CHAPTER 2

DISCUSSION QUESTIONS

2-1

Q2-1. (a) Cost is the current monetary value of economic resources given up or to be given up in obtaining goods and services.Economic resources may be given up by transferring cash or other property, issuing capital stock, performing services, or incurring liabilities.

Costs are classified as unexpired orexpired. Unexpired costs are assets andapply to the production of future rev-enues. Examples of unexpired costs areinventories, prepaid expenses, plant andequipment, and investments. Expiredcosts, which most costs become eventu-ally, are those that are not applicable tothe production of future revenues and arededucted from current revenues orcharged against retained earnings.

Expense in its broadest sense includesall expired costs; i.e., costs which do nothave any potential future economic benefit.A more precise definition limits the use ofthe term “expense” to the expired costsarising from using or consuming goods andservices in the process of obtaining rev-enues; e.g., cost of goods sold and market-ing and administrative expenses.

(b) (1) Cost of goods sold is an expired costand may be referred to as an expense inthe broad sense of the term. On theincome statement, it is most often identi-fied as a cost. Inventory held for salewhich is destroyed by an abnormalcasualty should be classified as a loss.(2) Uncollectible accounts expense is usu-ally classified as an expense. However,some authorities believe that it is moredesirable to classify uncollectible accountsas a direct reduction of sales revenue (anoffset to revenue). An uncollectible accountwhich was not provided for in the annualadjustment, such as bankruptcy of a majordebtor, may be classified as a loss.(3) Depreciation expense for plant machin-ery is a component of factory overheadand represents the reclassification of a

portion of the machinery cost to productcost (inventory). When the product is sold,the depreciation becomes a part of thecost of goods sold which is an expense.Depreciation of plant machinery during anunplanned and unproductive period of idle-ness, such as during a strike, should beclassified as a loss. The term “expense”should preferably be avoided when makingreference to production costs.(4) Organization costs are those coststhat benefit the firm for its entire period ofexistence and are most appropriatelyclassified as a noncurrent asset. Whenthere is initial evidence that a firm’s life islimited, the organization costs should beallocated over the firm’s life as anexpense or should be amortized as a losswhen a going concern foresees termina-tion. In practice, however, organizationcosts are often written off in the earlyyears of a firm’s existence.(5) Spoiled goods resulting from normalmanufacturing processing should betreated as a cost of the product manufac-tured. When the product is sold, the costbecomes an expense. Spoiled goodsresulting from an abnormal occurrenceshould be classified as a loss.

Q2-2. Cost objects are units for which an arrange-ment is made to accumulate and measurecost. They are important because of the needfor multiple dimensions of data (e.g., by prod-uct, contract, or department) to accomplishthe various purposes of cost accounting,including cost finding, planning, and control.

Q2-3. (a) To classify costs as direct or indirect, the cost accountant must first know theanswers to the questions “Directly tracedto what?” and “Indirectly identified with what?” Otherwise, there is no way toassess the direct or indirect nature of a cost. It is the choice of a cost object that answers those two questions.

(b) For example, the cost of a departmentmanager’s salary cannot be classified as

direct or indirect without selecting thecost object first. If the cost object is aproduct unit produced in the manager’sdepartment, then the salary is indirect. Ifthe cost object is the department, thesalary is direct.

Q2-4. (a) The product unit, batch, or lot is the costobject. (Be careful about the lack of clarity of the term “the product” when it is not known whether it is intended to mean (a) a single unit, batch, or lot of a product,as opposed to (b) any large number ofidentical units. It could easily be taken tomean, say, product #321, as opposed tosome other item in the company’s catalog,and that could suggest the grand total of allidentical pieces of #321 produced duringthe entire product life cycle. The signifi-cance of this distinction is that some costs,such as product design, prototyping, andinitial worker training, are direct costs withrespect to the total of all units ever pro-duced, but are indirect with respect to asingle unit, batch, or lot.)

(b) A disaggregation of overhead would beuseful for any study of how to better man-age costs, or of what causes costs to beincurred. Relatively few of the costsincurred in a factory are caused by theroutine production of one more unit of oneproduct.

(c) (1) A batch of identical units.(2) The sum of all identical units everproduced.(3) An activity or process carried out inproduction.(4) A group or “cell” of machines andworkers within a department.(5) A department in which productionoccurs.(6) A plant or other production facility.(7) A strategic goal of the firm (e.g.,improved quality).

Q2-5. A cost system is a combination of proceduresand records designed to provide the varioustypes of information required in the conduct ofthe enterprise; including cost finding, plan-ning, and control.

Q2-6. A good information system requires theestablishment of (a) long-range objectives; (b)an organization plan showing delegatedresponsibilities in detail; (c) detailed plans forfuture operations, both long- and short-term;

and (d) procedures for implementing and con-trolling these plans.

Q2-7. A chart of accounts is necessary to classifyaccounting data, so that the data may be uni-formly recorded in journals and posted to theledger accounts.

Q2-8. Advantages of the electronic data processingsystem for record keeping are: speed, largerstorage, single entry of multiple transactions,automatic control features, and flexibility inreport formats.

Q2-9. The following perceived weaknesses werementioned in the text:(a) Traditional measures attempt to serve

many purposes, and as a result they arenot universally regarded as serving anyone purpose ideally.

(b) Traditional measures are affected byaccounting choices that are not alwaysrelevant to the purpose at hand; exam-ples of these choices are cost flowassumptions and arbitrary fixed cost allo-cations.

(c) Traditional measures are calculated bysystems that are usually slow to respondto changing conditions.

(d) Traditional measures of plant utilizationcan seem to encourage overutilization ofcapacity.

(e) Traditional measures of efficiency areoften reported too late, are too aggregat-ed, and are easy to misinterpret.

Q2-10. Nonfinancial performance measures arebased on simple counts or other physical datarather than allocated accounting data, theyare unconnected to the general financialaccounting system, and they are chosen toreflect one specific aspect of performance.

Q2-11. Four examples of nonfinancial performancemeasures given in the text, and the aspects ofperformance they might be used to monitor,are (a) scrap weight as a percentage of total

shipped weight; to monitor efficiency of a process, particularly efficiency of materialusage

(b) processing time as a percentage of totaltime; to monitor cycle efficiency orinventory velocity

(c) distance moved by a unit while inside theplant; to monitor simplification of a process

(d) suggestions per year per employee; tomonitor employee involvement

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Q2-12. The challenge posed by the increased inter-est in nonfinancial performance measures isto define the cost accountant’s role broadlyenough to include more measures that arenot preceded by dollar signs and that are nottied to the financial accounting system.

Q2-13. Costs are most commonly classified based ontheir relationship to(a) the product (a single batch, lot, or unit of

the good or service);(b) the volume of activity;(c) the manufacturing departments, process-

es, cost centers, or other subdivisions;(d) the accounting period;(e) a proposed decision, action, or evaluation.

Q2-14. Indirect materials are those materials neededfor the completion of the product but whoseconsumption is either so small or so complexthat their treatment as direct materials wouldnot be feasible. For example, nails used tomake the product are indirect materials.

Q2-15. Indirect labor, in contrast to direct labor, islabor expended that does not affect the con-struction or the composition of the finishedproduct. For example, the labor of custodiansis indirect labor.

Q2-16. (a) A service department is one that is not directly engaged in production, but renders a particular type of service for thebenefit of other departments. Examples of service departments are receiving, storerooms, maintenance, timekeeping, payroll, and cafeteria.

(b) Producing departments classify theirshare of service department expenses asindirect overhead expenses.

Q2-17. (a) Capital expenditures are intended to benefit more than one accounting period.The expenditures should therefore be recorded by a charge to an asset account for allocation to the periods benefited.

Revenue expenditures benefit theoperations of the current period only.They should be recorded by charges tothe appropriate expense accounts.

(b) If a capital expenditure is improperly clas-sified as an expense, assets, retainedearnings, and income for the period willbe understated. In future periods, incomewill be overstated by any amount thatwould have been amortized had theexpenditure been properly capitalized.Assets and retained earnings will beunderstated on future balance sheets by

successively smaller amounts until theerror has been fully counterbalanced.

If a revenue expenditure is improperlycapitalized, assets, retained earnings,and income for the period will be over-stated. Income will be understated in sub-sequent periods as the improperlycapitalized item is charged to the opera-tions of those periods. Assets andretained earnings will continue to be over-stated in subsequent balance sheets bysuccessively smaller amounts until theimproperly capitalized item has beencompletely written off.

(c) The basic criterion for classifying outlaysas revenue or capital expenditures is theperiod of benefit. The amount of detailnecessary to maintain subsidiary records,the materiality of the expenditures, andthe consistency with which variousexpenditures recur from period to periodare other criteria generally considered inestablishing a capitalization policy.

Firms frequently establish an arbitraryamount below which all expenditures areexpensed, irrespective of their period ofbenefit. The level at which this amount isset is determined by its materiality in rela-tion to the size of the firm. The objective ofsuch a policy is to avoid the expense ofmaintaining excessively detailed sub-sidiary records. Expenditures for items thatfall below the set amount but are materialin the aggregate should be capitalized, iftotal expenditures for these items vary sig-nificantly from period to period. A capital-ization policy that reasonably applies thesecriteria, although it disregards the period ofbenefit and is therefore lacking in theoreti-cal justification, will not significantly mis-state periodic income.

Q2-18. Appendix In a typical balanced scorecard,the names of the four perspectives are growthand learning, internal business process, cus-tomer, and financial.

Q2-19. Appendix A balanced scorecard’s growth andlearning perspective is a report on three kindsof intangible resources: human capital, infor-mation, and the alignment of incentives.

Q2-20. Appendix The internal business process per-spective of a balanced scorecard reports onthe organization’s most important work, thework in which the organization must excel inorder to be successful.

Chapter 2 2-3

Q2-21. Appendix Performance measures found inthe financial perspective of most organiza-tions’ balanced scorecards are likely toinclude the amount or the growth rate of netincome, or of operating income, or of returnon investment. For a new, start-up organiza-tion, the most important financial measuresmay be net sales and gross margin. For anorganization whose products and technologyface obsolescence, the key financial measuremay be cash flow.

Q2-22. Appendix The predictions reflected in a bal-anced scorecard follow this sequence through

the four perspectives: growth and learning,internal business process, customer, andfinancial.

Q2-23. Appendix When the desired result is successin the financial perspective, the other threeperspectives of a balanced scorecard reportwhat management believes are necessaryconditions. The other three perspectives donot list sufficient conditions for financial suc-cess. Sufficient conditions would constitute aguarantee. A necessary condition, in contrast,is an essential prerequisite.

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EXERCISES

E2-1 (1) $6 + $3 = $9 prime cost(2) $3 + $1 = $4 variable conversion cost(3) $6 + $3 + $1 = $10 variable manufacturing cost(4) $1,000 fixed + ($10 × 500) = $6,000

E2-2 (1) $10 + $15 + $6 = $31 conversion cost(2) $32 + $10 = $42 prime cost(3) $32 + $10 + $15 + $3 = $60 variable cost(4) (($32 + $10 +$15 + $6 + $4) × 12,000)

+ ($3 × 8,000) = $804,000 + $24,000= $828,000 total cost incurred with 12,000units produced and 8,000 units sold

E2-3

First Method:Sales ($19,950,000 × 85%) ................................ $16,957,500Less: Variable costs ($11,571,000 × 85%) ...... $9,835,350

Fixed costs ............................................. 7,623,000 17,458,350Operating loss.................................................... $ (500,850)

Second Method:1st Step: Variable costs $11, 571, 000 = .58 variable cost ratio

20A sales $19,950,000

2nd Step:Sales ($19,950,000 × 85%)................................ $16,957,500Less: Variable costs ($16,957,500 × .58) ........ $ 9,835,350

Fixed costs ............................................. 7,623,000 17,458,350Operating loss.................................................... $ (500,850)

E2-4

1. d2. b3. b4. a5. f6. e7. c8. f

Chapter 2 2-5

E2-5 The cost of direct labor per computer is $100,000, calculated as follows:

Total manufacturing cost .............................. $600,000 (given)Less prime cost.............................................. 300,000 (given)Equals overhead cost .................................... $300,000

Conversion cost ............................................. $400,000 (given)Less overhead cost........................................ 300,000 (calculated above)Equals direct labor......................................... $100,000

E2-6 The amount of factory overhead cost per blade is $300, calculated as follows:

Total manufacturing cost .............................. $1,000 (given)Less conversion cost .................................... 400 (given)Equals direct material cost ........................... $ 600

Direct labor cost = 1/6 of direct material cost = 1/6 × $600 = $100

Conversion cost ............................................. $ 400 (given)Less direct labor cost.................................... 100 (calculated above)Equals overhead cost .................................... $ 300

E2-7 The direct labor cost per system is $200, calculated as follows:

Total manufacturing costs ............................ $1,000 (given)Less prime cost.............................................. 800 (given)Equals overhead cost .................................... $ 200

Conversion cost ............................................. $ 400 (given)Less overhead cost........................................ 200 (calculated above)Equals direct labor cost ................................ $ 200

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E2-8 The amount of factory overhead cost per machine is $1,500, calculated asfollows:

Total manufacturing cost .............................. $3,000 (given)Less conversion cost .................................... 2,000 (given)Equals direct material cost ........................... $1,000

Direct labor cost = 1/2 of direct material cost= 1/2 × $1,000 = $500

Conversion cost ............................................. $2,000 (given)Less direct labor cost.................................... 500 (calculated above)Equals overhead cost .................................... $1,500

E2-9

(1) The relevant cost objects are:(a) An item of merchandise.(b) The use of a bank credit card.

(2) It implies that cash-paying customers are paying a part of the cost of the banks’fees for processing credit card transactions, because these fees are paid by themerchant who then recovers them in the form of slightly higher prices for allmerchandise.

(3) The competitive implications are that the prices paid by cash customers are toohigh to be competitive with the prices charged by merchants who deal only incash, and the prices paid by customers using bank credit cards are too low toreflect all the costs of a credit sale.

(4) The reason for not reducing all prices and charging extra for the use of a creditcard is because of the psychological effect of an extra charge. To customers, itsounds like a penalty, as if the merchant wants to discourage the use of bankcredit cards. A discount for cash customers has a positive connotation, even ifprices marked on merchandise are higher to begin with. Raising all prices andoffering a cash discount yields the same net revenue as leaving prices alone andcharging extra for using a bank credit card, but the former method feels better tothe customer than the latter.

Chapter 2 2-7

E2-10

(1) The relevant cost objects are:(a) A repair.(b) A pickup and delivery.

(2) JTRS’s repair prices include an allocation of the cost of picking up and deliver-ing tractors, in addition to the cost of the repairs, administrative costs, market-ing costs, and profit. Competitors’ repair prices reflect only the cost of therepairs, administrative and marketing costs, and profit. Competitors should beable to price their repair services lower, because they do not have to reflectpickup and delivery costs in repair prices.

E2-11

(1) Direct labor...................................................................................... $ 2Variable factory overhead.............................................................. 5Fixed factory overhead .................................................................. 4Conversion cost.............................................................................. $11

(2) Direct material (lumber) ................................................................. $12Direct labor...................................................................................... 2Prime cost ....................................................................................... $14

(3) Direct material (lumber) ................................................................. $12Direct labor...................................................................................... 2Variable factory overhead.............................................................. 5Variable manufacturing cost ......................................................... $19

(4) Direct material (lumber) ................................................................. $12Direct labor...................................................................................... 2Variable factory overhead.............................................................. 5Variable marketing.......................................................................... 1Total variable cost .......................................................................... $20

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E2-11 (Concluded)

(5) Total cost = total variable manufacturing cost + total variable marketing cost+ total fixed cost

= 2,000 × ($12 + $2 + $5) + 1,900 × $1+ 2,000* × ($4 + $3)

= $38,000 + $1,900 + $14,000= $53,900

*The volume used here to calculate total fixed cost is the 2,000-unit volume levelthat was used originally to calculate the amounts of fixed costs per unit, asstated in the data given in the exercise. The 2,000-unit level of production statedin requirement (5) is not the reason that 2,000 is used here to calculate total fixedcost.

(6) The data indicate the bookcases are made of lumber, and some examples of theindirect materials used in making wooden bookcases would be glue, sandpaper,and nails.

(7) An estimate of costs referred to in the answer to requirement (6) would beincluded in the variable factory overhead of $5 per unit.

E2-12 Factory overhead = 1/3 × prime cost, so:

Totalmanufacturing = prime cost + factory overhead

cost= prime cost + (1/3 × prime cost)

= 4/3 × prime cost;

multiplying both sides by 3/4 gives:

Total3/4 × manufacturing = 3/4 × 4/3 × prime cost

cost

3/4 × $20,000 = 1 × prime cost$15,000 = prime cost.

Prime cost......................................................................... $15,000Less direct material cost................................................. 12,000 (given)Direct labor cost............................................................... $ 3,000

Chapter 2 2-9

E2-13 APPENDIX

1. GL (This is a measure of information systems.)2. GL3. C4. IBP5. F6. IBP7. F8. F9. IBP (This measure and the next one are measures of innovation, which is part

of the internal business process perspective.)10. IBP11. C12. GL13. GL

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CASES

C2-1

(1) The percentage profit margin will be 82.5%, calculated as follows:Revenues ($2 × 4) ..................................... $8.00 Cost of juice ($.20 × 4) ............................. $.80Cost of one delivery ................................. .60 1.40Profit........................................................... $6.60

Percentage profit margin = $6.60 profit divided by $8 revenue = 82.5%.

(2) The percentage profit margin will be 60%, calculated as follows:Revenues ($2 × 1) ..................................... $2.00Cost of juice ($.20 × 1) ............................. $.20Cost of one delivery ................................. .60 .80Profit........................................................... $1.20

Percentage profit margin = $1.20 profit divided by $2 revenue = 60%.

(3) The manager is treating the menu item as the cost object, for example, oneglass of orange juice.

(4) The refinement of the definition of cost object that would result in the plannedprofit margin is the use of two different kinds of cost object, the item and thedelivery, which can be priced separately at $.80 and $2.40, respectively.

Chapter 2 2-11

C2-1 (Concluded)

(5) For an order consisting of four glasses of orange juice, the profit margin will be75%, calculated as follows:

Revenues: ($.80 × 4) ........................... $3.20+ ($2.40 × 1) ......................... 2.40

$5.60Cost of juice ($.20 × 4) ............................. $.80Cost of one delivery ................................. .60 1.40Profit........................................................... $4.20

Percentage profit margin = $4.20 profit divided by $5.60 revenue = 75%.

For an order consisting of one glass of orange juice, the profit margin will alsobe 75%, calculated as follows:

Revenues: ($.80 × 1) ........................... $ .80+ ($2.40 × 1) ......................... 2.40

$3.20

Cost of juice .............................................. $.20Cost of one delivery ................................. .60 .80Profit........................................................... $2.40

Percentage profit margin = $2.40 profit divided by $3.20 revenue = 75%.

(6) The food service manager’s plan allocates the delivery costs over an arbitrarilyselected number of items (two). This plan would result in higher-than-plannedprofit margin percentages on room service orders that contain more than twoitems, as demonstrated in the answer to requirement (1). Prices on these orderswould be higher than those of a competitor who traces costs more carefully tocost objects and sets prices accordingly. The plan would also result in lower-than-planned profit margins on room service orders containing only one item,as demonstrated in the answer to requirement (2). Prices on these orders wouldbe lower than what is needed to achieve the target profitability.

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C2-2

(1) The cost objects for which some amount of cost is identified in the case, and theamount of cost identified for each, are:(a) A new product variation, Zeggo (which means all units of Zeggo ever to be

produced), $250,000.(b) A batch of Zeggo, $1,000.(c) A unit of Zeggo, $5 + $10 = $15. (Notice the $10 indirect cost amount includes

all indirect production costs, so it must include the $1 amount stated in theproblem, along with an allocation or averaging of the $1,000-per-batch setupcosts, a share of the $250,000 cost amount, and a share of any other indirectmanufacturing costs. It would be double-counting to add the $1 and arriveat a total of $16 per unit.)

(2) The other items mentioned in the case that could serve as cost objects, and apurpose each one could serve, are:(a) CCN Company, which is the relevant cost object when external financial

statements are prepared.(b) The assembly line on which Zeggo and other products are to be produced.

This cost object would be relevant in a decision on whether to discontinueproduction of all the products produced on the particular line, or a decisionto shut down the line and shift its production to other lines due to a reduc-tion in customer orders.

(3) The total cost expected to result from producing the first batch of 300 units ofZeggo is:Cost accounted for as direct cost of a unit ...... $ 5Cost treated as indirect by the CCN system .... 1

$ 6× 300 units

$1,800Add: setup cost ................................................... 1,000Total cost.............................................................. $2,800

(4) The cost expected to result from producing one more unit of Zeggo is $5 + $1 = $6.

(5) For the first batch of 300 units, the CCN cost accounting system will report acost of:($5 direct cost + $10 indirect cost allocation) × 300 units = $15 × 300 = $4,500

Chapter 2 2-13

C2-2 (Concluded)

(6) For the one additional unit, the CCN cost accounting system will report a cost of$5 + $10 = $15

(7) The additional costs allocated by the CCN accounting system are of two types:(a) Costs caused by activities other than the production of product units. Two

examples of these activities are mentioned in the problem: setting up theassembly line and perfecting new product variations. Other activities wouldinclude maintaining the assembly line and the department, ordering andinspecting raw materials, training newly hired workers, maintaining a costaccounting system, and expediting rush orders. (These are related to totalvolume in the long run; therefore, most accounting systems classify them asvariable overhead, but they are unrelated to the production of a single unitor batch of product.)

(b) Fixed costs that are incurred regardless of whether activities are carried out,such as plant depreciation, insurance, and property taxes. These are thecosts of having capacity, not of using it.

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