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Chapter 5Cost Behavior: Analysis and Use

Solutions to Questions

5-1a. Variable cost: The variable cost per

unit is constant, but total variable costchanges in in direct proportion tochanges in volume.

b. Fixed cost: The total fixed cost isconstant within the relevant range.

The averagefixed cost per unit variesinversely with changes in volume.

c. Mixed cost: A mixed cost contains bothvariable and fixed cost elements.

5-2a. nit fixed costs decrease as volume

increases.b. nit variable costs remain constant as

volume increases.c. Total fixed costs remain constant as

volume increases.d. Total variable costs increase as volume

increases.

5-3a. !ost behavior: !ost behavior refers to

the way in which costs change inresponse to changes in a measure ofactivity such as sales volume,production volume, or ordersprocessed.

b. "elevant range: The relevant range isthe range of activity within whichassumptions about variable and fixedcost behavior are valid.

5-4 An activity base is a measure ofwhatever causes the incurrence of avariable cost. #xamples of activity basesinclude units produced, units sold, letterstyped, beds in a hospital, meals served ina cafe, service calls made, etc.

5-5

a. Variable cost: A variable cost remainsconstant on a per unit basis, butincreases or decreases in totalin directrelation to changes in activity.

b. Mixed cost: A mixed cost is a cost thatcontains both variable and fixed costelements.

c. $tep%variable cost: A step%variable costis a cost that is incurred in largechun&s, and which increases ordecreases only in response to fairlywide changes in activity.

5-6 The linear assumption isreasonably valid providing that the costformula is used only within the relevant

range.

5-7 A discretionary fixed cost has afairly short planning hori'on(usually ayear. $uch costs arise from annualdecisions by management to spend oncertain fixed cost items, such asadvertising, research, and managementdevelopment. A committed fixed cost has

) The Mc*raw%+ill !ompanies, nc., -/. All rights reserved.

-0 Managerial Accounting, /1th #dition

Cost

Activity

Mixed Cost

Variable Cost

Step-Variable Cost

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a long planning hori'on(generally manyyears. $uch costs relate to a company2sinvestment in facilities, e3uipment, andbasic organi'ation. 4nce such costs havebeen incurred, they are 5loc&ed in6 formany years.



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5-a. !ommitted d. !ommittedb. 8iscretionary e. !ommittedc. 8iscretionary f. 8iscretionary

5-! 9es. As the anticipated level of

activity changes, the level of fixed costsneeded to support operations may alsochange. Most fixed costs are adustedupward and downward in large steps,rather than being absolutely fixed at onelevel for all ranges of activity.

5-1" The high%low method uses only twopoints to determine a cost formula. Thesetwo points are li&ely to be less than typicalbecause they represent extremes ofactivity.

5-11 The formula for a mixed cost is 9 ;a < b=. n cost analysis, the 5a6 termrepresents the fixed cost and the 5b6 termrepresents the variable cost per unit ofactivity.

5-12 n a least%s3uares regression, thesum of the s3uares of the deviations fromthe plotted points on a graph to the

regression line is smaller than could beobtained from any other line that could befitted to the data.

5-13 4rdinary single least%s3uaresregression analysis is used when a

variable cost is a function of only a singlefactor. f a cost is a function of more thanone factor, multiple regression analysisshould be used to analy'e the behavior ofthe cost.

5-14 The contribution approach incomestatement organi'es costs by behavior,first deducting variable expenses to obtaincontribution margin, and then deductingfixed expenses to obtain net operatingincome. The traditional approachorgani'es costs by function, such as

production, selling, and administration.>ithin a functional area, fixed and variablecosts are intermingled.

5-15 The contribution margin is totalsales revenue less total variable expenses.


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#$er%ise5-1@/7 minutes

/.

Cups of Coffee Servedin a Week

2,000 2,100 2,200

Fixed cost............................ B/,- B/,- B/,-

Variable cost........................ 00 0?- 0C0Total cost............................. B/,?0 B/,??- B/,?C

0Average cost per cup of

coffee served D..................B.C- B.E/ B.E?

7

D Total cost G cups of coffee served in a wee&

-. The average cost of a cup of coffee declines as the number ofcups of coffee served increases because the fixed cost isspread over more cups of coffee.


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#$er%ise 5-2@1 minutes

/. The scattergraph appears below:


$olutions Manual, !hapter 7 -C

B

B/,

B-,

B1,

B0,

B7,

B?,

-, 0, ?, C, /, /-, /0,

Units &rodu%ed

&ro%ess

in'Cost

9

=

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#$er%ise 5-4@- minutes/.

The Alpine +ouse, nc.ncome $tatement($&i 8epartment

For the Juarter #nded March 1/

$ales...............................................................B/7,

Variable expenses:

!ost of goods sold @- pairsD I B07 perpair........................................................... B,

$elling expenses @- pairs I B7 per pair. /,Administrative expenses @-K I B/,... -, /-,

!ontribution margin........................................ 0C,Fixed expenses:

$elling expensesLB1, @- pairs I B7 per pairN....... -,

Administrative expenses @CK I B/,... C, -C,Oet operating income...................................... B -,

DB/7, G BE7 per pair ; - pairs

-. $ince - pairs of s&is were sold and the contribution margintotaled B0C, for the 3uarter, the contribution of each pair ofs&is toward covering fixed costs and toward earning of profits

was B-0 @B0C, G - pairs ; B-0 per pair. Another wayto compute the B-0 is:

$elling price per pair.................... BE7Variable expenses:

!ost per pair.............................. B07$elling expenses........................ 7Administrative expenses

@B-, G - pairs............... / 7/!ontribution margin per pair........ B-0


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#$er%ise 5-5@- minutes

/. The company2s variable cost per unit is:

B/C,;B? per unit.

1, unitsn accordance with the behavior of variable and fixed costs, thecompleted schedule is:

Units produced and sold0,000 !0,000 "0,000

Total costs:

Variable costs.........B/C,

B-0,B1,

Fixed costs............. 1, 1, 1,

Total costs..............B0C,

B70,B?,

!ost per unit:

Variable cost.......... B ?. B ?. B ?.Fixed cost............... /. E.7 ?.

Total cost per unit... B/?. B/1.7 B/-.

-. The company2s income statement in the contribution format is:

$ales @07, units I B/? per unit................ BE-,Variable expenses @07, units I B? perunit.............................................................. -E,

!ontribution margin........................................ 07,Fixed expense................................................. 1,Oet operating income..................................... B/7,


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#$er%ise 5-6@continued

-. a. The scattergraph would be:

1. The cost of shipping units is li&ely to depend on the weight andvolume of the units and the distance traveled, as well as on thenumber of units shipped. n addition, higher cost shippingmight be necessary to meet a deadline.


$olutions Manual, !hapter 7 -/0

B

B7

B/,

B/,7

B-,

B-,7

B1,

- 0 ? C /

Units Shipped

Shipp

in'

#$pen

9

=

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#$er%ise 5-7@- minutes

/.%ilo&eters Driven

'otal(nnual

Cost)

+igh level of activity................... /7, B//,EHow level of activity.................... E, ,1C!hange....................................... 17, B -,7

/7, &ilometers I B.//0 per &ilometer ;B//,E

E, &ilometers I B./10 per &ilometer ;B,1C

Variable cost per &ilometer:

!hange in cost B-,7; ;B.E0 per &ilometer

!hange in activity 17, &ilometers

Fixed cost per year:

Total cost at /7, &ilometers.............. B//,EHess variable portion:

/7, &ilometers I B.E0 per&ilometer.............................................. E,EE

Fixed cost per year.................................. B 0,-

-. 9 ; B0,- < B.E0=

1. Fixed cost.................................................... B 0,-Variable cost:

C, &ilometers I B.E0 per&ilometer.................................................. 7,-

Total annual cost......................................... B/,/-


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#$er%ise 5- @- minutes

/.*uest

-

Days

Custodial

Supplies

E$pense+igh activity level @Puly.......... /-, B/1,7How activity level @March....... 0, E,7!hange................................... C, B ?,

Variable cost element:

!hange in expense B?,; ;B.E7 per guest%day

!hange in activity C, guest%days

Fixed cost element:

!ustodial supplies expense at high activitylevel............................................................ B/1,7

Hess variable cost element:/-, guest%days I B.E7 per guest%day.. ,

Total fixed cost.............................................. B 0,7

The cost formula is B0,7 per month plus B.E7 per guest%dayor

9 ; B0,7 < B.E7=

-. !ustodial supplies expense for //, guest%days:

Variable cost://, guest%days I B.E7 perguest%day........................................... B C,-7

Fixed cost............................................. 0,7Total cost.............................................. B/-,E7


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#$er%ise 5-! @1 minutes

/. The scattergraph appears below:


-/E Managerial Accounting, /1th #dition

B.

B-,...

B0,...

B?,...

BC,...

B/.,...

B/-,...

B/0,...

B/?,...

. -,... 0,... ?,... C,... /.,... /-,... /0,...

(uest-)ays

CustodialSu

ppliesCost

9

=

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#$er%ise 5-!@continued

-. @Oote: $tudents2 answers will vary considerably due to theinherent lac& of precision and subectivity of the 3uic&%and%dirtymethod.

Total costs at E,7 guest%days per month Lapoint falling on the line in @/N.......................... B,E7

Hess fixed cost element @intersection of the 9axis................................................................. 1,E7

Variable cost element......................................... B?,

B?, G E,7 guest%days ; B.C per guest%day

The cost formula is therefore B1,E7 per month, plus B.C perguest%day or

9 ; B1,E7 < B.C=,

where = is the number of guest%days.

1. The high%low method would not provide an accurate costformula in this situation because a line drawn through the highand low points would have a slope that is too flat and would beplaced too high, cutting the cost axis at about B0,7 permonth. The high and low points are not representative of all ofthe data in this situation.


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#$er%ise 5-1"@- minutes

/. a. 8ifference in cost:

Monthly operating costs at CK occupancy:

07 beds I CK ; 1? bedsR1? beds I 1 days I B1- per bed%day.......... B107,?Monthly operating costs at ?K occupancy

@given............................................................. 1-?,E8ifference in cost............................................... B /C,

8ifference in activity:CK occupancy @07 beds I CK I 1 days. /,C?K occupancy @07 beds I ?K I 1 days. C,/

8ifference in activity......................................... -,E

!hange in cost B/C,; ; BE per bed%day!hange in activity -,E bed%days

b. Monthly operating costs at CK occupancy@above.............................................................

B107,?

Hess variable costs:1? beds I 1 days I BE per bed%day............. E7,?

Fixed operating costs per month.........................B-E,

-. 07 beds I EK ; 1/7 beds occupied:

Fixed costs..........................................................B-E,

Variable costs: 1/7 beds I 1 days I BE per

bed%day............................................................ ??,/7

Total expected costs............................................B11?,/7


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&ro*le+ 5-11@07 minutes

/. Marwic&2s Sianos, nc.ncome $tatement

For the Month of August

$ales @0 pianos I B1,/-7 per piano......B/-7,

!ost of goods sold

@0 pianos I B-,07 per piano............. C,

*ross margin........................................... -E,$elling and administrative expenses:

$elling expenses:Advertising.......................................... B E$ales salaries and commissions

LB7 < @CK I B/-7,N............... /,78elivery of pianos

@0 pianos I B1 per piano............. /,-tilities................................................ 178epreciation of sales facilities............. C

Total selling expenses............................ /0,Administrative expenses:

#xecutive salaries............................... -,7nsurance............................................ 0!lerical

LB/, < @0 pianos I B- perpianoN.............................................. /,C

8epreciation of office e3uipment........ 1Total administrative expenses............... 7,

Total selling and administrative expenses /,

Oet operating income..............................B

C,


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&ro*le+ 5-11@continued

-. Marwic&2s Sianos, nc.ncome $tatement

For the Month of August

'otal+er

+iano$ales @0 pianos I B1,/-7 per piano......... B/-7, B1,/-7Variable expenses:

!ost of goods sold@0 pianos I B-,07 per piano.............. C, -,07

$ales commissions @CK I B/-7,........ /, -78elivery of pianos @0 pianos I B1 per

piano..................................................... /,- 1

!lerical @0 pianos I B- per piano........ C -Total variable expenses............................... //, -,E7!ontribution margin.................................... /7, B 1E7Fixed expenses:

Advertising............................................... E$ales salaries............................................ 7tilities..................................................... 178epreciation of sales facilities.................. C#xecutive salaries..................................... -,7

nsurance.................................................. 0!lerical..................................................... /,8epreciation of office e3uipment.............. 1

Total fixed expenses.................................... E,Oet operating income................................. B C,

1. Fixed costs remain constant in total but vary on a per unit basisinversely with changes in the activity level. As the activity levelincreases, for example, the fixed costs will decrease on a perunit basis. $howing fixed costs on a per unit basis on the

income statement might mislead management into thin&ingthat the fixed costs behave in the same way as the variablecosts. That is, management might be misled into thin&ing thatthe per unit fixed costs would be the same regardless of howmany pianos were sold during the month. For this reason, fixedcosts generally are shown only in totals on a contributionformat income statement.


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/. !ost of goods sold............. Variable

Advertising expense.......... Fixed$hipping expense.............. Mixed$alaries and commissions.. Mixednsurance expense............. Fixed8epreciation expense........ Fixed

-. Analysis of the mixed expenses:

UnitsS#ippingE$pense

Salaries andCo&&issions

E$pense+igh level of activity.. 7, AB1C, AB,How level of activity... 0, 10, EC,!hange...................... /, AB 0, AB/-,


!hange in costVariable rate ;

!hange in activity

AB0,$hipping expense: ; AB0 per unit/, units

AB/-,$alaries and commissions expense: ; AB/- per unit

/, units

Fixed cost element:

S#ippingE$pense

Salaries andCo&&issions

E$pense

!ost at high level ofactivity........................... AB1C, AB,

Hess variable costelement:7, units I AB0 per

unit.............................. -,7, units I AB/- per ?,


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unit..............................Fixed cost element............ AB/C, AB1,


The cost formulas are:$hipping expense:

AB/C, per month plus AB0 per unitor

9 ; AB/C, < AB0=$alaries and commissions expense:

AB1, per month plus AB/- per unitor

9 ; AB1, < AB/-=

1.Morrisey Urown, Htd.

ncome $tatementFor the Month #nded $eptember 1

$ales @7, units I AB/ per unit. .AB7,

Variable expenses:

!ost of goods sold@7, units I AB? per unit........

AB1,

$hipping expense@7, units I AB0 per unit........... -,

$alaries and commissions expense@7, units I AB/- per unit......... ?, 1C,

!ontribution margin............................ /-,Fixed expenses:

Advertising expense......................... -/,$hipping expense............................. /C,

$alaries and commissions expense. . 1,nsurance expense............................ ?,8epreciation expense....................... /7, ,

Oet operating income......................... AB 1,


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&ro*le+ 5-13 @1 minutes

/.

a.

1 c.

// e.

0 g.

- i.

b.

? d.

/ f. / h.

E

-. >ithout an understanding of the underlying cost behaviorpatterns, it would be difficult, if not impossible, for a managerto properly analy'e the firm2s cost structure. The reason is thatall costs don2t behave in the same way. 4ne cost might move inone direction as a result of a particular action, and another costmight move in an opposite direction. nless the behavior

pattern of each cost is clearly understood, the impact of afirm2s activities on its costs will not be &nown until aftertheactivity has occurred.


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/. +igh%low method:

u&er

ofScans

Utilities

Cost

+igh level ofactivity................ /7 B0,

How level ofactivity................ ? -,-

!hange.................. B/,C

!hange in cost B/,CVariable rate: ; ;B- per scan

!hange in activity scans

Fixed cost: Total cost at high level of activity.. .. B0,Hess variable element:

/7 scans I B- per scan............. 1,Fixed cost element.......................... B/,

Therefore, the cost formula is: 9 ; B/, < B-=.

-. $cattergraph method @see the scattergraph on the followingpage:

@Oote: $tudents2 answers will vary due to the inherentimprecision of the 3uic&%and%dirty method.

The line intersects the cost axis at about B/,-. The variablecost can be estimated as follows:

Total cost at / scans @a point that falls on theline................................................................ B1,

Hess the fixed cost element............................... /,-Variable cost element @total............................. B/,C

B/,C G / scans ; B/C per scan

Therefore, the cost formula is: 9 ; B/,- < B/C=.


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The completed scattergraph:


$olutions Manual, !hapter 7 --?

B

B7

B/,

B/,7

B-,

B-,7

B1,

B1,7

B0,

B0,7

- 0 ? C / /- /0 /?

,u+*er o S%ans

.otalUtilitie

s

C

=

9

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/. Maintenance cost at the E7, direct labor%hour level ofactivity can be isolated as follows:

.evel of (ctivity"0,000D./s

",000D./s

Total factory overhead cost.........../0,-7,

/E,?-7,8educt:

ndirect materials W / per8H+D........................................ 7,, E,7,

"ent........................................... ?,, ?,,Maintenance cost......................... 1,-7, 0,/-7,

D 7,, G 7, 8H+s ; / per 8H+

-. +igh%low analysis of maintenance cost:

Direct.aor-/ours

aintenanceCost

+igh level of activity. . . E7, 0,/-7,How level of activity. . . . 7, 1,-7,!hange........................ -7, CE7,


!hange in cost CE7,; ;17 per 8H+

!hange in activity -7, 8H+

Fixed cost element:

Total cost at the high level of activity......... 0,/-7,Hess variable cost element

@E7, 8H+s I 17 per 8H+.................. -,?-7,

Fixed cost element..................................... /,7,Therefore, the cost formula for maintenance is /,7, peryear plus 17 per direct labor%hour or

9 ; /,7, < 17=


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1. Total factory overhead cost at E, direct labor%hours is:

ndirect materials

@E, 8H+s I / per 8H+.... ..

E,,

"ent.................................................. ?,,Maintenance:

Variable cost element@E, 8H+s I 17 per 8H+......

-,07,

Fixed cost element......................... /,7,1,7,

Total factory overhead cost.............../?,7,


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&ro*le+ 5-16 @07 minutes

/. arc#.o3 4une/ig#5,000 Units 6,000 Units

8irect materials cost W B? per

unit......................................... B 1?, B 70,8irect labor cost W B/ per unit ?, ,Manufacturing overhead costD. . EC, /-,

Total manufacturing costs......... /E0, -0?,Add: >or& in process,

beginning............................... , 1-,/C1, -EC,

8educt: >or& in process,ending.................................... /7, -/,

!ost of goods manufactured.. ... B/?C, B-7E,D!omputed by wor&ing upwards through the statements.

-. Units+roduce

dCost

OservedPune(+igh level of activity..... , B/-,March(How level of activity... ?, EC,!hange................................... 1, B -0,

!hange in cost B-0,; ; BC. per unit!hange in activity 1, units

Total cost at the high level of activity..... B/-,Hess variable cost element

@BC. per unit I , units.............. E-,Fixed cost element................................. B 1,

Therefore, the cost formula is B1, per month plus BC.per unit produced or

9 ; B1, < BC.=


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1. The cost of goods manufactured if E, units are produced:

8irect materials cost @E, units I B?. per

unit.............................................................. B 0-,8irect labor cost @E, units I B/. perunit.............................................................. E,

Manufacturing overhead cost:

Fixed portion.................................................B1,

Variable portion @E, units I BC. per

unit........................................................... 7?, C?,Total manufacturing costs............................... /C,Add: >or& in process, beginning.....................

/C,8educt: >or& in process, ending.....................

!ost of goods manufactured...........................B/C,


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/. Maintenance cost at the , machine%hour level of activitycan be isolated as follows:

.evel of (ctivity

50,000 /s60,000

/sTotal factory overhead cost. .. B/E0, B-0?,8educt:

tilities cost W B.C perM+D.................................. 0C, E-,

$upervisory salaries............ -/, -/,Maintenance cost.................. B/7, B/71,

DB0C, G ?, M+s ; B.C per M+

-. +igh%low analysis of maintenance cost:

ac#ine-/ours

aintenance Cost

+igh activity level............... , B/71,How activity level................ ?, /7,!hange............................... 1, B 0C,

Variable rate:

!hange in cost B0C,; ; B/.? per M+!hange in activity 1, M+s

Total fixed cost:

Total maintenance cost at the high activitylevel..........................................................

B/71,

Hess variable cost element@, M+s I B/.? per M+................... /00,

Fixed cost element...................................... B ,

Therefore, the cost formula for maintenance is B, permonth plus B/.? per machine%hour or

9 ; B, < B/.?=.


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1. 7ariale Cost perac#ine-/our

8i$edCost

tilities cost................ B.C

$upervisory salariescost.......................... B-/,

Maintenance cost....... /.? ,Total overhead cost.... B-.0 B1,

Thus, the cost formula would be: 9 ; B1, < B-.0=.

0. Total overhead cost at an activity level of E7, machine%hours:

Fixed costs........................................... B 1,Variable costs: E7, M+s I B-.0

per M+............................................... /C,Total overhead costs............................. B-/,


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Case 5-1@ minutes

Oote to the instructor: This case re3uires the ability to build onconcepts that are introduced only briefly in the text. To somedegree, this case anticipates issues that will be covered in more

depth in later chapters.

/. n order to estimate the contribution to profit of the charityevent, it is first necessary to estimate the variable costs ofcatering the event. The costs of food, beverages, and labor areall apparently variable with respect to the number of guests.+owever, the situation with respect to overhead expenses isless clear. A good first step is to plot the labor hour andoverhead expense data in a scattergraph as shown below.



B.

B/.,...

B-.,...

B1.,...

B0.,...

B7.,...

B?.,...

BE.,...

BC.,...

BF.,...

. -,... 0,... ?,... C,...

/a*or 0ours

1verhead

#$penses

=

9

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Case 5-1@continued

This scattergraph reveals several interesting points about thebehavior of overhead costs:

X The relation between overhead expense and labor hours isapproximated reasonably well by a straight line. @+owever,there appears to be a slight downward bend in the plot as thelabor hours increase. $uch increasing returns to scale is acommon occurrence. $ee Ooreen $oderstrom, 5Are overheadcosts strictly proportional to activityY64ournal of (ccountingand Econo&ics, vol. /E, /0, pp. -77%-EC.

X The data points are all fairly close to the straight line. Thisindicates that most of the variation in overhead expenses isexplained by labor hours. As a conse3uence, there probablywouldn2t be much benefit to investigating other possible costdrivers for the overhead expenses.

X Most of the overhead expense appears to be fixed. Mariashould as& herself if this is reasonable. Are there, in fact, largefixed expenses such as rent, depreciation, and her own salaryY

The overhead expenses could be decomposed into fixed andvariable elements using the high%low method, least%s3uaresregression method, or even the 3uic&%and%dirty method based on

the scattergraph.X The high%low method throws away most of the data and bases

the estimates of variable and fixed costs on data for only twomonths. For that reason, it is a decidedly inferior method in thissituation. Oevertheless, if the high%low method were used, theestimates would be computed as follows:

.aorOver#ea

d/ours E$pense

+igh level of activity.. E,7 BEE,How level of activity. . -,7 77,!hange...................... 7, B--,

Variable cost ;!hange in cost B--,

!hange in activity 7, labor%hours;



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; B0.0 per labor%hour



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Case 5-1@continued

Fixed cost element ; Total cost Variable cost element; BEE, B0.0 per labor%hour I

E,7 labor%hours; B00,

X n this situation, the 3uic&%and%dirty method based on thescattergraph is probably better than the high%low method andshould give acceptable estimates of the fixed and variablecomponents of overhead expenses. The estimates should befairly close @within the inherent imprecision of the method tothe estimates that would result from using least%s3uaresregression.

X sing statistical software, the least%s3uares regression methodyields estimates of B1.7 per labor hour for the variable costand B0C,/-? per month for the fixed cost. The adusted "-is?K.

The total variable cost per guest is computed as follows:

Food and beverages............................... B/7.Habor @.7 hour I B/. per hour........ 7.4verhead @.7 hour I B1.7 per hour.... /.C

Total variable cost per guest................... B-/.C

And the total contribution from /C guests paying B1/ each iscomputed as follows:

$ales @/C guests I B1/. per guest... B7,7C.Variable cost @/C guests I B-/.C per

guest................................................... 1,7?.0!ontribution to profit.............................. B/,?-1.?

Fixed costs are not included in the above computation because

there is no indication that there would be any additional fixedcosts incurred as a conse3uence of catering the coc&tail party.f additional fixed costs were incurred, they should besubtracted from revenues as well to determine the profit of theparty.

-. Assuming that no additional fixed costs are incurred as a result


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of catering the charity event, any price greater than thevariable cost per guest of roughly B-- would contribute toprofits.


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Case 5-1@continued

1. >e would favor bidding slightly less than B1 to get thecontract. Any bid above B-- would contribute to profits and abid at the normal price of B1/ is unli&ely to land the contract.

And apart from the contribution to profit, catering the eventwould show off the company2s capabilities to potential clients.

The danger is that a price lower than the normal bid of B1/might set a precedent for the future or it might embroil thecompany in a price war among caterers. +owever, the priceneed not be publici'ed and the lower price could be ustified tofuture clients because this is a charity event. Anotherpossibility would be for Maria to maintain her normal price butthrow in additional services at no cost to the customer.

>hether to compete based on price or service is a delicateissue that Maria will have to decide after getting to &now thepersonality and preferences of her customers.


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Case 5-1! @07 minutes

/. The scattergraph of direct labor cost versus the number ofunits produced is presented below:

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

0 50 100 150

Thousands of Units Produced

DirectL

aborCost

X

Y



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Case 5-1! @continued

1. The number of paid days should be used as the activity baserather than the number of units produced. The scattergraphsreveal a much stronger relation @i.e., higher correlation

between direct labor costs and number of paid days thanbetween direct labor costs and number of units produced.Variations in the direct labor costs apparently occur because ofthe number of paid days in the month and have little to do withthe number of units that are produced. t appears that thedirect labor costs are basically fixed with respect to how manyunits are produced in a month. This would happen if the directlabor wor&ers are treated as full%time employees who are paideven if there is insufficient wor& to &eep them busy. Moreover,

for planning purposes, the company is li&ely to be able topredict the number of paid days in the month with muchgreater accuracy than the number of units that will beproduced.



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esear%h and Appli%ation 5-2"

/. Ulue Oile succeeds first and foremost because of its operationalexcellence customer value proposition. Sage 1 of the /%Z says5we have developed an efficient online cost structure [ that

eliminates traditional layers of diamond wholesalers andbro&ers, which allows us to generally purchase most of ourproduct offerings at lower prices by avoiding mar&ups imposedby those intermediaries. 4ur supply solution generally enablesus to purchase only those diamonds that our customers haveordered. As a result, we are able to minimi'e the costsassociated with carrying diamond inventory.6 4n page 0 of the/%Z, Ulue Oile2s growth strategy hinges largely on increasingwhat it calls supply chain efficiencies and operational

efficiencies. Ulue Oile also emphasi'es ewelry customi'ationand customer service, but these attributes do not differentiateUlue Oile from its competitors.

-. Ulue Oile faces numerous business ris&s as described in pagesC%/ of the /%Z. $tudents may mention other ris&s beyondthose specifically mentioned in the /%Z. +ere are four ris&sfaced by Ulue Oile with suggested control activities:

"is&: !ustomer may not purchase an expensive item such as

a diamond over the nternet because of concerns aboutproduct 3uality @given that customers cannot see theproduct in person prior to purchasing it.!ontrol activities: $ell only independently certified diamondsand mar&et this fact heavily. Also, design a web site thatenables customers to easily learn more about the specificproducts that they are interested in purchasing.

"is&: !ustomers may avoid nternet purchases because of

fears that security breaches will enable criminals to haveaccess to their confidential information.!ontrol activities: nvest in state%of%the%art encryptiontechnology and other safeguards.


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esear%h and Appli%ation 5-2" @continued

"is&: Uecause Ulue Oile sells luxury products that are often

purchased on a discretionary basis, sales may declinesignificantly in an economic downturn as people have accessto less disposable income.!ontrol activities: #xpand product offerings and expand thenumber of geographic mar&ets served.

"is&: The financial reporting process may fail to function

properly @e.g., it may not comply with the $arbanes%4xleyAct of -- as the business grows.!ontrol activities: mplement additional financial accountingsystems and internal control over those systems.

Ulue Oile faces various ris&s that are not easily reducedthrough control activities. Three such examples include:

f Ulue Oile is re3uired by law to charge sales tax on

purchases it will reduce Ulue Oile2s price advantage overbric&s%and%mortar retailers @see page /E of the /%Z.

"estrictions on the supply of diamonds would harm Ulue

Oile2s financial results @see page of the /%Z.

4ther nternet retailers, such as Ama'on.com, could offer the

same efficiencies and low price as Ulue Oile, while leveragingtheir stronger brand recognition to attract Ulue Oile2scustomers @see page / of the /%Z.

1. Ulue Oile is a merchandiser. The first sentence of the overviewon page 1 of the /%Z says 5Ulue Oile nc. is a leading onlineretailer of high 3uality diamonds and fine ewelry.6 >hile UlueOiles does some assembly wor& to support its 5Uuild 9our 4wn6feature, the company essentially buys ewelry directly fromsuppliers and resells it to customers. n fact, Ulue Oile never

ta&es possession of some of the diamonds it sells. Sage 0 of the/%Z says 5our diamond supplier relationships allow us todisplay suppliers2 diamond inventories on the Ulue Oile web sitefor sale to consumers without holding the diamonds in ourinventory until the products are ordered by customers.6 Thissentence suggests that items are shipped directly from thesupplier to the consumer.



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0. There is no need to calculate any numbers to ascertain thatcost of sales is almost entirely a variable cost. Sage -7 of the/%Z says 5our cost of sales consists of the cost of diamonds

and ewelry products sold to customers, inbound and outboundshipping costs, insurance on shipments and the costs incurredto set diamonds into ring, earring and pendant settings,including labor and related facilities costs.6 The overwhelmingmaority of these costs are variable costs. Assuming thewor&ers that set diamonds into ring, earring, and pendantsettings are not paid on a piece rate, the labor cost would bestep%variable in nature. The facilities costs are li&ely to becommitted fixed in natureR however, the overwhelming

maority of the cost of sales is variable.$imilarly, there is no need to calculate any numbers toascertain that selling, general and administrative expense is amixed cost. Sage -7 of the /%Z says 5our selling, general andadministrative expenses consist primarily of payroll and relatedbenefit costs for our employees, mar&eting costs, credit cardfees and costs associated with being a publicly tradedcompany. These expenses also include certain facilities,fulfillment, customer service, technology and depreciationexpenses, as well as professional fees and other generalcorporate expenses.6 At the bottom of page -7, the /%Z says5the increase in selling, general and administrative expenses in-0 was due primarily to[higher credit card processing feesbased on increased volume.6 This indicates that credit cardprocessing fees is a variable cost. At the top of page -? of the/%Z it says 5the decrease in selling, general andadministrative expenses as a percentage of sales in -0resulted primarily from our ability to leverage our fixed costbase.6 This explicitly recogni'es that selling, general and

administrative expense includes a large portion of fixed costs.#xamples of the various costs include:

Variable costs: cost of sales, credit card processing fees.

$tep%variable costs: diamond setting labor, fulfillment labor.

8iscretionary fixed costs: mar&eting costs, employee training

costs.



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!ommitted fixed costs: general corporate expenses, facilities

costs.



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7. The data needed to complete the table as shown below is found on page 0 of the /%Z:

200! 200"9uarte

r 19uarte

r 29uarte

r 9uarte

r !9uarte

r 19uarte

r 2

Oet sales..........................

B17,EC

0

B17,-

-

B11,CC

C

B?0,70

C

B00,//

?

B01,C-

?

!ost of sales....................-E,7E

--E,

7-?,7/

7,0

010,0-

11,C1

?*ross profit...................... C,-/- E,-E E,1? /0,/00 ,?CE ,$elling, general and

administrative expense.. 7,1C 7,/// 7,11 E,101 ?,/-1 ?,/C0

4perating income............B -,

0B -,C/

?B -,11

?B ?,C

/B 1,7?

0B 1,C

?

etsales

Selling, *eneral,and

(d&inistrative+igh Juarter @-0

J0...............................

B?0,70

C BE,101

How Juarter @-0 J1B11,CC

C B7,11

!hange........................B1,??

B-,1/

Variable cost ; B-,1/\B1,?? ; .E710- per dollar of revenue

Fixed cost estimate @using the low level of activity:


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B7,11 ] @B11,CCC I .E710- ; B-,0C @rounded up

The linear e3uation is: 9 ; B-,0C < .E710-=, where = is revenue.


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?. The contribution format income statement using the high%lowmethod for the third 3uarter of -7 would be as follows:

-7Third Juarter

Oet sales.....................................B07,7

!ost of sales...............................B17,/-

CVariable selling, general and

administrative.......................... 1,0-

C1C,77

?!ontribution margin.................... ?,00Fixed selling, general and

administrative.......................... -,0C

Oet operating income.................B 0,0?

0

E. Ulue Oile2s cost structure is heavily weighted towards variablecosts. Hess than /K of Ulue Oile2s costs are fixed. Ulue Oile2scost of sales as a percentage of sales is higher than bric&s andmortar retailers. Sage -- of the /%Z says 5As an onlineretailer, we do not incur most of the operating costs associated

with physical retail stores, including the costs of maintainingsignificant inventory and related overhead. As a result, whileour gross profit margins are lower than those typicallymaintained by traditional diamond and fine ewelry retailers,we are able to reali'e relatively higher operating income as apercentage of net sales. n -0, we had a --.-K gross profitmargin, as compared to gross profit margins of up to 7K bysome traditional retailers. >e believe our lower gross profitmargins result from lower retail prices that we offer to ourcustomers.6


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#$er%ise 5A-1@continued

>hile not a re3uirement of the exercise, it is always a good ideato plot the data on a scattergraph. The scattergraph can help spotnonlinearities or other problems with the data. n this case, the

regression line @shown below is a reasonably good approximationto the relationship between car wash costs and rental returns.

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

0 1,000 2,000 3,000 4,000

CarWashCosts

Rental Returns



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#$er%ise 5A-2@1 minutes

/.Week

Units:;

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