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www.downloadslide.net Module III PLANNING AND CONTROL OVER THE LONG TERM: MAXIMIZING PROFIT We devote Module III (Chapters 9–13) to long-term decisions. In the long term, costs associated with property, equipment, and salaried personnel (the costs of “capacity resources”), which are fixed in the short term, become controllable and relevant. Accordingly, long-term decisions focus on matching the supply and demand of these capacity resources and making the most effective use of capacity resources. It is often difficult, however, to estimate the controllable capacity costs related to equipment, space, and personnel. This difficulty arises because products and customers share capacity resources; that is, such costs are not directly traceable to individual products and customers. In the language of Chapter 2, capacity costs are indirect costs. As a practical solution, firms use cost allocations to approximate the long-term change in capacity costs. Chapter 9 provides an integrated discussion of the various demands for cost allocations within an organization. We first examine how and why firms make frequent use of cost allocations to estimate the costs that are relevant for long-term decisions. We then present and discuss other reasons for allocations: reporting income to external parties such as shareholders and the IRS, justifying cost-based reimbursements, and influencing behavior within the organization. In Chapter 10, we take a close look at the use of allocations for decision making. We focus particularly on activity-based costing (ABC), and illustrate how ABC can lead to better decisions by refining estimates of controllable capacity costs. We also discuss how ABC systems facilitate activity-based management, enabling firms to optimize their products, customers, and resources. Despite their widespread use, allocations have two limitations: (1) They do not consider the time value of money; and (2) they do not consider the lumpy nature of capacity resources. These limitations are of particular concern when the firm is considering a large expenditure on a long-lived resource. For such expenditures, organizations routinely engage in capital budgeting, which is the focus of Chapter 11. Chapter 12 examines long-term control decisions. In the long term, the goal is to measure whether we are putting organizational resources to their best or most effective use. A key step in doing so is to ensure that a firm’s performance evaluation and reward system fits with its organizational structure. Accordingly, we first describe common forms of decentralization and different types of responsibility centers found in organizations. Following this discussion, we consider the principles governing performance measurement and then apply them to each type of responsibility center. We focus on strategic planning and control in Chapter 13, the final chapter in this module. Strategy is a commitment to pursue a particular approach to www.downloadslide.net Long Term Short Term How do we match the supply and demand for resources? Are we using resources effectively? C11 (C9, C10) (C12, C13) How can we get the most from available resources? Are we using resources efficiently? (C4, C5, C6) Planning Control Exhibit III.1 Classifying Decisions by Time and Planning/Control business—it defines how a firm positions its products and services and distinguishes itself from its competitors to maximize returns. Organizations that successfully implement their strategies know their value chain and link their performance measures to critical success fac- tors. Accordingly, we discuss how management accounting helps a firm identify and configure its value chain. Finally, we discuss the balanced scorecard, a measurement system that provides a framework for motivating and monitoring strategic initiatives and outcomes. www.downloadslide.net Chapter 9 Cost Allocations: Theory and Applications T H E EZ-R E S T M AT T R E S S C O M PA N Y sells two types of mattresses, Standard and Deluxe, to university dormitories and hospitals. While both mattresses are the same size, the Deluxe mattress has extra padding and is of higher quality. Demand is high for both mattresses, allowing EZ-Rest to operate at full capacity. Craig Edwards, the chief executive officer (CEO) of EZ-Rest, is not satisfied with the firm’s performance. Currently, EZ-Rest sells 18,000 Standard mattresses and 12,000 Deluxe mattresses, for 30,000 total units every year. Craig wonders whether EZ-Rest could make more money by selling more of the Deluxe mattresses. His plan is to keep total sales volume the same, but to sell 10,000 Standard mattresses and 20,000 Deluxe mattresses. Craig believes that the company can achieve this goal within the next three years. Before he makes the necessary changes to the company’s operations, Craig asks you to evaluate the merits of this decision. APPLYING THE DECISION FRAMEWORK What Is the Problem? Even though EZ-Rest currently operates at capacity, CEO Craig Edwards wants the company to increase its profit. What Are the Options? We will examine two options: (1) Change the product mix to emphasize Deluxe mattresses; (2) Stay with the current product mix. What Are the Costs and Benefits? We will use cost allocations to estimate the change in EZ-Rest’s capacity costs and, thus, profit due to this long-term decision. Make the Decision! After estimating the profit associated with EZ-Rest’s two options, we will be able to recommend the better option to Craig. www.downloadslide.net Tanya Constantine/Digital Railroad, Inc. EZ-Rest is trying to figure the best mix of the two models of mattresses it makes. LEARNING OBJECTIVES After studying this chapter, you will be able to: 1 Understand how to use cost allocations to make long-term decisions. 2 Explain how cost allocations affect income under absorption costing relative to variable costing. 3 Describe the role of incentives in the choice of allocation procedures. In Chapters 4–8, we examined short-term decisions for which the costs associated with capacity resources, such as property, plant, and equipment, were not fixed. Accordingly, our goal was to make the best use of available capacity resources by maximizing contribution margin. In this chapter, we shift our attention to longer-term decisions. The key feature distinguishing these decisions is the ability to change capacity levels. That is, costs that we consider to be fixed in the short-run are not necessarily fixed in the long run. We therefore need to estimate the change in capacity costs associated with longer-term decisions. Most organizations use cost allocations for this purpose. We begin this chapter by discussing why firms frequently allocate capacity costs for long-term decisions. We then review the mechanics of cost allocations and allocate EZ-Rest’s capacity costs to its two products. Such allocations are a practical and often used method for estimating long-term costs of decision options. Finally, we describe other reasons why firms allocate capacity costs. www.downloadslide.net 362 Chapter 9 • Cost Allocations: Theory and Applications CHAPTER CONNECTIONS In Chapter 10, we focus on activity-based costing, a technique that refines the cost allocation procedures to make allocated costs more suitable for making effective decisions. Long-Term Decisions and Cost Allocations LEARNING OBJECTIVE 1 Understand how to use cost allocations to make long-term decisions. In the previous module, we frequently used contribution margin statements to address short-term decision problems. Exhibit 9.1 presents EZ-Rest’s contribution margin statement and accompanying unit-level data for the most recent year of operations. (Consistent with earlier chapters, we refer to capacity costs as “fixed” costs in this and subsequent exhibits) Exhibit 9.1 EZ-Rest Mattress Company: Contribution Margin Income Statement for the Most Recent Year Craig’s proposal is to change the product mix to 10,000 Standard and 20,000 Deluxe mattresses. Using the data in Exhibit 9.1, we could estimate the profit from Craig’s proposal as: EZ-Rest’s Deluxe mattress is more comfortable but is also more costly to make than the Standard mattress. (© Michael DeLeon/iStockphoto) Contribution margin from Standard mattresses Contribution margin from Deluxe mattresses Total contribution margin Less: Fixed costs Profit 10,000  $256/unit $2,560,000 20,000  $303/unit $6,060,000 $8,620,000 $7,560,000) $1,060,000 www.downloadslide.net Long-Term Decisions and Cost Allocations 363 This profit is up substantially from the current profit of $684,000. Craig’s proposal appears to be a good one, right? Not necessarily! EZ-Rest’s decision to change its product mix over the next three years is not a short-term decision. Shifting emphasis from Standard to Deluxe mattresses would take time and require a re-planning of existing capacity resources. EZ-Rest may have to replace equipment, reorganize the factory, and change personnel. These changes would likely alter both the nature and magnitude of EZ-Rest’s “fixed” capacity costs. To evaluate Craig’s proposal properly, we need to estimate the change in capacity costs. Treating them as noncontrollable (fixed) costs as we would for a short-term decision, is not appropriate. EZ-Rest’s long-term decision relates to changing the product mix. Other examples of long-term decisions include adding or dropping products and services, expanding or scaling down operations, and changing target markets. These decisions usually involve altering the level and mix of capacity resources in place. Dropping a product or scaling down operations could idle some existing equipment and machinery. Meanwhile, adding a new product or expanding operations frequently requires additional space, equipment, and staff. Commitments and contractual obligations expire with the passage of time. When excess supply exists in the long term, firms can dispose of unneeded capacity. Similarly, when excess demand exists, firms can acquire extra capacity. Because capacity costs are controllable over the long term, we need to consider them in our decision-making process. Consequently, our focus changes from maximizing contribution margin to maximizing profit margin. As we learned in Chapter 4, contribution margin equals revenues less variable costs. Profit margin equals contribution margin less allocated capacity costs and, thus, takes into account the change in capacity costs. While contribution margin is the appropriate measure of value for short-term decisions, profit margin is the appropriate measure for long-term decisions. How can we systematically estimate the cost of capacity resources? We discuss two general approaches: direct estimation and cost allocation. DIRECT ESTIMATION Direct estimation of capacity costs involves systematically examining each cost account to evaluate whether (and how much) a decision would change a capacity cost. For example, Ram Gupta, EZ-Rest’s Chief Operations Officer, estimates that shifting the product mix would increase costs for supervisory staff by $325,000, Connecting to Practice F ACEBOOK A DDING S ERVERS In 2011, Facebook had over 800 million users, with more than 250 million photos uploaded every day. (See www.facebook.com/press and click on statistics for more data.) Handling this deluge of information requires the use of many server farms. Analysts estimate that, relative to 2007, Facebook more than doubled the number of servers to 60,000 in 2010. In September 2011, Facebook announced plans to build a huge 5-acre server farm in Sweden, near the Arctic Circle, at a cost of $760 million. C OMMENTARY : The number of servers required depends on the volume of activity at a website. Google was estimated to have over 450,000 servers in 2006, and over a million in 2010. Managing server costs is an important aspect of running technology firms. For instance, Facebook likely selected a site in remote Sweden because this location has abundant renewable energy, and the favorable climate cuts down on cooling costs. www.downloadslide.net 364 Chapter 9 • Cost Allocations: Theory and Applications tooling costs by $206,000, and equipment costs by $359,000. The sum of these costs, $890,000, would then be the controllable capacity costs for the decision to change the product mix. With this estimate, Craig’s proposal does not appear to be wise. We estimate the profit from Craig’s proposal as: Contribution margin from Standard mattresses Contribution margin from Deluxe mattresses Total contribution margin Less: current fixed costs Increase in fixed costs Profit 10,000  $256/unit $2,560,000 20,000  $303/unit $6,060,000 $8,620,000 $7,560,000) $890,000) $170,000 In many ways, direct estimation is like the account classification method that you learned in Chapter 4. It involves identifying, on an account-by-account basis, which capacity costs would change, and by how much, for each decision option. Direct estimation of changes in capacity costs can be difficult and time-consuming. Moreover, its accuracy depends on the expertise and incentives of the person making the estimates. For these reasons, firms frequently use cost allocations, a simpler but potentially less-accurate approach to estimate controllable capacity costs. COST ALLOCATIONS Recall from Chapter 3 that to allocate is to distribute a common cost or benefit among two or more objects. For EZ-Rest, capacity costs (such as the costs of plant and machinery) are the common costs incurred to make the two product lines. Suppose we decide to allocate EZ-Rest’s fixed capacity costs to its two product lines using direct labor dollars (DL$) as the allocation basis. Referring back to Exhibit 9.1, the cost pool is the total fixed costs of $7,560,000, made up of $5,040,000 for manufacturing, $1,560,000 for marketing and sales, and $960,000 for administration. The cost objects are the two product lines (Standard and Deluxe mattresses). The cost driver is direct labor dollars, and the total number of direct labor dollars ($3,150,000) is the denominator volume. With this information, we can perform the two-step cost-allocation procedure for EZ-Rest: 1. Calculate the allocation rate by dividing the costs in the cost pool by the denominator volume: $7,560,000  $2.40 per DL$ Allocation rate  ______________ $3,150,000 DL$ Businesses often refer to this rate as the overhead rate because capacity costs are also termed overhead costs. Some firms refer to this rate as the burden because they charge, or burden, each product with this amount. CHAPTER CONNECTIONS In Chapter 4, we discussed the account classification method. This method allows firms to directly estimate the costs associated with an option by analyzing each cost item separately. While the account classification method can lead to accurate estimates, it is tedious and time consuming, and is subject to the biases and incentives of the decision maker. www.downloadslide.net Long-Term Decisions and Cost Allocations 365 Connecting to Practice W HY DOES THIS BOOK COST SO MUCH ? Many textbooks cost hundreds of dollars; mass-market hardcovers such as the books reviewed in the New York Times routinely list for $30; and, even an e-book may be priced at $9.99! Arguing that the cost of downloading a 2MB files is in the pennies, some are outraged by these prices. Yet, a closer look tells a different story. For a hardcover, the publisher usually gets 50% of the final price. Direct costs (such as paper and ink, author royalties of 10-15%) account for about 25% of the retail price. Netting the substantial indirect costs of acquiring, editing and typesetting reduces the margin to about $1–$2 per copy, even for a successful book. For e-books, retailers such as Apple keep as profit approximately 30% of the price to the consumer. Direct costs such as making versions for various platforms and royalties can cost another 25%. Again, the profit margin for the publisher is $1 or less per book sold. C OMMENTARY : Many of the indirect costs are product level costs and incurred before the book is ready for sale. This feature, coupled with the difficulty of forecasting demand, leads to publishers making a loss on many titles in their catalog. This cost structure also leads to significant scale economies. One reason for expensive textbooks could be that a very specialized work (such as advanced particle physics) has to recover upfront costs from a smaller number of copies. 2. For each product, multiply the cost driver units by the allocation rate: Standard  $1,350,000 DL$  $2.40 per DL$  $3,240,000 Deluxe  $1,800,000 DL$  $2.40 per DL$  $4,320,000 In this way, the allocation divides the total fixed costs of $7,560,000 between the two product lines. As you can verify in Check It! Exercise #1, the proportion of fixed costs allocated to each mattress line is identical to the proportion of direct labor dollars (the cost driver) in each product line (cost object). Dividing $3,240,000 by 18,000 Standard mattresses, we determine the allocated cost as $180 per Standard mattress. Similarly, dividing $4,320,000 by 12,000 mattresses gives us an allocated cost of $360 per Deluxe mattress. Alternatively, we could obtain the allocated cost per unit by multiplying the unit labor cost of each type of mattress by the overhead allocation rate of $2.40 per every labor dollar: Check It! Exercise #1 When allocating EZ-Rest’s fixed costs of $7,560,000 to mattresses, using direct labor dollars as the allocation basis, verify that the percentage of the cost allocated to each mattress line equals the percentage of direct labor dollars. Solution at end of chapter. www.downloadslide.net 366 Chapter 9 • Cost Allocations: Theory and Applications Standard mattress  $75 DL$  $2.40 per DL$  $180 per mattress Deluxe mattresses  $150 DL$  $2.40 per DL$  $360 per mattress Notice that with labor cost as the allocation base, the allocated cost per unit for Deluxe mattresses ($360 per mattress) is twice the amount allocated to each unit of the Standard mattress ($180 per mattress). How do allocations help long-term decisions? Allocations break up capacity costs into pieces attributable to individual products. We then use the product-level estimates to compute expected costs for a new volume of operations or a revised product mix. That is, allocations estimate long-run capacity costs as proportional to the volume of the underlying cost driver. Exhibit 9.2 presents the product-level income statement for EZ-Rest for the projected product mix using the above allocations. Our new estimate of capacity costs for Standard mattresses multiplies 10,000 units  $75 DL$ per unit  $2.40 allocation per DL$  $1,800,000. For Deluxe mattresses, the capacity cost estimate is 20,000 units  $150 DL$ per unit  $2.40 allocation per DL$  $7,200,000. The revised estimate represents a large increase in capacity costs. As per this analysis, EZ-Rest’s profit actually would decrease from a profit of $684,000 in Exhibit 9.1 to a loss of $380,000—a profit margin decrease of $1,064,000—if Craig changes the product mix. It is important to understand that the accuracy of our estimates depends crucially on the specific allocation procedure used. Check It! Exercise #2 emphasizes this observation. This exercise asks you to verify that EZ-Rest’s estimated capacity costs would not change from its current amount of $7,560,000 if we use sales volume in units as the allocation basis. Why is there no change? The answer is that the change in capacity cost Exhibit 9.2 EZ-Rest Mattress Company: Projected Profit with Modified Product Mix Using Allocations Check It! Exercise #2 Using the data from Exhibit 9.1, compute the allocation rate per mattress. Allocation rate  Total fixed costs/Total number of mattresses  $ ______/mattress. Using this allocation rate, verify that the projected capacity costs under the new product mix are $7,560,000. That is, there is no change in estimated capacity costs with the new product mix. Why is this conclusion likely erroneous? Solution at end of chapter. www.downloadslide.net Long-Term Decisions and Cost Allocations 367 is proportional to the change in the total units of the cost driver. In this Check It! Exercise, the total number of units sold (the cost driver for the allocation) does not change from the current to the proposed product mix. Thus, the total cost will remain the same. (In our primary calculations above, the cost driver was labor dollars, not units sold.) REFINING THE ALLOCATION As Check It! Exercise #2 shows, when we use allocated costs to make decisions, the quality of our decision depends on how well the allocation estimates the capacity cost associated with the various options. Constructing the right allocation procedure is a critical step in obtaining the best estimate of controllable capacity costs. A procedure that is too simple might give inaccurate estimates because it does not capture how different products consume capacity resources. However, highly sophisticated procedures may be difficult to implement because of the many measurements that may be required. The decision context, ease of collecting and analyzing data, and magnitude of the decision all play a role in determining how detailed an allocation procedure to use. (We explore this tradeoff more in Chapter 10.) Let us consider two ways to improve the accuracy of allocation procedures. Using Multiple-Cost Pools and Cost Drivers Sarah Andrews, Marketing Director at EZ-Rest, points out a potential issue in the allocation procedure we used earlier. Sarah agrees that the capacity costs associated with manufacturing the mattresses are likely to vary in proportion to the direct labor cost of each mattress. After all, greater labor cost means more manufacturing time, which means greater use of the factory’s capacity. Thus, she supports the use of direct labor costs to estimate the change in manufacturing overhead (equivalently, manufacturing capacity) costs. However, she sees no connection be-tween direct labor cost and the effort needed to market and sell the mattresses. In her experience, it takes the same amount of time to sell either a Deluxe or a Standard mattress. Moreover, the time taken for general administration, processing, and delivering the order is independent of the kind of mattress ordered. Sarah believes that sales volume is better suited for assigning the fixed marketing and administrative costs to the two product lines. Sarah’s observation highlights that a firm’s total capacity cost is the sum of the costs of many resources. Products generally consume different capacity resources in different proportions. A driver that is appropriate for some resources may not be appropriate for other resources. How should we deal with this problem? The solution is to use many cost pools. For each resource or class of similar resources, we could use a separate cost pool. We then use an allocation basis that best captures the consumption of the resources in each of these pools. For example, when estimating the cost of operating a checking account, Wells Fargo might use separate cost pools for the costs of operating the ATM network and of processing checks. It could then allocate these costs to individual accounts using the number of ATM transactions and the number of checks as the allocation bases, respectively. In the case of EZ-Rest, let us break the total fixed costs into two separate pools. The first pool contains manufacturing capacity costs and the second, marketing costs. Using the data from Exhibit 9.1, we classify $5,040,000 of the total fixed costs of $7,560,000 as manufacturing costs and the remaining $2,520,000 as marketing and administration costs. Next, we use direct labor dollars for allocating manufacturing costs, and the number of units sold for allocating marketing and administrative costs. As Exhibit 9.3 shows, after repeating the two cost allocation steps for each cost pool separately, we have $3,672,000 allocated to the Standard mattresses and $3,888,000 allocated to the Deluxe mattresses. Panels A and B in Exhibit 9.4 show the computations for the one- and two-pool systems, respectively. If using two cost pools is better than using one pool, how about using more cost pools? For instance, why not separately allocate the cost of machines, currently