Managerial Accounting by linxiaoqin


                               Managerial Accounting
                                   Spring Term, 2011

Professor Richard C. Sansing
Office: Tuck 307
Phone: (603) 646-0392
FAX: (603) 646-0995
Academic Coordinator: Rick Rielly, Woodbury 304

This course provides a comprehensive, graduate level exploration of managerial
accounting. The course focuses on the use of accounting data in the management of an
organization. Naturally, what accounting data are interesting and how they might be used
depend on what the manager is seeking to accomplish and what other information is

Course Content

This course uses the concepts of opportunity cost and organizational architecture as a
framework for the study of managerial accounting. Opportunity cost is the conceptual
foundation underlying decision-making; organizational architecture is the conceptual
foundation underlying the use of accounting as part of the firm’s control system. We
examine these issues using both a textbook and case discussions.

The list of specific topics we will address is shown in the attached course syllabus. One
way to differentiate this course from the core course is to say that the core course deals
primarily with the dissemination and use of accounting information in contexts external
to the firm, whereas this course deals with contexts internal to the firm.

Course materials
The textbook for the course is Accounting for Decision Making and Control (7th edition)
by Jerry Zimmerman. There is also a course packet that contains some of the cases we
will use in this course.

Class preparation

The syllabus provides a set of readings from the textbook, assigned problems, and case
discussion questions. The assigned problems illustrate the managerial accounting
principles being covered each week; the cases illustrate how these principles are used
when addressing a management problem. I expect each student to be prepared to answer
each assigned problem and case question. Furthermore, I expect each student to be
prepared to present a solution to the class, either using the document camera (which
requires a written document) or the computer. If you want to present your solution using
an Excel spreadsheet or other document, please place it in the “Students” folder in the
course folder before the start of class. After each class, I will place in the course folder a
suggested solution to each assigned problem and a discussion of the case questions.

Class attendance

I expect you to attend every class. If you are not able to attend class on a particular day, I
expect you notify me in advance. I interpret the absence of your name card as an effort to
attract a cold call.

Honor Principle

The Tuck Honor Principle applies to every aspect of this course. Although some of the
material is new each term, much of the material carries over from year to year. To
guarantee you the full opportunity for maximum learning from the cases, the following
ground rules apply:

1. Looking at notes, handouts, problem sets, or exams from prior years all constitute
violations of the Honor Code.
2. Discussion of the weekly problem sets and cases with other students in the class is
strongly encouraged.
3. After the course is over, you will not provide any materials from the class to next
year’s students.

Laptop Policy

Use of laptops to take notes during class is permitted.


All written work will be graded and returned to you promptly. Grading will be based on
three take-home quizzes (30% each) and your class participation (10%). The quizzes are
open book and open notes. The distribution of grades will be consistent with the
guidelines in the student handbook.

Week 1 (March 24 & 25): Accounting costs: Fixed and variable costs; cost-volume-
profit analysis; product and period costs; cost estimation. Reading: Chapters 1 and 2B-2F.
Case: Murfreesboro Sour Mash (course pack).

Week 2 (March 30 & 31): Opportunity costs: Opportunity cost of materials, labor,
capacity, and capital. Reading: Chapters 2A and 3 (review), and the abstract to “The
Effects of Accounting Knowledge and Context on the Omission of Opportunity Costs in
Resource Allocation Decisions” by Sandra Vera-Muñoz. The abstract is in the course
pack. Case: Tashtego (course pack).

Week 3 (April 6 & 7): Organizational architecture: Opportunity costs and investment
decisions; cost of capital; agency costs; organizational architecture. Reading: Chapter 4.
Case: Jones Ironworks (course pack).

Quiz #1: A take-home quiz will be distributed in class on Thursday, April 7 and is due in
class on Wednesday, April 13.

Week 4 (April 13 & 14): Responsibility accounting: Divisional performance measures;
EVA®; transfer pricing. Reading: Chapter 5. Case: Celtex (Case 5-2).

Week 5 (April 20 & 21): Budgeting: Budgets and incentives for communication;
flexible budgeting; marketing variances; the controllability principle. Reading: Chapters
6 and 13C. Case: Boston Creamery (course pack).

Week 6 (April 27 & 28): Cost allocation: Reasons to allocate costs; allocating capacity
costs; allocating service department costs; joint costs. Reading: Chapters 7 and 8. Case:
Wyatt Oil (course pack).

Quiz #2: A take-home quiz will be distributed in class on Thursday, April 28 and is due
in class on Wednesday, May 4.

Week 7 (May 4 & 5): Absorption cost systems: Allocating overhead; full absorption
costing; finding the optimal product mix; incentives to overproduce. Reading: Chapters 9
and 10A. Case: Baldwin Bicycles (course pack).

Week 8 (May 11 & 12): Criticisms of absorption costing: Activity-based costing.
Reading: Chapter 11. Case: Dyna Golf (Case 11-4).

Week 9 (May 18 & 19): Standard costs and variances: Standard cost systems; direct
labor and material variances; overhead variances; cost of quality; balanced scorecard.
Reading: Chapters 12, 13A-B and 14. Case: Rust Belt Mufflers (Case 12-2).

Quiz #3: A take-home quiz will be distributed in class on Thursday, May 19 and will be
due on Wednesday, May 25.

Assignments and case questions

Thursday, March 24

1. The Phantom’s Opera Company (POC) is considering two theaters, The Paris Opera
House and the L'Opera de Bastille, in which to stage a single performance. The cost of
staging the performance, not including the cost of renting the theater, is €8,000. Tickets
sell for €60. Each theater charges the user a fixed rental fee plus a percentage of the ticket
sales. The theaters are comparable and have seating capacity of 1,200.

                           Paris Opera House L’Opera de Bastille
       Fixed rental fee         €10,000          €19,000
       Percentage of sales        25%              10%

a. Find the break-even point for a performance at each theater.

b. POC can stage the performance at The Paris Opera House, L’Opera de Bastille, or
neither. You have an estimate µ of the number of tickets you expect to sell. Find a
decision rule that depends on µ to determine which course of action that POC should
choose if it is risk-neutral.

c. Which of the two theaters would impose more risk on the POC?

2. This is a variation of Bidwell Company (P 2-6).

a. Classify the $910,000 of accounting costs incurred by Bidwell as either fixed or
variable costs and as either product or period costs. The table below may help you.

                                 Fixed costs Variable costs Total costs
                 Product costs
                 Period costs
                 Total costs      $210,000        $700,000        $910,000

b. Find the contribution margin per unit, unit manufacturing cost, gross margin per unit,
and gross profit percentage (gross margin per unit divided by price per unit).

c. Bidwell treats direct labor as a variable cost. Under what circumstances should direct
labor be considered a fixed cost?

[continued on next page]

d. Classify the following items in terms of both fixed/variable and product/period

   i.     Commissions paid to company sales representatives
   ii.    Property taxes on the firm’s manufacturing facility
   iii.   Salary of the firm’s chief financial officer
   iv.    Material costs

e. Suppose this year Bidwell purchases a new building for $15 million that is depreciated
on a straight-line basis over 30 years; 60% of the building’s floor space is associated with
manufacturing activities and 40% is associated with selling and administrative activities.
How much would Bidwell’s product costs increase this year because of this purchase?

3. Sauron Ring Makers, Inc. manufactured and sold 50,000 rings in 2010. Operating
results for 2010 are summarized below.

Sales revenue                          $15,000,000
Cost of goods sold*                     ($9,000,000)
Selling and administrative**            ($2,500,000)
Net income                               $3,500,000

* The cost of goods sold reflects $2,000,000 of direct labor, $3,000,000 of direct
materials, and $4,000,000 of manufacturing overhead.
** All fixed

a. Suppose instead that Sauron had manufactured 50,000 rings but only sold 40,000 rings
in 2010. Find Sauron’s 2010 net income.

b. Repeat part ‘a’ assuming manufacturing overhead is treated as a period cost instead of
a product cost.

4. This is a continuation of Sauron Ring Makers.

a. Determine the manufacturing overhead per ring produced.

b. Monthly manufacturing overhead for Sauron during 2010 is detailed in an Excel
spreadsheet in the course folder. Use a linear regression model to estimate Sauron’s fixed
manufacturing overhead for 2010 and variable overhead per direct labor dollar.

c. Sauron is considering making a bid to produce a special order of 100 rings. Each ring
would cost $80 in direct materials and $60 in direct labor. Each ring would sell for $400.
Assuming direct labor and direct materials are both variable costs, use your answer from
part ‘b’ to determine the variable cost of producing this special order. [Note that variable
overhead depends on direct labor dollars (an input measure), not the number of rings
produced (an output measure.)]

Friday, March 25 (Murfreesboro Sour Mash)

Wednesday, March 30

1. This is a variation of Problem 2-10 (Emrich Processing). Suppose that the GX-100 was
recorded as an asset at its purchase price of $1,000 on May 12. Half of this expenditure
was expensed when the May 15 job was completed. Assume that variable costs
(disregarding the GX-100) for the June 1 “rush job” are $1,500.

a. Consider your bidding strategy for the June 1 rush job. At what price would you be
indifferent between getting the job and not getting the job?

b. What accounting profit would the job show using the price you calculated in part ‘a’?

c. What do we learn from Vera-Muñoz (1998) regarding the distinction between
accounting costs and opportunity costs?

2. Ralph is the manager of Escher Architecture. (The character “Ralph” is famous in
academic managerial accounting circles.) Fixed overhead is $600,000. Ralph allocates
overhead based on labor hour capacity of 50,000 hours. Business is slow and Ralph has
1,000 hours of architects’ time that is not committed to billable projects. Ralph keeps
architects on the payroll (at $45 per hour, regardless what tasks they perform) when times
are slack. If no projects are available, the architects perform pro bono work for local
charitable organizations. Ralph believes that these activities generate goodwill and name
recognition for Escher Architecture that is worth $10 per hour to the firm.

A prospective client offers $P per hour for 1,000 hours for Ralph’s help in designing a
waterfall. There is a 40% probability that another 1,000 hour project will be found for
which Ralph can charge the normal rate of $110 per hour. The new project cannot be
deferred to a future period, so if Ralph accepts the waterfall project, the new project
could not be accepted.

a. What is the average accounting cost (labor plus overhead) associated with each hour of
labor capacity, assuming architects are working full time on billable projects?

b. Ralph is pondering the offer. For what value of P is Ralph indifferent between
accepting and rejecting the offer?

c. Full accounting cost minimum bid strategies are prevalent in practice. What is an
advantage of this apparently nonsensical rule to never bid below your full accounting cost
that might help firms using it survive?

[continued on next page]

3. Sudoku Manufacturing Corporation can produce widgets and/or gadgets in a highly
automated factory. Price and cost information follow.

                              Widget                        Gadget
Sales price per unit          $30.00                          P
Material cost per unit          6.00                        15.00
Direct labor cost per unit      4.00                         8.00
Machine time per unit         4 minutes                     6 minutes

Annual manufacturing overhead (MOH), all fixed, is $7,200,000 per year. Machine
capacity is 50,000 hours per year. Materials and direct labor are variable costs. Sudoku’s
current production plan is to make 300,000 widgets and 300,000 gadgets.

a. Sudoku allocates fixed MOH to products on the basis of direct labor dollars. Calculate
the full cost per unit for each product at the current production plan. In addition,
determine the contribution margin, gross margin, and gross profit percentage for the

b. What must be the selling price P of the gadget if Sudoku is to be indifferent between
making widgets and gadgets, assuming Sudoku faces no demand constraints?

4. Rearden Steel Corporation enters into a 30-year land lease for $1 million per year.
Rearden will construct a plant on the land at a cost of $90 million, producing and selling
Q tons of steel per year. Cash operating costs, all variable, are $150 per ton of steel
produced. Steel sells for $400 per ton. The plant will be depreciated on a straight-line
basis over its 30-year life and will have no salvage value. Rearden’s cost of capital is
13%. Assume that the $90 million investment occurs at the start of the year, and all other
cash flows occur at the end of each of the 30 years.

a. What is the annual steel production Q for which Rearden Steel would break-even in an
accounting sense?

b. What is the annual steel production Q for which Rearden Steel would break-even in an
economic sense?

Thursday, March 31 (Tashtego)

1. Considering only revenue and cargo costs, how much is earned by transporting one ton
of tapioca from Balik Papan to Singapore? How much is earned by transporting one ton
of general merchandise from Singapore to Balik Papan? [Hint: Note the distinction
between “a ton of freight moved” and “tonnage of burden”; the latter is a measure of a
ship’s capacity to carry standard bulk, and thus is a trip cost rather than a cargo cost.]

2. Independent of the amount and type of cargo carried, what are the incremental trip
costs of sending Tashtego on a round trip between Singapore and Balik Papan? What are
the incremental trip costs of one of the large vessels? [Hint: The discussion in the second
paragraph of the case is literally true but oddly phrased. Regardless of whether the
tapioca business is handled by the Tashtego or a large vessel, the ship will make the same
number of stops at Balik Papan as it does at Singapore. For example, the Tashtego
currently stops 50 times in Balik Papan and 50 times in Singapore each year. It is easiest
to imagine either the Tashtego or a large vessel just sailing back and forth between Balik
Papan and Singapore. This implies that the Tashtego incurs, for example, $199 in
lighthouse fees each round trip, or $9,950 during the year.]

3. Considering revenue, cargo costs, and trip costs, how much is earned by the Tashtego
if it makes 50 round trips per year between Balik Papan and Singapore? How much
would a large vessel earn if it makes 53 round trips per year?

4. Use your answer to question 3 together with the information in Exhibits 3 and 4 to
determine to effect on profit if Macedonia Shipping moves the Tashtego and uses a large
vessel on the Balik Papan-Singapore route. [Hint: Regardless of how you use the
Tashtego, Macedonia Shipping has a fleet of 27 large vessels that operate 345 days per

5. What actions should Mr. Georgopoulis take? [Hint #1: What was Macedonia Shippings
average profit contribution per shipping day in 1963? Hint #2: Determine the IRR of the
Tashtego used on the tapioca route, ignoring taxes.]

Wednesday, April 6

1. This is a variation of Rearden Steel from Wednesday, March 30. Rearden owns the
land on which it is considering building the plant. The land, which was purchased 15
years ago, has a book value of $6 million and a market value of $10 million. What is the
economic break-even point for Rearden in this setting?

2. Stark Manufacturing can invest $441,000 today in a widget-making machine that will
generate 1,000 widgets per year in perpetuity, with the first cash flow arriving in one
year. The expected future contribution margin of a widget is $30, and the discount rate is
the risk-free rate of 6%.

Stark can instead wait one year, discovering whether the future widget contribution
margin per widget will be $24 or $36, which will occur with equal probability. The
machine will cost $441,000 in one year. Should Stark make the investment today?

3. Max Bialystock and Leo Bloom own and operate a theatrical production company.
Their upcoming play will cost $7,200,000 in up-front costs to produce, plus $25,000 each
time the play is performed. Average gross revenue per performance is $50,000. The
expected number (N) of performances before the play closes depends on the quality of
the play (q) chosen by the producers, where N = 1+318q, q ≥ 0. A high quality play will
run for many years; a flop will close in one night. Bialystock and Bloom have in the past
exhibited the ability to choose plays with an average quality of one.

a. How many performances must be performed for the play to break even in accounting

To help finance of the venture, Bialystock and Bloom sell 1% of the future gross revenue
stream to an outside investor for $120,000.

b. How many performances must be performed for an outside investor to break-even in
accounting terms?

c. Suppose that B&B sell 1% of future gross revenues to 80 different investors (80% in
total) for $120,000 each. What is an outside investor’s expected accounting profit or loss
from the $120,000 investment?

4. Coase Farm grows soybeans on farmland next to property owned by Taggart
Transcontinental Railroad. Taggart can operate zero, one, or two trains per day by Coase
Farm, yielding an annual net income of zero, $9 million, or $12 million. Coase Farm can
grow soybeans on zero, one or two fields, yielding an annual net income of zero, $15
million, or $18 million less environmental damages inflicted by Taggart’s trains of $4
million per train, per field planted, per year. The annual incomes of Taggart and Coase,
respectively, as a function of the number of trains that Taggart operates and the number
of fields that Coase uses to grow soybeans, are shown below.

                            Zero fields           One field                Two fields
Zero trains                   ($0, $0)            ($0, $15)                 ($0, $18)
One train                     ($9, $0)            ($9, $11)                 ($9, $10)
Two trains                   ($12, $0)            ($12, $7)                 ($12, $2)
                           Annual income for (Taggart, Coase)

Taggart Transcontinental cannot be held liable for the damages it causes to Coase Farm.
It is prohibitively expensive for Taggart Transcontinental and Coase Farm to enter into a
contract regarding either party’s use of its land.

a. What operating decisions will Taggart and Coase make if each strives to maximize its
own profits?

b. Suppose that Taggart Transcontinental and Coase Farm merge. What operating
decisions maximize the profits of the merged firm?

c. You are the CEO of the merged firm. You are contemplating how to allocate decision
rights and measure performance after the merger. Possibilities include, but are not limited
to (i) decentralize decision rights (TT chooses how many trains to run and CF chooses
how many fields to use) and evaluate divisions on divisional income; (ii) decentralize
decision rights and evaluate on the basis of divisional income, but charge TT for the
damages it causes CF, transferring the money to CF; (iii) decentralize decision rights but
evaluate everyone on the basis of firmwide income; (iv) centralize decision rights and
evaluate divisions as cost centers. What should you do?

    Thursday, April 7 (Jones Ironworks)

    Use the facts in the Jones Ironworks case to answer the following questions.

    1. On average, how long does a worker stay at Jones Ironworks? Show that the case fact
    that 750 different employees were on the payroll in the first six months of the year is
    consistent with the 400% annual turnover rate. [Hint #1:
                          workers hired in a year
    annual turnover =                             . Hint #2: Suppose all workers stay at Jones
                            size of work force
    Ironworks for six months. You walk into the foundry on January 1 and find the average
    worker. He has worked at Jones for three months. He quits on March 31. His replacement
    starts on April 1 and quits on September 30. His replacement starts on October 1; at the
€   end of the year, this worker will have been at Jones for three months. What is Jones’
    turnover? How many different people are on the payroll during a given calendar year?]

    2. Suppose that annual fixed manufacturing costs not mentioned in the case are $3
    million per year. What is annual gross margin under the current compensation system at
    Jones Ironworks in a year in which 220,000 units are made and sold? [Hint #1: The
    phrase “labor costs” include both wages and fringe benefits. Hint #2: You can infer the
    sales revenue, and hence the price per unit, as well as material costs per unit, using the
    fact that labor costs and material costs are each equal to 24 percent of sales.]

    3. Using the facts of the case, create a profile of the workforce (consisting of workers in
    the learning stage, “Boxers,” and everyone else) and the output that each part of the
    workforce generates during the year. [Note that there is not a unique answer to this
    question; but some answers are more equal than others. Be sure that your aggregate
    output is 220,000 units per year.]

    4. What would be the effect on Jones Ironworks’ annual output, gross margin, hours per
    unit, and wages paid per hour if Freddie’s piece rate system is implemented and the new
    system reduces turnover to 80%, but there is no other behavioral response? [Assume that
    the $10 piece rate replaces wages only; expenditures of about $391,000 on fringe benefits
    are not affected by going to the piece rate system.]

    5. Freddie’s piece rate system is also used at Lincoln Electric, whose system is described
    in Chapter 4. James Lincoln’s management philosophy is described in Exhibit 1 of the
    case. Is moving to a piece rate system a good idea or a bad idea? Can the proposal be
    improved? What do you think is the most likely outcome (turnover and annual output),
    and what is the gross margin, hours per unit and wage per unit associated with that

    6. Bonus question for English majors: How many Animal Farm references can you find
    in the case and in these questions?

Wednesday, April 13

1. Bateel Farm grows and sells dates. Operating results for 2010 were:

Revenue from date sales                                     $9,000,000
Operating costs                                              (6,300,000)
Accounting income                                           $2,700,000

Bateel Farm’s only asset is land with a market value and book vaue of $15 million; the
land is not expected to change in value over time. Bateel Farm has no debt and a cost of
equity capital of 14%. Bateel Farm is evaluated as an investment center.

a. Find Bateel Farm’s ROI. Decompose the ROI into return on sales and sales turnover.
What might you learn from this decomposition?

b. Find Bateel Farm’s residual income.

c. Bateel Farm is considering increasing its assets by $5 million to $20 million by buying
an olive orchard. It expects its annual accounting income to increase from $2,700,000 to
$3,500,000 if it buys the orchard. What happens to Bateel Farm’s ROI and residual
income if it purchases the olive orchard? Is the investment a good idea? Why or why not?

2. Roat Pharmaceuticals has the following accounting income for 2010.

Revenues                             $400 million
Operating expenses                    (275 million)
R&D expenses                           (15 million)
Accounting income                    $110 million

Roat’s accounting assets in 2010 were $850 million, but its assets for EVA® purposes
were $900 million, which included $50 million of unamortized R&D expenditures.
Roat’s 2010 amortization expense of capitalized R&D for EVA® purposes was $20
million. Roat, an all-equity firm, has a cost of equity capital of 12%.

a. Find Roat’s residual income and EVA® for 2010.

b. Explain intuitively the difference between the two numbers.

3. M & M Corporation, an all-equity firm, currently generates $6 million of accounting
earnings on $50 million of assets. Its cost of equity is 12%.

a. Find M & M’s residual income and return on equity.

b. Suppose M & M had been financed with $25 million of equity and $25 million of 4%
riskless debt. Find M & M’s accounting earnings, return on equity and residual income,
assuming no taxes. Has firm value increased due to leverage?

4. Upper Valley Dyes (UVD) is a division of Three Initial Corporation (TIC). UVD is
currently operating at full capacity, producing 10,000 tons of Hunter Green dye. Capacity
cannot be expanded in the short run. UVD has the following monthly projected operating
results for December 2010.

                                                   Upper Valley Dyes
               Revenues                              $1,800,000
               Variable manufacturing costs            (500,000)
               Fixed manufacturing costs               (800,000)
               Accounting income                       $500,000
               Capacity                               10,000 tons

TIC’s Texas division, Longhorn Products, is currently buying 1,000 tons of Burnt Orange
dye from an unrelated dye company each month for $190 per ton. TIC is considering
having UVD produce and transfer to Longhorn 1,000 tons of Burnt Orange dye. The
variable manufacturing cost of Burnt Orange dye is $40 per ton. Fixed manufacturing
costs are allocated to products on the basis of tons produced. The transfer price for
divisional transfers is 125% of full accounting cost.

a. Find the gain or loss to TIC from having UVD make and transfer 1,000 tons of Burnt
Orange dye to Longhorn, compared to the alternative of having Longhorn buy Burnt
Orange dye from the unrelated dye company.

b. How is the gain or loss you computed in part a divided between Upper Valley Dyes
and Longhorn Products?

c. Suppose that the economic downturn has reduced demand for dye throughout the
industry. How would your answers to parts a and b change if UVD were currently
producing only 9,000 tons of Hunter Green dye each month and the current supplier were
offering to sell Burnt Orange dye to Longhorn Products for $130 per ton?

Thursday, April 14 (Celtex, Case 5-2)

The case takes place in 2009, during an economic downturn. All divisions are currently
operating at about 80 percent of capacity, not considering the new product being
considered by Consumer Products.

1. How much more or less accounting income would each division of Celtex earn if the
Consumer Products division obtains one gallon today of Q47 from Meas instead of

2. How much more or less accounting income would Celtex earn if the Consumer
Products division obtains one gallon today of Q47 from Meas instead of Synchem?

A second external bid to provide Consumer Products with Q47 arrives. Birch Chemical
offers to provide each gallon of Q47 for $3.10. As part of its bid, Birch Chemical
commits to buying the base raw material, Q4, from Organic Chemical for $1.05 per
gallon. Each gallon of Q47 requires one gallon of Q4.

3. How much more or less accounting income would each division of Celtex earn if the
Consumer Products division obtains one gallon today of Q47 from Birch instead of

4. How much more or less accounting income would Celtex earn if the Consumer
Products division obtains one gallon today of Q47 from Birch instead of Synchem?

Demand for Celtex’s products is volatile and sensitive to economic conditions. In 2005, a
particularly good year, each of Celtex’s five divisions produced at capacity during the
entire year. Each division has a cost of capital of 14%. Operating results for 2005 are
shown below.

                                    Organic Chemical          Synchem
          Revenues                  $15,000,000               $70,000,000
          Variable costs              10,000,000               55,000,000
          Fixed manufacturing costs    2,300,000                6,000,000
          Accounting income          $ 2,700,000              $ 9,000,000
          Capacity                  12,500,000 gallons        20,000,000 gallons
          Assets                    $15,000,000               $50,000,000

5. Back to 2009. All the bids discussed above are for 50,000 gallons of Q4 and Q47 per
month for the next 48 months. You are Debra Donak. If you do nothing, Consumer
Products will buy 50,000 gallons a month of Q47 from the source that maximizes
Consumer Products’ income. How do you respond to Paul Juris’ request that you
intervene in this dispute? If you intervene, will you change anything else at Celtex (e.g.
transfer pricing rules, performance measures, etc.?)

6. You are Don Horigan. Make a case in defense of your bid of $3.20 per gallon.

Wednesday, April 20

1. Eppen Handgun Manufacturing, Inc. is considering building a plant in New Haven,
Connecticut. The plant will generate future cash flows with a present value of $21
million. You do not know the cost of the plant; it is either $12 million, $15 million, or
$18 million, with equal probability. Rick Antle, manager of Eppen’s Northeast Division,
knows the cost. If you budget less than cost of the plant, Antle will report that the plant
costs more than the budgeted amount and will not be built. If you budget exactly the cost
of the plant, Antle will build the plant at that cost. If you budget more than the cost of the
plant, Antle will report that the cost is equal to the budgeted amount and the plant will be
built; Antle will spend any difference between the true cost and the budgeted amount on
perquisites that add no value to the company.

a. Compare the consequences to Eppen for budgets of $12 million, $15 million, and $18
million. Which do you recommend, and why?

b. What are the consequences to Antle of the three budgets considered in part ‘a’?

c. How much would Eppen spend to discover the cost of the plant?

[This problem is based on Rick Antle’s and Gary Eppen’s “Capital Rationing and
Organizational Slack in Capital Budgeting,” Management Science (Spring 1983).]

2. Tim Gunn manages an apparel design business with two divisions, managed by Paul
and John. Tim evaluates the divisional managers based on residual income. Tim’s
management philosophy is to get rid of managers that he believes are below average.

The expected residual income for each division is $0. The actual residual income of
Paul’s division is YP = P+E, where P represents the effect of Paul’s ability and E
represents the effect of economic conditions. P is normally distributed with a mean of
zero and a variance of Var(P); E is normally distributed with a mean zero and a variance
of Var(E). [Note that the word variance is being used in its statistical sense here.] The
actual residual income of John’s division is YJ = J+E, where J represents the effect of
John’s ability and E represents the effect of economic conditions. J is normally
distributed with a mean of zero and a variance of Var(J). The three sources of variance of
the performance measures, Var(P), Var(J) and Var(E), are known and independent.

During 2010, Paul generated residual income of $100,000 and John generated residual
income of $200,000. You are considering two performance measures for Paul. An
absolute divisional performance measure would be YP = $100,000. A relative
performance measure would be based on the difference between Paul’s and John’s
absolute divisional performance measures, YP−YJ = −$100,000.

[continued on next page]

a. Is YJ a controllable performance measure by Paul?

b. Both the absolute and relative performance measures have expected values of zero.
One of the performance measures (YP) suggests that Paul’s performance is $100,000
above average. The other performance measure (YP−YJ) suggests that Pau’s performance
is $100,000 below average. Tim is trying to decide whether Paul is a below-average
performer, and has asked you for your opinion.

[Based on chapter 7 of the textbook “Economics, Organization & Management” by Paul
Milgrom and John Roberts, and Rick Antle’s and Joel Demski’s “The Controllability
Principle in Responsibility Accounting,” The Accounting Review (October 1988).]

3. This is a variation of Old Rosebud Farms (P 6-27). Prepare a flexible expense budget
for Old Rosebud Farms. Reconcile the difference between expenses under the flexible
budget and actual expenses for each cost category.

4. This is a continuation of Old Rosebud Farms. Suppose that Old Rosebud has two types
of customers, private owners and the University of Kentucky. U of K horses are given a
volume discount of $8 per mare per day. Budgeted and actual revenues broken down by
customer type are shown below. The decline in the thoroughbred industry caused demand
for Old Rosebud’s services from private owners to plummet, despite the price cut from
$29 to $26 per day. However, the price cut from $21 to $18 per day induced U of K to
outsource all of its horse breeding activity to Old Rosebud. The static budget and actual
results are shown in the following two tables.

       Static budget
            Customer type      Revenue per          Number of         Revenue
                               mare per day           mares
            Private owner          $29                 30             $317,550
               U of K              $21                 30             $229,950
                Total                                  60             $547,500

           Customer type       Revenue per          Number of         Revenue
                               mare per day           mares
            Private owner          $26                 13             $123,370
               U of K              $18                 39             $256,230
                Total                                  52             $379,600

Decompose the difference between budgeted revenue and actual revenue into a sales
variance, a mix variance, and a price variance. Provide an economic interpretation of
each variance. [Hint: I find the template below to be more helpful than the approach used
in Chapter 13.]

                        Quantity x Average Price = Revenue
                   Quantity      Average Price         Revenue
                   Budget        Static Budget     Static budget (A)
                    Actual       Static Budget            (B)
                    Actual      Flexible Budget Flexible budget (C)
                    Actual          Actual        Actual income (D)

Sales variance = B−A
Mix variance = C−B
Price variance = D−C

Thursday, April 21 (Boston Creamery)

1. Decompose the difference between budgeted income at forecasted volume ($645,400)
and budgeted income at actual volume ($763,100) into a market size variance, a market
share variance, and a mix variance using the approach outlined below.

(Market size x Market share x Contribution margin)−Fixed costs = Income
  Market size      Market share      Contribution      Fixed costs         Income
   Budget             Budget             Static          Budget         Static budget
                                        Budget                               (A)
    Actual            Budget             Static          Budget              (B)
    Actual            Actual             Static          Budget              (C)
    Actual            Actual            Flexible         Budget       Flexible budget
                                        Budget                               (D)

Market size variance = B−A
Market share variance = C−B
Mix variance = D−C

Hint: The contribution margin under the flexible budget on page 3 ($0.4539) differs from
the contribution margin under the static budget on page 2 ($0.4530), even though every
standard contribution margin per gallon is the same. This occurs because the average
contribution margin reflects a weighted average of the individual contribution margins
based on sales, and budgeted sales differed from actual sales (so the weighting changed.)

2. Reconcile the budgeted income at actual volume ($763,100) and actual income
($717,100), aggregating the many separate cost variances into a handful of managerially
meaningful parts. Be prepared to present your summary to Boston Creamery’s
management committee. [Hint: Exhibit 2 refers to price variances for milk and sugar. See
chapter 12 for a discussion of material price variances in a standard cost system.]

[continued on next page]

3. Frank Roberts reconciled the $71,700 difference between actual and budgeted income
into a $129,700 favorable sales variance and a $58,000 unfavorable operations variance.
If you were John Parker, how you would reconcile the difference? Be prepared to play
the role of John Parker, who will present his reconciliation to the management

4. Indicate the corrective actions you recommend as well as the areas that deserve
commendation, based on your profit variance analysis.

5. What do you see as the main weaknesses of profit variance analysis?

Wednesday, April 27

1. Glinda Upland is the chief executive officer of Maguire Enterprises, a multinational
textile conglomerate. Glinda is evaluating the profitability of one of the company’s retail
clothing stores in Rochester. The store consists of a dress department (Nessarose’s
Dresses), a suit department (Boq’s Suits) and a casual wear department (Fiyero’s

The firm’ chief financial officer, Elphaba Thropp, has recommended that the casual wear
department be closed. The year-end financials that Glinda just received show that
Fiyero’s Casuals has been operating at a loss for the past year, while Nessarose’s Dresses
and Boq’s Suits continues to show a respectable profit. Glinda is puzzled by this fact
because she considers all three managers to be very capable.

The store site consists of a 200,000 square-foot building where Fiyero’s, Boq’s, and
Nessarose’s use 40%, 30%, and 30% of the floor space, respectively. Fixed overhead
costs consist of the annual lease payment, fire insurance, security, maintenance, and
utilities. Fixed overhead is allocated based on percentage of floor space.

                       Operating results before taxes (in thousands)
                                  Fiyero’s        Boq’s      Nessarose’s       Total
                                  Casuals          Suits       Dresses

     Sales revenue                  $600           $800         $1,000        $2,400
        Cost of goods sold          (400)          (500)         (600)        (1,500)
        Sales commissions            (50)          (100)         (150)          (300)
        Fixed overhead              (200)          (150)         (150)          (500)
     Pretax net income              $(50)           $50          $100           $100

Evaluate Elphaba’s recommendation to close Fiyero’s Casuals.

2. The dean of the Wharton School at the University of Pennsylvania is deciding whether
to use 90 watt incandescent bulbs or 25 watt compact fluorescent bulbs. The annual bulb,
electricity, and labor costs for each type of bulb for each light fixture are shown below.

                      Annual bulb        Annual electricity      Annual          Total cost
                         cost                 cost              labor cost
Incandescent            $ 8.00               $30.00               $3.00              $41.00
Fluorescent             $18.00               $10.00               $1.00              $29.00

Bulb and labor costs incurred by the Wharton School are paid by Wharton. Electricity
costs at the University of Pennsylvania are paid by the university and allocated to
departments on the basis of building square footage; the Wharton School has 10% of the
university’s building square footage.

a. How much would Wharton’s accounting costs change if it were to switch to
fluorescent bulbs?

b. Do you have any advice for the university?

This problem is based on a presentation at the Tuck School on the adoption of
technological innovation by Professor Karl Ulrich, Professor of Operations and
Information Management at Wharton.

3. Eli Consulting Group (ECG) provides management consulting services for private and
public sector clients. ECG has two service departments, secretarial and computer.
Activity levels for the year are 60,000 hours of secretarial support time and 10,000 hours
of computer support time. Current usage of secretarial and computer time by the four
departments is shown below. The average cost of secretarial support time is $19 per hour;
the average cost of computer support time is $36 per hour.

                 Allocation   Secretarial     Computer        Private    Public          Total
 Secretarial       Labor
 department        hours        12,000             6,000      16,800     25,200         60,000
 Computer          Labor
 department        hours         5,000             1,000      3,000          1,000      10,000

Note that the above table means the computer department used 6,000 hours of secretarial
support time, whereas while the secretarial department used 5,000 hours of computer
support time.

ECG’s private sector clients pay fees based on the market price for consulting time. In
contrast, ECG’s public sector clients pay fees on a 100 percent cost reimbursement basis.

The allocation of the $1,500,000 of overhead costs to private and public sector clients
using the reciprocal method, the step-down method (secretarial department first), and the
step-down method (computer department first) are shown below. Calculations are in the
course folder.
                              Private                Public                  Total

Reciprocal                   $684,000                 $816,000               $1,500,000

Step-down                    $775,875                 $724,125               $1,500,000
secretarial first
Step-down                    $656,000                 $844,000               $1,500,000
computer first

a. Explain intuitively why the cost allocated to private sector clients is so much higher
under the step-down method with the secretarial department allocated first than under the
step-down method with computer department allocated first. Explain intuitively why the
cost allocation under the reciprocal method yields an allocation of costs to clients that is
between the two step-down methods.

b. How do the cost allocations to the two types of clients change if private sector clients
use 1,600 hours of computer support time and public sector clients use 2,400 hours of
computer support time? Why?

c. Which allocation method should ECG use?

d. Under certain circumstances, the reciprocal cost allocation method can be used to
make management decisions, such as whether to outsource certain services. For example,
under certain circumstances ECG would be willing to outsource secretarial support
services as long as the cost is less than $30 per hour, and would be willing to outsource
computer support services as long as the cost is less than $60 per hour; the details are in
the course folder. Under what circumstances is it appropriate to use these figures for
management decisions?

[Part d is based on Ken Baker’s and Robert Taylor’s “Cost Allocation and External
Acquisition when Reciprocal Services Exist,” The Accounting Review (October 1979).]

4. In 2010, D’Anconia Copper extracted 1,000 tons of ore from its mines at a joint cost of
$1,200,000 ($1,000,000 fixed, variable costs vary with number of tons extracted.) When
the ore is separated, it yields 800 tons of zinc and 200 tons of copper. Copper is sold for
$4,000 per ton. Zinc is sold for $1,000 per ton. The proportion of metals extracted from
the mines is fixed and cannot be altered by D’Anconia Copper.

a. Find the break-even point for D’Anconia Copper.

b. Find the cost per ton and gross profit percentage of each metal if joint costs are
allocated on the basis of weight.

c. Find the cost per ton and gross profit percentage of each metal if joint costs are
allocated on the basis of relative sales value.

d. D’Anconia Copper is considering using its zinc and copper to produce and sell brass.
Brass consists of 50% copper and 50% zinc; excess zinc would continue to be sold for
$1,000 per ton. D’Anconia would outsource the smelting of brass to Rearden Metal at a
cost of $300 per ton, with D’Anconia providing the copper and lead. What is the smallest
price $P per ton of brass for which D’Anconia should enter the brass business?

Thursday, April 28 (Wyatt Oil)

Wednesday, May 4

1. Simpson Clock Corporation produces electronic and mechanical clocks in four plants
in and around Springfield. Its direct variable costs (material and labor) per unit are the
same in each plant; manufacturing overhead in each plant, all fixed, is $18,000,000.

               Material cost per unit Labor cost per unit Machine time per unit
    Electronic          $30                   $8              12 minutes
    Mechanical          $20                  $24              12 minutes
                      Per unit costs and machine time inputs

                     Springfield       Shelbyville            Salem            Burlington
Electronic            750,000               0                300,000            375,000
Mechanical                0              500,000             300,000            250,000
                                     Output quantities

a. Find the unit manufacturing cost (UMC) for the two types of clocks made in the
Springfield and Shelbyville plants, respectively.

b. Find the UMC for electronic and mechanical clocks made in the plants in Salem and
Burlington, assuming that manufacturing overhead is allocated on the basis of machine
time. Which plant has the lower costs per unit? Why?

c. Find the UMC for electronic and mechanical clocks made in the plants in Salem and
Burlington, assuming that manufacturing overhead is allocated on the basis of labor costs
incurred. Which plant has the lower costs per unit? Why?

d. Assume Shelbyville plant planned to and did produce 600,000 mechanical clocks, but
only sells 500,000 of them. What happens to the UMC of mechanical clocks at the
Shelbyville plant? Will Simpson’s income change? By how much?

Parts b-c of this problem were inspired by Shyam Sunder’s “Simpson’s Reversal Paradox
and Cost Allocation,” Journal of Accounting Research (Spring 1983).

2. Green Acres can grow corn, wheat, and soybeans on its 100,000 acre farm. Green
Acres has the capacity to harvest 7 million bushels of crops each year. Operating costs
(C) of Green Acres behave in the following manner:

C = $16,100,000 + $2*B, where B is the number of bushels harvested. All operating costs
are allocated on the basis of bushels harvested.

The sales prices, acreage requirements, and allocated accounting costs for the three crops
are summarized below.

                                             Corn          Wheat        Soybeans
Bushels per acre                             100             50            20
Price per bushel                            $4.00          $5.00          $6.00
Accounting cost per bushel                  $4.30          $4.30          $4.30
Number of bushels                         4,750,000      2,000,000       250,000
Income (loss)                           ($1,425,000)    $1,400,000      $425,000

a. Find the gross profit percentage (gross margin divided by price) of each crop.

b. Find the production plan that maximizes the accounting income of Green Acres. What
is the relation between your answers to parts a and b? Why? [Some helpful hints for parts
b: Set up your constraints in the form “amount used” ≤ “amount available,” not “amount
unused” ≥ 0. On the “Engine” tab, choose “Standard LP/Quadratic Engine”, “Assume
Non-Negative”, and do not check the “Automatically Select Engine” box.]

After optimizing the model, obtain a sensitivity report by going to Reports 
Optimization  Sensitivity. It should look like this.

 Objective Cell (Max)
     Cell                  Name                 Final Value
    $B$18      Objectives Accounting Income
 Decision Variable Cells
                                               Final     Reduced     Objective     Allowable   Allowable
     Cell                  Name                Value          Cost   Coefficient   Increase    Decrease
    $C$5       Number of bushels Corn
    $D$5       Number of bushels Wheat
    $E$5       Number of bushels Soybeans

                                               Final        Shadow   Constraint    Allowable   Allowable
     Cell                  Name                Value         Price   R.H. Side     Increase    Decrease
    $F$14      Acres planted Used
    $F$15      Bushels harvested Used

c. Suppose the price per bushel of corn rose to $5.00. How would your production plan
change? Why?

3. This is a continuation of problem #2 above, using the original facts of the problem
(i.e., the price of corn is $4 per bushel). Using whatever methods you prefer (e.g., the
methods you used in Dec Sci), answer the three questions below. I will show how to use
the sensitivity report above to answer these questions in class.

a. Green Acres can lease an additional 1,000 acres of farmland. How much would they
pay to do so?

b. Consider the crop or crops that you chose not to produce. At what price would you be
willing to add each of these crops to your product mix?

c. Green Acres is considering adding flax to its product mix. Devoting one acre of land to
flax production would yield 40 bushels of flax. What is the minimum price for flax for
which Green Acres should consider growing flax?

4. Empco, Inc. is a sheet metal manufacturer with three departments: Cutting, Grinding,
and Drilling. Manufacturing overhead (primarily depreciation), all fixed, is aggregated at
the plant level and allocated among the three departments on the basis of each
department’s share of direct labor using a single plantwide rate. When Empco’s overhead
allocation system was first implemented in 1948, Empco’s manufacturing overhead rate
was 80%. Today, it is 400%, as shown below. Direct labor costs, allocated overhead, and
machine hours for each department are summarized below.

                             Cutting    Grinding    Drilling     Total
    Direct labor           $ 3,000,000 $2,000,000 $1,000,000 $6,000,000
    Overhead               $12,000,000 $8,000,000 $4,000,000 $24,000,000
    Total conversion costs $15,000,000 $10,000,000 $5,000,000 $30,000,000

The Grinding department is considering replacing half of its direct labor employees with
industrial robots. The robots will cost $8,000,000 and last for 10 years, depreciated on a
straight-line basis. Replacing employees with robots with reduce the Grinding
department’s direct labor costs by $1,000,000 per year while increasing overhead for the
plant by $800,000 per year.

a. What would be the effect of this investment on Empco’s manufacturing overhead rate?

b. What would be the effect of this investment on each department’s annual total
conversion costs (direct labor plus allocated overhead)?

c. Is replacing half of the Grinding department’s employees with industrial robots a good
investment for Empco, assuming that its cost of capital is 10%?

Thursday, May 5 (Baldwin Bicycles)

1. Suppose Baldwin accepts the offer to make the Challenger, and makes 25,000
Challenger bikes in the first year. Estimate the change in Baldwin’s pretax income if it
makes and sells one additional Challenger bike, ignoring any interactions with Baldwin’s
existing product lines.

2. The Challenger deal can interact with Baldwin’s existing product lines in at least two
ways. First, Suzanne Leister estimates that Baldwin will lose sales of about 3,000 bikes
due to competition from the Challenger. Second, Leister thinks it is possible that a few of
Baldwin’s current dealers might stop carrying Baldwin products if Baldwin starts making
bikes for Hi-Valu. Estimate the change in Baldwin’s pretax income if it makes and sells
one fewer of its own bikes.

3. Use your answers to questions #1 and #2 above to estimate the change in Baldwin’s
pretax income in a year in which it makes and sells 25K Challenger bikes, losing no sales
from its existing product line. How many of sales from your existing product line would
you lose for the Challenger deal to be a break-even proposition?

4. Suppose no sales of Baldwin bikes are lost if Baldwin makes the Challenger. Estimate
the effect of the Challenger deal on Baldwin’s pretax income if demand for bicycles is
20% higher than anticipated (e.g., 120K Baldwin bikes and 30K Challenger bikes),
assuming Baldwin stays at one shift and is committed under its contract to meet Hi-
Valu’s demand for bikes. Estimate the effect of the Challenger deal on Baldwin’s pretax
income if demand for bicycles is 20% lower than anticipated (e.g., 80K Baldwin bikes
and 20K Challenger bikes).

5. How would you describe Baldwin’s financial situation at the end of 1982? Assume that
the $2,354,000 of Selling and Administrative expenses includes interest expense of

6. Do you recommend accepting the Challenger deal?

Wednesday, May 11

1. This is a variation of Sauron Ring Makers (problem #4 from Thursday, March 24).
Monthly manufacturing overhead for Sauron during 2010 is detailed in the Excel
spreadsheet in the course folder. Use the data to estimate Sauron’s annual fixed costs and
to determine how variable overhead behaves. If the new type of ring is produced in
batches of 100, what is the estimated variable cost of a batch of 100 rings? How do these
answers compare to your answers from the original problem?

2. Brickley Chains produces five styles of silver chains in a highly automated batch
machining process. Inputs and product characteristics are summarized in the table below.
In addition to direct labor and direct material costs, Brickey incur $80,000 of fixed
manufacturing overhead. Assume that $35,000 of the overhead is associated with batch
costs, $21,000 of the overhead is associated with material handling costs, and the
remaining $24,000 is associated with engineering costs. Batch costs are allocated in
accordance with the number of batches run; material handling costs are allocated to the
number of total number of parts used (see table below); and engineering costs vary with
the number of products (not the number of units) that Brickley produces. Derive the cost
of each unit under (a) direct labor costing and (b) activity based costing. Explain why the
product costs differ under the two methods, focusing particularly on the difference
between chains A and E.

                                          A        B       C     D     E
             Direct labor per unit      $1.50    $2.10   $2.50 $2.75 $3.00
             Direct material per unit   $4.00    $4.50   $5.00 $6.00 $7.00
             Parts per unit               1        2        3     5     6
             Production volume          5,000    3,000   1,000 800    500
             Total parts used           5,000    6,000   3,000 4,000 3,000
             Batch size                  100      100      50    40    25

3. Stokke Golf (course pack)

Thursday, May 12 (Dyna Golf, Case 11-3)

1. Verify the full absorption product costs of $105.70 for drivers, $87.16 for wedges, and
$52.85 for putters when overhead is allocated using run labor. Find the gross margin for
each product assuming next year’s prices are the same as this year’s prices of $162.61 for
drivers, $125.96 for wedges and $105.70 for putters.

2. Next, use the information in the table below to compute the gross margin per unit using
activity based costing. Be prepared to provide an intuitive explanation for the differences
in product costs between the two methods.

                                    Dyna Golf Overhead
Cost category          Cost              Cost driver                     Quantity
Receiving              $ 224,000         Material dollars                   $700,000
Receiving              $ 76,000          Number of components                190,000
Engineering            $ 500,000         Change order percentages             100%
Machining              $ 700,000         Machine time                      10,000 hours
Packing                $ 96,000          Units shipped                        30,000
Packing                $ 104,000         Number of shipments                    26
Setup                  $    3,000        Setup hours                           150
Total                  $1,703,000

Dyna Golf is now planning its operations for the upcoming year. Material costs are
variable; variable machining costs are $12 per hour; fixed machining costs are $580,000.
All other costs are fixed due to Dyna Golf’s “no layoff” policy. Machine and labor
capacities, prior year uses, and average costs per unit of capacity are summarized in the
table below.

        Resource        Activity measure Capacity       Prior year       Wage rates
                                                      resource usage
     Skilled labor*         Hours           11,400        11,400        $20 per hour
     Engineering            Hours           20,000        20,000        $25 per hour
     Machine                Hours           11,000        10,000            N/A
     Unskilled labor        Hours           62,500        60,000         $8 per hour
   *Setup labor plus run labor

The uses of each type of resource by product are summarized below

                                          Driver Wedge Putter           Total
                Skilled run labor hours    5,000 5,000 1,250           11,250
                Skilled setup labor hours    10    30    110              150
                Engineering hours          5,000 7,000 8,000           20,000
                Machine hours              2,500 5,000 2,500           10,000
                Unskilled labor hours     10,000 30,000 20,000         60,000

3. Drivers are sold to a single distributor under an exclusive long-term arrangement, so
the demand for drivers is limited to 10,000 units at $162.61 per unit. Dyna Golf does not
face a demand constraint on wedges or putters. Find the preferred production plan for
Dyna Golf, assuming that Dyna Golf keeps the same number of production runs for each
club unchanged, changing only the number of units produced per run. Obtain the
sensitivity report. Note carefully the shadow prices on the four capacity constraints and
the demand constraint.

4. The distributor of the Dyna Golf Driver is interested in increasing its order by 10%
from 10,000 to 11,000 if Dyna Golf is willing to reduce the price by $2 per unit (on all
the units, not just the extra 1,000). Do you accept? If not, what is the lowest price per unit
for which you willing to increase driver production by 1,000? What are the implications
for the rest of the product mix? Why?

5. Suppose driver demand stays at 10,000 units. Skilled labor, engineering labor, and
unskilled labor capacity will decrease by 4% over the coming year via attrition unless
workers are replaced when they leave. Which workers do you replace, and which do you
not replace? What are the implications of your decision for your preferred production
plan? Why?

6. How did Dyna Golf set its target prices for putters and wedges last year? What
improvements could be made?

7. The setup times for each production run looks high. How much would Dyna Golf save
if it reduced its setup times by half?

8. What other improvements could be made in Dyna Golf’s manufacturing operations?

Wednesday, May 18

1. This problem is a prequel to Jones Ironworks from Thursday, April 7. At Jones
Ironworks in 1972, experienced workers make $4.25 per hour and inexperienced workers
make $3.75 per hour. About half of the workforce is expected to be in each group during
the year, yielding a standard wage of $4.00 per hour. The standard hours per unit is two

In 1972, Jones Ironworks made 220,000 units, using 506,000 labor hours and paying
wages of $1,948,100.

a. Find the wage rate and labor efficiency variances at Jones Ironworks in 1972.

b. Why do you think the two material and two labor variances have opposite signs? More
generally, what is happening at Jones Ironworks that is causing these variances?

2. Diego Cigars (course pack)

3. Galt Electric Motors builds motors in a fully automated plant. The standard materials
cost for a motor is $1,000. Galt plans to build 10,000 motors during December; budgeted
overhead for the month is $7 million. Galt started the month with zero material inventory,
finished goods inventory, or work in process. Galt bought $10 million of materials during
the month at the standard cost, using $9.8 million of material in the production of 9,800
motors. Galt sold 9,700 motors during the month. Actual overhead incurred during
December was $6.8 million. All cost variances are assigned to cost of goods sold.

a. What is the standard cost of a motor?

b. Of the $16,800,000 expenditures incurred by Galt during December, show how it is
divided among the following categories.

i. Standard cost of goods sold.
ii. Finished goods inventory
iii. Materials inventory
iv. Cost variances; be sure to indicate whether the net cost variance is favorable or

4. This is a continuation of Galt Electric Motors. Galt’s manufacturing overhead, MOH,
behaves in the following fashion:

MOH = f + v*MH, f is the fixed overhead and v is the variable overhead per machine
hour (MH).

Standard machine hours is 12 minutes per unit. Actual machine hours were 1,980 hours.

a. Characterize the spending, efficiency and volume variances as favorable, unfavorable,
zero, or indeterminate based on the facts provided assuming that some overhead is fixed
and some is variable (f > 0 and v > 0).

b. Calculate the variances in the special case in which all overhead is fixed (v = 0).

c. Calculate the variances in the special case in which all overhead is variable (f = 0).

Thursday, May 19 (Rust Belt Mufflers, Case 12-2)

1. Determine a static cost budget for each shop based on expected installations and a
flexible cost budget for each shop based on actual installations. Explain the difference
between the costs under the static and flexible budgets.

2. Explain the difference between costs under the flexible budget and actual costs
using variance analysis. Assume that the standard and actual materials input quantity per
installation is the same (i.e. one set of mufflers and pipes per installation.) This implies
that the only material variance will be a price variance.

3. Consider a hypothetical shop that has zero cost variances and faces a capacity
constraint 1/6 of the time, so one time out of six replacing a muffler causes you to lose a
potential customer. A replacement and a new installation cost the same; the only
difference is that the $121 revenue per installation is not collected for a replacement.
What is the expected cost of replacing a muffler at this shop?

4. Suppose at this hypothetical shop, the probability of a defect requiring a muffler
replacement is 1% each year that the car is still on the road (a constant defect rate model).
Suppose the survival rate for a car is 90%, so there is a 90% chance that the car is still on
the road in year 2, an 81% chance that the car is still on the road in year 3, etc. If the
discount rate is 10%, estimate the expected present value of all future defect costs
associated with a single installation at this shop.

5. The State, Dewey, and Mt. Hope shops replaced 500, 100, and 8 mufflers, respectively,
that had been installed that at that shop during the year. All replacements mentioned in
the case involved installations originally made during that same year; replacements of
prior year installations (before the standard costing system was implemented) are not
included in these numbers. This implies an annual defect rate of about 6.9%, 0.9%, and
0.14% at the three shops. [Note: If installations occur uniformly throughout the year, on
average each muffler installed during the year has only been on the car for six months.]
Use actual costs and actual defect rates for these shops in conjunction with the approach
you used in answering questions 3 and 4 above to evaluate the performance of the three

6. What other costs of defective installations might affect your evaluation of the three

7. Is the standard costing system effectively meeting its objectives? What improvements
should be made?


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