other data provided in the text, the net
present value analysis is:
Present Value
Amount of 18% of Cash
Year(s) Cash Flows Factor Flows
Cost of the machine .....................................
Now P(900,000) 1.000 P (900,000)
Installation and software .............................
Now P(650,000) 1.000 (650,000)
Salvage of the old machine .........................
Now P70,000 1.000 70,000
Annual cost savings .....................................
1-10 P285,000 4.494 1,280,790
Overhaul required .......................................
6 P(90,000) 0.370 (33,300)
Salvage of the new machine ........................10 P210,000 0.191 40,110
Net present value ......................................... P (192,400)
No, the etching machine should not be purchased. It has a negative net
present value at an 18% discount rate.
3. The intangible benefits would have to be worth at least P42,813 per year
as shown below:
Required increase in net present value P192,400
= = P42,813
Factor for 10 years 4.494
Thus, the new etching machine should be purchased if management
believes that the intangible benefits are worth at least P42,813 per year
to the company.
Problem 6
(1) (2) (1) (2) 12% Present
Items and Computations Year(s) Amount Tax After-Tax Factor Value of
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Effect Cash Cash

Flows Flows
Investment in new trucks ...........................................
Now P(450,000) P(450,000) 1.000 P(450,000)
Salvage from sale of the old trucks ...........................
Now P30,000 1 0.30 P21,000 1.000 21,000
Net annual cash receipts ...........................................
1-8 P108,000 1 0.30 P75,600 4.968 375,581
Depreciation deductions* ...........................................
1-8 P56,250 0.30 P16,875 4.968 83,835
Overhaul of motors ....................................................
5 P(45,000) 1 0.30 P(31,500) 0.567 (17,861)
Salvage from the new trucks .....................................
8 P20,000 1 0.30 P14,000 0.404 5,656
Net present value....................................................... P 18,211
* P450,000 8 years = P56,250 per year
Since the project has a positive net present value, the contract should be
accepted.
Problem 7
1. Factor of the internal Required investment

rate of return =
Annual cash inflow
P142,950
= = 3.812
P37,500
A factor of 3.812 equals an 18% rate of return.
Verification of the 18% rate of return:
Amount of Present Value

Cash 18% of Cash
Item Year(s) Flows Factor Flows
Investment in equipment ........................
Now P(142,950) 1.000 P(142,950)
Annual cash inflows ...............................
1-7 P37,500 3.812 142,950
Net present value .................................... P 0
2.
Factor of the internal Required investment
rate of return =
Annual cash inflow
We know that the investment is P142,950, and we can determine the factor
for an internal rate of return of 14% by looking at the PV table along the 7-
period line. This factor is 4.288. Using these figures in the formula, we get:
P142,950
= 4.288
Annual cash inflow
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Therefore, the annual cash inflow would have to be:

P142,950 4.288 = P33,337.
3. a. 5-year life for the equipment:

The factor for the internal rate of return would still be 3.812 [as
computed in (1) above]. Reading along the 5-period line of the PV table,
a factor of 3.812 is closest to 3.791, the factor for 10%. Thus, to the
nearest whole percent, the internal rate of return is 10%.
b. 9-year life for the equipment:

The factor of the internal rate of return would again be 3.812. From the
PV table, reading along the 9-period line, a factor of 3.812 is closest to
3.786, the factor for 22%. Thus, to the nearest whole percent, the internal
rate of return is 22%.
The 10% return in part (a) is less than the 14% minimum return that Dr.
Blue wants to earn on the project. Of equal or even greater importance,
the following diagram should be pointed out to Dr. Blue:
As this illustration shows, a decrease in years has a much greater impact

on the rate of return than an increase in years. This is because of the time
value of money; added cash inflows far into the future do little to
enhance the rate of return, but loss of cash inflows in the near term can
do much to reduce it. Therefore, Dr. Blue should be very concerned
about any potential decrease in the life of the equipment, while at the
same time realizing that any increase in the life of the equipment will do
little to enhance her rate of return.
4. a. The expected annual cash inflow would be:
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P37,500 x 120% = P45,000

P142,950
= 3.177
P45,000
Reading along the 7-period line of the PV table, a factor of 3.177 is

closest to 3.161, the factor for 25%, and is between that factor and the
factor for 24%. Thus, to the nearest whole percent, the internal rate of
return is 25%.
b. The expected annual cash inflow would be:
P37,500 x 80% = P30,000

P142,950
= 4.765
P30,000
Reading along the 7-period line of the PV table, a factor of 4.765 is

closest to 4.712, the factor for 11%. Thus, to the nearest whole percent,
the internal rate of return is 11%.
Unlike changes in time, increases and decreases in cash flows at a given

point in time have basically the same impact on the rate of return, as
shown below:
5. Since the cash flows are not even over the five-year period (there is an extra
P61,375 cash inflow from sale of the equipment at the end of the fifth year),
some other method must be used to compute the internal rate of return.
Using trial-and-error or more sophisticated methods, it turns out that the
actual internal rate of return will be 12%:
Item Year(s) Amount of 12% Present
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Cash Factor Value of

Flows Cash Flows
Investment in the equipment .............................
Now P(142,950) 1.000 P(142,950)
Annual cash inflow ...........................................
1-5 P30,000 3.605 108,150
Sale of the equipment .......................................
5 P61,375 0.567 34,800
Net present value .............................................. P 0
Problem 8
1. The income statement would be:
Sales revenue .............................................................. P200,000

Less commissions (40% P200,000) ........................ 80,000
Contribution margin ................................................... 120,000
Maintenance ........................................................... P50,000
Insurance ................................................................ 10,000
Depreciation* ......................................................... 36,000
Total fixed expenses ................................................... 96,000
Net operating income ................................................. P 24,000
*P180,000 5 years = P36,000 per year
2. The initial investment in the simple rate of return calculations is net of the
salvage value of the old equipment as shown below:
Simple Annual incremental net operating income

rate of return =
Initial investment
P24,000 P24,000
Yes, the games= would be purchased. The =return exceeds the 14%
= threshold
16%
P180,000
set by the company. P30,000 P150,000
3. The payback period would be:
Payback Investment required

period =
P180,000 P30,000 P150,000
= = = 2.5 years
P60,000* P60,000
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*Net annual cash inflow = Net operating income + Depreciation

= P24,000 + P36,000 = P60,000.
Yes, the games would be purchased. The payback period is less than the 3
years.
1. D 11. D 21. C 31. D

2. C 12. D 22. B 32. C
3. B 13. D 23. C 33. C
4. B 14. C 24. D 34. D
5. A 15. C 25. C 35. D
6. C 16. D 26. C 36. B
7. D 17. D 27. D 37. B
8. B 18. B 28. B 38. B
9. B 19. A 29. D 39. D
10. A 20. A 30. A 40. B
CHAPTER 21
DECENTRALIZED OPERATIONS AND

SEGMENT REPORTING
I. Questions
1. Decentralization means that decision making in an organization isnt
confined to a few top executives, but rather is spread throughout the
organization with managers at various levels making key operating
decisions relating to their sphere of responsibility.
2. The benefits include: (1) a spreading of decision-making responsibility
among managers, thereby relieving top management from day-to-day
problem solving and allowing them to focus their time on long-range
planning; (2) training in decision making for lower-level managers,
thereby preparing them to assume greater responsibility; (3) greater job
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satisfaction and greater incentive for lower-level managers; (4) better

decisions, since decisions are made at the level where the problem is
best understood; and (5) a more effective basis for measuring
managerial performance through the creation of profit and investment
centers.
3. The three business practices are (a) omission of some costs in the
assignment process, (b) the use of inappropriate allocation methods,
and (c) allocation of common costs to segments.
4. The contribution margin represents the portion of sales revenue
remaining after deducting variable expenses. The segment margin
represents the margin still remaining after deducting traceable fixed
expenses from the contribution margin. Generally speaking, the
contribution margin is most useful as a planning tool in the short run,
when fixed costs dont change. The segment margin is most useful as a
planning tool in the long run, when fixed costs will be changing, and as
a tool for evaluating long-run segment performance. One concept is no
more useful to management than the other; the two concepts simply
relate to different planning horizons.
5. A segment is any part or activity of an organization about which a
manager seeks cost, revenue, or profit data. Examples of segments
include departments, operations, sales territories, divisions, product
lines, and so forth.
6. Under the contribution approach, costs are assigned to a segment if and
only if the costs are traceable to the segment (i.e., could be avoided if
the segment were eliminated). Common costs are not allocated to
segments under the contribution approach.
7. A traceable cost of a segment is a cost that arises specifically because of
the existence of that segment. If the segment were eliminated, the cost
would disappear. A common cost, by contrast, is a cost that supports
more than one segment, but is not traceable in whole or in part to any
one of the segments. If the departments of a company are treated as
segments, then examples of the traceable costs of a department would
include the salary of the departments supervisor, depreciation of
machines used exclusively by the department, and the costs of supplies
used by the department. Examples of common costs would include the
salary of the general counsel of the entire company, the lease cost of the
headquarters building, corporate image advertising, and periodic
depreciation of machines shared by several departments.
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II. Problems
Problem 1 (Working with a Segmented Income Statement)
Requirement 1
P75,000 40% CM ratio = P30,000 increased contribution margin in Cebu.

Since the fixed costs in the office and in the company as a whole will not
change, the entire P30,000 would result in increased net operating income
for the company.
It is incorrect to multiply the P75,000 increase in sales by Cebus 25%

segment margin ratio. This approach assumes that the segments traceable
fixed expenses increase in proportion to sales, but if they did, they would not
be fixed.
Requirement 2
a. The segmented income statement follows:
Segments
Total Company Manila Cebu
Amount % Amount % Amount %
Sales ............................................
P800,000 100.0% P200,000 100% P600,000 100%
Less variable expenses ................ 420,000 52.5 60,000 30 360,000 60
Contribution margin .................... 380,000 47.5 140,000 70 240,000 40
Less traceable fixed
expenses ................................... 168,000 21.0 78,000 39 90,000 15
Office segment margin ................ 212,000 26.5 P 62,000 31% P150,000 25%
Less common fixed
expenses not traceable to
segments .................................. 120,000 15.0
Net operating income .................. P 92,000 11.5%
b. The segment margin ratio rises and falls as sales rise and fall due to the
presence of fixed costs. The fixed expenses are spread over a larger base
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as sales increase.
In contrast to the segment ratio, the contribution margin ratio is a stable

figure so long as there is no change in either the variable expenses or the
selling price of a unit of service.
Problem 2 (Segmented Income Statement)
Requirement 1
Geographic Market
Total Company East Central West
Amount % Amount % Amount % Amount %
Sales .....................................................................................................................................................................
P1,500,000 100.0 P400,000 100 P600,000 100 P500,000 100
Less variable expenses ............................................................................................................................................
588,000 39.2 208,000 52 180,000 30 200,000 40
Contribution margin ...............................................................................................................................................
912,000 60.8 192,000 48 420,000 70 300,000 60
Less traceable fixed expenses .................................................................................................................................
770,000 51.3 240,000 60 330,000 55 200,000 40
Geographic market segment margin .......................................................................................................................
142,000 9.5 P(48,000) (12) P 90,000 15 P100,000 20
Less common fixed expenses not
traceable to geographic markets* ......................................................................................................................
175,000 11.7
Net operating income (loss) ....................................................................................................................................
P (33,000) (2.2)
* P945,000 P770,000 = P175,000.
Requirement 2
Incremental sales (P600,000 15%)........................................................................ P90,000

Contribution margin ratio .........................................................................................
70%
Incremental contribution margin ..............................................................................63,000
Less incremental advertising expense ...................................................................... 25,000
Incremental net operating income ............................................................................
P38,000
Yes, the advertising program should be initiated.
Problem 3 (Basic Segmented Income Statement)
Total CD DVD
Sales* ............................................................................
P750,000 P300,000 P450,000
Variable expenses** ......................................................
435,000 120,000 315,000
Contribution margin ......................................................
315,000 180,000 135,000
Traceable fixed expenses .............................................. 183,000 138,000 45,000
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Product line segment margin ......................................... 132,000 P 42,000 P 90,000

Common fixed expenses not traceable to
products .....................................................................
105,000
Net operating income ....................................................
P 27,000
* CD: 37,500 packs P8.00 per pack = P300,000;

DVD: 18,000 packs P25.00 per pack= P450,000.
** CD: 37,500 packs P3.20 per pack = P120,000;
DVD: 18,000 packs P17.50 per pack= P315,000.
1. B 6. A 11. A
2. C 7. C 12. B
3. B 8. B
4. B 9. D
5. B 10. C
CHAPTER 22
BUSINESS PLANNING
I. Questions
1. Strategy, plans, and budgets are interrelated and affect one another.
Strategy describes how an organization matches its own capabilities
with the opportunities in the marketplace to accomplish its overall
objectives. Strategy analysis underlies both long-run and short-run
planning. In turn, these plans lead to the formulation of budgets.
Budgets provide feedback to managers about the likely effects of their
strategic plans. Managers use this feedback to revise their strategic
plans.
2. Budgeted performance is better than past performance for judging
managers. Why? Mainly because the inefficiencies included in past
results can be detected and eliminated in budgeting. Also, new
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opportunities in the future, which did not exist in the past, may be
ignored if past performance is used.
3. A company that shares its own internal budget information with other
companies can gain multiple benefits. One benefit is better
coordination with suppliers, which can reduce the likelihood of supply
shortages. Better coordination with customers can result in increased
sales as demand by customers is less likely to exceed supply. Better
coordination across the whole supply chain can also help a company
reduce inventories and thus reduce the costs of holding inventories.
4. The sales forecast is typically the cornerstone for budgeting, because
production (and, hence, costs) and inventory levels generally depend on
the forecasted level of sales.
5. Sensitivity analysis adds an extra dimension to budgeting. It enables
managers to examine how budgeted amounts change with changes in
the underlying assumptions. This assists managers to monitor those
assumptions that are most critical to a company attaining its budget or
make timely adjustments to plans when appropriate.
6. Factors reducing the effectiveness of budgeting of companies include:

1. Lack of a well-defined strategy,
2. Lack of a clear linkage of strategy to operational plans,
3. Lack of individual accountability for results, and
4. Lack of meaningful performance measures.
II. Problems
Problem 1 (Budgeted Income Statement)
Globalcom Company
Budgeted Income Statement for 2006
(in thousands)
Net sales P6,996

Equipment (P6,000 x 1.06 x 1.10) 1,908
Maintenance contracts (P1,800 x 1.06)
Total net sales P8,904
Cost of goods sold (P4,600 x 1.03 x 1.06) 5,022
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Gross margin 3,882

Operating costs:
Marketing costs (P600 + P250) 850
Distribution costs (P150 x 1.06) 159
Customer maintenance costs (P1,000 + P130) 1,130
Administrative costs 900
Total operating costs 3,039
Operating income P 843
Problem 2 (Comprehensive Operating Budget)
Requirement 1
Schedule 1: Revenue Budget

Units Selling Price Total Revenues

Skateboards 1,000 P450 P450,000
Total
Requirement 2
Schedule 2: Production Budget (in Units)

for the Year Ended December 31, 2006
Skateboards
Budgeted unit sales (Schedule 1) 1,000
Add target ending finished goods inventory 200
Total requirements 1,200
Deduct beginning finished goods inventory 100
Units to be produced 1,100
Requirement 3
Schedule 3A: Direct Materials Usage Budget

Wood Fiberglass Total
Physical Budget
To be used in production 5,500
(Wood: 1,100 x 5.00 b.f.
Fiberglass: 1,100 x 6.00 yards) 6,600
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5,500 6,600
Cost Budget
Available from beginning inventory
(Wood: 2,000 b.f. x P28.00 56,000
Fiberglass: 1,000 b.f. x 4.80) 4,800
To be used from purchases this period
(Wood: (5,500 2,000) x P30.00 105,000
Fiberglass: (6,600 1,000) x P5.00) 28,000
Total cost of direct materials to be used P161,000 P32,800 P193,800
Schedule 3B: Direct Materials Purchases Budget

Wood Fiberglass Total
Physical Budget
Production usage (from Schedule 3A) 5,500 6,600
Add target ending inventory 1,500 2,000
Total requirements 7,000 8,600
Deduct beginning inventory 2,000 1,000
Purchases 5,000 7,600
Cost Budget
(Wood: 5,000 x P30.00 P150,000
Fiberglass: 7,600 x P5.00) P38,000
P150,000 P38,000 P188,000
Requirement 4
Schedule 4: Direct Manufacturing Labor Budget

Cost Driver DML Hours per Total Wage

Labor Category Units Driver Unit Hours Rate Total
Manufacturing labor 1,100 5.00 5,500 P25.00 P137,500
Requirement 5
Schedule 5: Manufacturing Overhead Budget

At Budgeted Levels of 5,500

Direct Manufacturing Labor-Hours
Variable manufacturing overhead
costs (P7.00 x 5,500) P 38,500
Fixed manufacturing overhead costs 66,000
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Total manufacturing overhead costs P104,500
Requirement 6
P104,500
Budgeted manufacturing overhead rate: = P19.00 per hour
5,500
Requirement 7
Budgeted manufacturing overhead cost per output unit:

P104,500
=
1,100
= P95.00 per output unit
Requirement 8
Schedule 6A: Computation of Unit Costs of Manufacturing Finished

Goods in 2006
Cost per Unit
of Inputa Inputsb Total
Direct materials
Wood P30.00 5.00 P150.00
Fiberglass 5.00 6.00 30.00
Direct manufacturing labor 25.00 5.00 125.00
Total manufacturing overhead 95.00
P400.00
a
cost is per board foot, yard or per hour
b
inputs is the amount of input per board
Requirement 9
Schedule 6B: Ending Inventory Budget

December 31, 2006
Units Cost per Unit Total
Direct materials
Wood 1,500 P 30.00 P 45,000
Fiberglass 2,000 5.00 10,000
Finished goods
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Skateboards 200 400.00 80,000

Total Ending Inventory P135,000
Requirement 10
Schedule 7: Cost of Goods Sold Budget

for the year Ended December 31, 2006
From
Schedule Total
Beginning finished goods
inventory, January 1,
2006 Given P 37,480
Direct materials used 3A P193,800
Direct manufacturing labor 4 137,500
Manufacturing overhead 5 104,500
Cost of goods 435,800
manufactured
Cost of goods available for
sale 473,280
Deduct ending finished
goods inventory,
December 31, 2006 6B 80,000
Cost of goods sold P393,280
Requirement 11
Budgeted Income Statement for Pacific

for the Year Ended December 31, 2006
Revenues Schedule 1 P450,000
Costs
Cost of goods sold Schedule 7 393,280
Gross margin 56,720
Operating costs
Marketing costs
(P250 x 30) P 7,500
Other costs 30,000 37,500
Operating income P 19,220
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6. A 11. A 11. D
7. B 12. B 12. D
8. C 13. D 13. B
9. D 14. A 14. C
10. D 15. C 15. A
CHAPTER 23
STRATEGIC COST MANAGEMENT;

BALANCED SCORECARD
I. Questions
1.
Strategy Weakness
Cost leadership The tendency to cut costs in a way that
undermines demand for the product or
service.
Differentiation The firms tendency to undermine its strength
by attempting to lower costs or by lacking a
continual and aggressive marketing plan to
reinforce the perceived difference.
Focus The market niche may suddenly disappear due
to technological change in the industry or
change in consumer tastes.
2. The balanced scorecard is an accounting report that includes the firms
critical success factors in four areas: customer satisfaction, financial
performance, internal business processes, and innovation and learning
(human resources). The primary objective of the balanced scorecard is
to serve as an action plan, a basis for implementing the strategy
expressed in the critical success factors.
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3. The balanced scorecard is important to integrate both financial and non-

financial information into management reports. Financial measures
reflect only a partial- and short-term measure of the firms progress.
Without strategic non-financial information, the firm is likely to stray
from its competitive course and to make strategically wrong product
decisions to choose the wrong products, the wrong customers. The
balanced scorecard provides a basis for a more complete analysis than is
possible with financial data alone.
4. An analyst can incorporate other factors such as the growth in the
overall market and reductions in selling prices resulting from
productivity gains into a strategic analysis of operating income. To do
so, the analyst attributes the sources of operating income changes to the
particular factors of interests. For example, the analyst will combine the
operating income effects of strategic price reductions and any resulting
growth with the productivity component to evaluate a companys cost
leadership strategy.
5. A companys balanced scorecard should be derived from and support its
strategy. Since different companies have different strategies, their
balanced scorecards should be different.
6. The difference between the delivery cycle time and the throughput time
is the waiting period between when an order is received and when
production on the order is started. The throughput time is made up of
process time, inspection time, move time, and queue time. These four
elements can be classified between value-added time (process time) and
non-value-added time (inspection time, move time, and queue time).
7. The balanced scorecard is constructed to support the companys strategy,
which is a theory about what actions will further the companys goals.
Assuming that the company has financial goals, measures of financial
performance must be included in the balanced scorecard as a check on
the reality of the theory. If the internal business processes improve, but
the financial outcomes do not improve, the theory may be flawed and the
strategy should be changed.
8. If a company has an MCE of less than 1, it means the production process
includes non-value-added time. An MCE of 0.40, for example, would
mean that 40% of the throughput time consists of actual processing, and
that the other 60% consists of moving, inspection, and other non-value-
added activities.
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II. Problem (Measures of Internal Business Process Performance)
Requirement 1
a, b, and c
Month
1 2 3 4
Throughput time in days:
Process time....................................................
0.6 0.5 0.5 0.4
Inspection time ...............................................
0.7 0.7 0.4 0.3
Move time ......................................................
0.5 0.5 0.4 0.5
Queue time .....................................................
3.6 3.6 2.6 1.7
Total throughput time .....................................
5.4 5.3 3.9 2.9
Manufacturing cycle efficiency
(MCE):
Process time Throughput 11.1% 9.4% 12.8% 13.8%
time .................................................................
Delivery cycle time in days:
Wait time ........................................................
9.6 8.7 5.3 4.7
Total throughput time .....................................
5.4 5.3 3.9 2.9
Total delivery cycle time ................................
15.0 14.0 9.2 7.6
Requirement 2
The general trend is favorable in all of the performance measures except for
total sales. On-time delivery is up, process time is down, inspection time is
down, move time is basically unchanged, queue time is down, manufacturing
cycle efficiency is up, and the delivery time is down. Even though the
company has improved its operations, it has not yet increased its sales. This
may have happened because management attention has been focused on the
factory working to improve operations. However, it may be time now to
exploit these improvements to go after more sales perhaps by increased
product promotion and better marketing strategies. It will ultimately be
necessary to increase sales so as to translate the operational improvements
into more profits.
Requirement 3
a and b
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Month
5 6
Throughput time in days:
Process time.................................................... 0.4 0.4
Inspection time ............................................... 0.3
Move time ...................................................... 0.5 0.5
Queue time .....................................................
Total throughput time ..................................... 1.2 0.9
Manufacturing cycle efficiency (MCE):

Process time Throughput time ................. 33.3% 44.4%
As a company pares away non-value-added activities, the manufacturing

cycle efficiency improves. The goal, of course, is to have an efficiency of
100%. This will be achieved when all non-value-added activities have been
eliminated and process time equals throughput time.
11. D 16. C
12. D 17. D
13. C 18. C
14. A 19. D
15. A 20. A
CHAPTER 24
ADVANCED ANALYSIS AND

APPRAISAL OF PERFORMANCE:
FINANCIAL AND NONFINANCIAL
I. Questions
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1. Return on investment (ROI) is the ratio of profit to amount invested for

the business unit.
2. The measurement issues for ROI are:
a. The effect of accounting policies, which affect the determination of
net income.
b. Other measurement issues for income, which include the handling of
non-recurring items in the income statement, differences in the
effect of income taxes across units, differential effect of foreign
currency exchange, and the effect of cost allocation when two or
more units share a facility or cost.
c. Measuring investment: which assets to include.
d. Measuring investment: allocating the cost of shared assets.
3. The advantages of return on investment are:
a. It is intuitive and easily understood.
b. It provides a useful basis for comparison among SBUs.
c. It is widely used.
The limitations of return on investment are:
a. It has an excessive short-term focus.
b. Investment planning uses discounted cash flow analysis while
managers are evaluated on ROI.
c. It contains a disincentive for new investment by the most profitable
units.
4. The key advantage of residual income is that it deals effectively with the
limitation of ROI, that is ROI has a disincentive for the managers of the
most profitable units to make new investments. With residual income,
no matter how profitable the unit, there is still an incentive for new
profitable investment. In contrast, a key limitation is that since residual
income is not a percentage, it suffers the same problem of profit SBUs in
that it is not useful for comparing units of significantly difference sizes.
It favors larger units that would be expected to have larger residual
incomes, even with relatively poor performance. Moreover, relatively
small changes in the desired minimum rate of return can dramatically
affect the residual income for different size units. And, in contrast to
ROI, some managers do not find residual income to be as intuitive and
as easily understood.
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5. Economic value added (EVA) is a business units income after taxes and
after deducting the cost of capital. The idea is very similar to what we
have explained as residual income. The objectives of the measures are
the same to effectively motivate investment SBU managers and to
properly measure their performance. In contrast to residual income,
EVA uses the firms cost of capital instead of a desired rate of return.
For many firms the desired rate of return and the cost of capital will be
nearly the same, with small differences due to adjustments for risk and
for strategic goals such as the desired growth rate for the firm. Also,
while residual income is intended to deal with the undesirable effects of
ROI, EVA is used to focus managers attention on creating value for
shareholders, by earning profits greater than the firms cost of capital.
6. Examples of financial and nonfinancial measures of performance are:
Financial: ROI, residual income, and return on sales.
Nonfinancial: Manufacturing lead time, on-time performance, number
of new product launches, and number of new patents
filed.
7. The six steps in designing an accounting-based performance measure
are:
a. Choose performance measures that align with top managements
financial goal(s).
b. Choose the time horizon of each performance measure in Step 1.
c. Choose a definition of the components in each performance measure
in Step 1.
d. Choose a measurement alternative for each performance measure in
Step 1.
e. Choose a target level of performance.
f. Choose the timing of feedback.
8. Yes. Residual income (RI) is not identical to return on investment
(ROI). ROI is a percentage with investment as the denominator of the
computation. RI is an absolute amount in which investment is used to
calculate an imputed interest charge.
9. Economic value added (EVA) is a specific type of residual income
measure that is calculated as follows:
Economic After tax Weighted Total Assets
value added = operating Average Cost x minus Current
(EVA) income of Capital Liabilities
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10. Definitions of investment used in practice when computing ROI are:

a. Total assets available.
b. Total assets employed.
c. Working capital (current assets minus current liabilities) plus other
assets.
d. Equity.
11. Present value is the asset measure based on DCF estimates. Current cost
is the cost of purchasing an asset today identical to the one currently
held if identical assets can currently be purchased; it is the cost of
purchasing the services provided by that asset if identical assets cannot
currently be purchased. Historical-cost-based measures of ROI compute
the asset base as the original purchase cost of an asset minus any
accumulated depreciation.
Some commentators argue that present value is future-oriented and
current cost is oriented to current prices, while historical cost is past-
oriented.
12. Special problems arise when evaluating the performance of divisions in
multinational companies because
a. The economic, legal, political, social, and cultural environments
differ significantly across countries.
b. Governments in some countries may impose controls and limit
selling prices of products.
c. Availability of materials and skilled labor, as well as costs of
materials, labor, and infrastructure may differ significantly across
countries.
d. Divisions operating in different countries keep score of their
performance in different currencies.
13. a. Consider each activity and the organization itself from the
customers perspective,
b. Evaluate each activity using customer-validated measures of
performance,
c. Consider all facets of activity performance that affect customers and
are comprehensive, and
d. Provide feedback to help organization members identify problems
and opportunities for improvement.
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II. Exercises
Exercise 1 (ROI and Residual Income)
Requirement 1
A quick inspection of the data shows mortgage loans with a higher ROI to be
more successful. But see requirement 2 below.
Requirement 2
Division A Division B
(Mortgage Loans) (Consumer Loans)
Total Assets P2,000 P10,000
Operating Income 400 1,500
Return on 25% 15%
Investment
Residual Income:
(a) * at 11% P180 P400
(b) ** at 15% 100 0
(c) *** at 17% 60 (200)
* P400 (P2,000 x 0.11) = P1,500 (P10,000 x 0.11) = P 400

P180
** P400 (P2,000 x 0.15) = P1,500 (P10,000 x 0.15) = P 0
P100
*** P400 (P2,000 x 0.17) = P P1,500 (P10,000 x 0.17) = P(200)
60
There is no simple answer to which is more successful in terms of residual

income. Division B is more successful at low rates, while A is more
successful at high rates. This reflects an important limitation of residual
income; larger divisions (Division B in this case) are favored when the
desired return used to determine residual income is relatively low.
Exercise 2 (Return on Investment; Comparisons of Three Companies)
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Companies in the Same Industry

A B C
Sales P1,500,000 P 750,000 P3,750,000
Income 200,000 75,000 18,750
Investment (assets) 500,000 7,500,000 2,500,000
Return on sales 13% 10% 0.5%
Asset turnover 3 0.1 1.5
Return on investment 40% 1% 0.75%
Exercise 3 (ROI, RI, ROS, Management Incentives)
Requirement 1
If Magic Industries uses return on investment to measure the Jump-Start

Divisions (JSDs) performance, Tan may be reluctant to invest in the new
plant because, as shown below, return on investment for the plant of 19.2%
is lower than JSDs current ROI of 24%.
Operating income for new plant P480,000

New investment P2,500,000
Return on investment for new plant 19.2%
Investing in the new plant would lower JSDs ROI and, hence, limit Tans
bonus.
Requirement 2
The residual income computation for the new plant is as follows:

Residual income = Income - (Imputed interest x Investment)
Investment P2,500,000
Operating income for new plant P 480,000
Charge for funds
(Investment, P2,500,000 x 15%) 375,000
Residual income P 105,000
Investing in the new plant would add P105,000 to JSDs residual income.
Consequently, if Magic Industries could be persuaded to use residual income
to measure performance, Tan would be more willing to invest in the new
plant.
18-382
Requirement 3
Operating income 480,000
Return on Sales (ROS) = = = 20%
Sales 2,400,000
If Magic Industries uses ROS to determine Tans bonus, Tan will be more
willing to invest in the new plant because ROS for the new plant of 20%
exceeds the current ROS of 19%.
The advantages of using ROS are (a) that it is simpler to calculate and (b)
that it avoids the negative short-run effects of ROI measures that may induce
Tan to not make the investment in the new plant. Tan may favor ROS
because she believes that eventually increases in ROS will increase ROI and
RI.
The main disadvantage of using ROS is that it ignores the amount of

investment needed to earn a return. For example, ROS may be high but not
high enough to justify the level of investment needed to earn the required
return on an investment.
III. Problems
Problem 1 (RI, EVA)
Requirement 1
Truck Rental Transportation
Division Division
Total assets P650,000 P950,000
Current liabilities 120,000 200,000
Investment
(Total assets current 530,000 750,000
liabilities)
Required return (12% x 63,600 90,000
Investment)
Operating income before tax 75,000 160,000
Residual income
(Operating income before tax
18-383
required return) 11,400 70,000
Requirement 2
After-tax cost of debt financing = (1 0.4) x 10% = 6%

After-tax cost of equity financing = 15%
Weighted average P900,000 x 6% + 600,000 x 15%

= = 9.6%
cost of capital P900,000 + 600,000
Required return for EVA

9.6% x Investment
(9.6% x P530,000; 9.6% x
P750,000) P50,880 P72,000
Operating income after tax

0.6 x operating income before 45,000 96,000
tax
EVA (Operating income after tax

required return) (5,880) 24,000
Requirement 3
Both the residual income and the EVA calculations indicate that the
Transportation Division is performing better than the Truck Rental Division.
The Transportation Division has a higher residual income (P70,000 versus
P11,400) and a higher EVA [P24,000 versus P(5,880)]. The negative EVA
for the Truck Rental Division indicates that, on an after-tax basis, the
division is destroying value the after-tax economic return from the Truck
Rental Divisions assets is less than the required return. If EVA continues to
be negative, Lighthouse may have to consider shutting down the Truck
Rental Division.
Problem 2 (ROI, RI, Measurement of Assets)
The method for computing profitability preferred by each manager follows:
Manager of Method Chosen
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S Residual income based on net book value

P Residual income based on gross book value
F ROI based on either gross or net book value
Supporting Calculations:
Return on Investment Calculations

Operating Income Operating Income
Division Gross Book Value Net Book Value*
S P94,700 P800,000 = 11.84% (3) P94,700 P370,000 = 25.59% (3)
P P91,700 P760,000 = 12.07% (2) P91,700 P350,000 = 26.20% (2)
F P61,400 P500,000 = 12.28% (1) P61,400 P220,000 = 27.91% (1)
Residual Income Calculations

Division Operating Income 10% Gross BV Operating Income 10% Net BV*
S P94,700 P80,000 = P14,700 (2) P94,700 P37,000 = P57,700 (1)
P P91,700 P76,000 = P15,700 (1) P91,700 P35,000 = P56,700 (2)
F P61,400 P50,000 = P11,400 (3) P61,400 P22,000 = P39,400 (3)
* Net book value is gross book value minus accumulated depreciation.
The biggest weakness of ROI is the tendency to reject projects that will
lower historical ROI even though the prospective ROI exceeds the required
ROI. RI achieves goal congruence because subunits will make investments
as long as they earn a rate in excess of the required return for investments.
The biggest weakness of residual income is it favors larger divisions in
ranking performance. The greater the amount of the investment (the size of
the division), the more likely that larger divisions will be favored assuming
that income grows proportionately.
Problem 3 (Multinational Performance Measurement, ROI, RI)
Requirement 1
(a)
Operating income Operating income
Phil. Divisions ROI in 2005 = = P8,000,000 = 15%
Total assets
Hence, operating income = 15% x P8,000,000 = P1,200,000.
18-385
(b)
9,180,000 kronas
Swedish Divisions ROI in 2005 in kronas = 60,000,000 kronas = 15.3%
Requirement 2
Convert total assets into pesos at December 31, 2004 exchange rate, the rate
prevailing when the assets were acquired (8 kronas = P1)
60,000,000 kronas
24,000,000 kronas = = P7,500,000
8 kronas per peso
Convert operating income into pesos at the average exchange rate prevailing
when during 2005 when operating income was earned equal to
9,180,000 kronas
= P1,080,000
8.5 kronas per peso
P1,080,000
Comparable ROI for Swedish Division = = 14.4%
P7,500,000
The Swedish Divisions ROI calculated in kronas is helped by the inflation

that occurs in Sweden in 2005. Inflation boosts the divisions operating
income. Since the assets are acquired at the start of the year on 1-1-2005,
the asset values are not increased by the inflation that occurs during the year.
The net effect of inflation on ROI calculated in kronas is to use an inflated
value for the numerator relative to the denominator. Adjusting for
inflationary and currency differences negates the effects of any differences
in inflation rates between the two countries on the calculation of ROI. After
these adjustments, the Phil. Division shows a higher ROI than the Swedish
Division.
Requirement 3
Phil. Divisions RI in 2005 = P1,200,000 12% x P8,000,000

= P1,200,000 P960,000 = P240,000
Swedish Divisions RI in 2005 (in Phil. pesos) is
P1,080,000 12% x P7,500,000 = P1,080,000 P900,000 = P180,000.
18-386
The Phil. Divisions RI also exceeds the Swedish Divisions RI in 2005 by

P60,000 (P240,000 P180,000).
Problem 4 (ROI Performance Measures Based on Historical Cost

and Current Cost)
Requirement 1
ROI using historical cost measures:
P130,000
Luzon Division = 38.24%
P340,000
P220,000
Visayas Division = 19.13%
P1,150,000
P380,000
Mindanao Division = 23.46%
P1,620,000
The Luzon Division appears to be considerably more efficient than the

Visayas and Mindanao Divisions.
Requirement 2
The gross book values (i.e., the original costs of the plants) under historical
cost are calculated as the useful life of each plant (12) x the annual
depreciation:
Luzon 12 x P 70,000 = P 840,000

Visayas 12 x P100,000 = P1,200,000
Mindanao 12 x P120,000 = P1,440,000
Step 1: Restate long-term assets from gross book value at historical costs to
gross book value at current cost as of the end of 2005.
Gross book value
Construction cost index in 2005
of long-term assets x
at historical cost Construction cost index in year of construction
18-387
Luzon P 840,000 x (170 100) = P1,428,000

Visayas P1,200,000 x (170 136) = P1,500,000
Mindanao P1,440,000 x (170 160) = P1,530,000
Step 2: Derive net book value of long-term assets at current cost as of the
end of 2005. (Estimated useful life of each plant is 12 years).
Gross book value
of long-term assets Estimated useful life remaining
at current cost at x
Estimated total useful life
the end of 2005
Luzon P1,428,000 x (2 12) = P 238,000
Visayas P1,500,000 x (9 12) = P1,125,000
Mindanao P1,530,000 x (11 12) = P1,402,500
Step 3: Compute current cost of total assets at the end of 2005. (Assume
current assets of each plant are expressed in 2005 pesos.)
Current assets at the end Net book value of long-term assets at
of 2005 (given) + current cost at the end of 2005 (Step 2)
Luzon P200,000 + P238,000 = P 438,000
Visayas P250,000 + P1,125,000 = P1,375,000
Mindanao P300,000 + P1,402,500 = P1,702,500
Step 4: Compute current-cost depreciation expense in 2005 pesos.
Gross book value of long-term assets at current cost at the end of 2005
(from Step 1) x (1 12)
Luzon P1,428,000 x (1 12) = P119,000

Visayas P1,500,000 x (1 12) = P125,000
Mindanao P1,530,000 x (1 12) = P127,500
Step 5: Compute 2005 operating income using 2005 current-cost

depreciation.
Historical-cost Current-cost depreciation Historical-cost

operating income in 2005 pesos (Step 4) depreciation
Luzon P130,000 (P119,000 P70,000) = P 81,000

Visayas P220,000 (P125,000 P100,000) = P195,000
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Mindanao P380,000 (P127,500 P120,000) = P372,500
Step 6: Compute ROI using current-cost estimate for long-term assets and
depreciation.
Operating income for 2005 using 2005 current cost depreciation (Step 5)
Current cost of total assets at the end of 2005 (Step 3)
Luzon P 81,000 P 438,000 = 18.49%

Visayas P195,000 P1,375,000 = 14.18%
Mindanao P372,500 P1,702,500 = 21.88%
ROI: Historical Cost ROI: Current Cost

Luzon 38.24% 18.49%
Visayas 19.13% 14.18%
Mindanao 23.46% 21.88%
Use of current cost results in the Mindanao Division appearing to be the

most efficient. The Luzon ROI is reduced substantially when the ten-year-
old plant is restated for the 70% increase in construction costs over the 1995
to 2005 period.
Requirement 3
Use of current costs increases the comparability of ROI measures across

divisions operating plants built at different construction cost price levels.
Use of current cost also will increase the willingness of managers, evaluated
on the basis of ROI, to move from divisions with assets purchased many
years ago to division with assets purchased in recent years.
16. A 11. B 21. C 31. A

17. B 12. D 22. D 32. A
18. C 13. C 23. C 33. B
19. C 14. A 24. A 34. A
20. D 15. C 25. C 35. C
21. B 16. C 26. D 36. B
22. A 17. A 27. A 37. D
23. C 18. C 28. C
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24. B 19. B 29. D

25. A 20. A 30. D
CHAPTER 25
MANAGING PRODUCTIVITY AND

MARKETING EFFECTIVENESS
I. Questions
1. Productivity is the relationship between the output and the input
resources required for generating the output.
2. A critical success factor for a firm that competes as a cost leader is to be
the low cost provider. A low cost provider needs to perform the
required tasks for the same output with fewer resources than its
competitors.
3. Among criteria that often are used in assessing productivity and their
advantages and disadvantages are:
Using a prior years productivity as the criterion
Advantages:
Data readily available
Facilitates monitoring of continuous improvements
Disadvantages:
Difficult to assess adequacy of productivity improvements
Hard to compare productivity improvements between the years
Using the best performance as the criterion

Advantages:
Provides as the benchmark the utmost performance
Motivates people to strive for the maximum potential
Disadvantages:
18-390
The standard can be too high for the operation and frustrating to
workers
Data may be difficult to obtain
The criteria on which the operation is based may not be comparable
4. An operational productivity is the ratio of the output to the number of
units of an input resource.
A financial productivity measures the relationship between the output
and the cost of one or more of the input resources.
5. A partial productivity is a productivity measure that focuses only on the
relationship between the amount of one of the input resources and the
output attained.
A total productivity measures the relationship between the output and
the total input costs of all the required input resources for the output.
6. Manufacturing personnel often prefer operational productivity measures
over financial productivity measures because all the input data for
computing operational productivity measures are either results of their
activities or resources consumed for these activities. Financial
productivity measures use costs of resources that often are results of
activities by personnel outside of manufacturing functions.
7. Measurements of marketing effectiveness include market share, sales
price, sales mix, and sales quantity variances.
8. Sales quantity variance is a component of sales volume variance. A
sales volume variance can be the result of both sales mix and sales
quantity variances.
9. A market size variance measures the effect on the contribution margin
and operating income of a firm because of changes in the total market
size for all firms in the same industry or product segment. A market
share variance examines the effect on the contribution margin and
operating income of a firm because of deviations of the firms actual
market shares from its budgeted market shares.
10. a. No. A multi-product firm can still have an unfavorable sales volume
variance even if it sells more than the budgeted units of sales. The
unfavorable sales volume variance is a result of selling more of less
profitable products and less of more profitable products.
18-391
b. A favorable sales quantity variance reflects the marketing managers

excellent performances only if there is no adverse change in selling
prices, sales mix, or market size. A favorable sales quantity variance
is hardly favorable to the firm if the firm has lowered its selling
prices or sold more of low-priced, low-margin and less of high-
priced, high-margin products. Increases in the total market size in
which the firm operates often also leads to a favorable sales quantity
variance. A favorable sales quantity variance in an expanding total
market may not be favorable to the firm strategically if the firm also
has an unfavorable market share variance.
A firm can have a favorable market size variance and an unfavorable
market share variance if the proportional increase of the firms total
sales is less than those of the total market.
c. Yes. The Wall Street Journal reported on April 14, 1994 (p. B4) that
Colgate-Palmolive had slashed marketing spending to reach its
ambitious target of 15 percent annual earnings growth. The firm, for
example, spent P88.8 million on advertising in 1993, compared with
P97.5 million in 1992. The firm met the goal of a 15 percent
increase in per share earnings and its CEO, Mr. Mark, expected the
company to announce a similar increase for first quarter earnings
soon. The market share of the firm, however, have decreased in all
categories.
11. The sales volume variance is the sum of sales quantity and sales mix
variances. The sales quantity variance is the sum of market size and
market share variances.
II. Problems
Problem 1 (Operational and Financial Partial Productivity)
Requirement 1
Star Company
Comparative Income Statement
For the years 2005 and 2006
2005 2006
Sales 15,000 x P40 P600,000 18,000 x P40 P720,000
18-392
= =
Variable cost of sales:
Materials 12,000 x P 8 P 12,600 x P10 P126,000
= 96,000 =
Labor 6,000 x P20 = 120,000 5,000 x P25 = 125,000
Power 1,000 x P 2 = 2,000 x P 2 = 4,000
2,000
Total variable costs of P218,000 P255,000
sales
Contribution margin P382,000 P465,000
Change in profits from 2005: P465,000 P382,000 = P83,000 increase

Requirement 2
Operational Partial Productivity
2006 2005
DM 18,000 / 12,600 = 15,000 / 12,000 =
1.4286 1.25
DL 18,000 / 5,000 = 3.6 15,000 / 6,000 = 2.5
Power 18,000 / 2,000 = 9 15,000 / 1,000 = 15
Requirement 3
Total cost of production factors
2006 2005
DM 12,600 x P10 = P126,000 12,000 x P 8 = P 96,000
DL 5,000 x P25 = P125,000 6,000 x P20 = P120,000
Power 2,000 x P 2 = P 4,000 1,000 x P 2 = P 2,000
Financial Partial Productivity
2006 2005
DM 18,000 / 126,000 = 15,000 / 96,000 =
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0.1429 0.15625
DL 18,000 / 125,000 = 15,000 / 120,000 =
0.144 0.125
Power 18,000 / 4,000 = 4.5 15,000 / 2,000 = 7.5
Requirement 4
Both direct materials and direct labor operation partial productivity

improved from 2005 to 2006. In 2006 the firm was able to manufacture
more output units for each unit of materials placed into production and for
each hour spent on production. The operational productivity of power in
2006 deteriorated from 2005. It is likely that the firm used more equipment
in production in 2006 that reduced consumption of materials and production
hours.
The financial partial productivity for both direct materials and power
deteriorated from 2005 to 2006. Increases in direct materials costs were
more than the improvements in operational partial productivity for direct
materials. Like the operational partial productivity, the financial partial
productivity for direct labor also improved. The extent of improvements,
however, is much lower in financial partial productivity. The direct labor
operational partial productivity improved 44 percent in 2006 over those of
2005. The financial partial productivity, however, improved only 15.2
percent between the two years. The decrease in financial partial productivity
is likely a result of increases in direct labor wages.
Requirement 5
Operating Data for Decomposing Financial Productivity Measure
2006 2006 2006 2005

Output, Output Output Output
1/2006 1/2005 1/2005 1/2005
Productivity Productivity Productivity Productivity
2006 Input 2006 Input 2005 Input 2005 Input
cost cost cost cost
18-394
(1) Output
(unit):
18,000 18,000 18,000 15,000
(2) 1/Productivity
DM: 12,000/15,0 12,000/15,0 12,000/15,0
12,600/18,0 00 00 00
00 = 0.7 = 0.8 = 0.8 = 0.8
DL: 6,000/15,00 6,000/15,00 6,000/15,00
5,000/18,00 0 0 0
0 = 0.2778 = 0.4 = 0.4 = 0.4
Power: 1,000/15,00 1,000/15,00 1,000/15,00
2,000/18,00 0 0 0
0 = 0.1111 = 0.0667 = 0.0667 = 0.0667
(3) Cost per unit of input

DM: P10 P10 P 8 P 8
DL: P25 P25 P20 P20
Power: P 2 P 2 P 2 P 2
(4) Output x (1/Productivity) x Input cost

DM: 18,000 x 0.7 x 10 18,000 x 0.8 x 10 18,000 x 0.8 x 8 15,000 x 0.8 x 8
= P126,000 = P144,000 = P115,200 = P96,000
DL: 18,000 x 0.2778 x 18,000 x 0.4 x 25 18,000 x 0.4 x 20 15,000 x 0.4 x 20
25 = P180,000 = P144,000 = P120,000
= P125,010
Power: 18,000 x 0.1111 18,000 x 0.0667 x 18,000 x 0.0667 x 2 15,000 x 0.0667 x 2
x 2 = P4,000 2 = P2,401 = P2,001
= P2,401
Total P255,010 P326,401 P261,601 P218,001
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Decompositi
on
DM: 18,000 / 18,000 / 18,000 / 15,000 /
126,000 144,000 115,200 96,000
= 0.1429 = 0.125 = 0.15625 = 0.15625
DL: 18,000 / 18,000 / 18,000 / 15,000 /
125,010 180,000 144,000 = 120,000
= 0.1440 = 0.1 0.125 = 0.125
Power: 18,000 / 18,000 / 15,000 /
18,000 / 2,401 2,401 2,001
4,000 = 7.4969 = 7.4969 = 7.4963
= 4.5
Productivity Input price Output change

change change
DM: 0.1429 0.125 0.15625 0.15625

0.125 = 0.03125 U 0.15625
= 0.0179 F =0
DL: 0.144 0.1 0.1 0.125 0.125 0.125
= 0.044 F = 0.025 U =0
Power: 4.5 7.4969 7.4969 7.4969 7.4963
7.4969 =0 = 0.0006
= 2.9969 U (rounding)
Summary of
Result
Change as % of 2005 Productivity
Productivity Input Price Total Productivity Input Price Total
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Change Change Change Change Change Change

DM: 0.0179 F 0.03125 0.01335 11.46% 20% U 8.54%
U U F U
DL: 0.044 F 0.025 U 0.019 35.2% 20% U 15.2% F
F F
Power: 2.9969 U 0 2.9969 39.98% 0 39.98%
U U U
Requirement 6
Productivity for both direct materials and direct labor improved in 2006.
The percentages of improvements in productivity are 11.46 and 35.2 for
direct materials and direct labor, respectively, of the 2005 productivity.
However, cost increases in direct materials and direct labor reduced the
gains in productivity on these two manufacturing factors
Problem 2 (Direct Labor Rate and Efficiency Variances, Productivity

Measures, and Standard Costs)
Requirement 1
Assembly Department Direct Labor Variances

2005:
Total actual direct labor hours: 25 x 20,000 = 500,000
Total standard direct labor hours: 24 x 20,000 = 480,000
P30 x 500,000 P28 x 500,000 P28 x 480,000

= P15,000,000 = P14,000,000 = P13,440,000
Rate variance Efficiency variance

= P1,000,000 U = P560,000 U
2006:
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P36 x 400,000 P35 x 400,000 P35 x 420,000

= P14,400,000 = P14,000,000 = P14,700,000

= P400,000 U = P700,000 F
Testing Department Direct Labor Variances

2005:
P20 x 240,000 P21 x 240,000 P21 x 280,000

= P4,800,000 = P5,040,000 = P5,880,000

= P240,000 F = P840,000 F
2006:
P24 x 200,000 P25 x 200,000 P25 x 220,000

= P4,800,000 = P5,000,000 = P5,500,000

= P200,000 F = P500,000 F
Recap:
Assembly Testing Department
Department
18-398
2005 2006 2005 2006

Rate P1,000,000 P400,000 P240,000 P200,000
variance U U F F
Efficiency P560,000 P700,000 P840,000 P500,000
variance U F F F
Requirement 2
Assembly Department Operational Partial Productivity
2005: 20,000 / 500,000 = 0.04

2006: 20,000 / 400,000 = 0.05
Testing Department Operational Partial Productivity
2005: 20,000 / 240,000 = 0.0833

2006: 20,000 / 200,000 = 0.1
Requirement 3
Assembly Department Financial Partial Productivity
2005: 20,000 / P15,000,000 = 0.001333

2006: 20,000 / P14,400,000 = 0.001389
Testing Department Financial Partial Productivity
2005: 20,000 / P4,800,000 = 0.004167

2006: 20,000 / P4,800,000 = 0.004167
Requirement 4
Operational partial productivity

2005 2006 Change
Assembly 0.04 0.05 0.01 F 25% F
Testing 0.0833 0.1 0.0167 20% F
F
18-399
Financial partial productivity

2005 2006 Change
Assembly 0.001333 0.001389 0.000056 4.2%
F
F
Testing 0.004167 0.004167 -0- -0-
Operational partial productivity improved in both departments from 2005 to
2006. The financial partial productivity in the Assembly also improved
while the Testing remains unchanged.
Requirement 5
The standards in a standard costing system often are determined

independently and incorporate changes in operating factors. The standard
for the operation of a year may change because of changes in, for example,
technology, quality of materials, experience of production workers, designs,
or processes.
Productivity measures use as the criterion the productivity of a prior year

without adjusting for changes occurred or the expected changes for the
current year. As a result, assessments of productivity may depict an entirely
different picture than those of variance analyses in a standard costing
system.
Problem 3 (Sales Variance)
Requirement 1
Selling price variances (in 000)

Flexible budget sales:
Master Budget for 2005 Budgeted Total Units Flexible
Total Selling Price Sold in Budget
Sales Units Per Unit 2005 Sales
Premium P36,000 240 = P150 x 180 = P27,000
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Regular P43,200 360 = P120 x 540 = P64,800

Premium Regular
Selling Selling
Flexible Price Flexible Price
Actual Budget Variance Actual Budget Variance
Barrels 180 180 540 540
Sales P28,800 P27,000 P1,800 F P62,100 P64,800 P2,700 U
Total selling price variance of the firm = P1,800 F + P2,700 U = P900 U
Requirement 2
Sales volume variances for the period for each of the products and for the
firm
Flexible budget variable expenses:

Master Budget for 2005 Budgeted Total Flexible
Total Variable Units Budget
Variable Number of Expenses Sold in Variable
Expenses Units Per Unit 2005 Expenses
Premium P21,600 240 = P90 x 180 = P16,200
Regular P27,000 360 = P75 x 540 = P40,500
Premium Regular
Sales Sales
Flexible Master Volume Flexible Master Volume
Budget Budget Variance Budget Budget Variance
Barrels 180 180 540 360
Sales P27,000 P36,000 P64,800 P43,200
Variable
expenses 16,200 21,600 40,500 27,000
Contribution
margin P10,800 P14,400 P3,600 U P24,300 P16,200 P8,100 F
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Fixed
expenses 10,000 10,000 5,000 5,000

Operating
income P 800 P 4,400 P3,600 U P19,300 P11,200 P8,100 F
Total sales volume variance of the firm = P3,600 U + P8,100 F = P4,500 F
Requirement 3
Sales quantity variances for the firm and for each of the products. (See next
page.)
Requirement 4
Sales mix variances for the period for each of the products and for the firm
(000 omitted).
Calculation for sales mixes:
Budgeted Actual
Total Sales Sales Total Sales Sales
in Units Mix in Units Mix
Premium 240 0.40 180 0.25
Regular 360 0.60 540 0.75
600 1.00 720 1.00
Flexible Budget Master Budget

Total actual units of all products Total actual units of Total budgeted units of
sold x Actual sales mix x all products sold x sales for all products x
Standard contribution margin per Budgeted sales mix Budgeted sales mix x
unit x Standard Standard contribution
contribution margin margin per unit
per unit
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Premium
720 x 0.25 x P60 = 720 x 0.40 x P60 = 600 x 0.40 x P60 = P14,400
P10,800 P17,280
Sales mix variance Sales quantity variance

= P6,480 U = P2,880 F
Sales volume variance

= P10,800 P14,400
= P3,600 U
To verify: Sales volume variance

= Sales mix variance + Sales quantity variance
= P6,480 U + P2,880 F
= P3,600 U
Regular
720 x 0.75 x P45 = 720 x 0.60 x P45 = 600 x 0.60 x P45 = P16,200
P24,300 P19,440
Sales mix variance Sales quantity variance

= P4,860 F = P3,240 F
Sales volume variance

= P24,300 P16,200
= P8,100 F
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To verify: Sales volume variance

= Sales mix variance + Sales quantity variance
= P4,860 F + P3,240 F
= P8,100 F
Total
Sales mix variance = P6,480 U + P4,860 F = P1,620 U
Sales quantity variance = P2,880 U + P3,240 F = P6,120 F
Requirement 5
Verification
Sales mix variance + Sales quantity variance = Sales

volume variance
Premium P6,480 U P2,880 F P3,600 U
Regular P4,860 F P3,240 F P8,100 F
Total P1,620 U P6,120 F P4,500 F
Requirement 6
Market size variances. (See below.)
Requirement 7
Market share variances (000 omitted. See below.)
Weighted average budgeted contribution margin per

unit
Master budget total contribution margin P30,600
Master budget total sales units 600
Weighted-average budgeted contribution margin
per unit P 51
Calculation for market shares:
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Budgeted: Total sales in units 600 Total sales

of the industry 1,500 = 0.40
Actual: Total sales in units 720 Total sales of the
industry 1,600 = 0.45
Calculation for variances:

Actual total Actual total Budgeted total
market size x market x market size x
Actual market Budgeted Budgeted market
share x market share share x Average
Average x Average budgeted
budgeted budgeted contribution margin
contribution contribution per unit
margin per margin per
unit unit
1,600 x 0.45 x 1,600 x 0.40 x 1,500 x 0.40 x P51
P51 P51
= P36,720 = P32,640 = P30,600
Market share Market size variance

variance
= P4,080 F = P2,040 F
Sales quantity variance

= P4,080 F + P2,040 F
= P6,120 F
Requirement 8
The sum of market size variance and market share variance and verification
that this total equals the sales quantity variance.
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Total market size variance+ Total market share variance Total quantity variance
=
P2,040 F P4,080 F P6,120 F
Problem 4 (Productivity and Ethics)
Requirement 1
The operational partial productivity deteriorates slightly from 0.0051 in 2005

(500/99,000) to 0.005 in 2006 (560/112,000). Manipulating accounting
numbers in order to show a desirable result is an unethical behavior
regardless the intention.
Requirement 2
Tan should not follow the order without following a consistent accounting
method. If the firm believes that certain cost items should be reclassified as
indirect costs, the same procedure should be followed for all years. Tan
should then go back and revise operating results of previous years.
Problem 5 (Small Business Market Size and Share Variances)
Requirement 1
Budget Actual
Empress Empress
Designs Industry Share Designs Industry Share
WS 50 500 10.0% 45 425 45/425
DH 25 200 12.5% 35 150 35/150
Requirement 2
Weighted Average Budgeted Contribution Margin Per Unit:

(50 welcome signs x P2) + (25 doghouses x P5.20) / 75 = P3.07
Market Share Variance

Welcome Signs: (45/425 0.1) x 425 x P3.07 = P7.68 F
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Doghouses: (35/150 25/200) x 150 x P3.07 = P49.89 F
Requirement 3
Market Size Variance

Welcome Signs: (45 500) x 50/500 x P3.07 = P23.03 U
Doghouses: (150 200) x 25/200 x P3.07 = P19.19 U
Requirement 4
Among possible reasons are quality changes, pricing changes, less producers
due to seasonal variations, and market no longer there.
Requirement 5
Among alternatives are improving costs through adopting activity based

costing, making different signs, using less expensive wood, finding
competitive advantage.
21. A 16. A 31. A

22. C 17. B 32. D
23. B 18. A 33. C
24. D 19. B 34. D
25. A 20. C
26. C 21. D
27. C 22. B
28. B 23. C
29. C 24. A
30. D 25. D
Operational partial productivity
2005 2006
Output Input Partial Output Input Partial
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Resource Productivity Resource Productivity

Used Used
X-45 60,000 75,000 = 0.8 64,000 89,600 = 0.7143
(1)
Direct
labor 60,000 10,000 = 6.0 64,000 10,847 = 5.9002
(2)
Financial partial productivity
2005 2006
Cost of Cost of
Input Input
Units of Resource Partial Units of Resource Partial
Output Used Productivity Output Used Productivity
X-45 60,000 P540,000 = 0.1111 64,000 P609,280 = 0.1050
(3)
Direct
labor 60,000 300,000 = 0.2 64,000 P347,104 = 0.1844
Total productivity in units (4)
2005 2006
(a) Total units 60,000 64,000
manufactured
(b) Total variable
manufacturing costs P840,000 P956,384
incurred
(c) Total productivity (a) 0.071429(5)0.066919
(b)
(d) Decrease in 0.071429 0.00451
productivity 0.066919 = (6)
Total productivity in sales pesos
2005 2006
(a) Total sales P1,500,000 P1,600,000
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(b) Total variable

manufacturing costs P840,000 P956,384
incurred
(c) Total productivity (a) P1.7857(5) P1.6730
(b)
(d) Decrease in P1.7857 P0.1127 (6)
productivity P1.6730 =
(7) Operational partial productivity:
Actual Production 9,500
Operational Partial Productivity = = = 1.06
Actual Input 8,950
(8) Financial partial productivity:

2005 2006
(1) Output 400,000 486,000
(2) Direct materials:
Quantity 160 180
Unit cost x P3,375 x P3,125
Total direct materials cost P540,000 P562,500
(3) DM financial partial
productivity (1) (2) 0.7407 0.864
(4) Direct labor:
Hour spent 10,000 13,500
Hourly wage x P26 x P25
Total direct labor cost P260,000 P337,500
(5) DL financial partial
productivity (1) (4) 1.5385 1.44
(9) Total productivity:

2005 2006
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(1) Output 400,000 486,000

Total cost:
Direct materials cost P540,000 P562,500
Direct labor cost 260,000 337,500
(2) Total cost P800,000 P900,000
(3) Total productivity (1) (2) 0.5 0.54
Market Share
Firm Total Market Market Share

Actual 100,000 / 2,000,000 = 5%
Budget 90,000 / 1,500,000 = 6%
1. Market size variance: (2,000,000 1,500,000) x 0.06 x P8 = P240,000 F (10)

2. Market share variance: (5% - 6%) x 2,000,000 x P8 = P160,000 U (11)
3. Sales quantity variance: (100,000 90,000) x P8 = P 80,000 F (12)
(13)
Product A Product B Total
Budgeted sales
unit 30,000 60,000 90,000
Budgeted
contribution x x
margin per unit P4.00 P10.00
Budgeted total
contribution
margin P120,000 P600,000 P720,000
Budgeted average
contribution
margin per unit P8.00
(14)
Product Product Total
A B
Actual units sold 35,000 65,000
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Budgets sales unit

30,000 60,000
Differences in sales
units 5,000 5,000
Budgeted contribution x x
margin per unit P4.00 P10.00
Sales volume
contribution margin P20,000 P50,000 P70,000
variance F F F
Sales mixes:
Budgeted Actual
Unit % Unit %
Product A 30,000 1/3 35,000 35
Product B 60,000 2/3 65,000 65
TOTAL 90,000 100 100,000 100
(15)Sales mix contribution margin variance:

Product A: (0.35 1/3) x 100,000 x P4 = P 6,667 F
Product B: (0.65 2/3) x 100,000 x P10 = 16,667 U
Total sales mix contribution margin variance P10,000 U
(16)Sales quantity contribution margin variance:

Product A: (100,000 90,000) x 1/3 x P4 = P13,333 F
Product B: (100,000 90,000) x 2/3 x P10 = 66,667 F
Total sales quantity contribution margin variance P80,000 F
(17)Weighted average budget contribution margin per unit:

P8.00 (calculated in no. 13)
Market size contribution margin variance:
(2,000,000 1,500,000) x 90,000 / 1,500,000 x P8 = P240,000 F
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(18)Market share contribution margin variance:

(100,000 / 2,000,000 90,000 / 1,500,000) x 2,000,000 x P8 =
P160,000 U
(19)Flexible budget contribution margin variance:

Flexible
Budget
Total Contribution margin Contribution
Actual Operating Result Flexible Budget Margin Variance
Product A 35,000 x P3 = 35,000 x P4 = P 35,000 U
P105,000 P140,000
Product B 65,000 x P12 = 65,000 x P10 = P130,000 F
P780,000 P650,000
TOTAL P885,000 P790,000 P 95,000 F
(20)Total contribution margin price variance (given) P50,000 F

Sales price variance:
Product A: (P12 P10) x 35,000 = P70,000 F
Product B: (P24 P25) x 65,000 = P65,000 U
Total sales price variance 5,000 F
Total variable cost price variance P45,000 F
(21)Total flexible budget contribution margin variance P95,000 F

Total contribution margin price variance (given) 50,000 F
Total variance cost efficiency variance P45,000 F
(22)Sales mix ratio:

Actual Budget
Quantity Ratio Quantity Ratio
R66 1,000 0.50 1,200 0.75
R100 1,000 0.50 400 0.25
TOTAL 2,000 1.00 1,600 1.00
R66 sales quantity variance: (2,000 1,600) x 0.75 x P10 = P3,000 F
(23)R100 sales mix variance: (0.5 0.25) x 2,000 x P70 = P35,000 F
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(24)Total sales volume variance:
R66: (1,000 1,200) x P10 = P 2,000 U

R100: (1,000 400) x P70 = 42,000 F
Total P40,000 F
CHAPTER 26
EXECUTIVE PERFORMANCE MEASURES

AND COMPENSATION
I. Questions
1. Incentive compensation is a monetary reward that is based on measured
performance. Organizations where employees have been given the
responsibility to make decisions are best suited for incentive
compensation systems.
2. The four guidelines are: fairness, participation, basic wage level, and
independent wage policy.
Fairness deals with the ratio of salaries of the highest paid to lowest paid
employees.
Participation states that all employees should be included in a
compensation plan. Although, they do not need to be included in the
same one.
Basic wage level states that a market wage should be paid, and incentive
compensation should not be used to adjust the market wage downward.
Independent wage policy states that the incentive compensation system
for the most senior levels of the organization should be set by a group
that is independent of senior management.
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3. a. based on salary easy to administer, likely to be considered fair,

and, to the extent that salary reflects the relative ability to contribute
to results, is based on contribution;
based on equal share easy to administer, likely to be considered
fair, and reflects how people often divide up rewards when left to
their own devices;
based on position same as based on salary;
based on individual performance ties reward most closely to
performance and likely to have the highest motivational impact.
b. based on salary may convince lower level employees that they
have little to contribute, does not necessarily reflect contributions;
based on equal share may have little motivational effect, may lead
to feeling of inequity if some people contribute nothing;
based on position same as based on salary;
based on individual performance may be difficult and costly to
administer, may lead to arguments about interpreting the
performance measure.
4. A cash bonus is a cash reward tied to measured performance. A cash
bonus is a bonus that is best related to activities oriented to short-run
performance that should be rewarded immediately to provide a
reinforcement effect. Cash bonuses are best tied to measures of
achieved operating performance such as quality improvement, sales
increases, and success at short-run cost control.
Profit-sharing is a cash bonus incentive compensation plan where the
total of all cash bonuses paid to all employees is determined by a
formula involving the organizations, or an organization units, reported
profit. Profit-sharing is used to focus organization members on team
activities to improve the organizations short-term performance.
Gain-sharing is a cash bonus incentive compensation plan where the
total of all cash bonuses paid to all employees is determined by a
formula involving cost performance (on materials or labor that the group
is deemed able to control) relative to some standard. Gain sharing is
best used when there is a visible and agreed performance standard and
the employees can work as a group to improve performance relative to
that standard.
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A stock option plan is a process where employees, deemed to be able to

affect the value of an organizations shares, are given the option to
purchase those shares at a specified price which is usually higher than
the share price at the time the option is issued. Stock options are best
used to focus attention of senior people, who can affect the
organizations long-run performance by their decisions, on long-run
performance.
II. Problems
Problem 1
Requirement (a)
P20,000,000 (0.18 x P60,000,000) = P9,200,000

P9,200,000 x 0.20 = P1,840,000
Therefore, P2,000,000 would be larger.
Requirement (b)
P50,000 / P12,000,000 x P2,000,000 = P8,333.33
Problem 2
Requirement (a)
P30,000,000 (0.18 x P72,000,000) = P17,040,000

P17,040,000 x 0.25 = P4,260,000
Therefore, P4,260,000 would be larger.
Requirement (b)
P40,000 / P10,000,000 x P4,260,000 = P17,040
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26. C 21. C 35. C

27. A 22. B 36. D
28. D 23. D 37. B
29. C 24. B 38. D
30. B 25. A
31. D 26. D
32. D 27. C
33. A 28. B
34. D 29. B
35. B 30. B
CHAPTER 27
MANAGING ACCOUNTING IN
A CHANGING ENVIRONMENT
I. Questions
1. The American Heritage Dictionary defines quality as 1. a characteristic
or attribute of something; property; a feature. 2. the natural or essential
character of something. 3. excellence; superiority.
Quality for a product or service can be defined as a product or service
that conforms with a design which meets or exceeds the expectations of
customers at a price they are willing to pay.
2. Procter & Gamble defines TQM as the unyielding and continually
improving effort by everyone in an organization to understand, meet, and
exceed the expectations of customers. Typical characteristics of TQM
include focusing on satisfying customers, striving for continuous
improvement, and involving the entire workforce.
TQM is a continual effort and never completes. Global competition,
new technology, and ever-changing customer expectations make TQM a
continual effort for a successful firm.
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3. The core principles of TQM include (1) focusing on satisfying the

customer, (2) striving for continuous improvement, and (3) involving the
entire work force.
4. Continuous improvement (Kaizen) in total quality management is the
belief that quality is not a destination; rather, it is a way of life and firms
need to continuously strive for better products with lower costs.
In todays global competition, where firms are forever trying to
outperform the competition and customers present ever-changing
expectations, a firm can never reach the ideal quality standard and needs
to continuously improve quality and reduce costs to remain competitive.
5. The Institute of Management Accountants (IMA) believes an effective
implementation of total quality management will take between three and
five years and involves the following tasks:
Year 1
Create a quality council and staff
Conduct executive quality training programs
Conduct quality audits
Prepare gap analysis
Develop strategic quality improvement plans
Year 2
Conduct employee communication and training programs
Establish quality teams
Create measurement systems and set goals
Year 3
Revise compensation / appraisal / recognition systems
Launch external initiatives with suppliers
Review and revise
6. Reward and recognition are the best means of reinforcing the emphasis
on TQM. Moreover, proper reward and recognition structures can be
very powerful stimuli to promote TQM. Efforts and progress will most
likely be short-lived if no change is made to the compensation / appraisal
/ recognition systems to make them in line with the objectives of the
firms TQM.
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7. The purposes of conducting a quality audit are to identify strengths and

weaknesses in quality practices and levels of a firms quality and to help
the firm identify the target areas for quality improvements.
8. A gap analysis is a type of benchmarking that includes analyzing the
differences in practices between the firm and the best-in-class. The
objective of gap analyses is to identify strengths, weaknesses, and target
areas for quality improvement.
9. Some examples of costs associated with cost of quality categories are:
Prevention costs: Training costs such as instructors fees, purchase of
training equipment, tuition for external training, training wages and
salaries; salaries for quality planning and executions, cost of preventive
equipment, printing and promotion costs for quality programs, awards
for quality.
Appraisal costs: Costs of raw materials, work-in-process, and finished
goods inspections.
Internal failure costs: Scrap, rework, loss due to downgrades,
reinspection costs, and loss due to work interruptions.
External failure costs: Sales returns and allowance due to quality
deficiency, warranty cost, and canceled sales orders due to quality
deficiency.
10. Prevention costs rise during the early years of implementing TQM as the
firm engages in education to prepare its employees and in the planning
and promotion of the quality program. Appraisal costs will also likely
rise during the early years of TQM, because the firm needs to ensure that
quality is actually being achieved. The increase in appraisal cost,
however, is most likely to occur at a slower pace than those of the
prevention costs because at the beginning of a TQM program there will
be substantial increases in quality training and in promotion to raise
awareness on the importance of quality.
The firm may see some decreases in internal and external failure costs in
the early years of implementing a TQM. However, these two costs most
likely will remain at about the same level as before during the first
several years of TQM. Many firms may actually see internal failure cost
rise, because of the higher standard demanded by the TQM or the higher
level of employees awareness on the critical importance of perfection in
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every step of the process. As the firm makes progress in TQM, both
internal failure and external failure costs should decrease.
11. Costs of conformance are costs incurred to ensure that products or
services meet quality standards and include prevention costs and
appraisal costs.
Internal and external failure costs are costs of non-conformance. They
are costs incurred or opportunity costs because of rejection of products
or services.
12. Better prevention of poor quality often reduces all other costs of quality.
With fewer problems in quality, appraisal is needed because the products
are made right the first time. Fewer defective units also reduce internal
and external failure costs as the occasion for repairs, rework, and recalls
decrease.
It is easier to design and build quality in than try to inspect or repair
quality in. Theoretically, if prevention efforts are completely successful,
there will be no need to incur appraisal costs and there will be no
internal failure or external failure costs. In practice, appraisal costs
usually do not decrease, partly because management needs to ensure that
quality is there as expected. Nonconformance costs, however, decrease
at a much faster pace than prevention costs increase.
13. The role of management accountants in total quality management
includes gathering all relevant quality information, participating actively
in all phases of the quality program, and reviewing and disseminating
quality cost reports.
14. To meet the challenges of total quality management, management
accountants need to have a clear understanding of TQM methodology.
They must be able to design, create, or modify information systems that
measure and monitor quality and evaluate progress toward total quality
as expected of each organizational unit and the total enterprise.
15. Just-in-time (JIT) purchasing is the purchase of goods or materials such
that a delivery immediately precedes demand or use. Benefits include
lower inventory holdings (reduced warehouse space required and less
money tied up in inventory) and less risk of inventory obsolescence and
spoilage.
16. The sequence of activities involved in placing a purchase order can be
facilitated by use of the Internet. A company can streamline the
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procurement process for its customers e.g., having online a complete

price list, information about expected shipment dates, and a service order
capability that is available 24 hours a day with email or fax
confirmation.
17. Just-in-time (JIT) production is a demand-pull manufacturing system
that has the following features:
Organize production in manufacturing cells,
Hire and retain workers who are multiskilled,
Aggressively pursue total quality management (TQM) to
eliminate defects,
Place emphasis on reducing both setup time and manufacturing
lead time, and
Carefully select suppliers who are capable of delivering quality
materials in a timely manner.
18. Reengineering is the fundamental rethinking and redesign of business
processes to achieve improvements in critical measures of performance
such as cost, quality, service, speed, and customer satisfaction.
19. The three main measures used in the theory of constraints are:
a. Throughput contribution equal to sales revenue minus direct
materials costs.
b. Investments (inventory) equal to the sum of materials costs of direct
materials inventory, work-in-process inventory and finished goods
inventory, research and development costs, and costs of equipment
and buildings.
c. Other operating costs equal to all operating costs (other than direct
materials) incurred to earn throughput contribution.
20. The four key steps in managing bottleneck resources are:
Step 1: Recognize that the bottleneck operation determines throughput
contribution.
Step 2: Search for, and find the bottleneck.
Step 3: Keep the bottleneck busy, and subordinate all nonbottleneck
operations to the bottleneck operation.
Step 4: Increase bottleneck efficiency and capacity.
21. (a) Product warranty costs should be lower because a world-class
manufacturer (WCM) will make fewer defectives.
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(b) Salaries of quality control inspectors should be lower because a

WCM will have its workers inspect as they go, rather than having
separate inspections. Nor will a WCM inspect incoming materials
and components because it will deal only with vendors whose
quality has been demonstrated.
(c) Amounts paid to vendors for parts and components should be higher
because a WCM will not search out the lowest prices, but will seek
high-quality components delivered when needed.
(d) Wages rates for direct laborers should be higher because a WCMs
workers will multiskilled and should therefore command premium
wages.
(e) Total supervisory salaries should be lower because a WCMs
workers will not need as much supervision.
(f) Warehousing costs should be lower because a WCM will produce as
needed and so will not require storage space for materials or finished
product.
22. At the final assembly stage in a JIT system, a signal is sent to the
preceding workstation as to the exact parts and materials that will be
needed over the next few hours for the final assembly of products. Only
those parts and materials are provided. The same signal is sent back
through each preceding workstation so that a smooth flow of parts and
materials is maintained with no buildup of inventories at any point.
Thus, all workstations respond to the pull exerted by the final
assembly stage.
The pull approach just described can be contrasted to the push
approach used in conventional systems. In a conventional system,
inventories of parts and materials are built upoften simply to keep
everyone busy. These semi-completed parts and materials are pushed
forward to the next workstation whether or not there is actually any
customer demand for the products they will become part of. The result is
large stockpiles of work in process inventories.
23. A number of benefits accrue from reduced setup time. First, reduced
setup time allows a company to produce in smaller batches, which in
turn reduces the level of inventories. Second, reduced setup time allows
a company to spend more time producing goods and less time getting
ready to produce. Third, the ability to rapidly change from making one
product to making another allows the company to respond more quickly
to customers. Finally, smaller batches make it easier to spot
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manufacturing problems before they result in a large number of defective

units.
II. Exercises
Exercise 1 (Quality Cost Classification)
Inter Exter
nal nal
Preven Apprai Failur Failur
tion sal e e
a. Warranty repairs x
b. Scrap x
c. Allowance granted
due to blemish x
d. Contribution margins
of lost sales x
e. Tuition for quality
courses x
f. Raw materials
inspections x
g. Work-in-process
inspection x
h. Shipping cost for
replacements x
i. Recalls x
j. Attorneys fee for
unsuccessful defense
of complaints about
quality x
k. Inspection of x
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reworks
l. Overtime caused by
reworking x
m. Machine
maintenance x
n. Tuning of testing
equipment x
Exercise 2 (Cost of Quality Report)
Requirements 1 & 2
Bali Company
Cost of Quality Report
For 2005 and 2006
Cost of Quality 2006 2005

Category Peso % Peso %
Prevention costs:
Quality manual P 40,000 P 50,000
Product design 300,000 P 340,000 5.67 270,000 P320,000 5.33
Appraisal costs:
Testing P 80,000 80,000 1.33 P 60,000 60,000 1.00
Internal failure costs:
Rework P200,000 P250,000
Retesting 50,000 90,000
Disposal of defective
units 90,000 340,000 5.67 85,000 425,000 7.08
External failure costs:
Product recalls P360,000 P500,000
Field service 230,000 590,000 9.83 350,000 850,000 14.17
Total cost of quality P1,350,000 22.50 P1,655,000 27.58
a. There were slight increases in both prevention and appraisal costs from
2005 to 2006. Each of these two cost of quality increased by
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approximately 0.33 percent of the total sales. These two costs increased
by P40,000 over the two years.
b. Both internal failure costs and external failure costs decreased
substantially in 2006 as compared to those in 2005. The firm
experienced a 1.41 percent decrease in internal failure and a 4.34 percent
decrease in external failure costs with the total savings of P345,000.
The savings was 863 percent of the increases in prevention and appraisal
costs.
Requirement 3
Among nonfinancial measures the firm may want to monitor are:

The number of defects or the processes yield (ratio of good output to
total output)
The percentage of defective units shipped to customers to total units
of products shipped
The number of customer complaints
Difference between delivery date requested by the customer
On-time delivery percentage (total units shipped on or before the
scheduled date to the total units shipped)
Surveys of customer satisfaction
It should be noted that nonfinancial measures by themselves often have

limited meaning. Nonfinancial measures are more informative when trends
of the same measure over time are examined.
Exercise 3 (Cost of Quality Category)
Requirement 1
Costs of Preventi Apprais Internal External

Quality on al Failure Failure
Rework P
6,000
Recalls P15,000
Reengineering P
18-424
efforts 9,000
Repair 12,000
Replacements 12,000
Retesting 5,000
Supervision P18,000
Scrap 9,000
Training 15,000
Testing of
incoming
materials 7,000
Inspection of
work in
process 18,000
Downtime 10,000
Product
liability
insurance 9,000
Quality audits 5,000
Continuous
improvemen
t 1,000
Warranty
repairs 15,000
Requirement 2
Total spent by
category P25,000 P48,000 P42,000 P51,000
Requirement 3
The company is currently spending the least on preventive costs. They

should concentrate their efforts on preventive costs because they prevent
poor quality products from being manufactured.
18-425
By increasing amount spent on prevention, they could reduce spending on

the other cost of quality categories.
Exercise 4 (Cost of Quality Analysis, Nonfinancial Quality Measures)
Requirements 1 and 2
2006 2005
Revenues P12,500,000 P10,000,000
Percenta Percenta
ge of ge of
Revenue Revenue
s (2) = s (4) =
(1) (3)
Cost P12,500 Cost P10,000
Costs of Quality (1) ,000 (3) ,000
Prevention costs
Design P240,0 P100,0
engineering 00 00
Preventive
maintenance 90,000 35,000
Training 120,00
0 45,000
Supplier
evaluation 50,000 20,000
Total
prevention 500,00 200,00
costs 0 4.0% 0 2.0%
Appraisal costs
18-426
Line inspection 110,00

85,000 0
Product-testing
equipment 50,000 50,000
Incoming
materials
inspection 40,000 20,000
Product-testing
labor 220,00
75,000 0
Total
appraisal costs 250,00 400,00
0 2.0% 0 4.0%
Internal failure
costs
Scrap 200,00 250,00
0 0
Rework 135,00 160,00
0 0
Breakdown
maintenance 40,000 90,000
Total internal
failure costs 375,00 500,00
0 3.0% 0 5.0%
External failure
costs
Returned 145,00
goods 0 60,000
Customer
support 30,000 40,000
Product liability 100,00 200,00
claims 0 0
18-427
Warranty
repair 200,00 300,00
0 0
475,00 600,00
0 3.8% 0 6.0%
Total costs of P1,600, P1,700,
quality 000 12.8% 000 17.0%
Between 2005 and 2006, Gabriels costs of quality have declined from 17%
of sales to 12.8% of sales. The analysis of individual costs of quality
categories indicates that Gabriel began allocating more resources to
prevention activities design engineering, preventive maintenance, training
and supplier evaluations in 2006 relative to 2005. As a result, appraisal
costs declined from 4% of sales to 2%, costs of internal failure fell from 5%
of sales to 3%, and external failure costs decreased from 6% of sales to
3.8%. The one concern here is that, although external failure costs have
decreased, the cost of returned goods has increased. Gabriels management
should investigate the reasons for this and initiate corrective action.
Requirement 3
Examples of nonfinancial quality measures that Gabriel Corporation could

monitor are:
a. Number of defective grinders shipped to customers as a percentage of

total units of grinders shipped.
b. Ratio of good output to total output at each production process.
c. Employee turnover.
Exercise 5 (Costs of Quality Analysis, Nonfinancial Quality Measures)
Requirements 1 and 2
Revenues, Costs of Quality and Costs of Quality as a

Percentage of Revenues for Victoria
Revenues = P2,000 x 10,000 units = P20,000,000
18-428
Percentage of
Revenues
Costs (2) = (1)
Costs of Quality (1) P20,000,000
Prevention costs
Design engineering (P75 x
6,000 hours) P 450,000 2.25%
Appraisal costs
Testing and inspection
(P40 x 1 hour x 10,000
units) 400,000 2.00%
Internal failure costs
Rework (P500 x 5% x
10,000 units) 250,000 1.25%
External failure costs
Repair (P600 x 4% x
10,000 units) 240,000 1.20%
Total costs of quality P1,340,000 6.70%
Revenues, Costs of Quality and Costs of Quality as a

Percentage of Revenues for Vancouver
Revenues = P1,500 x 5,000 units = P7,500,000
Costs of Quality Costs Percentage of
18-429
(1) Revenues
(2) = (1)
P7,500,000
Prevention costs
Design engineering (P75 x
1,000 hours) P 75,000 1.00%
Appraisal costs
Testing and inspection
(P40 x 0.5 x 5,000
units) 100,000 1.33%
Internal failure costs
Rework (P400 x 10% x
5,000 units) 200,000 2.67%
External failure costs
Repair (P450 x 8% x 5,000
units) 180,000 2.40%
Estimated forgone
contribution margin on
lost sales [(P1,500
P800) x 300] 210,000 2.80%
Total external failure
costs 390,000 5.20%
Total costs of quality P765,000 10.20%
Costs of quality as a percentage of sales are significantly different for

Vancouver (10.20%) compared with Victoria (6.70%). Canada spends very
little on prevention and appraisal activities for Vancouver, and incurs high
costs of internal and external failures. Canada follows a different strategy
with respect to Victoria, spending a greater percentage of sales on prevention
and appraisal activities. The result: fewer internal and external failure costs
and lower overall costs of quality as a percentage of sales compared with
Vancouver.
18-430
Requirement 3
Examples of nonfinancial quality measures that Canada Industries could

monitor as part of a total quality-control effort are:
a. Outgoing quality yield for each product

b. Returned refrigerator percentage for each product
c. On-time delivery
d. Employee turnover
III. Problems
Problem 1 (Quality Improvement, Relevant Cost Analysis)
Requirement 1
Cost of new equipment and installation P12,000,000

Training 3,000,000
Total additional cost of the new process P15,000,000
Requirement 2
Quality cost if no change is made:
Rework 3,000 x 40% x P2,000 = P 2,400,000

Repair 3,000 x 15% x P2,500 = 1,125,000
Appraisal 600,000
Inspection 3,000 x P50 = 150,000
Lost contribution:
Contribution margin per unit P12,000 x 85% - P2,500 = P7,700
Lost sales 3,000 0.8 3,000 = x 750 5,775,000
Total current cost of quality P10,050,000
Quality cost with the new process:
Warranty repair 3,000 0.8 x 5% x P1,000 = 187,500
Savings from the new process each year P 9,862,500
Years effective x 3
Total P29,587,500
Appraisal and inspection cost in Year 1 750,000
Total savings over 3 years P28,837,500
18-431
Requirement 3
Yes. The cost of the new process is P15,000,000 and the expected benefits is
P28,837,500 over three years. The firm can expect to earn a return of over
90%.
Requirement 4
The following factors should be considered before making the final decision:
a. Accuracy of cost estimates including

Costs of current repair and rework
Cost of repair with the new process
Cost of the new process
b. Reliability of estimations of
Rates of rework and repair
Lost sales
Amount of time before the current product become obsolete
c. Reaction of competitors
Requirement 5
The member of the board would be right if we ignore the financial payoff of
the new process and if the firm is going to be in business for only three
years. Having high quality products, especially for a high-end product such
as the one the firm is selling, is crucial for a long term success.
Problem 2 (Preparing a Cost of Quality Report)
The Adoracion Company

Comparative Costs of Quality Report
Costs Increase
Categories 2005 2006 (Decrease)
Prevention
costs:
18-432
Training P P P
75,000 100,000 25,000
Product
design 150,000 175,000 25,000
Total 225,000 275,000 50,000
prevention
Appraisal
costs:
Testing 50,000 150,000 100,000
Calibration
75,000 100,000 25,000
Total 125,000 250,000 125,000
appraisal
Internal
failure costs:
Rework 325,000 100,000 (225,000)
Retesting
250,000 200,000 (50,000)
Total 575,000 300,000 (275,000)
internal
failure
External
failure costs:
Warranty 150,000 75,000 (75,000)
repairs
Product 400,000 200,000 (200,000)
recalls
Product
liability 125,000 75,000 (50,000)
18-433
Total
external 675,000 350,000 (325,000)
failure
Total costs of P1,600,000 P1,175,000 P
quality (425,000)
Problem 3 (JIT Production, Relevant Benefits, Relevant Costs)
Requirement 1
Incremental
Costs under Incremental
Current Costs under
Production JIT Production
Relevant Items System System
Annual tooling costs P150,000
Required return on investment
12% per year x P900,000 of
average inventory per year P108,000
average inventory per year 24,000
Insurance, space, materials
handling, and setup costs 200,000 140,000a
Rework costs 350,000 280,000b
Incremental revenues from
higher selling prices (90,000)c
Total net incremental costs P658,000 P504,000
Annual difference in favor of JIT
production P154,000
a
P200,000 (1 0.30) = P140,000
b
P350,000 (1 0.20) = P280,000
c
P3 x 30,000 units = P90,000
Requirement 2
18-434
Other nonfinancial and qualitative factors that Francisco should consider in

deciding whether it should implement a JIT system include:
a. The possibility of developing and implementing a detailed system

for integrating the sequential operations of the manufacturing
process. Direct materials must arrive when needed for each
subassembly so that the production process functions smoothly.
b. The ability to design products that use standardized parts and reduce
manufacturing time.
c. The ease of obtaining reliable vendors who can deliver quality direct
materials on time with minimum lead time.
d. Willingness of suppliers to deliver smaller and more frequent orders.
e. The confidence of being able to deliver quality products on time.
Failure to do so would result in customer dissatisfaction.
f. The skill levels of workers to perform multiple tasks such as minor
repairs, maintenance, quality testing and inspection.
Problem 4 (JIT Purchasing, Relevant Benefits, Relevant Costs)
Requirement 1
Incremental
Costs under Incremental
Current Costs under
Purchasing JIT Purchasing
System Policy
Required return on investment
average inventory per year P120,000
20% per year x P0 of
inventory per year P 0
Annual insurance costs 14,000 0
Warehouse rent 60,000 (13,500)a
Overtime costs
18-435
No overtime 0
Overtime premium 40,000
Stockout costs
No stockouts 0
P6.50b contribution margin
per unit x 20,000 units 130,000
Total incremental costs P194,000 P156,500
Difference in favor of JIT
purchasing P37,500
a
P(13,500) = Warehouse rental revenues, [(75% x 12,000) x P1.50].
b
Calculation of unit contribution margin
Selling price (P10,800,000 900,000 units) P12.00
Variable costs per unit:
Variable manufacturing costs per unit
(P4,050,000 900,000 units) P4.50
Variable marketing and distribution
costs per unit
(P900,000 900,000 units) 1.00
Total variable costs per unit 5.50
Contribution margin per unit P6.50
Note that the incremental costs of P40,000 for overtime premiums to make
the additional 15,000 units are less than the contribution margin from losing
these sales equal to P97,500 (P6.50 x 15,000). Josefina would rather incur
overtime than lose 15,000 units of sales.
Problem 5 (Theory of Constraints, Throughput Contribution, Relevant

Costs)
Requirement 1
Finishing is a bottleneck operation. Hence, producing 1,000 more units will

generate additional throughput contribution and operating income.
Increase in throughput contribution (P72 P32) x 1,000 P40,000

Incremental costs of the jigs and tools 30,000
Net benefit of investing in jigs and tools P10,000
18-436
Zashi should invest in the modern jigs and tools because the benefit of
higher throughput contribution of P40,000 exceeds the cost of P30,000.
Requirement 2
The Machining Department has excess capacity and is not a bottleneck

operation. Increasing its capacity further will not increase throughput
contribution. There is, therefore, no benefit from spending P5,000 to
increase the Machining Departments capacity by 10,000 units. Zashi should
not implement the change to do setups faster.
Problem 6 (Theory of Constraints, Throughput Contribution, Relevant

Costs)
Requirement 1
Finishing is a bottleneck operation. Hence, getting an outside contractor to

produce 12,000 units will increase throughput contribution.
Increase in throughput contribution (P72 P32) x 12,000 P480,000

Incremental contracting costs P10 x 12,000 120,000
Net benefit of contracting 12,000 units of finishing P360,000
Zashi should contract with an outside contractor to do 12,000 units of

finishing at P10 per unit because the benefit of higher throughput
contribution of P480,000 exceeds the cost of P120,000. The fact that the
costs of P10 are double Zashis finishing cost of P5 per unit are irrelevant.
Requirement 2
Operating costs in the Machining Department of P640,00, or P8 per unit, are

fixed costs. Zashi will not save any of these costs by subcontracting
machining of 4,000 units to Rainee Corporation. Total costs will be greater
by P16,000 (P4 per unit x 4,000 units) under the subcontracting alternative.
Machining more filing cabinets will not increase throughput contribution,
which is constrained by the finishing capacity. Zashi should not accept
Rainees offer. The fact that Rainees costs of machining per unit are half of
what it costs Zashi in-house is irrelevant.
18-437
Problem 7 (Theory of Constraints, Throughput Contribution, Quality)
Requirement 1
Cost of defective unit at machining operation which is not a bottleneck

operation is the loss in direct materials (variable costs) of P32 per unit.
Producing 2,000 units of defectives does not result in loss of throughput
contribution. Despite the defective production, machining can produce and
transfer 80,000 units to finishing. Therefore, cost of 2,000 defective units at
the machining operation is P32 x 2,000 = P64,000.
Requirement 2
A defective unit produced at the bottleneck finishing operation costs Zashi

materials costs plus the opportunity cost of lost throughput contribution.
Bottleneck capacity not wasted in producing defective units could be used to
generate additional sales and throughput contribution. Cost of 2,000
defective units at the finishing operation is:
Lost of direct materials P32 x 2,000 P 64,000

Forgone throughput contribution (P72 P32) x 2,000 80,000
Total cost of 2,000 defective units P144,000
Alternatively, the cost of 2,000 defective units at the finishing operation can
be calculated as the lost revenue of P72 x 2,000 = P144,000. This line of
reasoning takes the position that direct materials costs of P32 x 2,000 =
P64,000 and all fixed operating costs in the machining and finishing
operations would be incurred anyway whether a defective or good unit is
produced. The cost of producing a defective unit is the revenue lost of
P144,000.
18-438
Problem 8
Requirement (a)
The following table reclassified the cost-of-quality expenses:
Anthony Foods
Quality Costs
2005-2006
(Millions)
2005 2006
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Quality assurance
administration P 6.20 P 6.52 P 6.86 P 7.19 P 7.93 P 8.74 P 9.61 P10.53
Training 13.10 14.39 15.90 17.46 21.12 25.50 30.37 36.35
Process
engineering 2.20 2.46 2.76 3.11 3.87 4.86 6.13 7.58
Prevention 21.50 23.37 25.52 27.76 32.92 39.10 46.11 54.46
Inspection 1.40 1.56 1.75 1.95 2.39 2.96 3.63 4.46
Testing 1.60 1.72 1.85 1.99 2.29 2.62 3.01 3.45
Appraisal 3.00 3.28 3.60 3.94 4.68 5.58 6.64 7.91
Rework 15.80 12.65 10.03 8.49 7.25 6.16 5.56 5.00
Scrap 17.60 14.48 11.92 10.32 8.92 7.72 7.00 6.34
Internal failure 33.40 27.13 21.95 18.81 16.17 13.88 12.56 11.34
Returns 26.90 21.09 16.35 13.53 11.32 9.50 8.43 7.52
Customer complaint
dept. 3.90 3.45 3.03 2.76 2.50 2.27 2.14 2.01
Lost sales 49.20 40.31 33.11 28.42 24.45 21.08 19.20 17.44
External failure 80.00 64.85 52.49 44.71 38.27 32.85 29.77 26.97
Total costs P137.90 P118.63 P103.56 P95.22 P92.04 P91.41 P95.08 P100.68
Requirement (b)
From the preceding data we see that prevention and appraisal costs are
increasing while internal and external failure costs have been decreasing.
The following graph plots three series: prevention and appraisal costs,
failure costs, and total quality costs.
18-439
140
120
100
80
60
40
20
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2005 Quarters 2006
Appraisal and prevention costs

Failure costs
Total quality costs
A preliminary conclusion from the graph is that Anthony Foods is probably

now spending too much on trying to improve quality. Assuming that the
underlying production processes have not changed over time, quality costs
were minimized in the second quarter of 2006. Since then, the additional
money spent on appraisal and prevention has yielded smaller internal- and
external-failure costs savings.
Problem 9 (Applying TQM in Manufacturing versus Administration)
The ability of TQM to deliver cost savings and performance enhancements

depends directly on how easy it is to measure and observe the output of the
process. If a TQM teams output is easy to measure, it is easier to hold the
team members responsible for improving quality. If quality improvements
are difficult to observe, then holding team members responsible imposes
more risk on them. It is easier for them to argue that they didnt achieve
their goals because they were hard to observe. If the benefits from TQM are
lower because it is more difficult to observe the TQM output, less will be
invested in such activities.
18-440
Measuring quality improvements in a manufactured process tends to be

easier than a service. Engineering standards can be set for a manufactured
good and conformance to the standards can be relatively easy to measure.
But the output of many administrative departments is multidimensional and
often hard to observe. Manufacturing involves repetitive processes with few
exceptions. Administrative functions often involve handling numerous
exceptions. It is likely to be easier to observe quality improvements in a
television set than it is in a human resources department or a legal
department.
31. C 26. C
32. B 27. A
33. C 28. C
34. D 29. B
35. D 30. C
36. A 31. D
37. C 32. D
38. C 33. D
39. D 34. A
40. D 35. A
18-441

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MANAGEMENT ACCOUNTING - Solutions Manual

Chapter 1 1-1 1-19

4 Financial Statements Analysis I 4-1 4-9

14 Responsibility Accounting and Transfer Pricing 14-1 14-26

23 Strategic Cost Management; Balanced Scorecard 23-1 23-4

MANAGEMENT ACCOUNTING: AN OVERVIEW

1. Use of the word need in the quoted passage is pejorative. It implies an

2. a. Historical costs are of limited use in making planning decisions in a

and prices, the historical costs are inadequate approximations of the

6. Line authority is exerted downward over subordinates. Staff authority is

7. Cost accounting is the controllers primary means of implementing the

VP, Production VP, Finance VP, Sales

Special Cost Tax Internal General System &

Cost Budget & Performance

Cost Payroll Accounts Accounts Billing General

9. Management accountants contribute to strategic decisions by providing

10. In most organizations, management accountants perform multiple roles:

12. Management accounting is an integral part of the controllers function in

13. Management accountants have ethical responsibilities that are related to

The controller of one company described the job as a business advisor

Audience: Internal: Workers, managers, executives

16. The competitive environment has changed dramatically. Companies

17. As measurements are made on operations and, especially, on individuals

measurements and systems must be accompanied with an analysis of the

a. (1) Problem solving

Problem 1 (Problem Solving, Scorekeeping, and Attention Directing)

Problem 2 (Management Accounting Information System)

Problem 3 (Role of Management Accountants)

Planning. The management accountant gains an understanding of the impact

Controlling. The management accountant ensures the integrity of financial

Evaluating Performance. The management accountant judges and analyzes

Ensuring Accountability of Resources. The management accountant

External Reporting. The management accountant prepares reports in

Problem 4 (Line Versus Staff)

Stephen Santos is a line manager. He has direct responsibility for producing

Problem 5 (Professional Ethics and End-of-Year Games)

reductions in their earnings growth rates may attract a sizable increase in

Several of the end-of-year games clearly are in conflict with these

consideration and willingly agrees to accept the assignment, the

Case 1 (Financial vs. Managerial Accounting)

Case 2 (You get what you measure!)

2. Indiscriminately increasing selling price to widen the profit margin

In all of the above situations, customer patronage could eventually be

Case 3 (The Roles of Managers and Management Accountants)

1. Managerial accounting, Financial accounting

Case 4 (Ethics in Business)

If cashiers routinely short-changed customers whenever the opportunity

Case 5 (Ethics and the Manager)

Case 6 (Preparing an Organization Chart)

Case 7 (Ethics in Business)

Manager, Manager, Manager,

(Departments) (Departments) (Departments) (Departments)

Case 8 (Ethics in Business)

Communication of confidential information to anyone outside the company

V. Multiple Choice Questions

1. D 11. D 21. B 31. D 41. A 51. B

1. Managerial accounting information often brings to the attention of

2. Non-value-added costs are the costs of activities that can be eliminated

3. Managers rely on many information systems in addition to managerial-