ACCT 223 Lecture Notes - Lecture 2: Finished Good, Fixed Cost, Income Statement
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1.A key difference between managerial and financial accounting is that
| Managerial is only historical data and financial is only future data | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Managerial users are typically internal and financial users typically external | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Managerial is highly regulated and financial is not | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Financial uses much more economic data than managerial
--------------------- 3.Major inventory accounts in a manufacturing environment typically include all of the following except
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Cost-Based Pricing
Companies use various strategies to set price. Since cost is animportant determinant of supply and is known to the producer, manycompanies base price on cost. Still other companies use atarget-costing strategy, or strategies based on the initialconditions in the market.
A cost-based pricing approach starts with product cost and thendesired profit is added. Usually, there is some cost base and amarkup. The markup is a percentage applied to base cost; itincludes desired profit and any costs not included in the basecost. Companies that bid for jobs routinely base bid price oncost.
Example: Linder Company makes and sells vitaminsupplements. The following information from last year's accountingrecords showed:
| Cost of Goods Sold | $254,000 |
| Selling and administrativeexpense | 86,360 |
| Operating income | 111,760 |
The markup percentage must include all costs that are not a partof cost of goods sold plus the desired profit. For Linder Company,the markup on COGS is found as follows:
| Markup on COGS | = (Selling and administrativeexpenses + Operating income)/COGS |
| = ($86,360 + $111,760)/$254,000 =0.78 or 78% |
Now, if Linder Company produces a new product with manufacturingcost of $2 per unit, the unit price at this markup is:
| Price = $2 + (0.78 Ã $2) = $2.00 +$1.56 = $3.56 |
A Company does not have to use Cost of Goods Sold as the basisof the markup. For example, a job-order firm might decide to usethe markup on prime costs (direct materials and direct labor) tocost jobs. Suppose that Carl's Custom Cabinetry wants to price jobsbased on prime costs plus a markup on prime cost. Last year'sincome statement revealed the following information:
| Prime costs | $134,000 |
| Overhead | 73,700 |
| Selling and administrativeexpense | 38,860 |
| Operating income | 50,920 |
| Markup on Prime Cost | = (Overhead + Selling andadministrative expenses + Operating income)/Prime cost |
| = ($73,700 + $38,860 +$50,920)/$134,000 = 1.22 or 122% |
Carl is pricing a new job with estimated direct materials of$4,300 and direct labor of $1,800. The estimated price is:
| Price = ($4,300 + $1,800) + (1.22 Ã$6,100) = $6,100 + $7,442 = $13,542 |
Neither Linder Company nor Carl's Custom Cabinets must use theprice figured according to the markup. This is just a firstapproximation. Carl, for example, may want to set a lower price inhopes of getting more business from this particular customer.Linder Company may want to charge a higher price based on marketconsiderations.
Target Costing
Another approach to pricing a product or service is targetcosting. The target cost is based on the price (target price) thatcustomers are willing to pay. The Marketing Department determineswhat characteristics and price for a product are most acceptable toconsumers. Then, it is the job of the company's engineers to designand develop the product such that cost and profit can be covered bythat price. Japanese firms have been doing this for years; Americancompanies are beginning to use target costing. So first the targetprice is set. Then the desired profit is deducted, and theremaining amount is the target cost.
| Target cost = Target price -Desired profit |
Determining the target cost is relatively easy. Actuallydesigning and manufacturing a product that will achieve the targetcost and sell for the target price is more difficult. As a result,target costing is an iterative process as the firm works to refinethe proposed product to meet the cost and price targets.
Price Discrimination
Price discrimination refers to the charging of different pricesto different customers for essentially the same product. TheRobinson-Patman Act was passed in 1936 as a means of outlawingprice discrimination by manufacturers or suppliers; services andintangibles are not included under the act.
The Robinson-Patman Act does allow price discrimination undercertain specified conditions: (1) if the competitive situationdemands it and (2) if costs (including costs of manufacture, sale,or delivery) can justify the lower price. According to the secondcondition, a lower price offered to one customer must be justifiedby identifiable cost savings and the amount of the discount must beat least equaled by the amount of cost saved.
To compute a cost differential, the company creates classes ofcustomers based on the average costs of selling to those customers.Then all customers in each group are charged a cost-justifiableprice.
Example: Raul Company manufactures specializedelastic bandages used to reinforce athletes' wrists or ankles. Raulsells to a number of individual physical therapists and athletictrainers as well as to Medallion Gym, a national chain of physicalfitness facilities. The average manufacturing cost is $169 per case(a case contains 100 plastic-wrapped elastic bandages). RaulCompany sold 350,000 cases last year to the following two classesof customer.
| Price | Quantity | |
|---|---|---|
| Medallion Gym | $235 | 175,000 |
| Individual trainers and physicaltherapists | $241 | 175,000 |
Medallion Gym requires that the bandages be individuallypackaged in boxes with the Medallion name on the label. This boxand special labelling costs $0.34 per unit. Raul also pays allshipping costs, which amounted to $1,400,000 last year.
The individual trainers and physical therapists order in smalllots that require special picking and packing in the factory; thespecial handling adds $20 to the cost of each case sold. Salescommissions to the independent jobbers who sell Raul products tothe trainers and physical therapists average 10 percent of sales.Bad debts expense amounts to 1 percent of sales.
The cost per case for each customer category can be computed asfollows:
| Medallion Gym: | |
|---|---|
| Manufacturing cost per case | $169.00 |
| Box and special labelling ($0.34 Ã100) | 34.00 |
| Shipping ($1,400,000/175,000cases) | 8.00 |
| Total cost per case | $211.00 |
| Individual Trainers and PhysicalTherapists: | |
|---|---|
| Manufacturing cost per case | $169.00 |
| Special handling | 20.00 |
| Sales commission ($241 x 0.10) | 24.10 |
| Bad debts expense ($241 x0.01) | 2.41 |
| Total cost per case | $215.51 |
Profit and profit percentages are as follows:
| Medallion Gym | Trainers and Physical Therapists | |
|---|---|---|
| Price per case | $235.00 | $241.00 |
| Less: cost per case | 211.00 | 215.51 |
| Profit per case | $24.00 | $25.49 |
| Profit percentage | 10.21% | 10.58% |
The company will need to see if the profit percentages range areclose to one another; if so, there would be a cost justificationfor the price differential. If not, the company may need toconsider potential price discrimination and change its price forthe customer group that it considers to be "out of line."
For each of the following situations, determine whether or notthere is price discrimination according to the Robinson-PatmanAct.
| 1. | Dr. Jeffrey Lowman, M.D., chargesless to patients who he feels cannot afford his usual fee.- Selectyour answer -YesNoItem 1 |
| 2. | Damian Company manufacturesspecialty jams and jellies. Damian is located in Amarillo, Texas,and sells only to stores in the Amarillo area. Sometimes Damianoffers a price break to store owners whose children attend the sameschools as Damian's children. - Select your answer -YesNoItem2 |
| 3. | A national manufacturer of hairproducts charges a significantly lower price to large chain storesthan to smaller stores. The price differential is not supported bycost differences. - Select your answer -YesNo |
INSOURCING/OUTSOURCING
Rentex Motor Drives is a division of a large U.S. manufacturer of industrial machinery and equipment. The parent company makes circulating pumps, high-capacity cooling fans, and compressors. Rentex Motor Dnves manufactures the electric motors that power much of this machinery and equipment. Rentex has a world-wide customer base and sells motors not only to its parent company, but also to other customers across the globe â some of whom are direct competitors of Rentex's parent company.
Recently the company developed an electric motor assembly that will be a key component in a new circulating pump being manufactured and sold by one of Rentex's sister companies. The circulating pump will be sold to the manufacturers of oil-fired burners used for home heating. Each circulating pump will require a single electric motor assembly.
Rentex must now decide whether or not it should outsource or internally manufacture the motor assembly. To help with the analysis, a cross-functional team has been formed. Members of the team have been assigned the responsibility of analyzing from a total cost perspective whether or not Rentex should outsource or internally manufacture the electric motor assembly.
A European supplier that produces motors for a number of Fortune 500 companies has submitted a detailed proposal to Rentex for building the subassembly. However, confounding this analysis is an internal bias against outsourcing the motor, particularly since there is a strong union presence within Rentex's facilities. Furthermore, management at Rentex believes that the electric motor assembly design might be adapted in the future to enable its use in new applications in the chemical processing industry, thereby representing a future growth opportunity.
As an initial step the cross-functional team has gathered the required information to guide the firm's decision process.
Outsourcing Costs
Unit Costs: Rentex's marketing group estimates that volumes for the motor assembly are:
| Year 1 | 5,500 units |
| Year 2 | 6,250 units |
| Year 3 | 7,000 units |
The European supplier of electric motors has quoted a price of $105 per unit, FOB ex-works, 1&2 with 5% price decreases per year for Year 2, and again for Year 3. Remember â the Year 3 price decrease is based off the Year 2 figure). The team assumes these price decreases are due to productivity improvements from higher volumes, the positive effects of learning at the supplier, and greater operating efficiencies. These prices have not been negotiated and the purchasing team believes that negotiation may lead to a lower unit price. If the new line of circulating pumps is successful, it is estimated that the life of the product cycle will be six years, reaching a peak of 8,000 units in Year 4, with a 10% reduction per year in volume after that as the product reaches the end of its life. It is estimated that the product will be completely phased out at the end of Year 6.
Shipping, handling, and receiving: Shipping, handling, and receiving costs at the buyer are estimated to be $15 per unit and should remain constant.
Tooling: The supplier has stated that it will cost $30,000 to fabricate the tooling and fixtures required to produce the electric motor. Rentex's policy is to assume ownership of tooling, so Rentex is responsible for the tooling costs. It's estimated that the tooling will have a usable life span of at least 6 years, with proper preventive maintenance (which the supplier has agreed to perform at no additional cost). The purchasing team plans to allocate the tooling costs evenly over the first three years.
Quality-related costs: The team has decided to include quality-related costs in its outsourcing calculations. During the investigation of the supplier, a team member collected data on the process that would likely produce the motors. The team estimates that the supplier's defect level, based on process measurement data, is 1,000 parts per million (ppm). Rentex's quality assurance department estimates that each supplier defect will cost Rentex $1,750 in direct nonconformance costs. Unfortunately, with quality problems there are always hidden costs that are difficult, if not impossible, to model.
Supplier capacity/safety stock: The team has concluded the supplier has available capacity to satisfy Rentex's current and near-term requirements for the motor. To mitigate supply chain risk, Rentex plans to hold one month's worth of the assembly as safety stock. The team assumes that this is a new cost each year.
Insourcing Costs
Rentex's cost engineering department has provided the following per unit cost estimates for internally manufacturing and assembling the motors during Year 1 of a three-year planning cycle:
| Direct labor | $19.75 | Cost of receiving components | $4.25 |
| Direct materials | $35.25 | Supplemental factory supplies | $2.15 |
| Transfer profit 3 | $21.75 |
Initial tooling and line modification costs: The start-up costs (including tooling) to modify existing production lines and equipment to accommodate production of the new motor will be $42,000, which will be spread out evenly over the first three years.
Depreciation expense: Depreciation expense on production equipment and tooling is considered a noncash item and is not included in the insourcing analysis.
Engineering design costs: Engineering costs to design, develop, and improve the production process will be $75,000 and will be spread evenly across the first three years of production.
Factory and corporate overhead: Overhead is allocated at 180% of direct labor costs.
Cost increases: In Years 2 and 3, management expects a 2% annual increase in direct material costs and a 3% increase in direct labor rates. (This increase is compounded so the increase in Year 3 costs is based off Year 2 cost figures).
Quality-related costs: The team estimates that Rentex's finished electric motor quality defects to be 2,500 ppm. Rentex's quality assurance department estimates that each defect costs the company $1,500 in nonconformance costs.
Preventive maintenance costs: Rentex's maintenance manager estimates that preventive maintenance of the production equipment required to produce the motors will cost $15,000 in Year 1, and will increase at the rate of 3% per year thereafter.
NOTES:
1. FOB (free on board) vessel means the supplier is responsible for transportation charges to the port in China.
2. Buyer is responsible for the cost and delivery of goods from the seller's location.
3. Transfer profit is the internal profit from selling to another unit in the company. This company views its units as profit centers, so profit must be included. Furthermore, the supplier has included profits in its quoted price.
Calculate the total cost per year for insourcing and outsourcing. Also calculate the cost per unit.
