CH-24 Performance Evaluation for Managers – Accounting : Book Guide

Chapter 24: Performance evaluation for managers Please note: GST versions of the end-of chapter questions are not appropriate for this chapter. Discussion questions 1. ‘Distinguishing between direct cost, controllable cost and avoidable cost is difficult, since they all really mean the same except they are used in different contexts.’ Discuss. A direct cost can be identified directly with a departmental unit. If the cost can be identified with a particular unit, then one can assume that such cost is controllable by the manager of that unit. Whether direct costs are avoidable costs or unavoidable costs depends on the circumstances of each situation. A direct cost may not necessarily be avoided if the departmental unit is shut down. For example, some costs which are directly associated with a department, e.g. management salaries, may not be avoided even if a particular department is closed. A direct cost may also be uncontrollable by a departmental manager, e.g. the decision to invest in particular non-current assets could be made at senior level and therefore the depreciation expense of the department is determined outside of the departmental manager’s control. Therefore, the assessment of whether a cost is direct, controllable, or avoidable depends on the circumstances in which the assessment is made. 2. It is much more time consuming to involve all managers accountable for responsibility centres in the planning process. Given the extra time and resources of this approach what are some of the benefits of participation of all managers. What are some possible downsides? Targets are more accurate and realistic goals as they are set by those who actually interact with the customers or are involved in the actual business processes so they have a better understanding of what is achievable. Managers are more likely to be motivated to achieve budgets if they are involved in setting them and believe they are realistic and achievable. If managers do not believe budgets are realistic then they tend to ignore them. Involvement in the planning process encourages managers to take ownership of the goals. However, reaching a consensus may be more difficult and managers may be tempted to set targets that are easy to achieve. 3. Save More is a large retail warehouse store which sells a wide range of products at discounted prices to the public. For each of the following business segments identify what type of responsibility centre would be appropriate: (a) staff cafeteria (b) gardening — retail division (c) purchasing department (d) homeware — retail division (e) human resources department (f) Save More Car Washing Ltd. (a) Cost centre (b) Profit centre (c) Cost centre (d) Profit centre (e) Cost centre (f) Investment centre 4. ‘Although determining gross profit for departments in a department store has some merit, the idea of trying to determine departmental profit is questionable because of all the indirect costs usually involved. Allocation of these costs is so arbitrary that the allocation process makes the departmental income statement virtually useless.’ Discuss. Determining gross profit for departments is based on being able to identify costs and expenses which are directly involved in the trading operations of a department. To determine a departmental profit, some allocation of costs and expenses is necessary, as departments will share common costs and common expenses, e.g. depreciation of the building accommodating the departments. In trying to allocate indirect costs across departments, it is essential to establish appropriate cost drivers, e.g. floor space, number of orders, level of sales, etc. If reasonable correlation can be established between the incurrence of costs and cost drivers, then it is possible to do a reasonably accurate allocation of indirect costs to departments. Such a process is desirable to enable some profitability analysis to be carried out on departments to identify which are profitable and which are unprofitable. While it is true that approximations are used in allocating costs and expenses if these are logically and thoughtfully determined, the resultant information is useful to decision makers. The profit figures which result from the allocation of indirect expenses should be interpreted with the knowledge of the limitations of allocation. The question is whether or not such a detailed analysis of costs by department will be of use to management. 5. The manager of a newly established department store asked the accountant to make recommendations regarding reports which should be produced for management use. The accountant was adamant that an income statement that disclosed departmental contributions was far superior to the fully departmentalised one which disclosed departmental profits. Do you agree with the accountant? What advice would you give to the manager? Explain. A departmental profit report does involve allocation of indirect expenses and can lead to misleading interpretations about departmental performance. The satisfactory performance or otherwise of a departmental unit needs to be looked at very carefully to determine whether or not such department should be continued or discontinued. In many cases, what appears on the surface to be an easy decision, can be reversed if analysed within a managerial context of departmental contribution. The principle behind the departmental contribution is that it gives a more realistic assessment of a department’s profitability performance than a profit figure, which includes many arbitrary allocations. Departmental contribution is based on a differential analysis, in that it takes account of those revenues and expenses that would be avoided if the department did not exist. The contribution margin approach can also be used to evaluate the performance of managers. Some consideration could be given to whether both sets of reports should be produced, and be dependent upon the type of decisions being made, i.e. the continuation or otherwise of a department can be based on departmental contribution report rather than a detailed profit report. 6. When preparing departmental contribution income statements, all direct expenses are controllable by department managers. Discuss, giving examples. Not all direct expenses that can be traced to a department are controllable by its manager. For example, the salary of the manager of a department is unlikely to be able to set their own salary level. Yet, the manager’s salary is directly attributable to the department. Similarly, the rent on the section of a business that is used by a department is likely to be negotiated by senior management as part of the rent on the whole premises. Yet, using the area of the premises occupied by a department, it is reasonable to directly allocate the cost of rent to each department. 7. What are two factors that need to be taken into account when determining whether a department should be maintained or closed down? Give examples to illustrate each factor. The contribution margin of the department needs to be taken into account and compared with the expected decrease in indirect expenses if the department is closed down. For example, a shoe department in a store may be making a contribution margin of $50 000 per year and not covering its total costs. If the shoe department is closed down then the store has to determine whether indirect costs will fall by more or less than $50 000. If indirect costs fall by less than $50 000 then the profit of the store will decrease. The interdependence of departments has to be taken into account. For example, if people come into the store expecting to buy a complete outfit of clothes and they can no longer buy shoes then in future they may go to another store that sells shoes as well as the rest of the clothes someone wants. Or, people may come into the store to buy shoes and see other goods that they like and buy them too. By closing the shoe department the store may have a decrease in sales in its other departments. 8. ‘Variable costs represent the “flex” in the flexible budget and fixed costs really are of no use in such a budget.’ Discuss. Flexible budgets are usually prepared over a range of activity and over that particular range, the variable costs will vary with activity, while the fixed costs will remain constant. In this sense, within that particular range, the variable costs do produce the ‘flex’ of flexible budgets. Fixed costs can change as the relevant level of activity changes. Fixed costs are only fixed over the relevant range being considered. Fixed costs are also troublesome since the unit fixed costs vary inversely with the level of activity. Fixed costs can ‘flex’ depending on their nature and level of activity. When performance appraisal is done by comparing budget with actual results, it is necessary to compare both variable and fixed costs elements, since even the actual fixed costs can vary from planned fixed costs. While fixed costs have no impact within a relevant range of activity, they are still important for comparison with actual results, and can ‘flex’ if the relevant range of activity varies. 9. ‘The only difference between fixed (static) and flexible budgets is the number of fixed budgets — with a fixed budget there is one, with a flexible budget there are many fixed budgets.’ Discuss. The statement is true. Fixed budgets provide budget estimates for a single level of activity. Flexible budgets are designed to respond to changes in the level of activity. Flexible budgets are usually based on some formula recognising both variable and fixed cost elements, with variable unit cost rates determined for each cost item. It is possible to develop a flexible budget for every single discreet unit of activity in the relevant range; usually a limited number of budgets are prepared at expected activity levels, representing typical activity within the overall relevant range. The major difference lies in the usefulness for performance evaluation; a fixed budget is only relevant if the activity level on which the fixed budget is prepared is achieved. If the activity level is not achieved, the fixed budget has limited use for performance evaluation. Flexible budgets allow the development of a specific budget for the activity level actually attained, and therefore reflect what should have happened in terms of revenues and costs for the activity level achieved. 10. In performance evaluation, is a fixed budget or a flexible budget more likely to provide a better measure of how well a manager has performed? Explain your answer by using examples. In performance evaluation a flexible budget is more likely to provide a better measure of how well a manager has performed. A manager responsible for sales, or the overall level of activity, in a business needs to be evaluated to a certain extent based on the fixed budget as they need to provide explanations on why the actual level of activity was different from the original budgeted level of activity. Managers who do not control the overall level of activity are better evaluated using flexible budgets. For example, if actual sales are 10 percent higher than the original budget the manager responsible for cost of sales or purchasing of inventory should be evaluated using a flexible budget. If sales increase by 10 percent then it is likely that the cost of sales will increase by a similar percentage. To evaluate such a manager by comparing the actual cost of sales to the original fixed budget would be unrealistic. 11. Standard costs are predetermined measures of what it should cost to produce a product or perform an operation. How are standard costs derived and what factors should be taken into account when determining standard costs? Standard costs are carefully derived using multiple sources of data including time and motion studies, work sampling, simulation and historical cost information. For new products management judgement combined with engineering studies will be used to provide estimates of standard costs. External factors such as economic conditions, industrial relations legislation and market influences must be considered when determining standard costs. Firms typically also factor in allowances for waste, work interruptions, machine breakdowns and human error when setting standards. 12. ‘The principles of responsibility accounting are just as relevant for the balanced scorecard management system as for an accounting system.’ Discuss. The main principles and features of both RA and BSC should be revisited – see text. Similarities : • both emphasise setting targets • both require the establishment of a suitable organisation structure • both are concerned with obtaining feedback through a suitable reporting system • both are concerned with evaluating the performance of managers • both require participation of managers to be evaluated in establishing targets/budgets, etc. • both use the principle of ‘management by exception’ and taking corrective action. Differences: • RA emphasise activities whereas BSC emphasise strategies. • RA concentrates on financial measures whereas BSC makes use of both financial and non-financial measures. • RA focuses on budgets/targets, while BSC focuses on ‘metrics’ (measures of strategic outcomes). • RA focuses on organisational units while BSC focuses on the four ‘perspectives’ of the organisation. While there are similarities and differences, the principles of RA are not incompatible with the BSC. An RA system can easily operate within the framework of the BSC. The BSC operates at a higher ‘plane’ than traditional RA. The principles of RA are evident with the BSC approach to evaluating performance. Exercises Exercise 24.1 Responsibility accounting Tania is the production manager for Manikato Winery. Tania has responsibility for all aspects of white wine production by Manikato. Red wines are produced at a different geographical locations and managed separately. For the current year, classify each of the following items as controllable income, expenses or investments for Tania’s operation. Explain your decision and indicate where responsibility might lie. (LO1) Item Decision Explanation Staff wages – white wine facility. Controllable expense. Tania responsible for employing and scheduling employees hours. Machine operating costs – white wine facility. Controllable expense. Tania responsible for all aspects of white wine production. New machine purchase – red wine facility. Not controllable. Responsibility – Red Wine Production Manager (controllable investment) Supermarket Sales – white wine. Not controllable. Responsibility – Sales Manager (controllable income) Market research expenses – new sparkling wine product. Not controllable. Responsibility –Marketing Manager (controllable expense) Increased direct material cost for white wine due to recipe change. Controllable expense. Tania responsible for approving changes to recipes. General managers salary. Not controllable. Tania has no influence over this. Insurance for white wine facility. Not controllable. Determined by market forces and environmental factors. Sales returns for white wine due to spoilage. May be controllable expense depending on when the spoilage occurred. Was spoilage due to production error or due to improper storage? Exercise 24.2 Variance analysis Following is a performance report for Oasis Villas. Required (a) Calculate the variances, stating whether they are favourable or unfavourable, and suggest possible reasons for variances that you consider significant. (LO1) (a) The variances that are significant are the staff wages, food and supplies and repairs and maintenance due to their size relative to the budgeted amount. The wages are up by 14% and it needs to be determined if this is in line with wage increases across the industry or if there are other reasons that can be controlled. The repairs and maintenance are unfavourable and are 31% above budget. This may be due to old fixtures, and unexpected replacements, or too little spent on repairs and maintenance in the past causing major problems in the latest accounting period. Food and supplies are down by 23% and it needs to be determined why this has happened and whether the budget was unrealistic. There may also be other explanations such as new suppliers and negotiated agreements. Exercise 24.3 Departmental gross profit Awesome Appliances operates two departments — whitegoods and electronics. During the year ended 30 June 2020, the store had the following financial results. In addition, indirect expenses that were not allocated to the departments amounted to $35 890. Required (a) Prepare a departmental income statement for the year ended 30 June 2020 based on the departmental gross profit approach. (Use three columns headed whitegoods, electronics, and total store.) (LO2) (a) AWESOME APPLIANCES Income Statement Departmental gross profit approach for the year ended 30 June 2020 Whitegoods Electronics Total Store Sales income $176 800 212 600 389 400 Less Sales returns 3 500 1 380 4 880 Net sales revenue 173 300 211 220 384 520 Cost of sales 138 640 (1) 126 732 (1) 265 372 GROSS PROFIT $34 660 $84 488 $119 148 Direct expenses 77 400 Indirect expenses 35 890 113 290 PROFIT $5 858 (1) Calculation of cost of sales: Reference books $173 300  80% = $138 640 Fiction books $211 220  60% = $126 732 Exercise 24.4 Departmental gross profit and departmental contribution Daisy Discount Store operates two departments — stationery and kitchenware. During the year ended 30 June 2020, the store had the following financial results. In addition, indirect expenses that were not allocated to the departments amounted to $23 894. Required (a) Prepare departmental income statements for the year ended 30 June 2020, based on the departmental gross profit and the departmental contribution approaches. (Use three columns headed stationery department, kitchenware department, and total store.) (LO2) (a) DAISY DISCOUNT Income Statement Departmental gross profit approach for the year ended 30 June 2020 Stationery Kitchenware Total Store Sales income $247 560 289 200 536 760 Less: Cost of sales 198 048 (1) 159 060 (1) 357 108 GROSS PROFIT $49 512 $130 140 $179 652 Direct expenses 191 120 Indirect expenses 23 894 215 014 LOSS $35 362 (1) Calculation of cost of sales: Stationery Dept $247 560  80% = $198 048 Kitchenware Dept $289 200  55% = $159 060 DAISY DISCOUNT Income Statement Departmental contribution approach for the year ended 30 June 2020 Stationery Kitchenware Total Store Sales income $247 560 289 200 536 760 Less: Cost of sales 198 048 (1) 159 060 (1) 357 108 GROSS PROFIT $49 512 $130 140 $179 652 Direct expenses 55 000 136 120 191 120 DEPARTMENTAL CONTRIBUTION ($5 488) ($5 980) ($11 468) Indirect expenses 23 894 LOSS ($35 362) Exercise 24.5 Indirect expense allocation Port Hills Gondola is a tourist operation on the outskirts of Dunedin. It provides cable car trips to the highest peak and also operates a café and gift shop on the mountain. Port Hills Gondola allocates indirect expenses to its three departments on the basis of gross profit percentage. The most recent data for the three departments is provided in the following table. Indirect expenses for the current year total $124 500. Required (a) Determine the allocation of indirect expenses for the current year. (LO3) (a) Allocation of indirect expenses for the year. Cable Car Cafe Gift Shop Total Sales revenue $215 000 $125 000 $75 000 $415 000 Indirect expenses allocations 87 150 12 450 24 900 124 500 Exercise 24.6 Indirect expense allocation with sales Perfect Health Pharmacy allocates indirect expenses to its three departments on the basis of sales. For the year ended 30 June 2019, the following allocations were made. Assume that, during the year ended 30 June 2020, the dispensary items and cosmetics departments have the same sales they had in the previous year, but hair care sales increase to $171 734 because of the popularity of a new product line. Assume further that the total indirect expenses of $710 000 increase by 15%. Required (a) Determine the allocation of indirect expenses for the year ended 30 June 2020, using sales. (b) Are the results of requirement A logical for an equitable allocation of indirect expenses? Explain. (LO3) (a) Allocation of indirect expenses for the year ended 30 June 2020. Dispensary items Cosmetics Hair care Total Sales revenue $766 200 383 100 171 734 1 321 034 Indirect expenses allocations 473 570 236 785 106 145 816 500 (b) Unless the increase in sales required substantially more support, the results are not logical and show the danger of arbitrary expense allocations. Hair Care has been penalised for increasing its sales by $44 034 despite the fact that the results were beneficial to the business. The reason is the increased expense allocation of $106 145 in the current year compared with only $71 000 in the previous years. On the other hand, the other departments are rewarded with smaller proportional increases while not increasing their sales. Exercise 24.7 Alternative allocations of indirect costs Petaling Products is a manufacturer of leather goods and for management and control purposes is divided into three departments. For the year ended 30 June the following information has been collected to determine the best way to allocate rent expense to each department. The rent for the year for the store is $150 000. The manager of each department is paid a bonus of 5% of any profit in excess of 10% of sales for the department. The owner of Petaling Products is considering allocating the rent expense to each department using as the base either the percentage of total sales or the floor area occupied. Required (a) Determine which method of allocating the rent would be preferred by the manager of each department. (LO3) (a) Bonuses with rent allocation based on percentage of total sales: Hand Bags Luggage Accessories Total Sales $960 000 $576 000 $384 000 $1 920 000 Percentage of total sales 50% 30% 20% 100% Profit before rent allocation $192 000 $84 000 $76 000 $352 000 Rent allocation (1) 75 000 (2) 45 000 (3) 30 000 150 000 Profit after rent allocation $117 000 $39 000 $46 000 $202 000 Bonus (4) $1 050 (5) 0 (6) $380 (1) $150 000  50% = $75 000 (2) $150 000  30% = $45 000 (3) $150 000  20% = $30 000 (4) ($117 000 – $960 000  10%)  5% = $1050 (5) ($39 000 – $576 000  10%) = $(18 600), hence no bonus (6) ($46 000 – $384 000  10%)  5% = $380 Bonuses with rent allocation based on floor area occupied: Hand Bags Luggage Accessories Total Sales $960 000 $576 000 $384 000 $1 920 000 Percentage of floor area 30% 50% 20% 100% Profit before rent allocation $192 000 $84 000 $76 000 $352 000 Rent allocation (7) 45 000 (8) 75 000 (9) 30 000 60 000 Profit after rent allocation $147 000 $9 000 $46 000 $202 000 Bonus (10) $2 550 (11) $0 (12) $380 (7) $150 000  30% = $45 000 (8) $150 000  50% = $75 000 (9) $150 000  20% = $30 000 (10) ($147 000 – $960 000  10%)  5% = $2550 (11) ($9 000 – $576 000  10%) = $(48 600), hence no bonus (12) ($46 000 – $384 000  10%)  5% = $380 The manager of Hand Bags would prefer the rent to be allocated based on floor area. Although the manager of Luggage doesn’t get a bonus under either allocation they are more likely to get a bonus if rent is allocated using percentage of total sales. The manager of Accessories would be indifferent assuming current levels of sales remain the same. Exercise 24.8 Effect of unavoidable costs Fitness Fantastic operates four gymnasiums in suburban areas. The Richmond club has recently reported an operating loss of $35 000. Total revenue for this club was recorded at $215 000. If this club is closed down Fitness Fantastic estimate they will still incur costs of $86 000. Required (a) Should the Richmond branch of Fitness Fantastic be closed? (LO5) (a) Total Unavoidable Avoidable Expenses $250 000 $86 000 $164 000 Keep Drop Revenue $215 000 — Avoidable $164 000 — Unavoidable $86 000 $86 000 Net Loss ($35 000) ($86 000) Fitness Fantastic should not close the Richmond Club. It is providing a contribution of $51 000 towards unavoidable costs. Assuming the operations of the other three gyms remain unchanged if the Richmond club is closed down, the company will be $51 000 worse off. Exercise 24.9 Effect of unavoidable costs One of the Marshland Ltd’s four departments has reported a loss of $90 000 after deducting $204 000 of expenses. Assume that only $130 000 of the expenses can be eliminated if the department is discontinued. Required (a) Should the business keep operating the department showing the loss when these facts only are considered? Explain. (b) Will the performance of the three other departments ever be considered in the decision to eliminate this department? Explain. (LO5) (a) Total Unavoidable Avoidable Expenses $204 000 $74 000 $130 000 Keep Drop Revenue $114 000a — Avoidable $130 000 — Unavoidable $74 000 $74 000 Net Loss ($90 000) ($74 000) a. ($90 000) + $204 000 = $114 000 From the facts that are given, it is evident that the department reporting the loss is not covering the avoidable costs nor providing a contribution to the unavoidable expenses. Assuming the operations of the other three departments remain unchanged if the loss department is closed down, the company will be $16 000 better off. (b) Yes! In deciding to close down the loss department, consideration must be given to the performances of the remaining three departments which must carry the additional burden of the $74 000 of unavoidable costs. It may well be the remaining departments will report losses under the additional cost burden. There may also be interdependence between the three departments and the loss making one. Exercise 24.10 Indirect expense allocation Shirley Cycles Ltd operates three selling departments — mountain bike, road bike and hybrid. Certain indirect expenses are allocated to the selling departments as follows. The following information is obtained from store records for the last financial year. Required (a) Prepare a schedule allocating the indirect expenses to the three departments. (LO3) (a) Expense Mountain Road Hybrid Total Marketing 14 000 (1) 33 600 (2) 8 400 (3) 56 000 Repairs department 39 840 (4) 53 120 (5) 39 840 (6) 132 800 Building occupancy 28 880 (7) 25 270 (8) 18 050 (9) 72 200 Insurance on inventory 25 760 (10) 27 232 (11) 20 608 (12) 73 600 Administration 14 700 (13) 35 280 (14) 8 820 (15) 58 800 Total 123 180 174 502 95 718 393 400 (1) $56 000  420 000/1 680 000 (2) $56 000  1 008 000/1 680 000 (3) $56 000  252 000/1 680 000 (4) $132 800  45/150 (5) $132 800  60/150 (6) $132 800  45/150 (7) $72 200  800/2 000 (8) $72 200  700/2 000 (9) $72 200  500/2 000 (10) $73 600  115 500/330 000 (11) $73 600  122 100/330 000 (12) $73 600  92 400/330 000 (13) $58 800  420 000/1 680 000 (14) $58 800  1 008 000/1 680 000 (15) $58 800  252 000/1 680 000 Exercise 24.11 Indirect expense allocation Even Electronics Ltd operates three selling departments. Certain indirect expenses are allocated to the selling departments as follows. The following information is obtained from store records for the last financial year. Required (a) Prepare a schedule allocating the indirect expenses to the three departments. (b) Assuming all products are priced so that they provide a 60 % gross margin, calculate the contribution of each department and comment on why the business may still choose to keep all three departments. (LO3) (a) Expense Computers Software Accessories Total Administration 112 000 (1) 32 000 (2) 16 000 (3) $160 000 Personnel department 42 000 (4) 25 200 (5) 16 800 (6) 84 000 Marketing 17 500 (7) 5 000 (8) 2 500 (9) 25 000 Utilities 86 000 (10) 51 600 (11) 34 400 (12) 172 000 Insurance on inventory 84 960 (13) 23 600 (14) 9 440 (15) 118 000 Total 342 460 137 400 79 140 $559 000 (1) $160 000  840 000/1 200 000 (2) $160 000  240 000/1 200 000 (3) $160 000  120 000/1 200 000 (4) $84 000  5/10 (5) $84 000  3/10 (6) $84 000  2/10 (7) $25 000  840 000/1 200 000 (8) $25 000  240 000/1 200 000 (9) $25 000  120 000/1 200 000 (10) $172 000  1 000/2 000 (11) $172 000  600/2 000 (12) $172 000  400/2 000 (13) $118 000  135 360/188 000 (14) $118 000  37 600/188 000 (15) $118 000  15 040/188 000 (b) Computers Software Accessories Total Sales 840 000 240 000 120 000 1 200 000 Cost of Sales 336 000 96 000 48 000 480 000 Gross Profit 504 000 144 000 72 000 720 000 Indirect Expenses 342 460 137 400 79 140 559 000 Contribution 161 540 6 600 (7 140) 161 000 Although the accessories department is making a negative contribution it may be worth keeping as it could reduce costs by only having one staff member. It appears to be overstaffed given the level of sales relative to the other two departments. Further, three other factors should be considered: (1) the basis of the allocation of the costs needs to be considered to determine its reasonableness (2) if the accessories department is eliminated will all of the indirect costs associated with it also be eliminated or will they have to be allocated to the other departments. (3) the computer and software departments may get some sales currently because people come in to purchase accessories and are up sold on computers and software. Exercise 24.12 Avoidable versus unavoidable costs McKee’s Outdoor Store Ltd operates three departments, including a department that has consistently shown losses. For the year just ended, the fishing supplies department showed the following performance. The expenses include allocated indirect expenses amounting to $42 600, which will be incurred whether the department is operated or not. The remainder of the expenses are direct, but include $30 000 that will have to be reassigned to another department because that amount is the salary of the owner’s daughter, who will be kept employed regardless of the decision made about the fishing supplies department. Required (a) Should the fishing department be eliminated? Support your answer with calculations showing the effect on storewide profits of eliminating the department. (LO5) (a) MCKEE’S OUTDOOR STORE LTD Fishing Supplies Department Income Statement (relevant costs only) for the year ended … Sales $76 000 Cost of sales 20 000 GROSS PROFIT $56 000 Less: Relevant (avoidable) operating expenses (1) 6 200 Departmental contribution $49 800 The effect on profit of eliminating the department will be a decrease in profit of $49 800. (1) Operating expenses $78 800 Less: unavoidable costs ($42 600 + $30 000) 72 600 $6 200 Exercise 24.13 Elimination of a department Dairy Delights operates with three departments. The owner–manager wants to close Department B because it continually shows a loss. During the past year ending 30 June 2020, the departmental performances were as follows: In analysing these results, the accountant determines that insurance expense ($18 000) and travel expense ($7000) are the only indirect expenses that can be avoided if Department B is closed. All direct expenses are avoidable. Required (a) What would the effect be on the store’s overall profits of closing down Department B? (LO5) (a) Department B Gross profit $48 000 Less: Relevant (avoidable) expenses Direct expenses $24 000 Indirect expenses 25 000 49 000 Department B contribution ($1 000) Effect on store’s profits of eliminating Department B: increase in profit of $1000. Exercise 24.14 Flexible budget for selling expenses European Motors Ltd uses flexible budgets in order to control selling expenses. Monthly sales range from $200 000 to $300 000. Budgeted fixed monthly expenses for the Sales Department are $63 000 for salaries of sales staff, $5000 for depreciation of equipment, and $12 000 for insurance. Variable expenses expressed as a percentage of sales are: training expenses for sales staff, 5%; advertising, 12%; sales commissions, 3%; and sundry selling expenses, 2%. Required (a) Prepare a flexible budget using increments of $50 000 over the expected range of sales. (LO6) (a) Flexible Budget (Selling Expenses) Levels of activity: Sales $200 000 $250 000 $300 000 Variable costs: Training expenses 5% 10 000 12 500 15 000 Advertising 12% 24 000 30 000 36 000 Sales commissions 3% 6 000 7 500 9 000 Sundry selling 2% 4 000 5 000 6 000 Total variable costs 44 000 55 000 66 000 Fixed costs: Sales staff salaries $63 000 $63 000 $63 000 Depreciation 5 000 5 000 5 000 Insurance 12 000 12 000 12 000 Total fixed costs 80 000 80 000 80 000 Total selling expenses $124 000 $135 000 $146 000 Exercise 24.15 Flexible budget Nathan’s Demolition Ltd wants to prepare flexible budget cost estimates for the following items within a range of 32 000 to 40 000 chargeable hours. Required (a) Prepare a flexible overhead budget for 32 000, 36 000 and 40 000 chargeable hours. (b) Calculate the fixed, variable and total overhead rates if 35 000 hours are actually charged to clients during the budget period. (LO6) (a) Flexible Overhead Budget Levels of activity: Direct labour hours 32 000 36 000 40 000 Variable costs: per Chargeable Hrs Depreciation $0.20 6 400 7 200 8 000 Electricity 0.40 12 800 14 400 16 000 Insurance 1.20 38 400 43 200 48 000 Maintenance 0.15 4 800 5 400 6 000 Supplies .55 17 600 19 800 22 000 Total variable costs $2.50 80 000 90 000 100 000 Fixed costs: Depreciation 18 000 18 000 18 000 Electricity 3 600 3 600 3 600 Insurance 8 600 8 600 8 600 Maintenance 7 400 7 400 7 400 Administration 16 920 16 920 16 920 Equipment Lease 14 400 14 400 14 400 Supplies 2 480 2 480 2 480 Total fixed costs 71 400 71 400 71 400 Total overhead costs 151 400 161 400 171 400 (b) Fixed overhead rate $71 400/35 000 = $2.04/DLH Variable overhead ($0.20 + 0.40 + 1.20 + 0.15 + .55 ) = 2.50/DLH Total overhead rate per DLH = $4.54/DLH Exercise 24.16 Flexible budget Fiscal Fixes Ltd is preparing flexible budget cost estimates for the following items within a range of 16 000 to 24 000 chargeable hours. Required (a) Prepare a flexible overhead budget for 16 000, 20 000 and 24 000 chargeable hours. (b) Calculate the fixed, variable and total overhead rates if 19 000 hours are actually charged to clients during the budget period. (LO6) (a) Flexible Overhead Budget Levels of activity: Direct labour hours 16 000 20 000 24 000 Variable costs: per Chargeable Hrs Electricity $0.20 3 200 4 000 4 800 Insurance 0.38 6 080 7 600 9 120 Training 1.40 22 400 28 000 33 600 Temp Secretarial 25.00 400 000 500 000 600 000 Sundry 1.40 22 400 28 000 33 600 Total variable costs $28 .38 454 080 567 600 681 120 Fixed costs: Rent 154 000 154 000 154 000 Electricity 7 000 7 000 7 000 Insurance 8 000 8 000 8 000 Training 3 000 3 000 3 000 Non-billable hours 35 000 35 000 35 000 Sundry expenses 21 000 21 000 21 000 Total fixed costs 228 000 228 000 228 000 Total overhead costs 682 080 795 600 909 120 (b) Fixed overhead rate $228 000/19 000 = $ 12.00/DLH Variable overhead ($0.20 + 0.38 + 1.40 + 25.00 + 1.40) = 28.38/DLH Total overhead rate per DLH = $40.38/DLH Exercise 24.17 Flexible budget and a performance report MBK Bags uses an annual flexible budget based on standard direct machine hours for the following factory overhead items. During the year, 18 000 direct machine hours were recorded for the production achieved. The following actual costs were incurred. Required (a) Why is a flexible budget performance report a better basis for assessing a manager’s performance than a fixed budget performance report? (b) Prepare a flexible budget for the three cost items using 12 000, 15 000 and 18 000 direct machine hours. (c) Prepare a flexible budget performance report for the three cost items, based on the actual results for the year. (LO6) (a) A flexible budget performance report is a better basis of assessing a manager’s performance than a fixed budget performance report as the budget estimates and the actual results are comparable as they are based on the same level of activity. Variances caused by the level of activity are therefore eliminated from the analysis. (b) Flexible Overhead Budget Level of activity: Direct machine hours 12 000 15 000 18 000 Variable costs: per DMH Supplies $0.30 3 600 4 500 5 400 Electricity $0.20 2 400 3 000 3 600 Indirect labour $1.10 13 200 16 500 19 800 Total variable costs $1.60 $19 200 $24 000 $28 800 Fixed costs Supplies 16 000 16 000 16 000 Electricity 19 600 19 600 19 600 Indirect labour 24 400 24 400 24 400 Total fixed costs 60 000 60 000 60 000 Total costs $79 200 84 000 88 800 (c) Flexible Budget Performance Report Budget Actual Variance Direct machine hours 18 000 18 000 — Variable costs Supplies 5 400 5 100 300F Electricity 3 600 3 700 100U Indirect labour 19 800 19 800 — Total variable costs $28 800 $28 600 $200F Fixed costs Supplies 16 000 16 500 500U Electricity 19 600 18 800 800F Indirect labour 24 400 24 400 — Total fixed costs 60 000 59 700 300F Total costs 88 800 88 0300 500F Exercise 24.18 Balanced scorecard The balanced scorecard goes beyond financial measures to provide a broader range of performance measures. Refer to The Balanced Scorecard Institute at the following website: www.balancedscorecard.org. Required For each of the following perspectives suggest non-financial measures that could be used in performance management: (a) customer (b) learning and growth (c) internal business processes. (LO8) Non-financial measures that are suggested for performance management on the www.balancedscorecard.org website include: (a) Customers: •customer satisfaction and dissatisfaction •customer retention and behaviour •customer acquisition •customer profitability. (b) Learning and growth: •product and service quality •productivity •waste •product and service costs •market potential •market growth rate •market share •organizational capabilities •infrastructure capabilities •stakeholder capabilities. (c) Internal business processes: •stakeholder satisfaction and dissatisfaction •stakeholder retention and behaviour •product/service profitability •strategic goals and the objectives necessary to achieve them. •process quality and capability. Problems Problem 24.19 Responsibility accounting You are provided with the profit centre responsibility accounting reports for Owen’s Department Stores. Required (a) Explain the relationship between the three profit responsibility reports for Owen’s Department Stores. (b) Explain to whom the three managers who receive the reports for Owen’s Department Stores are responsible. (c) Assuming Owen’s Department Stores investigates variances in excess of 5% of budget, outline which items each of the three managers shown are likely to focus on in their respective reports and suggest what non-financial information would also be useful in investigating these variances. (LO1) (a) The three profit responsibility reports for Owen’s Department Stores work from the bottom up. The totals in the Cookware manager’s report are summarised as one line in the Homeware manager’s report. The totals in the Homeware manager’s report are summarised as one line in the General manager’s report. The Cookware manager should be able to control the profitability of the frying pans, cooking utensils, crockery, cutlery and glassware sections of the Cookware department. The Homeware’s manager is one step removed from the actual sales but has oversight of the linen, cookware, cushions and pictures and prints departments. Finally, the general manager has an even less direct control over actual sales and costs of each section within each department but has oversight over the whole store. (b) The manager of the Cookware department is responsible to the Homeware’s manager who is responsible to the General manager who is responsible to the owners or shareholders of Owen’s Department Stores. (c) The Cookware manager would focus on cooking utensils, crockery and glassware. These are all unfavourable variances. Non-financial information that could be useful in investigating variances would be customer requests for items that are not stocked by the store, what brands and products similar stores are stocking, what products have been advertised by Owen’s and by its competitors and information about whether economic conditions have changed since the budgets were set. The Homewares manager would focus on all four departments for which they are responsible. Linen department has a favourable variance but the other three departments have unfavourable performances suggesting that there has been an unexpected downturn in demand for homeware goods. Non-financial information that could be useful in investigating the variances would include whether the number of customers entering the store as a whole have decreased and general economic conditions. The General manager would focus on the Homewares department and Furniture departments. Non-financial information that could be useful in investigating the variances could include the number of customers entering the store, general fashion trends within each department and general economic conditions. Problem 24.20 Departmental accounting Pretty in Pink Ltd specialises in bridal wear. The store operates two departments — gowns and shoes. The following information was obtained from the store’s accounting records for the year ended 30 June 2020. Indirect expenses are $106 200 per year. Required (a) Prepare a departmental income statement showing the departmental gross profit for each department and the store’s profit for the year. (b) Calculate the gross profit percentage for each department. (c) Prepare a departmental income statement that shows the profit of each department after the indirect operating expenses are allocated on the basis of sales (round to two decimal places). (LO2) (a) PRETTY IN PINK LTD Income Statement for the year ended 30 June 2020 Gowns Shoes Combined Depts Sales revenue Net sales revenue $588 000 $152 000 $740 000 Cost of sales Beginning inventory 63 800 26 650 90 450 Net purchases 334 460 83 430 417 890 Freight inwards 740 530 1 270 Goods available for sale 399 000 110 610 509 610 Ending inventory 74 500 23 970 98 470 Cost of sales 324 500 86 640 411 140 GROSS PROFIT $263 500 $65 360 $328 860 Operating expenses Direct operating expenses 141 625 Indirect operating expenses 106 200 247 825 PROFIT $81 035 (b) Gross profit $263 500/$588 000 = 44.8% $65 360/$152 000 = 43.0% (c) PRETTY IN PINK LTD Income Statement for the year ended 30 June 2020 Gowns Shoes Combined Depts Sales revenue Net sales revenue $588 000 $152 000 $740 000 Cost of sales 324 500 86 640 411 140 GROSS PROFIT $263 500 $65 360 $328 860 Operating expenses Direct operating expenses 110 000 31 625 141 625 Indirect operating expenses (1) 84 386 21 814 106 200 194 386 53 439 247 825 PROFIT(LOSS) $69 114 $11 921 $81 035 (1) Indirect operating expenses allocations: Gowns 588/740  106 200 = $84 386 Shoes 152/740  106 200 = $21 814 $106 200 Problem 24.21 Departmental accounting Rugged Rooms Ltd is a rug and drapery retailer. Rugged Rooms specialises in selling floor rugs and window dressings. The following information was derived from the shop’s accounting records for the year ended 30 June 2020. Indirect expenses are $146 800 per year. Required (a) Prepare a departmental income statement showing the departmental gross profit for each department and the store’s profit for the year. (b) Calculate the gross profit percentage for each department. (c) Prepare a departmental income statement that shows the profit of each department after the indirect operating expenses are allocated on the basis of gross profit. (LO2) (a) RUGGED ROOMS LTD Income Statement for the year ended 30 June 2020 Floor Rugs Windows Dressings Combined Depts Sales revenue Net sales revenue $532 000 $456 000 $988 000 Cost of sales Beginning inventory 193 400 149 200 342 600 Net purchases 255 600 324 520 580 120 Goods available for sale 449 000 473 720 922 720 Ending inventory 202 600 148 900 351 500 Cost of sales 246 400 324 820 571 220 GROSS PROFIT $285 600 $131 180 $416 780 Operating expenses Direct operating expenses 234 500 Indirect operating expenses 146 800 381 300 PROFIT $35 480 (b) Gross profit $285 600/$532 000 = 53.7% $131 180/$456 000 = 28.7% (c) RUGGED ROOMS LTD Income Statement for the year ended 30 June 2020 Floor Rugs Windows Dressings Combined Depts Sales revenue Net sales revenue $532 000 $456 000 $988 000 Cost of sales 246 400 324 820 571 220 GROSS PROFIT $285 600 $131 180 $416 780 Operating expenses Direct operating expenses 156 000 78 500 234 500 Indirect operating expenses (1) 100 595 46 205 146 800 256 595 124 705 381 300 PROFIT(LOSS) $29 005 $6 475 $35 480 (1) Indirect operating expenses allocations: Floor rugs 285 600/416 780  146 800 = $100 595 Window dressings 131 180/416 780  146 800 = $ 46 205 $146 800 Problem 24.22 Indirect expense allocation Sam’s Storage Solutions operates four departments — kitchen, bathroom, office and laundry. When preparing a departmental income statement, the store’s accountant allocates indirect expenses using the following allocation bases. The following data were obtained for the four departments. The kitchen department is located at the front of the store and the other departments are at the back. For the purposes of the allocation of the rent expense, it is assumed that the front of the store is twice as valuable as the back. Required (a) Prepare a schedule showing the allocation of the indirect expenses to the three departments. (LO3) (a) Indirect Expense Amount Allocation Base Kitchen Bathroom Office Laundry Total Rent $280 000 Relative value floor space $168 000 $56 000 $28 000 $28 000 $280 000 Personnel $60 000 Number of employees 24 000 12 000 18 000 6 000 60 000 Insurance $90 000 Value of inventory 18 000 45 000 9 000 18 000 90 000 Advertising $240 000 Sales 96 000 48 000 72 000 24 000 240 000 $670 000 $306 000 $161 000 $127 000 $76 000 $670 000 Allocation bases: Rent 594*/990 198/990 99/990 99/990 Personnel 4/10 2/10 3/10 1/10 Insurance 74 000/370 000 185 000/370 000 37 000/370 000 74 000/370 000 Advertising 624 400/1 561 000 312 200/1 561 000 468 300/1 561 000 156 100 / 1 561 000 *Weighted  2 times. Problem 24.23 Income statement with departmental contributions Cranford Cars Ltd operates a car sales business with two locations — new cars and second-hand cars. The company’s accountant has prepared an income statement for the year ending 30 June 2020. The beginning inventory of new cars was $185 000, and ending inventory was $157 000. The beginning inventory for the second-hand cars was $78 000, and ending inventory was $65 000. The company’s records indicate that the following percentages of each expense or revenue are directly chargeable to the departments. Any balance left in an expense account is an indirect expense. Required (a) Prepare a departmental income statement for the year ending 30 June 2020 that shows the departmental contribution for each department. (LO4) (a) CRANFORD CARS LTD Departmental Income Statement for the year ended 30 June 2020 New Cars Second-hand Cars Total Net sales revenue $ 791 000 (70%) $339 000 30%) $1 130 000 Less: Cost of goods sold Beginning inventory 185 000 78 000 263 000 Purchases 342 698 (53%) 303 902 (47%) 646 600 Goods available for sale 527 698 381 902 909 600 Ending inventory 157 000 65 000 222 000 Cost of sales 370 698 316 902 687 600 GROSS PROFIT $420 302 $22 098 $442 400 Direct operating expenses Advertising 20 511 (43%) 15 264 (32%) 35 775 Salaries 45 050 (34%) 27 825 (21%) 72 875 Insurance 16 416 (36%) 11 856 (26%) 28 272 Depreciation 3 420 (19%) 4 140 (23%) 7 560 Supplies 9 625 (35%) 9 075 (33%) 18 700 Total direct expenses 95 022 68 160 163 182 Departmental contribution $325 280 ($46 062) $279 218 Indirect operating expenses Advertising (25%) 11 925 Salaries (45%) 59 625 Insurance (38%) 17 328 Depreciation (58%) 10 440 Supplies (32%) 8 800 Interest (100%) 38 160 $146 278 PROFIT $132 940 Problem 24.24 Income statement with departmental contributions Versatile Vacuums sells two products — domestic and commercial. The store’s income statement for the year ending 30 June 2020 has been prepared from the accounting records. The company’s records indicate that the following percentages of each expense or revenue account are directly chargeable to the departments. (Any balance left in an expense account after allocation of direct charges is treated as an indirect expense.) The beginning inventory for the domestic department was $64 000 and the ending inventory was $44 000. The beginning inventory for the commercial department was $78 000 and the ending inventory was $54 600. Required (a) Prepare a departmental income statement for the year ended 30 June 2020 that shows the departmental contribution for each department. (LO4) (a) VERSATILE VACUUMS Departmental Income Statement for the year ended 30 June 2020 Domestic Commercial Total Net sales revenue $560 000 (35%) $1 040 000 (65%) $1 600 000 Less: Cost of goods sold Beginning inventory 64 000 78 000 142 000 Purchases 153 000 (30%) 357 000 (70%) 510 000 Goods available for sale 217 000 435 000 652 000 Ending inventory 44 000 54 600 98 600 Cost of sales 173 000 380 400 553 400 GROSS PROFIT $387 000 $659 600 $1 046 600 Direct operating expenses Sales salaries 138 000 (32%) 293 250 (68%) 431 250 Advertising 18 500 (25%) 37 000 (50%) 55 500 Depreciation 12 400 (20%) 15 500 (25%) 27 900 Rent 26 610 (30%) 44 350 (50%) 70 960 Sundry expenses 15 120 (28%) 17 280 (32%) 32 400 Total direct expenses 210 630 407 380 618 010 Departmental contribution $176 370 $252 220 $428 590 Indirect operating expenses Advertising (25%) 18 500 Depreciation (55%) 34 100 Managerial salaries (100%) 140 000 Rent (20%) 17 740 Utilities (100%) 20 000 Sundry expenses (40%) 21 600 Total indirect expenses $251 940 PROFIT $176 650 Problem 24.25 Closing down a department Fabric Wholesalers Ltd operates three departments. The accessories department has not been performing very well and has shown a loss for the past 3 years according to the company’s income statement. Competition in the accessories line is strong and the margins are low. The departmental income statement for the year ended 30 June 2020 was as follows. Indirect expenses of $53 000 are avoidable if the accessories department is eliminated. Required (a) Calculate the departmental margin for accessories department. (b) Should the accessories department be closed down? Justify your answer. (c) Prepare an income statement for the two remaining departments, assuming the Accessories Department is dropped, to confirm your results in requirement B. (LO5) (a) Accessories department contribution: Gross profit $122 000 Direct operating expenses 56 900 Departmental contribution $65 100 (b) No! The Accessories department is making a positive contribution of $65 100 towards operations, before the allocation of indirect operating expenses. Overall profit will decrease by $12 100 as $25 600 of indirect expenses will not be eliminated. (Refer to C.) KEEP DROP Gross Profit $122 000 $ — Direct Expenses 56 900 — Indirect Expenses 78 600 25 600 Net Effect ($13 500) ($25 600) (c) FABRIC WHOLESALERS LTD Income Statement (Two remaining departments) for the year ended 30 June 2020 INCOME Sales $1 500 200 Cost of sales 671 200 GROSS PROFIT 829 000 Direct operating expenses (235 500) Indirect operating expenses ($198 200 + $25 600) (223 800) PROFIT/(LOSS) $369 700 Profit: Two remaining departments: $395 300 – $369 700 = $25 600 decrease Profit: Overall: $381 800 – $369 700 = $12 100 decrease Problem 24.26 Closing down a department Daisy Supermarket operates four departments. Management is concerned about the financial results of the dried goods department, which has shown a loss for the past 3 years according to the company’s income statement. Competition in dried goods is exceptionally strong in the area in which the company operates. The departmental income statement for the year ended 30 June 2020 was as follows. If the dried goods department is closed, direct expenses amounting to $13 000 would be shifted to the other three departments. In addition, indirect expenses of $3 700 are unavoidable if the department is eliminated. Required (a) Calculate the departmental margin for the dried goods department. (b) Should the dried goods department be closed down? Justify your answer. (c) Prepare an income statement for the three remaining departments, assuming the Dried Goods is dropped, to confirm your results in requirement (b). (LO5) (a) Dried Goods department contribution: Gross profit $95 000 Direct operating expenses 143 800 Departmental contribution ($48 800) (b) Yes! The Dried Goods department is contributing a loss of $48 800 towards operations, before the allocation of indirect operating expenses. Overall, profit will increase by $52 600 as $130 800 of direct expenses and $16 800 of indirect expenses will be avoided. Keep Drop Gross Profit $95 000 — Direct Expenses 143 800 13 000 Indirect Expenses 20 500 3 700 Net Effect ($69 300) ($16 700) (c) Daisy Supermarket Income Statement (Three remaining departments) for the year ended 30 June 2020 INCOME Sales $1 865 000 Cost of sales 1 118 700 GROSS PROFIT 746 300 Direct operating expenses ($292 700 + $13 000) (305 700) Indirect operating expenses ($246 300 + $3 700) (250 000) PROFIT/(LOSS) $190 600 Profit: Three remaining departments: $207 300 – $190 600 = $16 700 Profit: Overall: $138 000 – $190 600 = $52 600 (Increase) Problem 24.27 Preparing a flexible budget performance report Barrington Ltd has prepared the following fixed budget performance report. The variable cost rates per unit for Barrington Ltd are as follows. Required (a) Prepare a flexible budget performance report for the actual level of activity. (b) Comment on the significant variances in the flexible budget performance report and explain why this is a better method of measuring variances than a fixed budget performance report like the one above. (c) If the units produced was less than budget what disadvantages might a flexible budget performance report have? (LO6) (a) BARRINGTON LTD Fixed Budget Performance Report for the year ended 30 June 2020 Flexible Budget Actual Variance Units produced 55 000 55 000 Variable costs: Direct materials $ 770 000 $ 824 000 $ 54 000 U Direct labour 330 000 390 000 60 000 U Indirect materials 66 000 61 600 4 400 F Indirect labour 44 000 50 400 6 400 U Electricity and gas 82 500 61 600 20 900 F Total variable costs 1 292 500 1 387 600 95 100 U Fixed costs: Supervisor’s salary 88 000 84 000 4 000 F Rent 120 000 120 000 0 Insurance 23 000 24 000 1 000 U Maintenance 15 000 18 000 3 000 U Depreciation 18 000 18 000 0 Total fixed costs 264 000 264 000 0 Total manufacturing costs $1 556 500 $1 651 600 $95 100 U U indicates an unfavourable variance. F indicates a favourable variance. (b) The only variances that would not be considered significant in the flexible budget performance report are the supervisor’s salary and insurance variances. All other variances are greater than 5% different from the flexible budget amount and would therefore be considered material. Direct materials, direct labour, indirect labour and maintenance are greater than budget and therefore reflect either inefficient use of resources or poor budgeting. Supervisor salary, indirect materials and electricity and gas less than budget and therefore suggest efficient use of resources or poor budgeting. Flexible budgets are a better way of measuring variances than fixed budgets as they adjust for the change in the level of production. For example, if actual production is different from the original amount budgeted, then it is expected that a different amount of direct material would be used. What is of more interest is whether the actual amount of material used is correct for the actual level of production. For Barrington Ltd the actual level of production was 5000 units more than the original budget so it is expected that more material should be used in production than the original budget. By comparing to the fixed budget there is a direct material variance of $124 000 but we can’t tell how much of this is due to producing 5000 more units than originally budgeted for and how much is due to efficient, or inefficient, use of material. The flexible budget shows that $70 000 is due to producing more units and only $54 000 is as a result of inefficient use of direct materials. (c) If the number of units produced is less than budget then the flexible budget does not reflect how poor overall performance was relative to the initial plans of the business. Management may only concentrate on the variances due to efficient, or inefficient, use of resources and not consider the overall implications at operating at a lower level than was initially planned. Problem 24.28 Flexible budgets and performance reporting Perjaya Plastics Ltd has prepared the following fixed budget performance report for the production department’s financial results during the year ended 30 June 2020. Required (a) Should the production department manager be rewarded for the significantly large favourable variance reported for the year? Explain. (b) Prepare a flexible budget performance report for the company’s results. Comment on the manager’s performance. (LO6) (a) The actual level of activity was less than that used to prepare the fixed (static) budget by 18 000 units. Logically, it can be anticipated that prime costs will register favourable variances against the static budget ($70 800 + $73 440) = $144 240 which accounts for the majority of the total favourable total variance of $164 360. So the production department manager should not be rewarded. (b) Flexible Budget Performance Report For the year ended 30 June 2020 Budget Actual Variance Production units 126 000 126 000 — Variable costs: Per unit Direct materials $4.50 567 000 $577 200 10 200 U Direct labour 3.5 441 000 430 560 10 440 F Indirect labour 0.25 31 500 32 760 1 260 U Supplies 0.40 50 400 54 600 4 200 U Repairs 0.30 37 800 28 080 9 720 F Total variable costs $8.95 1 127 700 1 123 200 4 500 F Fixed costs: Depreciation 127 200 127 440 240 U Insurance 2 400 2 920 520 U Rent 12 000 12 000 0 Salaries 16 800 17 280 480 U Total fixed costs 158 400 159 640 1 240 U Total manufacturing costs $1 286 100 $1 282 840 $3 260 F In contrast to the static/actual comparisons, the comparison between the flexible budget and actual reveals a more realistic performance evaluation. Static/actual F variance of $164 360 Flexible/actual F variance of $3 260 Problem 24.29 Flexible budgeting and performance reporting The fixed budget performance report for the year ended 30 June 2020 for Motueka Mint is as follows. Required (a) Convert the fixed budget performance report prepared by Motueka Mint to a flexible budget performance report. (b) Why does a report based on a flexible budget provide a better means of evaluating performance as opposed to a fixed budget? (LO6) (a) Flexible Budget Performance Report For the year ended 30 June 2020 Budget Actual Variance Production units 94 000 94 000 0 Factory overhead: Variable costs: Per unit Indirect labour $2.30 $216 200 $216 200 0 Supplies 1.60 150 400 178 600 28 200 U Maintenance 0.80 75 200 112 800 37 600 U Total variable overhead $4.70 441 800 507 600 65 800 U Fixed costs: Factory insurance 12 000 13 500 1 500 U Utilities 18 600 24 000 5 400 U Depreciation 14 500 13 800 700 F Management salaries 86 000 92 000 6 000 U Total fixed overhead 131 100 143 300 12 200 U Total factory overhead $572 900 $650 900 $78 000 U (b) A fixed budget is prepared for a static level of activity. For a budget to be comparable with actual performance, it must be prepared based on the same level of activity as the actual result. A flexible budget provides expected outcomes for the same level as the actual outcomes. Problem 24.30 Flexible budgeting and performance reporting Coola Vents Ltd has prepared a fixed budget performance report for the year ended 30 June 20207 as follows. Required (a) Convert the fixed budget performance report prepared by Coola Vents Ltd to a flexible budget performance report. (b) Explain why there is no variable overhead in the flexible budget for Coola Vents Ltd. Does this mean that expenditure on variable overhead items is satisfactory? (LO6) (a) Flexible Budget Performance Report For the year ended 30 June 2020 Budget Actual Variance Production units 75 200 75 200 0 Factory overhead: Variable costs: Per unit Indirect labour $1.50 $112 800 $120 320 $7 520 U Supplies 0.55 41 360 41 360 0 Repairs 0.35 26 320 18 800 7 520 F Total variable overhead $2.40 180 480 180 480 0 Fixed costs: Insurance of factory 16 600 24 600 8 000 U Occupancy costs 24 800 25 400 600 U Depreciation 20 700 20 700 0 Supervisory salaries 43 400 42 200 1 200 F Total fixed overhead 105 500 112 900 7 400 U Total factory overhead $285 980 $293 380 $7 400 U (b) The total variable overhead variance is zero because the unfavourable Indirect Labour Variance is cancelled out by the favourable Repairs variance. However, care must be taken when viewing the flexible budget performance report. Coola Vents should investigate the unfavourable variance for indirect labour as this may be caused by inefficient activities or wages increases. Coola should also investigate the favourable repairs variance as there may be an issue with the budget. It is important to look at individual line items as well as total overhead variances to ensure that variances are investigated appropriately. Problem 24.31 Elimination of a department Universal Solar Ltd operates three departments — a lighting department, a water heating department, and an equipment department. The store’s accountant has prepared an income statement by department for the year ended 30 June 2020 and, for the third year in a row, the equipment department has shown a loss. If the company decides to shut down the unprofitable department, 30% of the space occupied by the equipment department will be used by the lighting department and 30% will be used by the water heating department. The other 40% of the space will no longer be rented by Universal Solar Ltd. The company does not believe that eliminating the equipment department and at the same time enlarging the remaining two departments will change the sales or gross profits of the lighting and water heating departments. The accountant has also provided the following information. 1. At present, there are three salespeople and a manager in the equipment department. If the department is eliminated, the manager would be transferred to the lighting department and the three salespeople’s employment would be terminated. The manager’s salary is $52 000 per year. 2. Electricity, rent and insurance are allocated on the basis of floor space. The insurance would decrease $4000 a year if the department is eliminated; the rent and electricity would decrease by 40% of equipment department expense in line with the area given up. 3. Indirect advertising expenses of $60 000 were allocated to the departments on the basis of sales. The direct advertising expenditures incurred by the equipment department would be eliminated. 4. The equipment in the equipment department would be transferred to the other departments — 40% to the lighting department and 20% to the water heating department and the other 40% would be scrapped. 5. The managing director’s salary of $60 000 p.a. has been allocated equally over the departments. Required (a) Should the equipment department be closed down? What would be the impact on company total profit if it is eliminated? (b) Prepare a departmental income statement that would result if the equipment department is dropped. (LO5) (a) and (b) UNIVERSAL SOLAR LTD Income Statement for the year ended 30 June 2020 Lighting Water Heating Total INCOME Sales $766 000 $459 600 $1 225 600 Less: Cost of sales 306 400 206 820 513 220 GROSS PROFIT 459 600 252 780 712 380 EXPENSES Salaries (1) 206 990 (2) 84 410 291 400 Electricity (3) 18 480 (3) 18 480 36 960 Advertising (4) 133 780 (4) 82 970 216 750 Rent on building (5) 36 080 (5) 36 080 72 160 Depreciation on equipment (6) 39 506 (7) 27 418 66 924 Insurance (8) 11 650 (9) 11 650 23 300 Total expenses 446 486 261 008 707 494 PROFIT (LOSS) $ 13 114 $(8 228) $ 4 886 (1) $144 990 + $52 000(Equip Mger salary) + $10 000 (Mging Drctr salary) = $206 990 (2) $74 410 + $10 000 (Mging Director salary) = 84 410 (3) $12 600  30% = $3 780; $14 700 + $3 780 = $18 480 (4) Current allocation of advertising expense: Equipment: $306 400/$1 532 000  $60 000 = $12 000 indirect advertising $86 590 – $12 000 = $74 590 direct advertising, which is eliminated. Lighting: $766 000/$1 532 000  $60 000 = $30 000 indirect advertising $126 280 – $30 000 = $96 280 direct advertising Water heating: $459 600/$1 532 000  $60 000 = $18 000 indirect advertising $78 470 – $18 000 = $60 470 direct advertising New allocation of advertising expense: Business ($766 000/$1 225 600  $60 000) + $96 280 = $133 780 Home ($459 600/$1 225 600  $60 000) + $60 470 = $82 970 Check: $291 340 – $74 590 = $216 750 (5) $24 600  30% = $7 380; $28 700 + $7 380 = $36 080 (6) $19 840  40% + $31 570 = $39 506 (7) $19 840  20% + $23 450 = $27 418 (8) ($27 300 – $4 000)/2 = $11 650 (9) ($27 300 – $4 000)/2 = $11 650 The Equipment Department should not be closed down as it will reduce the total profit by $88 804 ($93 690 – $4 886). This is due to the loss in departmental contribution from Equipment as follows: GROSS PROFIT $ 199 160 Decrease in expenses: Salaries ($80 950 – $52 000 – $20 000) $8 950 Electricity ($12 600  40%) 5 040 Advertising (direct advertising) 74 590 Rent on building ($24 600  40%) 9 840 Depreciation on equipment ($19 840  40%) 7 936 Insurance 4 000 110 356 Decrease in departmental contribution $ 88 804 Problem 24.32 Responsibility accounting Wagons and Wheels Ltd is a farm machinery dealership. In recent years, the company has experienced unsatisfactory profit results because of declining sales in the area. At the suggestion of the company’s public accountant, responsibility accounting was implemented at the beginning of 2020. The following departments were organised as profit centres: •new machinery sales •used machinery sales •service •tyres •parts and accessories. Monthly reports are prepared showing the profit results of each of the five departments. On 13 April 2020, the parts and accessories manager and the used machinery manager requested a meeting with the company’s general manager to discuss the way responsibility accounting was being applied. In particular, they are protesting against two policies that currently are in effect. 1. The parts and accessories department must transfer all parts and accessories internally to other departments at their original invoice cost. 2. The used machinery sales department is charged the full dollar amount allowed by the new machinery sales department on a used machine traded in for a new machine. In many cases, this amount exceeds the ultimate selling price of the used machine. The used machinery sales manager tells the general manager about a recent case that is typical. A machine with a wholesale market value of $19 000 was traded in on a new machine with a list price of $48 000 and a dealer cost of $40 600. A trade-in allowance of $26 100 was given on the used machine to promote the deal and the customer paid cash of $21 900. Consequently, a profit of $7400 (i.e. $26 100 + $21 900 - $40 600) was recognised by the new machinery sales department. The retail market value of the used machine was $22 080 and it was sold at that price 2 weeks later. Since the used machine sales department was charged $26 100 when the used machine was added to the inventory, it incurred a loss of $4020 on the ultimate sale. Both managers (parts and accessories and used machinery) are upset by what they consider unfair practices and violation of the basic premise of responsibility accounting. Required (a) Do you agree or disagree with the two managers? (b) What would you do to improve the situation, if anything? (LO1) (a) Yes, one would have to agree that this is a bad application of responsibility accounting. Neither department in question is being treated within the context of controllability as it is used in a proper application of responsibility accounting. The two departments cannot control the factors that contribute to profit so they should not be profit centres. At best, they might be cost centres unless different policies are adopted. For example, the parts and accessories department cannot make the items up to include a profit margin for internal transfers. Also, the used machinery sales department must record used machines acquired at a cost that is inflated because of the amount of trade-in allowance required to sell a new machines. (b) The two deficiencies discussed in part A should be eliminated and the two departments should be allowed to operate as true profit centres. The parts and accessories department should make up all items transferred internally to other departments by a fair amount. In many dealerships, this is accomplished by adding a certain gross profit percentage to the cost of the interdepartmental transfers, thereby enabling the parts and accessories department to earn a profit. Used machines should be added to inventory at the wholesale market value that can be easily determined from a number of objective sources published regularly. When the used machines are sold, profit or loss is measured by the difference between the selling price and the inventory cost, which is the same treatment as in other retailing activities. As such, the used machinery sales manager is responsible for earning a profit on the department’s operation. In the situation discussed in this case, the department would have an inventory cost of $19 000 that would be matched with ultimate selling price of $22 080 so the profit on the used machine would be $3080. Consequently, the profit recognised on the new machine also would have been $300 ($21 900 + $19 000 – $40 600). Note that the assignment of the actual profit on the new machine and old machine combined is the basic issue. As reported, the new machinery sales department had a profit of $7400 and the used machinery sales department a loss of $4020. The difference between the two is $3380, the actual profit on the two sales. The alternative treatment suggested above provided the proper profit incentive for both departments, rather than for the new machinery sales department alone. Problem 24.33 Flexible budgets and performance evaluation Steph Gates, sales manager of Pluto Computers Ltd, was given the following budget performance report for selling expenses in the marketing software department for the month of April 2020. The recently appointed managing director of the company was pleased that Steph had been able to increase her department’s sales by 20% over the budgeted sales of 12 000 units. On the other hand, Steph came in for some severe criticism for the apparent blow-out of selling expenses in her department. Steph felt that the criticism she received was unfounded, because she believed that, given the level of sales volume achieved, the selling expenses were under control. She is unsure how to argue her case with the managing director, and approaches you as an accountant to help her. Required (a) Prepare a report based on flexible budget principles. (b) Does Steph deserve the criticism she received for not controlling selling expenses in her department? (c) Should the format of future budget reports be changed and, if so, why? (LO6) (a) Flexible Budget Performance Report For the month ended 30 April 2020 Budget Actual Variance Sales units 14 400 14 400 — Fixed costs: Sales salaries 1 800 1 800 — Office salaries 1 200 1 200 — Rent 2 250 2 250 — Depreciation 750 750 — Total fixed costs 6 000 6 000 — Variable costs: Per unit Sales commissions $0.20 2 880 $3 168 288 U Advertising 0.10 1 440 1 200 240 F Samples & Promotions 0.12 1 728 2 016 288 U Travel 0.50 7 200 6 912 288 F Total variable costs $0.92 13 248 13 296 48 U Total manufacturing costs $19 248 $19 296 48 U (b) Steph does not deserve the criticism. She has only spent $48 more than budget. The flexible budget comparison reduces a $2 256 unfavourable variance to a $48 unfavourable variance by comparing the flexible budget at actual level of activity with the actual performance. (c) Clearly, comparing static budgets with actual performance is giving misleading performance comparisons. The flexible budget approach provides a sound and informative analysis. Case studies Decision analysis To open or not to open? Penny Farthing, proprietor of the Healthy Holiday Resort, had generally been satisfied with the results of her resort in past years. However, she had felt for some time that business always seemed to be a little quiet towards the end of each financial year ending on 30 June. As a matter of curiosity, she had her accountant prepare an analysis of the last financial year’s results by quarters. The analysis yielded the figures set out below. The analysis revealed what Penny had suspected. The resort was running at a loss for the final quarter of the year. She then reasoned that she could either stop trading for the unprofitable quarter and take her family on holiday to somewhere cooler, or earn some additional money by being a tour guide in the nearby national park. Her accountant determined that, if the resort closed for the fourth quarter, fourth-quarter expenses would be affected in the following ways. Wages and salaries included an unavoidable $30 600 fixed component; interest on loan and lease payments would still need to be paid; 40% of advertising costs were fixed; insurance premiums would reduce by $960; 60% of maintenance costs could be saved; a minimum electricity charge of $1050 would still apply; depreciation of $1680 would still need to be charged. Required (a) Should Penny close her resort in the fourth quarter and take her family on holiday? Explain why. (b) Should Penny close her resort in the fourth quarter and seek employment as a tour guide? Explain your conclusion. (a) HEALTHY HOLIDAY RESORT Income Statement for the quarter ended 31 December 2020 Sales revenue $125 660 Less: Avoidable operating expenses: Advertising ($4 220  60%) 2 532 Wages & salaries ($87 650 – $30 600) 57 050 Maintenance ($2 110  60%) 1 266 Electricity ($20 060 – $1 050) 19 010 Insurance 960 Depreciation ($4 220 – $1 680) 2 540 Total avoidable expenses 83 358 Quarterly contribution $42 302 Unavoidable operating expenses: Advertising ($4 220  40%) 1 688 Wages & salaries 30 600 Lease of land 31 680 Maintenance ($2 110  40%) 844 Electricity 1 050 Insurance ($5 280 – $960) 4 320 Depreciation 1 680 Interest on loan 6 330 78 192 LOSS $35 890 Profitability for the first three quarters will decrease due to the need to absorb the unavoidable costs from the December quarter. Combined profit first three quarters $110 890 ($23 210 + $61 260 + $26 420) Less: December quarter unavoidable costs 78 192 PROFIT $32 698 As can be observed the decrease in profit equals the December quarter contribution. Penny should not close the restaurant for the December quarter because the year’s results would be $42 302 worse off. (b) To justify closing the restaurant and seeking employment as a tour guide, Penny would need to be certain of earning, at a minimum, a net equivalent of the December quarter contribution of $42 302. $42 302 per quarter translates into $169 208 per year. Do tour guides earn this kind of money? If so, Penny is probably better off to close the resort entirely. Critical thinking Employee bonuses Elena works for a medium-sized family-owned firm and was employed on a low retainer with the majority of her income based on bonuses. Elena is in charge of one of four responsibility centres and the bonuses were based on the final profit for each centre. Elena was not satisfied with this arrangement and renegotiated her contract so that bonuses are now based on gross profit. Required (a) Why was Elena, who is accountable for a responsibility centre, not satisfied with bonuses based on final profit for the centre? (b) Why might it not be in the best interests of the owner-manager of the firm to base employee bonuses on the gross profit of the responsibility centre? (c) What would be the most effective way of determining employee bonuses that should satisfy the requirements of both employees and the owner-manager? (a) Elena would not be satisfied with bonuses based on the final profit for the centre as this measure of profit would include allocations of indirect or overhead expenses that she could not influence. For example, if the owner decided to give themselves a $40 000 pay rise and this was allocated evenly over the four departments then Elena’s department’s final profit would fall by $10 000 and her bonus would be reduced. The reduction in bonus would not be due to poor performance on Elena’s part but rather an arbitrary decision by the owner that Elena had no control over. Elena would not consider this to be fair as she is being disadvantaged by someone else’s decisions. (b) It might not be in the best interest of the owner manager of the firm to base employee bonuses on the gross profit of their responsibility centre because although this would encourage employees to maximise sales and to minimise cost of sales it gives them no incentive to control other direct costs related to their department. For example, Elena may decide to increase the advertising for her department by 100% as this could significantly increase sales and the gross profit on which her bonus is based. Elena would then receive a greater bonus. However, the 100% increase in advertising expenses may not result in enough increase in the gross profit to cover the increased advertising and so, although the departments gross profit has increased, the final profit for the department may actually decrease. (c) The most effective way of determining employee bonuses is to work out the direct operating expenses for each department that can be controlled by the departmental managers and to calculate departmental contribution. A bonus scheme based on departmental contribution would provide an incentive for the managers to not only control sales and cost of sales but also the direct operating expenses that they can influence. This would give Elena an incentive to consider the cost benefit of the increased advertising expense discussed in part B. If the increase in gross profit from increased advertising was less than the increased advertising cost then Elena would affect her bonus. Communication and leadership Read the extract and discuss the questions that follow. Required (a) Do you agree with the author’s view that divisional conflicts are common in organisations? Why? Why not? (b) Identify other departments which are likely to have competing interests and provide examples of potential conflicts. (c) Devise some strategies to address each of the author’s root causes. (a) Divisional conflicts can be evident in many different type of organisations. Students may have different ideas and experiences that can be shared to discuss this issue. (b) Conflicts can arise in many different areas. Potential sites include: i. Between purchasing and manufacturing in regards to quality and price of materials; ii. Accounting and manufacturing in regards to cost considerations. iii. Human resources and other departments in regards to working conditions and remuneration rates. (c) Different subcultures and mental maps for success – develop and communicate organisational goals and culture, build a positive company culture, identifying competitors as common enemy to bring departments together. Group dynamics – encourage departments to view issues from other perspectives, utilise cross-disciplinary skills. Inconsistent and incomplete information – consider utilising enterprise resource planning software, conduct cross functional training so that individuals are more fully aware of what other departments need. Performance measures that seek to maximize the performance of one function, not the company as a whole – consider alternative forms of performance measurement, balanced scorecard measures etc. Poor communication – encourage direct communication channels rather than email, facilitate opportunities for staff in different departments to meet and develop relationships. Ethics and governance Personal human resources Bill Robbie works for a human resource management firm, People 4 U (P4U), that searches for middle and senior managers for large businesses. The firm receives a fee equivalent to 80% of the salary package of the people the firm successfully finds for clients. Each job is allocated direct expenses, such as the time spent by staff looking for potential employees and interviewing them, stationery, advertising costs, phone calls and secretarial time. As well as the direct costs, each job is allocated overhead costs determined by the accountant, Crea Tive, who estimates what proportion of total work done by the firm each year applies to each job. This estimate is very subjective. Bill regularly takes Crea out to lunch or for drinks after work at the local hotel. Crea believes Bill is interested in a relationship with her, but Bill has a steady partner and does not reciprocate Crea’s feelings. Each employee of P4U earns a base salary and a bonus equal to 10% of the profit on each job. The profit on each job is calculated by deducting the direct costs and allocated overhead costs from the fee charged to the client. Bill has borrowed a large amount to finance a new house, and is having difficulties meeting his repayments. At lunch one day, Bill intimated that it might be in Crea’s interests if she allocated less of overhead costs to Bill’s jobs and that some of the direct costs could easily be charged to other jobs that Bill was not involved with. Eager to please Bill, Crea agrees and charges some of the phone calls, stationery and secretarial costs for Bill’s jobs to Nadia’s, as she doesn’t like Nadia anyway. Crea also reduces the amount of overhead costs allocated to Bill’s jobs. In return, Bill takes Crea to lunch more often just to keep her on side, as he has no intention of developing a personal relationship with her. Required (a) Who are the stakeholders? (b) What are the ethical issues, if any, involved? (c) How are the actions of Crea likely to affect the performance evaluation of Nadia? (a) Stakeholders would include Crea, Bill, Nadia and the managers of the firm People 4 U. (b) The ethical issues are that Crea is intentionally misallocating expenses and using her subjective judgement on the indirect expenses in a biased manner. This is dishonest. This will result in higher bonuses for Bill and lower bonuses for Nadia. Bill is also behaving in an unethical manner by leading Crea on. (c) Crea’s actions are likely to lead to Nadia getting lower bonuses than she deserves. Financial analysis Refer to the latest financial report of JB Hi-Fi Limited on its website, www.jbhifi.com.au, and answer the following questions: 1. Is JB Hi-Fi Limited segmented? 2. Could JB Hi-Fi Limited be described as a diversified economic entity? Explain why. 3. Describe how segmental information is presented in the report and comment on the degree of disclosure of segmental performance and position in the income statement and balance sheet. 4. Do you believe that the users of the annual report would be better served if segmental information was presented in the income statement? Explain. 1. Please refer to section 31 (a) – JB Hi-Fi is not segmented. 2. JB Hi-Fi Ltd cannot be described as a diversified economic entity as it has only one segment. 3. Students should describe the geographic segment information that is provided on a segmental basis in section 31 (b). 4. Segmental accounting is primarily for management use. The information given in the Operating and Financial Review pages and the Statistical Analysis is probably more than adequate for the general users of the annual report. Solution Manual for Accounting John Hoggett, John Medlin, Claire Beattie, Keryn Chalmers, Andreas Hellmann, Jodie Maxfield 9780730344568