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 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.

2 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

3 DSP, Inc.: Revenue & Cost Data Job Type PlumbingWindow Cleaning Gutter Guards Landscaping Labor Hours/job2 hours4 hours3 hours5 hours Revenue/job$130$170$200$250 Material Cost$30$10$70$75 Labor Cost$20$40$30$50 Current Monthly Output 90 jobs70 jobs80 jobs60 jobs Note: Total number of jobs per month = = 300 jobs. At current output level, capacity used= 90 x x x x 5 = 1,000 hours per month

4 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

5 DSP, Inc.: Summary Cost Table

6 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 $ x $ x $35 = $4,100 per month. DSP, Inc.

7 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?

8 DSP, Inc.: Summary Cost Table Job Type PlumbingWindow Cleaning Gutter Guards Landscaping Labor Hours/job2 hours4*100= 4003 hours5*120 = 600 Revenue/job$130$170$200$250 Material Cost$30$10$70$75 Labor Cost$20$40$30$50 Administrative Overhead Allocation $60 Non-Administrative Overhead Allocation Profit-$10$30$10$35 $30 Current Output 90/25070/16080/14560/120

9 We may think the Total Profit is: 120*35= *30 = = 7200 Profit DSP, Inc.

10 DSP, Inc.: Summary Cost Table Job Type Window Cleaning Landscaping Labor Hours4*100= 4005*120 = 600 Revenue/job (170*100) $47000 (250*120) Material Cost(10*100) 1000 $10000(75*120) 9000 Labor Cost10000 Administrative Overhead Allocation Non-Administrative Overhead Allocation 9000 Current Output 100/160120/120 Instead of 7200 Profit, We have 0 Profit, While with original plan we had 4100 Profit

11 DSP, Inc.: Summary Cost Table Job Type Window Cleaning Landscaping Labor Hours5*120 = 600 Revenue/job Material Cost1075 Labor Cost Administrative Overhead Allocation Non-Administrative Overhead Allocation Current Output 100/160120/ (18000/220) (9000/220) *100 = 400

12 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%

13 Job TypePlumbingWindow Cleaning Gutter Guards Landscaping Admin O/H Allocated = %age effort x $18,000 $5,400$6,300$3,600 Number of Jobs 90 jobs70 jobs80 jobs60 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

14 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

15 Job Type PlumbingWindow Cleaning Gutter Guards Landscaping Labor Hrs./job2 hours4 hours3 hours5 hours Revenue/job$130$170$200$250 Material Cost$30$10$70$75 Labor Cost$20$40$30$50 Administrative Overhead Allocation $60$90$45 Non-Administrative Overhead Allocation DSP, Inc.: Improved Allocation with ABC Profit$2-$6$28$35 $18 $36 $27 $45 Current Output 90 jobs70 jobs80 jobs60 jobs Profit-$10$30$10$35

16 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?

17 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

18 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 $ x $28 = $7,924. With this product mix, the apparent profit seems to be: Not the true profit. Why? Answer: Unabsorbed overheads. DSP, Inc.

19 DSP, Inc.: Reconciling Variances 120 Landscaping and 133 Gutter Guard jobs will each recover $45 of Administrative Overhead, that is: $45 x $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. $ $6,634 = $1,290.

20 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.

21 DSP, Inc. ProductPlumbingW. CleanG. GuardLandscape Demand for product250 jobs160 jobs145 jobs120 jobs Marginal Profit (Rev. – Var. Cost) $130-$30 = $100 $170-$10 = $160 $200-$70 = $130 $250-$75 = $175 # of hours needed per job 2 hours4 hours3 hours5 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.

22 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*$ *$ *$160 = $46,410. Net Marginal Profit = 250*$ *$ *$160 = $46,440. $46,440 - $37,000 = $9,440.

23 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

 2008, M. Srinivasan 24 Traditional Decision Making Inventory Valuation and Cost Accounting

25 An Inventory Conundrum Raw Material cost per unit:$10 WIP value per unit:$20 Finished Goods value per unit:$35 Sale Price per unit:$50 Other Operating Expenses: $4 Million in 2006; $3.75 Million in Beginning WIP Inventory (1000 units) Beginning FG Inventory (1000 units) Raw Material (1000 units) Sales (1000 units) Ending WIP Inventory (1000 units) Ending FG Inventory (1000 units) 40 10

26 An Inventory Conundrum: The Income Statement 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 1,000 1,400 4,0003,300 4,0003,750 1, , ,0008,900 12,00011,100

27 Traditional Decision Making: Product Costs How can we calculate a company’s profit? Net Profit =  p Revenue p -  c Expense c. But how do we use this information to, say, decide on launching a new product? Net Profit p = Revenue p - Expense p, and so, Net Profit =  p Net Profit p  Allocate! If we allocate overhead costs correctly:

28 Obtaining Accurate Product Costs How do we allocate overhead costs properly so that product costs are accurate?  Standard Costing  Activity Based Costing (ABC)