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Winter 06 Lecture 2 relevant cost analysis updated

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Winter 06 Lecture 2 relevant cost analysis updated Powered By Docstoc
					            January 12
• Review Solutions to the Entrance Exam

• Relevant Cost Concepts and Terminology

• The Jennie Mae Frog Farm

• Break

• Relevant Cost Exercise
            January 12
• Review Solutions to the Entrance Exam

• Relevant Cost Concepts and Terminology

• The Jennie Mae Frog Farm

• Break

• Relevant Cost Exercise
   Entrance Exam Question #1
The owner of a barber shop pays each hair stylist in
the shop $10 for each customer. The owner is not
currently seeing customers himself. Out of the $10,
each stylist must pay for all disposable supplies such
as hair gel, hair spray, and shaving cream. When the
annual costs of the lease on the building, insurance,
depreciation, advertising, etc. are averaged over all
customers, these costs average $3 per customer.
Hence, at the current level of customer traffic, the
total cost to the owner per customer is $13. If the
owner can increase demand by 50%, using the same
equipment and facilities as before, what will be the
new average cost per customer (i.e., per haircut)?
    Entrance Exam Question #1
The $3 per customer represents the allocation of a large
lump sum averaged over all customers. Let that lump
sum equal X, and the number of customers equal Y.
     X÷Y=3
When the number of customers increases by 50%, the
lump-sum X does not change. Therefore, we need to
know the answer to:
     X ÷ 1.5Y
Since we know from above that X = 3Y, we get
     3Y ÷ 1.5Y = 2
The $10 per customer does not change, so the total cost
would now be $10 + $2 = $12.
     Entrance Exam Question #2
Nate sells beer at the State Fair for $3 per glass. Nate’s
cost for the beer is $1.20 per glass. He pays $280 per
day to rent the booth and equipment. How many beers
will Nate have to sell to generate profits of $80 per
day?
     Entrance Exam Question #2
Nate sells beer at the State Fair for $3 per glass. Nate’s
cost for the beer is $1.20 per glass. He pays $280 per
day to rent the booth and equipment. How many beers
will Nate have to sell to generate profits of $80 per
day?


Nate makes a profit (contribution margin) of $1.80
per glass ($3.00  $1.20)
He needs to generate $360 to cover his fixed costs and
his desired profit ($280 + $80).
Therefore, he must sell $360 ÷ $1.80 = 200 glasses.
    Entrance Exam Question #3
Kaypro has ten desktop computers that cost $410
each to make. The computers are obsolete, and can
only be sold for $100 each. They can be turned into
pre-school toys at a cost of $50 per computer, and
sold for $140 each. Alternatively, they can be donated
to a museum, resulting in a charitable tax contribution
worth $90 per computer (i.e., a reduction in the
company’s income tax expense and liability of $90 per
computer). What should Kaypro do?
    Entrance Exam Question #3
Kaypro has ten desktop computers that cost $410 each
to make. The computers are obsolete, and can only be
sold for $100 each. They can be turned into pre-school
toys at a cost of $50 per computer, and sold for $140
each. Alternatively, they can be donated to a museum,
resulting in a charitable tax contribution worth $90 per
computer (i.e., a reduction in the company’s income tax
expense and liability of $90 per computer). What should
Kaypro do?
The cost of $410 is a sunk cost, and is irrelevant. The
future net cash flow from selling the computers is $100
per computer. This exceeds the net cash flow of $90
($140  $50) from selling them as pre-school toys or
the net cash flow of $90 from the charitable donation.
   Entrance Exam Question #4
Due to a kitchen fire, the Albuquerque Baking
Company has only one working oven for the next
several weeks. The company makes pies and cookies.
The oven can hold four pies or two dozen cookies.
The pies require 60 minutes to bake. The cookies
require 12 minutes to bake. Since the pies and
cookies bake at different temperatures, they cannot be
baked at the same time. Pies sell for $9 each. A
dozen cookies sell for $5. The ingredients to make
each pie cost $3. The ingredients to make a dozen
cookies cost $2. Should the Albuquerque Baking
Company use its one functional oven to make cookies,
pies, or some combination? Why?
   Entrance Exam Question #4
In one hour, making only pies, profits are:
      4 pies x ($9 sales price  $3 cost) = $24


In one hour, making only cookies, profits are:
      2 dozen per batch x 5 batches per hour
      x ($5 sales price  $2 cost) = $30


Therefore, make cookies.
  Entrance Exam Question #5
Explain the difference between revenue and income
on an income statement prepared in accordance
with Generally Accepted Accounting Principles. Also,
explain the difference between operating income
and net income.
    Entrance Exam Question #5
Explain the difference between revenue and income on
an income statement prepared in accordance with
Generally Accepted Accounting Principles. Also, explain
the difference between operating income and net
income.
Revenue represents sales. It does not consider the costs
associated with generating those sales. Revenue is
usually the first line on an income statement.
Income is sales minus costs. Operating income is sales
minus the costs associated with the company’s recurring
operations. Net income is operating income minus other
costs, such as income tax expense and restructuring
charges.
   Entrance Exam Question #6
Cat Company has sales of $50,000 in March,
$60,000 in April, $70,000 in May, and $65,000
in June. 50% of sales are cash sales, for which Cat
receives the cash at the time the customer makes
the purchase. The other 50% are credit sales, for
which Cat receives the cash in the month following
the purchase. Calculate the balance in Accounts
Receivable on May 31.
   Entrance Exam Question #6
Cat Company has sales of $50,000 in March,
$60,000 in April, $70,000 in May, and $65,000
in June. 50% of sales are cash sales, for which Cat
receives the cash at the time the customer makes
the purchase. The other 50% are credit sales, for
which Cat receives the cash in the month following
the purchase. Calculate the balance in Accounts
Receivable on May 31.


$70,000 x 50% = $35,000
     Entrance Exam Question #7
  Following is information about the Concord
  Merchandising Company:

                                   2004    2005
Beginning inventory                    0     100
Units purchased                      900     900
Units sold                           800     800
Ending inventory                     100     200
Sales price per unit                 $30     $30
Per-unit cost of units purchased     $15     $20



 Calculate Cost of Goods Sold for 2005, using LIFO
 (last-in, first-out). What is the cost of ending
 inventory at the end of 2005 under LIFO?
      Entrance Exam Question #7
                                      2004        2005
 Beginning inventory                         0        100
 Units purchased                           900        900
 Units sold                                800        800
 Ending inventory                          100        200
 Sales price per unit                      $30        $30
 Per-unit cost of units purchased          $15        $20

Calculate Cost of Goods Sold for 2005, using LIFO (last-in, first-out).
What is the cost of ending inventory at the end of 2005 under LIFO?
COGS: $20 per unit x 800 units sold = $16,000
Ending inventory:
(100 units x $15 per unit) + (100 units x $20 per unit) = $3,500
     Entrance Exam Question #8
  Following is information about the Concord
  Merchandising Company:

                                   2004    2005
Beginning inventory                    0     100
Units purchased                      900     900
Units sold                           800     800
Ending inventory                     100     200
Sales price per unit                 $30     $30
Per-unit cost of units purchased     $15     $20



 Calculate Cost of Goods Sold for 2005, using FIFO
 (first-in, first-out). What is the cost of ending
 inventory at the end of 2005 under FIFO?
       Entrance Exam Question #8
                                       2004        2005
 Beginning inventory                          0        100
 Units purchased                            900        900
 Units sold                                 800        800
 Ending inventory                           100        200
 Sales price per unit                       $30        $30
 Per-unit cost of units purchased           $15        $20


Calculate Cost of Goods Sold for 2005, using FIFO (first-in, first-out).
What is the cost of ending inventory at the end of 2005 under FIFO?

COGS:
($15 per unit x 100 units) + ($20 per unit x 700 units) = $15,500

Ending inventory: 200 units x $20 per unit = $4,000
    Entrance Exam Question #9
A machine is purchased for $50,000. The machine has
an estimated life of five years. The machine is
anticipated to have a salvage value of $10,000 at the
end of its useful life. If the machine is depreciated
using the straight-line method, and if the salvage
value reduces the total amount of depreciation
expense, what will be the depreciation expense
recorded on the income statement in year 4, and what
will be the net balance in the balance sheet account
(historical cost less accumulated depreciation) at the
end of year 4?
   Entrance Exam Question #9
Annual depreciation expense:
($50,000  $10,000) ÷ 5 years = $8,000 per year.


Net balance on the Balance Sheet at the end of
Year 4:
Four years’ worth of depreciation expense will have
been charged to the accumulated depreciation
account. Hence:
$50,000  ($8,000 x 4) = $18,000
  Entrance Exam Question #10
Precisely what is the matching principle, as
that term is used in accounting? Explain why
it is a principle of financial accounting.
   Entrance Exam Question #10
Precisely what is the matching principle, as that
term is used in accounting? Explain why it is a
principle of financial accounting.


Match against revenue the expenses incurred to
generate those revenues.
The matching principle attempts to provide a
measure of profitability in each period.
However, the matching principle is not followed
for all expenses.
            January 12
• Review Solutions to the Entrance Exam

• Relevant Cost Concepts and Terminology

• The Jennie Mae Frog Farm

• Break

• Relevant Cost Exercise
       Terminology
Sunk Costs:
Costs that have already been
incurred. Sunk costs are
irrelevant for all decisions,
because they cannot be changed.
       Terminology
Opportunity Costs:
The profit foregone by selecting
one alternative instead of
another; the net return that could
be realized if a resource were put
to its best alternative use.
         Terminology
Relevant Costs:
Also sometimes called Differential
Costs or Incremental Costs
A differential cost for a particular
decision is one that changes if an
alternative decision is chosen.
    When are Costs and
    Revenues Relevant?
Answer: The relevant costs and revenues
are those which, as between the alternatives
being considered, are expected to be
different in the future.
   When are Costs and
   Revenues Relevant?
Hence, variable costs may be relevant, or
not, depending on whether the variable
costs will differ in the future, as between
the alternatives under consideration.
Also, fixed costs may be relevant, or not,
depending on whether the fixed costs will
differ in the future, as between the
alternatives under consideration.
            January 12
• Review Solutions to the Entrance Exam

• Relevant Cost Concepts and Terminology

• The Jennie Mae Frog Farm

• Break

• Relevant Cost Exercise
    The Jennie Mae Frog Farm
Jennie Mae’s Frog Farm has fixed costs of $5,000 per
month and variable costs of $2 per frog. All fixed costs
are avoidable, in the sense that Jennie Mae could close
the farm tomorrow, and not incur any fixed costs next
month. However, she doesn’t want to do that because
times are good in the frog business: she is operating at
capacity, making and selling 1,000 frogs per month.
Jennie Mae’s usual sales price is $9 per frog. The U.S.
Army has approached Jennie Mae and proposed a one-
time purchase of 300 frogs for $7 per frog. The sale
would occur next month. Jennie Mae’s $2 per frog
variable cost includes $0.25 of product packaging that
would be unnecessary for frogs designated for the Army.
    The Jennie Mae Frog Farm
Question #1: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, what is Jennie Mae’s
opportunity cost?
     The Jennie Mae Frog Farm
Question #1: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, what is Jennie Mae’s
opportunity cost?

Since Jennie Mae is operating at capacity, her opportunity
cost is her profit foregone from the regular sales that are
displaced by the sales to the Army. These profits are
calculated either as $9 sales price minus $2 variable
costs = $7 per frog, multiplied by 300 frogs = $2,100;
or as the difference between this $7 per frog contribution
margin and her contribution margin from sales to the
Army of the $7 sales price less $1.75 in variable costs =
$5.25 per frog. This difference is $7 minus $5.25 =
$1.75, multiplied by 300 frogs = $525.
    The Jennie Mae Frog Farm
Question #2: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are sunk,
and hence, are irrelevant to her decision?
     The Jennie Mae Frog Farm
Question #2: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are sunk,
and hence, are irrelevant to her decision?

No costs are sunk. Even the fixed costs are avoidable.
Hence, although the fixed costs are irrelevant to Jennie
Mae’s decision, they are not sunk.
     The Jennie Mae Frog Farm
Question #3: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are
differential costs (i.e., relevant, or incremental costs)?
     The Jennie Mae Frog Farm
Question #3: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are
differential costs (i.e., relevant, or incremental costs)?

The differential costs are the $0.25 product packaging
costs. Nothing else is differential, because whether or not
Jennie Mae sells to the Army, she will produce at capacity.
    The Jennie Mae Frog Farm
Question #4: Now assume that times are not so good,
and Jennie Mae has excess capacity to make 500 frogs.
The Army approaches Jennie Mae and proposes a one-
time purchase of 300 frogs. What is the lowest price
Jennie Mae should be willing to charge the Army per frog?
     The Jennie Mae Frog Farm
Question #4: Now assume that times are not so good, and Jennie
Mae has excess capacity to make 500 frogs. The Army approaches
Jennie Mae and proposes a one-time purchase of 300 frogs. What is
the lowest price Jennie Mae should be willing to charge the Army per
frog?

$1.75 per frog, the variable cost of production, assuming Jennie Mae
was going to continue operations. However, with only 500 customers,
she is not covering her costs, and the price to the Army that will
allow her to break even is $6.75, as follows:

Revenues:
       from the Army: $6.75 x 300 =                     2,025
       from normal customers: $9 x 500 =                4,500
Costs:
       Variable costs (500 x $2) + (300 x $1.75) =      1,525
       Fixed costs                                      5,000
Income                                                  $   0
     The Jennie Mae Frog Farm
Question #5: Now assume that times are really bad, the
market for frogs crashes, and Jennie Mae gets out of the
frog business and starts producing platypuses instead.
Jennie Mae has an aging inventory of frogs sufficient to
meet market demand for 10 months (300 frogs per
month), but unfortunately, frogs only have a useful life of
5 months and her inventory becomes obsolete after that.
These frogs cost $7 each to make, consisting of $2 in
variable costs and $5 in allocated fixed overhead. What is
the lowest price Annie should accept from the Air Force
for a one-time-only purchase of 300 frogs? What is her
opportunity cost?
     The Jennie Mae Frog Farm
Question #5: Now assume that times are really bad, the
market for frogs crashes, and Jennie Mae gets out of the
frog business and starts producing platypuses instead.
Jennie Mae has an aging inventory of frogs sufficient to
meet market demand for 10 months (300 frogs per
month), but unfortunately, frogs only have a useful life of
5 months and her inventory becomes obsolete after that.
These frogs cost $7 each to make, consisting of $2 in
variable costs and $5 in allocated fixed overhead. What is
the lowest price Annie should accept from the Air Force
for a one-time-only purchase of 300 frogs? What is her
opportunity cost?

Jenny should accept any price above zero. Her
opportunity cost is zero.
            January 12
• Review Solutions to the Entrance Exam

• Relevant Cost Concepts and Terminology

• The Jennie Mae Frog Farm

• Break

• Relevant Cost Exercise
            January 12
• Review Solutions to the Entrance Exam

• Relevant Cost Concepts and Terminology

• The Jennie Mae Frog Farm

• Break

• Relevant Cost Exercise
You are a big fan of rock musician Billy Joel. (There’s no
   accounting for taste.) You decide to spend $200 for
   you and your fiancé to go to an upcoming Billy Joel
   concert, and you buy a pair of tickets. On your way
   to the concert, you realize that you have lost the
   tickets! At first, you panic. Then you realize that,
   most probably, your little sister put the tickets down
   the kitchen disposal the other day when she was
   mad at you. Anyhow, she put something down the
   disposal, and seemed to derive great satisfaction
   from it. You make a mental note to kidnap her
   beanie baby collection. In the meantime, at the box
   office, you learn that seats are still available, and
   you can buy new tickets for $200 that are
   comparable to the ones you lost. Evaluate the logic,
   in terms of the relevant cost concepts of incremental
   cost, sunk cost and/or opportunity cost, with respect
   to each of the following responses to the question of
a. You should forego the concert, because although
     the concert was worth $200 to attend, it’s not
     worth $400 to attend.

b. You should buy the tickets, even though you
      never would have spent $400 to attend, because
      at this point, the incremental cost is only $200.

c. You should buy the tickets, even though you
      never would have spent $400 to attend, because
      at this point, if you don’t, your fiancé will be
      disappointed.
You decide its not worth another $200 to attend the
   concert, and you and your fiancé decide to go
   bowling. On the way out of the lobby, a wealthy and
   happy (and intoxicated) looking couple whom you
   have never seen before confront you, tell you they
   have decided to fly to Paris tonight, and ask if you
   want their tickets. You say “yes,” of course, and
   “thank you.” A bystander standing in line to buy
   tickets sees this happening, and offers to buy the
   tickets from you for $200. Evaluate the logic, in
   terms of relevant cost concepts, with respect to each
   of the following responses to the question of “What
   should you do now?”
a. You should attend the concert, since you are now in
   exactly the same situation you were in when
      you were driving to the concert and thought you
      had the original tickets.

b. You should sell the tickets for $200, since you
      had already decided, only a few minutes ago, that
      you didn’t want to spend another $200 to buy the
      tickets.

				
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