Download - Class 05 --The Problem of Overhead
Managerial Accounting
Product Costing:The Problem of
Overheadmyeducator.co
m
Today’s Agenda• The price of wedding announcements
– Setting prices based on costs– Opportunity costs
• Making Airplanes• Lily Ice Cream Company
– Allocating overhead based on business activities– Activity-based Costing (ABC)
myeducator.com
What SHOULD You Have DoneBefore the Start of Class Today?
1. Done the MyEducator preparation for Quiz 5a.
2. Completed the pre-class Quiz (5a).
myeducator.com
Helping a Friend
Wild Horse Wedding Announcements
• “Fair” price = Cost + $50• 40 orders per month• Loses $3,000 in a typical month
myeducator.com
Helping a Friend
Wild Horse Wedding AnnouncementsMonthly Income StatementRevenue $16,000
Cost of Goods Sold: Direct materials cost (10,000) Direct labor cost (4,000)Gross profit $2,000
Operating expenses Electricity (300) Rent (1,000) Insurance (400) Bookkeeping (800) Equipment depreciation (2,500)Total operating expenses (5,000)
Operating income (loss) ($3,000)
Income taxes (40%) 0
Net income (loss) ($3,000)myeducator.co
m
Helping a Friend
Wild Horse Wedding Announcements
Your friend calculates that the production cost of each wedding announcement order is $350 ($14,000 ÷ 40). Accordingly, your friend is setting the price at $400 ($350 + $50).
• What mistake is your friend making?
• What price would you suggest?
myeducator.com
Helping a Friend
Wild Horse Wedding Announcements• Better cost estimate
Direct materials cost $10,000 Direct labor cost 4,000 Overhead cost 5,000Total $19,000
÷ 40 orders per month $475
Plus $50??
myeducator.com
Wild Horse Wedding Announcements
New Selling Price = $475 + $50 = $525Monthly Income StatementRevenue $21,000
Cost of Goods Sold: Direct materials cost (10,000) Direct labor cost (4,000)Gross profit $7,000
Operating expenses Electricity (300) Rent (1,000) Insurance (400) Bookkeeping (800) Equipment depreciation (2,500)Total operating expenses (5,000)
Operating income (loss) $2,000
Income taxes (40%) (800)
Net income (loss) $1,200
myeducator.com
Helping a Friend
Wild Horse Wedding Announcements
Your friend has invested her life savings of $300,000 to buy the equipment and get this business going.
• Does this change your advice about a reasonable selling price per order?
• Explain.myeducator.co
m
Helping a Friend
Wild Horse Wedding Announcements
Assume that your friend can earn, after income taxes, an average of 12% per year (1% per month) by relaxing and just investing her $300,000.
Monthly “opportunity” cost of having the money tied up in this business:
$300,000 × 0.01 = $3,000myeducator.co
m
Helping a Friend
Wild Horse Wedding Announcements40 orders × $600 each
Revenue $24,000
Cost of Goods Sold: Direct materials cost (10,000) Direct labor cost (4,000)Gross profit $10,000
Operating expenses Electricity (300) Rent (1,000) Insurance (400) Bookkeeping (800) Equipment depreciation (2,500)Total operating expenses (5,000)
Operating income (loss) $5,000
Income taxes (40%) (2,000)
Net income (loss) $3,000myeducator.co
m
Helping a Friend
Wild Horse Wedding Announcements
Your friend has a couple of part-time employees who work a total of 200 hours per month. Your friend herself works in the business about 60 hours per week.
• Does this change your advice about a reasonable selling price per order?
• Explain.
myeducator.com
Helping a Friend
Wild Horse Wedding Announcements
Assume that your friend can earn, after income taxes, $60,000 per year ($5,000 per month) by shutting down Wild Horse and getting a job.
“Opportunity” cost of using your time to run the business:
$5,000 per month
myeducator.com
Helping a Friend
Wild Horse Wedding Announcements40 orders × $808.33 each
Monthly Income StatementRevenue $32,333
Cost of Goods Sold: Direct materials cost (10,000) Direct labor cost (4,000)Gross profit $18,333
Operating expenses Electricity (300) Rent (1,000) Insurance (400) Bookkeeping (800) Equipment depreciation (2,500)Total operating expenses (5,000)
Operating income (loss) $13,333
Income taxes (40%) (5,333)
Net income (loss) $8,000 myeducator.com
Helping a Friend
Wild Horse Wedding Announcements
• $808.33 per order!!!• Quite a bit more than $400
Does it now pay Dugway people to drive to Grantsville, Tooele, or even Salt Lake to get their wedding announcements?
myeducator.com
Wild Horse Wedding Announcements
Key Points• When products are specialized, cost is
an important input into determining price.
• Someone has to pay your overhead costs … either you or your customers.
• Don’t forget your opportunity costs.
myeducator.com
What Causes Overhead?
Boeing1. How does a design change create extra
overhead?
2. If Boeing allocates overhead based on direct labor hours, do customers order too many design changes? Explain.
myeducator.com
What Causes Overhead?
Boeing3. If Boeing allocates overhead based on direct labor
hours, which mistakes will Boeing make?a. Highly customized aircraft are sold at a price that
is too low.b. Generic aircraft are sold at a price that is too high,
reducing demand.c. Some unprofitable orders are accepted.d. Some potentially profitable orders are rejected.e. Allow Airbus to take over the aerospace industry.
myeducator.com
More Practice with Product Costs
Lily Ice Cream Company• Lily manufactures ice cream• Traditionally she has produced and sold just
plain vanilla• In the past, Lily has made solid profits
• Lily has decided to start making and selling her own flavors of gourmet ice cream
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyNew overhead costs• Flavor chemist• Many new quality control inspectors
– Inspection at start and end of every batch• New machine workers, setup for the many new
batches• Machines need to be cleaned more frequently• Accounting costs have gone up
– Ordering different ingredients– More reports
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyTraditionally, Lily has had a very simple method of overhead allocation.
• Total overhead divided by number of gallons of ice cream produced
• Each gallon of ice cream allocated the same amount of overhead
This was fine because everything was VANILLA.
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyHere are Lily’s problems.• Overall profitability has slipped since the
introduction of the new flavors.• The vanilla ice cream is now being sold at a
loss.
myeducator.com
Traditional Profitability Report
Lily Ice Cream Company Double
Marshmallow Gingerbread Strawberry Dutch PeanutCaramel Cheesecake Banana Chocolate Butter
Vanilla Delight Supreme Surprise Brownie Swirl TotalNumber of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000
Production cost:Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000Overhead ($1.16 per gallon) 580,000 290,000 232,000 58,000 464,000 116,000 1,740,000
Total f lavor production cost 905,000 590,000 582,000 123,000 964,000 316,000 3,480,000
Flavor gross profit ($155,000) $35,000 $18,000 $2,000 ($164,000) $34,000 ($230,000)
myeducator.com
More Practice with Product Costs
Lily Ice Cream Company
Lily is considering dropping
vanilla ice cream!!!(and chocolate )
myeducator.com
Activity-Based Costing
Batches and Flavors
Vanilla and Chocolate – LARGE Batches
----------V----------- ---------- C ----------
6 Flavors – small Batches VCSGMPVCSGMPVCSGMPVCSGMPVCSGMPV
Vanilla and Chocolate – small BatchesVCVCVCVCVCVCVCVCVCVCVCVCVCVCVCVCVC
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyFive Steps in implementingand using an ABC system
1.Identify overhead cost activities2.Analyze individual overhead costs in terms of
cost activities3.Identify measurable cost drivers4.Assign overhead5.Use the ABC data to make decisions
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyComplete Analysis of Overhead Cost Items
Overhead Cost Activities
Overhead || Ice Cream Ice
Cream Ice
Cream Keeping Factory
Overhead Cost Items Costs || Production Batches Flavors Open Electricity $200,000 || $200,000 $0 $0 $0 Machine depreciation 400,000 || 400,000 0 0 0 Factory cleaners 300,000 || 90,000 210,000 0 0 Machine repairpersons 100,000 || 15,000 85,000 0 0 Production supervisor 200,000 || 30,000 100,000 70,000 0 Flavor chemist 170,000 || 0 0 170,000 0 Accounting department 150,000 || 15,000 45,000 30,000 60,000 Building depreciation 80,000 || 0 0 0 80,000 Security guards 90,000 || 0 0 0 90,000 Building insurance 50,000 || 0 0 0 50,000 Total $1,740,000 || $750,000 $440,000 $270,000 $280,000
Cost Pools myeducator.co
m
More Practice with Product Costs
Lily Ice Cream Company Cost Cost Activity Driver Operating the Gallons of ice cream ice cream production process produced Producing Batches produced a specific batch of ice cream
Servicing Number the special needs of ingredients of each individual ice cream flavor Keeping the factory open Not applicable
myeducator.com
More Practice with Product Costs
Lily Ice Cream Company Overhead Cost Number of per Overhead cost activity Cost Pool Amount Cost Driver Events Cost Driver Event Ice cream production $750,000 1,500,000 gallons $0.50 per gallon Ice cream batches 440,000 500 batches $880 per batch Ice cream flavors 270,000 100 ingredients $2,700 per ingredient Keeping the factory open 280,000 not assigned not assigned
myeducator.com
Traditional Profitability Report
Lily Ice Cream Company Double
Marshmallow Gingerbread Strawberry Dutch PeanutCaramel Cheesecake Banana Chocolate Butter
Vanilla Delight Supreme Surprise Brownie Swirl TotalNumber of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000
Production cost:Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000Overhead ($1.16 per gallon) 580,000 290,000 232,000 58,000 464,000 116,000 1,740,000
Total f lavor production cost 905,000 590,000 582,000 123,000 964,000 316,000 3,480,000
Flavor gross profit ($155,000) $35,000 $18,000 $2,000 ($164,000) $34,000 ($230,000)
myeducator.com
ABC Profitability Report
Lily Ice Cream Company
Using the detailed overhead analysis data, recompute gross profit for each of the 6 flavors.
myeducator.com
ABC Profitability Report
Lily Ice Cream Company Number of Number of Number of Flavors Gallons Batches Ingredients Vanilla 500,000 25 5 Marshmallow Caramel Delight 250,000 50 20 Gingerbread Cheesecake Supreme 200,000 235 25 Strawberry Banana Surprise 50,000 60 10 Double Dutch Chocolate Brownie 400,000 30 10 Peanut Butter Swirl 100,000 100 30 Total 1,500,000 500 100
myeducator.com
ABC Profitability Report
Lily Ice Cream CompanyABC overhead calculation: VANILLAProduction
500,000 gallons × $0.50 = $250,000Batches
25 batches × $880 = $22,000Flavors
5 ingredients × $2,700 = $13,500myeducator.co
m
ABC Profitability Report
Lily Ice Cream Company (VANILLA)Traditional ABC
Vanilla VanillaNumber of gallons 500,000 500,000
Sales $750,000 $750,000
Production cost:Direct materials 200,000 200,000Direct labor 125,000 125,000
Overhead (traditional) 580,000
Overhead (using ABC):Gallons of ice cream 250,000Number of batches 22,000Number of ingredients 13,500 Total 285,500
Total f lavor production cost 905,000 610,500
Flavor gross profit ($155,000) $139,500
myeducator.com
ABC Profitability Report
Lily Ice Cream CompanyWhat is ABC GROSS PROFIT for•Gingerbread Cheesecake Supreme ice cream?
myeducator.com
ABC Profitability Report
Lily Ice Cream CompanyABC overhead calculation:Gingerbread Cheesecake SupremeProduction
200,000 gallons × $0.50 = $100,000Batches
235 batches × $880 = $206,800Flavors
25 ingredients × $2,700 = $67,500myeducator.co
m
ABC Profitability Report
Lily Ice Cream CompanyDouble
Marshmallow Gingerbread Strawberry Dutch PeanutCaramel Cheesecake Banana Chocolate Butter
Vanilla Delight Supreme Surprise Brownie Swirl TotalNumber of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000
Production cost:Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000Overhead (using ABC):Gallons of ice cream 250,000 125,000 100,000 25,000 200,000 50,000 750,000Number of batches 22,000 44,000 206,800 52,800 26,400 88,000 440,000Number of ingredients 13,500 54,000 67,500 27,000 27,000 81,000 270,000
Total f lavor production cost 610,500 523,000 724,300 169,800 753,400 419,000 3,200,000
Flavor gross profit $139,500 $102,000 ($124,300) ($44,800) $46,600 ($69,000) $50,000
Facility support costs 280,000
Company gross prof it ($230,000)
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyGingerbread Cheesecake Supreme lost $124,300.
What can we do to make this flavor profitable?
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyGingerbread Cheesecake Supreme
Use of cost drivers:• 200,000 gallons• 235 batches• 25 ingredients
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyGingerbread Cheesecake Supreme
Further investigation reveals the following:
The large number (235) of Gingerbread Cheesecake Supreme batches is the result of one customer, an ice cream retail chain, that insists on having its Gingerbread Cheesecake Supreme ice cream produced fresh daily.
myeducator.com
More Practice with Product Costs
Lily Ice Cream CompanyGingerbread Cheesecake Supreme
What would the flavor gross profit of Gingerbread Cheesecake Supreme be if the number of batches could be cut to approximately one per WEEK (50) instead of one per working DAY (235)?
myeducator.com
More Practice with Product Costs
Lily Ice Cream Company 235 batches 50 batches Gingerbread Gingerbread Cheesecake Cheesecake Supreme Supreme Number of gallons 200,000 200,000 Sales $600,000 $600,000 Production cost: Direct materials 250,000 250,000 Direct labor 100,000 100,000 Overhead (using ABC): Gallons of ice cream 100,000 100,000 Number of batches 206,800 44,000 Number of ingredients 67,500 67,500 Total flavor production cost 724,300 561,500 Flavor gross profit ($124,300) $38,500
myeducator.com
More Practice with Product Costs
Lily Ice Cream Company
A good managerial accounting measure
• Reflects economic reality• Motivates correct behavior
myeducator.com
Today’s Agenda• The price of wedding announcements
– Setting prices based on costs– Opportunity costs
• Making Airplanes• Lily Ice Cream Company
– Allocating overhead based on business activities– Activity-based Costing (ABC)
myeducator.com
For Next Time1. Launch QUIZ 5b by Friday at 11:59 p.m.2. Study website topics for Day 6 in preparation
for Quiz 6.3. Decide whether you need/want to come to
class on Tuesday. 4. Launch QUIZ 6 on MyEducator by WEDNESDAY
at 11:59 p.m.
myeducator.com