1 Exercise in Cost Accounting: De Niro, Scorsese and Pesci, Inc. DSP, Inc. is a home maintenance services operation, started by three men, De Niro, Scorsese

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Exercise in Cost Accounting:De Niro, Scorsese and Pesci, Inc.

DSP, Inc. is a home maintenance services operation, started by three men, De Niro, Scorsese and Pesci.

Services offered: Plumbing, Window Cleaning, Gutter Guard Installation, and Landscaping.

There is ample demand for these services. However, there is also a shortage of qualified workers in the area.

DSP has had a motto: “Teach Your Children Well,” ever since their younger days. They have employed their children, 5 high-school graduates, to run operations.

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Monthly wage per employee = $2,000 including benefits

Hours budgeted per employee per month = 200 hours

Monthly capacity with 5 employees = 1,000 hours

Total Direct Labor cost per month = $10,000

Direct labor rate = $10,000/1,000 = $10 per hour

DSP, Inc.: Labor Costs

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DSP, Inc.: Revenue & Cost DataJob Type Plumbing Window

CleaningGutter Guards

Landscaping

Labor Hours/job 2 hours 4 hours 3 hours 5 hours

Revenue/job $130 $170 $200 $250

Material Cost $30 $10 $70 $75

Labor Cost $20 $40 $30 $50

Current Monthly Output

90 jobs 70 jobs 80 jobs 60 jobs

Note:

Total number of jobs per month = 90 + 70 + 80 + 60 = 300 jobs.

At current output level, capacity used = 90 x 2 + 70 x 4 + 80 x 3 + 60 x 5

= 1,000 hours per month

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In standard cost accounting, indirect costs are allocated to the product based on the volume of the cost driver they have consumed. There may be more than one single cost driver. The cost driver could be other than labor cost based on the nature of the business. Here it is # of Jobs.

Monthly Administrative Overhead (Salaries) = $18,000.

Monthly Non-Administrative Overhead (Rent, Truck Fleet Maintenance, Marketing, Depreciation) = $9,000.

Overhead is currently allocated to products based on production volume. Current volume is 300 jobs per month.

Administrative Overhead per job $18,000/300 = $60.

Non-Administrative Overhead per job = $9,000/300 = $30.

DSP, Inc.: Overheads

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DSP, Inc.: Summary Cost Table

` PlumbingWindow Cleaning

Gutter Guards

Landscaping

Market 250 160 145 120Current Output 90 70 80 60Revenue /Job 130 170 200 250Material Cost /Job 30 10 70 75Labour Hours/Job 2 4 3 5Labor Cost /Job 20 40 30 50Administrative /Job

300

1800060 60 60 60

9000Non Administrative /Job 30 30 30 30

Profit /Job -10 30 10 35

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CSN is using all its labor capacity, and is absorbing all overheads. So there is no labor variance or overhead absorption variance to worry about.

Therefore, the total profit is:

90 x (-$10) + 70 x $30 + 80 x $10 + 60 x $35 =

$4,100 per month.

DSP, Inc.

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DSP, Inc., Demand for Services

Suppose the monthly demand for these services is:

Plumbing: 250 jobs

Window cleaning: 160 jobs

Gutter guard installs: 145 jobs

Landscaping: 120 jobs

Suppose, too, that CSN, Inc., can choose which products to go after.

What is the best product offering for CSN, Inc., that will maximize its profit?

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DSP, Inc.: Summary Cost TableJob Type Plumbing Window

CleaningGutter Guards

Landscaping

Labor Hours/job 2 hours 4*100= 400 3 hours 5*120 = 600

Revenue/job $130 $170 $200 $250


Labor Cost $20 $40 $30 $50

Administrative Overhead Allocation

$60 $60 $60 $60

Non-Administrative Overhead Allocation

Profit -$10 $30 $10 $35

$30 $30 $30 $30

Current Output 90/250 70/160 80/145 60/120

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We may think the Total Profit is:

120*35=4200

100*30 =3000

4200+3000= 7200 Profit

DSP, Inc.

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DSP, Inc.: Summary Cost TableJob Type Window

CleaningLandscaping

Labor Hours 4*100= 400 5*120 = 600

Revenue/job (170*100) 17000

$47000 (250*120)30000

Material Cost (10*100)1000

$10000 (75*120)9000

Labor Cost 10000


18000


9000

Current Output 100/160 120/120

Instead of 7200 Profit, We have 0 Profit, While with original plan we had 4100 Profit

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DSP, Inc.: Summary Cost TableJob Type Window

CleaningLandscaping

Labor Hours 5*120 = 600

Revenue/job 170 250

Material Cost 10 75

Labor Cost



Current Output 100/160 120/120

40 50

(18000/220) 81.82

(18000/220) 81.82

(9000/220) 40.1

(9000/220) 40.1

4*100 = 400

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DSP, Inc.: Activity-Based Costing

CSN, Inc. wants to use a better method to allocate the overheads (using Activity-Based Costing).

To accurately allocate Administrative Overhead, CSN gathers data on the time the administrators, Cromby, Steele and Nash, devote to the four products, each month. The data reveals the following breakdown on the time administration spends on the 4 products:

Plumbing: 30%; Window Cleaning: 35%

Gutter Guards: 20%; Landscaping: 15%

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Job Type Plumbing Window Cleaning

Gutter Guards

Landscaping

Admin O/H Allocated = %age effort x $18,000

$5,400 $6,300 $3,600

Number of Jobs 90 jobs 70 jobs 80 jobs 60 jobs

Administrative O/H Allocation per job

$60 $90 $45

Percentage Effort 30% 35% 20% 15%

DSP, Inc.: Administrative Overhead Allocation using ABC

$45

$2,700

Administrative Overhead to be allocated = $18,000

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DSP, Inc.: Non-Administrative Overhead Allocation using ABC

Non-Administrative Overhead to be allocated = $9,000.

The allocation is made based on labor hours.

Total labor hours = 1,000. So,

Non-Admin. O/H rate = $9,000/1,000 = $9.00 per labor hour.

Since Plumbing takes 2 hours, the Non-Admin. Overhead allocated to a Plumbing job is = $9 x 2 = $18.

Thus the Non-Administrative Overhead allocation per job is:

Plumbing (2 hours): $18; W. Cleaning (4 hours): $36

G. Guards (3 hours): $27; Landscaping (5 hours):$45

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Job Type Plumbing Window Cleaning

Gutter Guards

Landscaping

Labor Hrs./job 2 hours 4 hours 3 hours 5 hours

Revenue/job $130 $170 $200 $250


Labor Cost $20 $40 $30 $50


$60 $90 $45 $45


DSP, Inc.: Improved Allocation with ABC

Profit $2 -$6 $28 $35

$18 $36 $27 $45

Current Output 90 jobs 70 jobs 80 jobs 60 jobs

Profit -$10 $30 $10 $35

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DSP, Inc., Demand for Services

Suppose the monthly demand for these services is:

Plumbing: 250 jobs

Window cleaning: 160 jobs

Gutter guard installs: 145 jobs

Landscaping: 120 jobs

Suppose, too, that CSN, Inc., can choose which products to go after.

What is the best product offering for CSN, Inc., that will maximize its profit?

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DSP, Inc.

Can CSN do better? Let’s use ABC cost figures.

Which is the most profitable product?

Compute profits if they first complete meeting the demand for the most profitable product, then focus on the next most profitable product, and so on. Use the following pages for your calculations.

Landscaping

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First complete demand for 120 Landscaping jobs.

That uses up , leaving of capacity.

Next work on Gutter Guards. Each job takes 3 hours.

600 hours 400 hours

Can complete 400/3 =133 jobs.(1 hour of labor unused.)

120 x $35 + 133 x $28 = $7,924.

With this product mix, the apparent profit seems to be:

Not the true profit. Why?

Answer: Unabsorbed overheads.

DSP, Inc.

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DSP, Inc.: Reconciling Variances120 Landscaping and 133 Gutter Guard jobs will each recover $45 of Administrative Overhead, that is:

$45 x 120 + $45 x 133 = $11,385.

Admin. Overhead Variance = $18,000 - $11,385 = $6,615.

So, “optimal” profit is less than earlier profit! Why?

The 1 hour of unused labor gives a Labor Usage Variance of $10 and Non-Admin. Overhead Variance of $9.

So, the total of all the Variances is:

Actual profit with ABC is thus:

$6,634.

$7924 - $6,634 = $1,290.

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DSP, Inc.: A Better Approach

a) Consider only the variable costs in the profit equation – use marginal profits.

b) Focus on the constraint. Evaluate rate at which marginal profits are generated at the constraint (Throughput). Best product is the one with the highest Throughput. Complete demand on this product, move to next most profitable product, and so on, till you run out of capacity at constraint.

c) Find total marginal profit, and subtract out fixed costs to get total net profit.

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DSP, Inc.

Product Plumbing W. Clean G. Guard Landscape

Demand for product 250 jobs 160 jobs 145 jobs 120 jobs

Marginal Profit (Rev. – Var. Cost)

$130-$30 = $100

$170-$10 = $160

$200-$70 = $130

$250-$75 = $175

# of hours needed per job

2 hours 4 hours 3 hours 5 hours

Profit Generation Rate (Throughput)

$50.00 per hour

$40.00 per hour

$43.33 per hour

$35.00 per hour

Capacity at the constraint (total labor hours) = 1,000 hours.

Fixed costs are: Labor + Administrative O/H + Non-Admin. Overhead

= $10,000 + $18,000 + $9,000 = $37,000.

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DSP, Inc.

Do 250 plumbing jobs first (250 x 2 = 500 hours).

Next, do 145 gutter guards (145 x 3 = 435 hours).

With the remaining 65 hours, you can complete 65/4 = 16 window cleaning jobs (64 hours)

Net Marginal Profit = 250*$100 + 145*$130 + 16*$160 = $46,410.

Net Marginal Profit = 250*$100 + 144*$130 + 17*$160 = $46,440.

$46,440 - $37,000 = $9,440.

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DSP, Inc.: Summary

Summary:“Optimal profit” with Standard Costing : $0

“Optimal profit” with ABC: $1,290

Profit with arbitrary product mix: $4,100

Optimal profit with Throughput Accounting: $9,410

24 ã 2008, M. Srinivasan

Traditional Decision Making

Inventory Valuation and Cost Accounting

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An Inventory Conundrum

Raw Material cost per unit: $10WIP value per unit: $20Finished Goods value per unit: $35Sale Price per unit: $50

Other Operating Expenses: $4 Million in 2006; $3.75 Million in 2007

2006 2007

Beginning WIP Inventory (1000 units) 50 50

Beginning FG Inventory (1000 units) 40 40

Raw Material (1000 units) 400 330

Sales (1000 units) 400 400

Ending WIP Inventory (1000 units) 50 10

Ending FG Inventory (1000 units) 40 10

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An Inventory Conundrum: The Income Statement

2002 2007

Sales (1000 $)

Beginning WIP Inventory (1000 $)

Beginning FG Inventory (1000 $)

Raw Material Purchase (1000 $)

Other Expenses (1000 $)

Ending WIP Inventory (1000 $)

Ending FG Inventory (1000 $)

Cost of Goods Sold (1000 $)

Profit (1000 $)

20,000 20,0001,000 1,0001,400 1,4004,000 3,3004,000 3,7501,000 2001,400 350

8,000 8,900

12,000 11,100

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Traditional Decision Making:Product Costs

How can we calculate a company’s profit?

Net Profit = Sp Revenuep - Sc Expensec.

But how do we use this information to, say, decide on launching a new product?

Net Profitp = Revenuep - Expensep, and so,

Net Profit = Sp Net Profitp

Allocate! If we allocate overhead costs correctly:

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Obtaining Accurate Product Costs

How do we allocate overhead costs properly so that product costs are accurate? Standard Costing

Activity Based Costing (ABC)

Documents

1 Exercise in Cost Accounting: De Niro, Scorsese and Pesci, Inc. DSP, Inc. is a home maintenance services operation, started by three men, De Niro, Scorsese