CHAPTER 17 FULL COSTS AND THEIR USES ‘Changes from the Eleventh Edition ‘Two new terms—strategic cost management and value chains—were introduced, All other changes were minor, Approach This chapter introduces the general concept of cost and describes, in a preliminary way, methods of recording costs in an accounting system. Some of the problems that many students seem to have are: 1. Students think that there is such a thing as "the" cost. They don't realize that the measurement of cost always relates to some specific cost object, and that what is an item of cost for one cost object may rot be at all relevant for another cost object. As one way of overcoming this misconception, we have emphasized the idea of “cost object" from the outset 2. Students think in terms of product costs. This is because in financial accounting the students! principal contact with "cost" was in connection with measuring inventory cost and cost of goods sold. They. therefore, fal to appreciate that products (literally "goods") are only one of a number of possible cost ‘objects. They think, for example, that direct material and direct labor are always relevant costs, and ‘that the word "direct" means that the material and labor are directly associated with the product, whereas for certain cost objects (¢.g., advertising), direct material and direct labor are inappropriate terms. Furthermore, an item of cost may be direct to a certain cost object, such as the cost of a department or responsibility center, even though the item is indirect with respect to a product manufactured in that responsibility center. It is true that we do focus on produet costs in Chapters 17 and 18, but the definitions and statements are made broad enough so that they can be used without modification when other cost objects are discussed. 3. Students think that the definitions ore applied more precisely in practice than actually is the case They tend to regard an item of cost as being direct labor only if they can visualize the worker as physically touching the product, for example. We do not attempt to describe the wide diversity that exists in actual practice because this diversity tends to confuse beginning students, The point is that students should not be overly concemed about drawing a fine line between direct and indirect costs, or between manufacturing and non-manufacturing costs We have decided not to stress the idea that cost is a “sacrifice,” which is central to many definitions of cost. The word "sacrifice" implies something bad, something to be avoided, whereas a company gladly incurs a cost when it believes it will receive revenue or some other benefit by doing so. We think it more meaningful to students to think of cost as measuring the use of resources. They should visualize the resources themsclves—the physical material, the hours of labor service—and think of costs as being ‘monetary measures of how much of these resources were used for a given cost object. In general, we think it desirable to usc the word "product" as referring cither to a good or to a service: that is, products are the sum of goods and services. We cannot do this uniformly, however, because the term “product cost” is in widespread use, whereas in the above terminology it really should be "goods cost." (This isa small point, but it can create confusion if not properly handled, The author of this paragraph did not comprehend the distinctions made above until many years after he had completed his first course inAccounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant cost accounting.) ‘The description of the cost flow through a pen factory is a central part of the pedagogy. Students should be able to explain each line on the flowchart and each of the related joumal entries. We have tried to avoid the twin dangers of, on the one hand, being critical of cost accounting because it does not yield costs that are entirely "true" or "accurate" and, on the other hand, creating the impression that cost accounting does in fact provide true and accurate costs, Students tend to go too far toward one or the other of these extremes, and it is difficult for them (as well as for many managers) to take the appropriate middle ground, This middle ground, we believe, is that although it is impossible to measure the costs of a cost object with absolute accuracy whenever indirect costs exist, it is nevertheless possible to measure costs with sufficient accuracy so that they are useful to management for many purposes. ‘Managements would not continue to spend large amounts of money in the operation of cost accounting systems if they did not believe that the results were worthwhile. In recent years, full-cost pricing is being given an increasing amount of attention, for a number of reasons the growth of cost-reimbursement pricing in hospitals and in government relationships of various types, the fact that some foreign producers have been found to have sold goods in the U.S. at less than full cost, and the growth in the understanding that business has a social responsibility to set "fait" prices, that is, prices that do not produce extraordinarily high profits Students who have been exposed to economics should also realize that contribution pricing is not slighted. As the text states, this topic is discussed in depth in Chapter 26, where it belongs, and in this discussion a distinction is drawn between situations in which full-cost pricing is appropriate and situations in which contribution pricing is appropriate. Of course, if students have not been exposed to a course in economics of the type implied above, then this problem will not even arise. It is desirable that the relationship between profit and assets employed be emphasized. This relationship ‘was introduced in Chapter 13, and it will come up several times in later chapters in this book. It is not an casy relationship to grasp (especially the relationship between profit percentage, asset turnover, and return on investment), but once the student understands it, he or she has a model that explains how the parts of a business, and decisions on these parts, relate {o one another. Since the general public (including ‘newspaper stories and television news programs) tends to think of profits as a percentage of sales, itis not casy to get students to think in terms of the broader and more valid concept of return on investment Any discussion of pricing necessarily includes a discussion of profit. Some students are emotionally antagonized by the basic concept of profit; they confuse "profit" and “profiteering,” or they have the impression that business extracts an unconscionable amount of profit from the consumer. If they are to understand what normal pricing practices actually are, they must overcome this emotional block. It is hoped that the reiteration of the point that a business must earn a reasonable return on its investment if it isto survive may help in overcoming this block. Cases Delaney Motors raises the general issue of “what is cost?” and enables a discussion of the possible uses of full cost information, Lipman Bottle Company deals with the use of cost data in product pricing decisions Shelter Partnership, Inc., allows students to sce the multiple purposes for which cost accounting is used in a nonprofit organization and to consider whether additional cost accuracy is desirable,©2007 MeGraw-Hillirwin Chapter 17 Problems Problem 17-1: Martin Company (000s omitted) Raw Materials Inventory Balance, Sept. T. ms 80. | Issued. fo.use, 2 Purchases. .55.| To.balance..... Balance, October Loenssnnnnsnnind Sulu Balance, Sept. Direct material Direct labor... Overhead... Balance, October 1 Balance, Sept. | Goods manufactured... Balance, October 1 Problem 17-2: Burtis Company Calculation of normal selling price for 20x3 assuming continued use of full cost 20x2 Dircet material Direct labor. Indirect manufacturing... Selling and administrative. Total full cost. Profit (10%) Selling price. "12 percent increase for diret material ( 12x $4.00 = $48) and for direct labor (12x §7.00= 5.84) $6,000 inerease with volume of 10,000 units = increase of $.60 per unit Problem 17-3: Micha Si Total_costs $5,700 + Desired profit $3,300 Fee per hour = 150 hours = $60.00 per hour b. Revenue, 100 hours @ $60. ses oases armsoacrra enemas BONO, Costs, wSiTO0. Profit. . . S00...Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Problem 17-4: Valade Company a, Calculation of selling prices: Total Product Company = _J__ Direct manufacturing COSt....ensnensmnsninnn $8 TDD, SADOLLDD Indirect manufacturing COSt...co.nnrnnnnvnnnenn .280,000.......1.60,000.. Selling and administrative cost evened 000 000. FULL C08t cen so rnnnernnessnssns ey 20,000 640,004 ..80,000, Desired profit* 230_000.....60,000......120,000, Sales revente. sn veneers $1400,000..... $800,000.....$600,000.. Divide by units. - ™ Selling price per unit. ‘The desied profit of 280,000 forthe company asa whole is 25 percent ofthe company’s fall cost. Therefore a 25 percent profit ‘margin poreorags is appli to he fl eos ofeach produto obtain the sling peice ‘The profit percentage is equal to: (Desired profit + Selling and administrative cost) * Full production cost, For Product A it equals ($160,000 + 80,000)/560,000 ~ 42.86% which is the same as for product K ~ ($120,000 + $60,000)/ $420,000 = 42.86% Total b. Company. Sales revenue*, $1,248,000. Full cost... ceca reume peas eran era LOMO OOD, Profit. $208,000. ‘Sales Revenue Ar 5,000 units @ $76.80 = $384,000 1B: 15,000 units «ae $57.60 = $864,000 “Full Cost A: 66,000) (, B: (15,000 units) c. Profit margin pricing results in product prices containing identical profit percentages. However, the product with the higher price will yield the higher total dollar profit. Therefore, a shift in product mix toward lower price items will reduce total dollar profits for the company as a whole.©2007 MeGraw-Hillirwin Chapter 17 Note: This case is unchanged from the Bleventh Edition, Approach This case was written to illustrate the use of cost information and cost systems in a nonprofit setting. The case is particularly interesting because managers at Shelter Partnership were actively considering whether the possible undercosting of one of the organization's major elements (Shelter Resource Bank) might be adversely affecting their fundraising, Suggested Assignment Questions ‘Suggested questions appear at the end of the case. Case Analysis A, What is the main purpose of cost information at Shelter Partnership? ‘The class should discuss three purposes: 1, Product costing, Managers should know the costs of the different services the organization provides. If the costs of a particular service are judged to exceed value, that particular service can be discontinued. For example, the Salvation Army managers analyzed the costs of their organization's various programs. They decided to discontinue pick-up service of donated goods at private residences ‘The cost of doing so was greater than the value of the goods received. Instead, they decided to use donation centers in major traffic areas (which gave them economies of scale) Students should understand, however, that use of eost information for product costing purposes is limited in Shelter Partnership because this is not a client-supported organization. Most of the revenues come from donations, not sales or service fees, and costing has little to do with pricing Fund raising. Cost estimates help determine the level of fundraising necessary to support Shelter Partnership's activities. (Note that some students question Ruth Schwartz’s assumption that higher costs facilitate fund raising.) 3. Sourcing decisions. Managers can make decisions as to whether to have the organization provide its own services or contract them to outsiders (make or buy) Cost control purposes seem not to be greatly served by the cost system, Shelter Partnership did not have reliable cost standards, so actuals vs. standards comparisons were not possible However, some actuals vs, history comparisons were uscfil B. The Shelter Partnership cast system. “This teaching nove was propared by Kenneth A, Merchant. Copyright © 1998 by Kenneth A. MerchantAccounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Cost Direct bank cost Indirect costs ‘warehouse and donations people ‘warehouse costs Subjective estimatesfof proportion of resourges consumed trace Resource Bank Alllother services, Service CC. Shelter Partnership provides four products or services: a. technical—fund raising and distribution 'b. program development—conferences, publicity public policy support—research studies, educational programs 4. Resource Bank But Ms. Schwartz does not express interest in tracing exception of the Resource Bank to the individual services, with the Dz Isasingle-stage ct system appropriate? Why or why not? ‘The students can quickly identify the cost pools and recognize how the costs are distributed across the difference services. There are three main categories of cost pools: (1) personnel (which includes salaries, benefits, and payroll tax expenses); (2) other operating costs: and (3) independent contractor costs. Some students will develop systems that add a "fi jon to the system, in which expenditures from the budget line items are pooled according to a common cost driver. Then they calculate burden rates for each cost pool and assign costs through a second stage allocation down to the cost object (service or program) level. Their cost drivers are commonly labor dollars of the "personnel pool,” and floor space for the "other operating costs" pool, etc. The students will argue their scheme will make the costs of the Various cost objects more "accurate." It is impossible to reach consensus on that, but most students will agree with Ms. Schwartz that Shelter Partnership has no particular need for this level of sophistication. It would be time-consuming and therefore costly, to identify the activities performed and to attach costs to each of these activities, thereby constructing a true activity-based (2-stage) cost system. The©2007 MeGraw-Hillirwin Chapter 17 benefits would probably not exceed the costs. E_ How many cost centers should Shelter Parmership idemtify? Shelter Partnership uses nine cost centers. There are two personnel cost centers because different categories of people are allocated in different proportions to the Resource Bank. The costs of the donations distribution and solicitation managers and warehouse staff are allocated 100% to the Resource Bank. The costs of the administrative personnel (associate director, development director, office managers, and receptionists) are allocated 50% to the Resource Bank and 50% to the other three services. Students will question why no personnel costs related to the executive director and program manager are allocated t0 the Resource Bank. They will also question whether it is desirable to make salary information essentially public by incorporating them into the allocations. Shelter Partnership uses four costs centers for the other operating costs: a, Warehouse expenses (100% assigned to the Resource Bank), b. Office rent, office expenditures, postage, photocopying, printing, telephone, insurance, local travel, community training/board education, training and education, and equipment (50% assigned to the Resource Bank); ¢.Nonlocal travel, newsletters, and publications (one-third assigned to Resource Bank); 4d. (Not mentioned in text) Professional fees (assigned on a project-by-project basis). Three cost centers are used for the independent contractor costs: a. Trucking and warehouse temporary labor costs (traced 104 % to the Resource Bank); b, Accountant expense (50% assigned to Resource Bank): ©. Development consultant (which were zero in 1990) and the temporary consultant (0% to Resource Bank), ‘Are these enough cost centers? Too many? The d cost information (Question 1). sion should refer back to the purposes of the F. Are Ruth Schwartz's estimates accurate enough? This is a difficult question to answer, but it gets students thinking in the right direction. The students realize that Ruth could interview her staff and get better estimates as to how they direct their time toward the four services nization provides. They also realize that, for the personnel and independent contractor expenses, the allocation bases (which map directly into the percentages) are labor hours, measured with respect to some "actual capacity” estimate of total labor time available for all four services. ‘Ask the students what happens if, for example, the associate director quits and nobody else is hired to replace hinvher” It is clear that the percentages would have to be recalculated because both the numerator and denominator are changing. If the change is temporary, the use of “standard pereentages” scems appropriate. The allocation basis used for the four cost centers related to “other expenses” (such as office and expenditures) is not clear. Students can propose alternative allocation bases for each, on which the percentages might have been based, Some students, of course, will propose that Shelter Parinership do a study to better understand the purposes served by each of these various categories of expenses. G. Isaccuracy (or trush) the desired goal for Shelier Partnership's cost system?Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant For intemal decision making purposes, approximation of the real costs is probably desirable. However, in communications to outside parties, Ms. Schwartz suggests that Shelter Partnership might want to overstate the costs of the Resource Bank, or at least recognize the full casts of the Bank. She ‘thinks that higher costs will make the Bank appear more substantial and will be more likely to attract the attention of foundations If accuracy is not the goal of the cost system, why should management even be concerned with truth? Why not just assign almost every cost possible to the Resource Bank? This, of course, raises a number of legal and ethical issues. But if Ms. Schwartz's argument that higher costs will attract foundation attention is correct, then she should have the cost system reflect the full costs of the Resource Bank. She should fully value the donation of space from the General Services Administration and she should assign the bulk of the insurance costs to the warehouse. Students will see that assignments like these make cost accounting more an art than a science. Some students may raise the counter argument that Ms. Schwartz also has incentives to understate the costs of the Bank, 10 make it look more efficient. Where are the controls on the organization's internal accounting (cost) systems? H. What do vou think of Shelter Partmership’s budgeting system? ‘At some point in the class, some attention can be usefully directed toward Shelter Partnership's budgeting system. Budgeting plays (or should play) key roles for Shelter Partnership. It might be used for resource planning and allocation purposes, and it might serve cost control roles. ‘The case does not provide much information about Shelter Partnership's budgeting system, but Exhibit I shows that the organization has a budget and that it appears to be only an aggregated, line- item budget. The organization would probably benefit from using program budgeting, instead of their line-item-based system. And where should standards come from for efficiency (actuals vs. standard) ‘comparisons? 1. Should the Resource Bank be tracked and evaluated as a cost center or a revenue center? It could be done either way. If the Bank is considered a profit center, a value will have to be imputed to the donations "These games are apparently relatively common. See, for example, R. Khalaf, "The Accounting Games Charities Ply." Forbes (October 26, 1992}, pp. 252-254