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Accounting Master

Program
2007
By: Isam Rimawi
irimawi@hotmail.com
Master Program Advanced Managerial accounting 12/20/2010 last update

http://www.geocities.com/irimawi/

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Master Program Advanced Managerial accounting 12/20/2010 last update

Managerial Accounting and the Business Environment Chapter One

Work of Management
Planning
Identify alternatives. Select alternative that does the best job of furthering organization’s objectives.
Develop budgets to guide progress toward the selected alternative.

Directing and Motivating


Directing and motivating involves managing day-to-day activities to keep the rganization running
smoothly.
 Employee work assignments.
 Routine problem solving.
 Conflict resolution.
 Effective communications.

Controlling
• The control function ensures that plans are being followed.
• Feedback in the form of performance reports that compare actual results with the budget are an
essential part of the control function

Planning and Control Cycle

Formulating
Begin
Formulatinglong-and
long-andshort-
short-
term plans (Planning)
term plans (Planning)

Comparing
Comparingactual
actual Decision Implementing
Implementing
to planned performance
to planned performance plans
plans(Directing
(Directingand
and
(Controlling)
(Controlling)
aking
M Motivating)
Motivating)

Measuring
Measuringperformance
performance
(Controlling)
(Controlling)

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Comparison of Financial and Managerial Accounting


Financial Accounting Managerial Accounting
1. Users External persons who Managers who plan for
make financial decisions and control an organization
2. Time focus Historical perspective Future emphasis
3. Verifiability versus Emphasis on verifiability Emphasis on relevance
relevance for planning and control
4. Precision versus Emphasis on precision Emphasis on timeliness
timeliness
5. Subject Primary focus is on Focuses on segments
the whole organization of an organization
6. GAAP Must follow GAAP Need not follow GAAP
and prescribed formats or any prescribed format
7. Requirement Mandatory for external reports Not Mandatory

Organizational Structure

Decentralization
Decentralizationis
isthe
thedelegation
delegationof
ofdecision-
decision-
making
makingauthority
authoritythroughout
throughoutananorganization.
organization.
C o r p o r a t e O r g a n i z a t i o n C h
B o a r d o f D i r e c t o r s

P r e s i d e n t

P u r c h a s i nP g e r s o n n V e ilc e P r e s C i d h ei e n f t F i n a n c i a l
O p e r a t i o n Os f f i c e r

T r e a s u C r eo r n t r o ll e r

Line and Staff Relationships


Line positions are directly related to achievement of the basic objectives of an organization.
 Example: Production supervisors in a manufacturing plant
Staff positions support and assist line positions.
 Example: Cost accountants in the manufacturing plant.

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The Chief Financial Officer (CFO)


A member of the top management team responsible for:
 Providing timely and relevant data to support planning and control activities.
 Preparing financial statements for external users.

The Changing Business Environment


Business environment changes in the past twenty years
1. Just-in-time production
2. Total quality management
3. Process reengineering
4. Theory of constraints
5. International competition
6. E-commerce

Just-in-Time (JIT) Systems

Complete
Completeproducts
products
Receive
Receivecustomer
customer just
justin
intime
timeto
to
orders.
orders. ship customers.
ship customers.

Schedule
Schedule
production.
production.

Receive
Receivematerials Complete
materials Completeparts
partsjust
justin
in
just
just in timefor
in time for time for assembly into
time for assembly into
production.
production. products.
products.

JIT Consequences
1. Improved plant layout
2. Reduced setup time
3. Zero production defects
4. Flexible workforce
JIT purchasing
Fewer, but more ultra reliable suppliers. Frequent JIT deliveries in small lots. Defect-free supplier
deliveries.

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Benefits of a JIT System


Reduced inventory costs
Higher quality products
Increased throughput
Freed-up funds
Greater customer satisfaction
More rapid response to customer orders

Total Quality Management (TQM)


TQM improves productivity by encouraging the use of fact and analysis for decision making and
if properly implemented, avoids counter-productive organizational infighting.
• Systematic problem solving using tools such as benchmarking
• Continuous Improvement
• Central Focus is Serving Customers

Process Reengineering
1. A business process is diagrammed in detail.
2. Every step in the business process must be justified.
3. The process is redesigned to eliminate all non-value-added activities

Anticipated results:
1. Process is simplified.
2. Process is completed in less time.
3. Costs are reduced.
4. Opportunities for errors are reduced.

Process Reengineering versus TQM


Process Reengineering Total Quality Management
• Radically overhauls existing • Tweaks existing processes to realize
processes. gradual improvements.
• Likely to be imposed from above and • Uses a team approach involving people
to use outside consultants. who work directly in the process.

Theory of Constraints
A constraint (also called a bottleneck) is anything that prevents you from
getting more of what you want.

The constraint in a system is determined


Theorybyofthe step that has the smallest capacity.
Constraints
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Only actions that 2.2.Allow


Allowthetheweakest
weakest
strengthen the link
link to set thetempo.
to set the tempo.
weakest link in the
“chain” improve the
process. 1.1.Identify 3.3.Focus
Identify Focusonon
the weakest improving the
improving the
the weakest
link. weakest
weakestlink.
link.
link.

4.4.Recognize
Recognizethat
thatthe
the
weakest
weakestlink
link
isisno
no longerso.
longer so.

International Competition
Increasing
Increasing sophistication
sophistication
in
in international
international markets.
markets.

Fewer
Fewer tariffs,
tariffs, Improvements
Improvements
quotas, Competition has
quotas, andand in
in global
global
other barriers become worldwide
other barriers transportation
transportation
to in most industries.
to free
free trade.
trade. systems.
systems.

An
Anexcellent
excellentmanagement
managementaccounting
accountingsystem
systemisisneeded
needed
to succeed in today’s competitive global marketplace.
to succeed in today’s competitive global marketplace.

E-Commerce

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In recent years, many dot.com businesses failed that might have benefited from the application of
managerial accounting tools:
 Cost concepts (Chapter 2)
 Cost estimation (Chapter 5)
 Cost-volume-profit (Chapter 6)
 Activity-based costing (Chapter 8)
 Budgeting (Chapter 9)
 Decision-making (Chapter 13)
 Capital budgeting (Chapter 14)
Code of Conduct for Management Accountants
The Institute of Management Accountant’s (IMA) Standards of Ethical Conduct for Practitioners
of Management Accounting and Financial Management have two major parts offering guidelines
for:
ΠEthical behavior.
 Resolution for an ethical conflict.
IMA Guidelines for Ethical Behavior
Follow
Followapplicable
applicablelaws,
laws,regulations
regulationsand
and
standards.
standards.

Maintain
Maintain
professional
professional Competence
competence.
competence.

Prepare
Preparecomplete
completeand
andclear
clearreports
reports
after appropriate analysis.
after appropriate analysis.

IMA Guidelines for Ethical Behavior


Do
Donot
notdisclose
discloseconfidential
confidentialinformation
information
unless
unless legally obligated todo
legally obligated to doso.
so.

Do
Donot
notuse
useconfidential
confidential
information
informationfor
for Confidentiality
personal
personaladvantage.
advantage.

Ensure
Ensurethat
thatsubordinates
subordinatesdodonot
notdisclose
disclose
confidential information.
confidential information.

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IMA Guidelines for Ethical Behavior


Avoid
Avoidconflicts
conflictsofofinterest
interestand
andadvise
advise
others
othersofofpotential
potentialconflicts.
conflicts.

Do
Donot
notsubvert
subvert
organization’s
organization’slegitimate
legitimate Integrity
objectives.
objectives.

Recognize
Recognizeand
andcommunicate
communicatepersonal
personaland
and
professional limitations.
professional limitations.

IMA Guidelines for Ethical Behavior


Avoid
Avoidactivities
activitiesthat
thatcould
could
affect your ability to perform
affect your ability to perform
duties.
duties.

Refuse
Refusegifts
giftsor
or
Refrain
Refrainfrom
from favors that
favors that
activities
activitiesthat
that might
might
could discredit
could discredit
the
theprofession.
profession.
Integrity influence
influence
behavior.
behavior.

Communicate
Communicateunfavorable
unfavorableasas
well as favorable information.
well as favorable information.

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IMA Guidelines for Ethical Behavior


Communicate
Communicateinformation
informationfairly
fairlyand
andobjectively.
objectively.

Objectivity

Disclose
Discloseall
allinformation
informationthat
thatmight
mightbe
beuseful
usefultotomanagement.
management.

IMA Guidelines for Resolution of an Ethical Conflict


• Follow established policies.
• For unresolved ethical conflicts:
 Discuss the conflict with immediate superior or next highest uninvolved manager.
 Make reference to the Sarbanes-Oxley Act passed by Congress in 2002 in part to give
legal protection to those reporting corporate misconduct.
 If immediate superior is the CEO, consider the board of directors or the audit committee.

IMA Guidelines for Resolution of an Ethical Conflict


• Follow established policies.
• For unresolved ethical conflicts:
 Except where legally prescribed, maintain confidentiality.
 Clarify issues in a confidential discussion with an objective advisor.
 Consult an attorney as to legal obligations.
 The last resort is to resign.

Why Have Ethical Standards?

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Ethical
Ethicalstandards
standardsininbusiness
businessare
areessential
essentialfor
foraa
smooth
smoothfunctioning
functioningadvanced
advancedmarket
marketeconomy.
economy.

Without ethical standards in business, the


economy, and all of us who depend on it for
jobs, goods, and services, would suffer.

Abandoning ethical standards in business would


lead to a lower quality of life with less
desireable goods and services at higher prices.

Codes of Conduct on the International Level


The Guidelines on Ethics for Professional Accountants, issued by the International Federation of
Accountants (IFAC), govern the activities of professional accountants worldwide
In addition to competence, objectivity, independence, and confidentiality, the IFAC’s code deals
with the accountant’s ethical responsibilities in:
• Taxes
• Fees and commissions
• Advertising and solicitation
• Handling of monies
• Cross-border activities.

Certified Management Accountant


A management accountant who has the necessary qualifications and who passes a rigorous
professional exam earns the right to be known as a Certified Management Accountant (CMA).
Information about becoming a CMA and the CMA program can be accessed on the IMA’s website
at www.imanet.org or by calling 1-800-638-4427.

End of Chapter 1

Costs Terms, Concepts and Classifications Chapter Two


Manufacturing Costs

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1. Direct Materials
2. Direct Labor
3. Manufacturing Overhead
Direct Materials
Raw materials that become an integral part of the product and that can be conveniently traced
directly to it.
Example: A radio installed in an automobile
Direct Labor
Those labor costs that can be easily traced to individual units of product.
Example: Wages paid to automobile assembly workers
Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units produced.

Examples:
Examples: Indirect
Indirect labor
laborand
and indirect
indirectmaterials
materials

Materials used to support the


Wages paid to employees who are
production process.
not directly involved in production
work.
Examples: lubricants and cleaning
Examples: maintenance workers,
supplies used in the automobile
janitors and security guards.
assembly plant.

Classifications of Costs
Manufacturing costs are often classified as follows:

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Material
Material Labor
Labor Overhead
Overhead

Prime Conversion
Cost Cost

Non-manufacturing Costs
Marketing or Selling Cost : Costs necessary to get the order and deliver the product.
Administrative Cost : All executive, organizational, and clerical costs.
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Product Costs Versus Period Costs

Inventory Cost of Good Sold


Product costs include direct Period costs include all
Expense
materials, direct
Sale labor, and marketing or selling costs
manufacturing overhead. and administrative costs.

Balance Income
Sheet Statement Income
Statement
Quick Check ü
Which of the following costs would be considered a period rather than a product cost in a
manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
E. Sales commissions. , B, E,

Comparing Merchandising and Manufacturing Activities


Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell finished
goods.

Balance Sheet
Merchandisers . . . Manufacturers . . .
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
 Prepaid Expenses  Prepaid Expenses
 Merchandise Inventory  Inventories
Raw Materials
Work in Process
Finished Goods
Raw Materials Materials waiting to be processed.
Work in Process Partially complete products – some material, labor, or overhead has been added.
Finished Goods Completed products awaiting sale.

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The Income Statement


Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.

Merchandising Company Manufacturing Company


Cost of goods sold: Cost of goods sold:
Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $ 248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $ 236,250

Inventory Flows

Beginning
Additions Available
balance + $$$ = $$$$$
$$

Available _ Withdraw Ending


$$$$$
als = balance
$$$ $$

Quick Check ü
If your inventory balance at the beginning of the month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would be the balance at the end of the month?
A. $1,000.
B. $ 800.

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C. $1,200.
D. $ 200. . , B, $1,000 + $100 = $1,100 $1,100 - $300 = $800

Schedule of Cost of Goods Manufactured


• Calculates the cost of raw material, direct labor and manufacturing overhead used in
production
• Calculates the manufacturing costs associated with goods that were finished during the period.
Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process Finished Goods

Beginning raw Direct materials Beginning finished


materials inventory goods inventory
+ Raw materials + Cost of finished
purchased As items are removed from goods mfg.
= Raw materials raw materials inventory and = Finished goods
available for use placed into the production available for sale
in production process, they are called - Ending finished
– Ending raw materials direct materials. goods inventory
inventory = Cost of finished
= Raw materials used goods sold
in production

Work In
Raw Materials Manufacturing Costs Process

Beginning raw Direct materials


materials inventory + Direct labor
Raw materials + Mfg. overhead Conversion costs are costs
purchased = Total manufacturing incurred to convert the direct
Raw materials costs material into a finished product.
available for use
in production
Ending raw materials
inventory
Raw materials used
in production
Manufacturing Work
Raw Materials Costs In Process Finished Goods

Beginning raw Direct materials Beginning work in Beginning finished


materials
inventory + Direct labor process inventory goods inventory
+ Raw materials + Mfg. overhead + Total manufacturing + Cost of finished
purchased = Total manufacturing costs goods mfg.

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= Raw materials costs = Total work in = Finished goods


available for
available for use process for the sale
in production period - Ending finished
– Ending raw materials goods inventory
inventory All manufacturing costs incurred during = Cost of finished
= Raw materials used the period are added to the beginning goods sold
in production balance of work in process.

Manufacturing Work
Raw Materials Costs In Process Finished Goods

Beginning raw Direct materials Beginning work in Beginning finished


materials
inventory + Direct labor process inventory goods inventory
+ Raw materials + Mfg. overhead + Total manufacturing + Cost of finished
purchased = Total manufacturing costs goods mfg.
= Raw materials costs = Total work in = Finished goods
available for
available for use process for the sale
in production period - Ending finished
– Ending work in goods inventory
process inventory = Cost of finished
= Cost of goods goods sold
Costs associated with the goods that are manufactured
completed during the period are
transferred to finished goods inventory.

Work In Process Finished Goods

Beginning work in Beginning finished


process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished

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process inventory goods inventory


= Cost of goods Cost of goods
manufactured sold

Manufacturing Cost Flows

Balance Sheet Income


Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in


Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and


Administrative Administrative

Quick Check ü
Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was
purchased. A count at the end of the month revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $2,000 . ,C
The Answer C
Beg. raw materials $ 32,000
+ Raw materials
purchased 276,000
Raw materials
= available
for use in
production $ 308,000
– Ending raw materials
inventory 28,000

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= Raw materials used


in production $ 280,000

Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory
overhead was $180,000. What were total manufacturing costs incurred for the month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined. . ,B

The Answer B
Direct Materials $280,000
+ Direct Labor 375,000
+ Mfg. Overhead 180,000
= Mfg. Costs Incurred
for the Month $835,000

Beginning work in process was $125,000. Manufacturing costs incurred for the month were
$835,000. There were $200,000 of partially finished goods remaining in work in process inventory
at the end of the month. What was the cost of goods manufactured during the month?
A. $1,160,000
B. $ 910,000
C. $ 760,000
D. Cannot be determined. . C ,
The Answer C
Beginning work in
process inventory $ 125,000
+ Mfg. costs incurred
for the period 835,000
= Total work in process
during the period $ 960,000
– Ending work in
process inventory 200,000
= Cost of goods
manufactured $ 760,000
Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month
was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods
sold for the month?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000. . ,B

The Answer B
$130,000 + $760,000 = $890,000
$890,000 - $150,000 = $740,000

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Cost Classifications for Predicting Cost Behavior


How a cost will react to changes in the level of activity within the relevant range.
 Total variable costs change when activity changes.
 Total fixed costs remain unchanged when activity changes.

Total Variable Cost


Your total long distance telephone bill is based on how many minutes you talk
Total Long Distance
Telephone Bill

Minutes Talked

Variable Cost Per Unit


Telephone Charge
Per Minute

Minutes Talked

Total Fixed Cost


Your monthly basic telephone bill probably does not change when you make more local calls.

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Telephone Bill
Monthly Basic

Number of Local Calls

Fixed Cost Per Unit


The average fixed cost per local call decreases as more local calls are made.
Monthly Basic Telephone
Bill per Local Call

Number of Local Calls

Cost Classifications for Predicting Cost Behavior


Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

Quick Check ü
Which of the following costs would be variable with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be more than one correct answer.)
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A. The cost of lighting the store.


B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers . C , D ,B

Assigning Costs to Cost Objects


Direct costs Indirect costs
• Costs that can be • Costs that cannot be easily and
easily and conveniently traced to a unit conveniently traced to a unit of
of product or other cost object. product or other cost object.
• Examples: direct material and direct • Example: manufacturing overhead
labor

Cost Classifications for Decision Making


• Every decision involves a choice between at least two alternatives.
• Only those costs and benefits that differ between alternatives are relevant in a decision. All
other costs and benefits can and should be ignored.

Differential Costs and Revenues


Costs and revenues that differ among alternatives
Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a
neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month.
Differential revenue is:
$2,000 – $1,500 = $500
Differential cost is:
$300

Opportunity Costs
The potential benefit that is given up when one alternative is selected over another
Example: If you were not attending college, you could be earning $15,000 per year.
Your opportunity cost of attending college for one year is $15,000

Sunk Costs
Sunk costs have already been incurred and cannot be changed now or in the future. They should
be ignored when making decisions.
Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

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Quick Check ü
Suppose you are trying to decide whether to drive or take the train to Portland to attend a
concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the
cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket
affect the decision of whether you drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant. A,

Suppose you are trying to decide whether to drive or take the train to Portland to attend a
concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the
annual cost of licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant B,

Suppose that your car could be sold now for $5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost. B,

Summary of the Types of Cost Classifications


• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making

Idle Time
• Machine Breakdowns
• Material Shortages
• Power Failures
The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.

Overtime
The overtime premiums for all factory workers are usually considered to be part of
manufacturing overhead

Labor Fringe Benefits


Fringe benefits include employer paid costs for insurance programs, retirement plans,
supplemental unemployment programs, Social Security, Medicare, workers’ compensation and
unemployment taxes.
• Some companies include all of these costs in manufacturing overhead.
• Other companies treat fringe benefit expenses of direct laborers as additional direct labor
costs.
Quality of Conformance
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When the overwhelming majority of products produced conform to design specifications and are
free from defects.

Prevention and Appraisal Costs

Support activities whose purpose


Prevention Costs is to reduce the number of
defects

Incurred to identify defective


Appraisal Costs products before the products are
shipped

Internal and External Failure Costs

Internal Failure Incurred as a result of identifying


defects before they are shipped
Costs

External Failure Incurred as a result of defective


products being delivered to
Costs customers

Examples of Quality Costs


Prevention Costs
• Quality training
• Quality circles
• Statistical process control activities
Internal Failure Costs
• Scrap
• Spoilage
• Rework
Appraisal Costs
• Testing & inspecting incoming materials
• Final product testing
• Depreciation of testing equipment
External Failure Costs
• Cost of field servicing & handling complaints
• Warranty repairs

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• Lost sales

Distribution of Quality Costs


• When quality of conformance is low, total quality cost is high and consists mostly of
internal and external failure.
• Companies can reduce their total quality cost by focusing on prevention and
appraisal. The cost savings from reduced defects usually swamps the costs of the
additional prevention and appraisal efforts.

Quality cost reports provide an estimate of the financial consequences of


the company’s current defect rate.
Ventura Company Quality Cost Report For Years 1 and 2
Year 2 Year 1
Amount Percent* Amount Percent*
Prevention costs:
Systems development $ 400,000 0.80% $ 270,000 0.54%
Quality training 210,000 0.42% 130,000 0.26%
Supervision of prevention activities 70,000 0.14% 40,000 0.08%
Quality improvement 320,000 0.64% 210,000 0.42%
Total prevention cost 1,000,000 2.00% 650,000 1.30%

Appraisal costs:
Inspection 600,000 1.20% 560,000 1.12%
Reliability testing 580,000 1.16% 420,000 0.84%
Supervision of testing and inspection 120,000 0.24% 80,000 0.16%
Depreciation of test equipment 200,000 0.40% 140,000 0.28%
Total appraisal cost 1,500,000 3.00% 1,200,000 2.40%

Internal failure costs:


Net cost of scrap 900,000 1.80% 750,000 1.50%
Rework labor and overhead 1,430,000 2.86% 810,000 1.62%
Downtime due to defects in quality 170,000 0.34% 100,000 0.20%
Disposal of defective products 500,000 1.00% 340,000 0.68%
Total internal failure cost 3,000,000 6.00% 2,000,000 4.00%

External failure costs:


Warranty repairs 400,000 0.80% 900,000 1.80%
Warranty replacements 870,000 1.74% 2,300,000 4.60%
Allowances 130,000 0.26% 630,000 1.26%
Cost of field servicing 600,000 1.20% 1,320,000 2.64%
Total external failure cost 2,000,000 4.00% 5,150,000 10.30%
Total quality cost $ 7,500,000 15.00% $ 9,000,000 18.00%

* As a percentage of total sales. In each year sales totaled $50,000,000.


Quality Cost Reports: Graphic Form
Quality reports can also be prepared in graphic form.

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20
$10

Quality Cost as a Percentage of Sales


18
9
16
8
Quality Cost (in millions)

14
7 External External
External External 12
6 Failure Failure
Failure Failure
10
5

4 8 Internal
Internal
Failure Failure
3 Internal 6 Internal
Failure Failure
2 4
Appraisal Appraisal
Appraisal 2 Appraisal
1
Prevention Prevention 0 Prevention Prevention
0
1 2 1 2
Year Year

Uses of Quality Cost Information


1. Help managers see the financial significance of defects.
2. Help managers identify the relative importance of the quality problems
3. Help managers see whether their quality costs are poorly distributed.

Limitations of Quality Cost Information


1. Simply measuring quality cost problems does not solve quality problems.
2. Results usually lag behind quality improvement programs.
3. The most important quality cost, lost sales, is often omitted from quality cost reports.
ISO 9000 Standards
ISO 9000 standards have become an international measure of quality. To become ISO 9000
certified, a company must demonstrate:
1. A quality control system is in use, and the system clearly defines an expected level of
quality.
2. The system is fully operational and is backed up with detailed documentation of quality
control procedures.
3. The intended level of quality is being achieved on a sustained basis.

End of Chapter 2

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Cost Behavior : Analysis and Use Chapter Five

Types of Cost Behavior Patterns


Recall the summary of our cost behavior discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Total variable cost is proportional Variable cost per unit remains the
Variable to the activity level within the same over wide ranges of activity.
relevant range.
Total fixed cost remains the same Fixed cost per unit goes down as
Fixed even when the activity level activity level goes up.
changes within the relevant range.

The Activity Base

Units
Machine
produce
hours
d
A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours

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True Variable Cost Example


A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is based on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
Types of Cost Behavior Patterns
Recall the summary of our cost behavior discussion from an earlier chapter.

Variable Cost Per Unit Example


A variable cost remains constant if expressed on a per unit basis. The cost per minute talked is constant.
For example, 10 cents per minute.
Per Minute
Telephone
Charge

Minutes Talked

Extent of Variable Costs


The proportion of variable costs differs across organizations. For example . . .
1. A public utility with large investments in equipment will tend to have fewer variable costs.
2. A service company will normally have a high proportion of variable costs.

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Master Program Advanced Managerial accounting 12/20/2010 last update

3. A manufacturing company will often have many variable costs.


4. A merchandising company usually will have a high proportion of variable costs like cost of
sales.

Examples of Variable Costs


1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials, direct labor, and variable overhead.
3. Merchandising and manufacturing companies – commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and clerical.

True Variable Cost


Direct materials is a true or proportionately variable cost because the amount used during a period will
vary in direct proportion to the level of production activity.
Co
st

Volume

Step-Variable Costs
A resource that is obtainable only in large chunks (such as maintenance workers) and whose costs
increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost.

Small changes in the level of production are not likely to have


Cost

any effect on the number of maintenance workers employed.

Only fairly wide changes in the activity level will cause a


change in the number of maintenance workers employed

Volum
e
The Linearity Assumption and the Relevant Range

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Economist’s A
A straight
straight line
line
closely
closely
Curvilinear Cost
approximates
approximates aa
Function curvilinear
curvilinear
variable
variable cost
cost
line
line within
within the
the
Relevant relevant range.
relevant range.
Range
Total Cost

Accountant’s Straight-Line
Approximation (constant unit
variable cost)

Activity

Types of Fixed Costs


1. Committed
Long-term, cannot be significantly reduced in the short term.
Examples
Depreciation on Equipment and Real Estate Taxes
2. Discretionary
May be altered in the short-term by current managerial decisions
Examples
Advertising and Research and Development

The Trend Toward Fixed Costs


The trend in many industries is toward greater fixed costs relative to variable costs.
As machines take over many mundane tasks previously performed by humans, “knowledge workers” are
demanded for their minds rather than their muscles
Knowledge workers tend to be salaried, highly-trained and difficult to replace. The cost to compensate
these valued employees is relatively fixed rather than variable.

Is Labor a Variable or a Fixed Cost?


• The behavior of wage and salary costs can differ across countries, depending on labor regulations,
labor contracts, and custom. In France, Germany, China, and Japan anagement has little flexibility
in adjusting the size of the labor force.
• Labor costs are more fixed in nature. In the United States and the United Kingdom management has
greater latitude. Labor costs are more variable in nature.

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Fixed Costs and Relevant Range


90
Thousands
of Dollars

Rent Cost

Total
Total cost
cost doesn’t
in

doesn’t
Relevant change
change forfor aa wide
wide
60 Range range
range ofof activity,
activity,
and
and then
then jumps
jumps toto aa
new
new higher
higher cost
cost for
for
30 the
the next
next higher
higher
range of activity.
range of activity.
00 1,000 2,000 3,000
Rented Area (Square Feet)

Fixed Costs and Relevant Range


The relevant range of activity for a fixed cost is the range of activity over which the graph of the
cost is flat.
Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square
feet. As the business grows more space is rented, increasing the total cost.

Fixed Costs and Relevant Range


How does this type of fixed cost differ from a step-variable cost?
1. Step-variable costs can be adjusted more quickly and . . .
2. The width of the activity steps is much wider for the fixed cost.

Quick Check ü
Which of the following statements about cost behavior are true?
1. Fixed costs per unit vary with the level of activity.
2. Variable costs per unit are constant within the relevant range.
3. Total fixed costs are constant within the relevant range.
4. Total variable costs are constant within the relevant range. 1 , 2 , 3 ,

Mixed Costs
A mixed cost has both fixed and variable components. Consider the example of utility cost.

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Master Program Advanced Managerial accounting 12/20/2010 last update

Y
Utility
Total

Cost

o st
ed
c
ix
ta lm
To Variable
Cost per KW

Fixed Monthly
Activity (Kilowatt Hours)
X Utility Charge

The total mixed cost line can be expressed as an equation: Y = a + bX

Where: Y = the total mixed cost


a = the total fixed cost (the
vertical intercept of the line)
b = the variable cost per unit of
activity (the slope of the line)
X = the level of activity

Mixed Costs Example


If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill?

Y = a + bX

Y =
Y = $40 + ($0.03 × 2,000)

Y = $100
Y = $100

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Analysis of Mixed Costs


Account Analysis and the Engineering Approach
• Each account is classified as either variable or fixed based on the analyst’s knowledge of how the
account behaves.
• Cost estimates are based on an evaluation of production methods, and material, labor and overhead
requirements.
The Scatter graph Method
Plot the data points on a graph (total cost vs. activity).

Y
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

The Scatter graph Method


Draw a line through the data points with about an equal numbers of points above and below the line.

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Y
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

Use one data point to estimate the total level of activity and the total cost.

Y Total maintenance cost = $11,000


20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800

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Make a quick estimate of variable cost per unit and determine the cost equation.
Total maintenance at 800 patients $ 11,000
Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,00
= $1.25/patient-
Variable cost per unit = 800
day
800
Y
Y == $10,000
$10,000 ++ $1.25X
$1.25X

Total
Total maintenance
maintenance Number
Number of
of patient
patient
cost
cost days
days

The High-Low Method


Assume the following hours of maintenance work and the total maintenance costs for six months.
Month Hours of Total maintenance
maintenance Cost The variable cost
Jan 625 7,950 per hour of
Feb 500 7,400 maintenance is
Mar 700 8,275
Apr 550 7,625
equal to the
May 775 9,100 change in cost
Jun 800 9,800 divided by the
High Level 800 9,800 change in hours.
Low Level 500 7,400
Change 300 2,400

$2,400
= $8.00/hour
300

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Master Program Advanced Managerial accounting 12/20/2010 last update

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)


Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400

The Cost Equation for Maintenance


Y = $3,400 + $8.00X

Quick Check ü
Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the variable portion of sales salaries and
commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit ,b,

High le ve l
Units
120,000
Cost
$ 14,000
$4,000 ÷ 40,000 units
Low le ve l
Cha nge
80,000
40,000 $
10,000
4,000 = $0.10 per unit

Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000 ,a,

Total cost = Total fixed cost +


Total variable cost
$14,000 = Total fixed cost +
($0.10 × 120,000 units)
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000

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Least-Squares Regression Method


A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship
between the X and Y variables.
• This method uses all of the data points to estimate the fixed and variable cost components of a mixed
cost
• The goal of this method is to fit a straight line to the data that minimizes the sum of the squared
errors.

• Software can be used to fit a regression line through the data points.
• The cost analysis objective is the same: Y = a + bX
Least-squares regression also provides a statistic, called the R2, that is a measure of the
goodness of fit of the regression line to the data points.

R2 is the percentage of the variation in


total cost explained by the activity.

Y
20
* ** *
Cost
Tota
l

* * **
10 * * R varies from 0% to 100%, and
2

the higher the percentage the better.

X
0 0 1 2 3 4
Activity

Comparing Results From the Three Methods


• The three methods just discussed provide slightly different estimates of the fixed and
variable cost components of the mixed cost.
• This is to be expected because each method uses differing amounts of the data points
to provide estimates.
• Least-squares regression provides the most accurate estimate because it uses all the
data points.

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Master Program Advanced Managerial accountingLet’sput12/20/2010
our last update
knowledge of cost
The Contribution Format behavior to work by
Total Unit preparing a
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30 contribution format
Contribution margin $ 40,000 $ 20 income statement.
Less: Fixed costs 30,000
Net operating income $ 10,000

The contribution margin format emphasizes


cost behavior. Contribution margin covers
fixed costs and provides for income.

Uses of the Contribution Format


The contribution income statement format is used as an internal planning and decision making tool. We
will use this approach for:
1. Cost-volume-profit analysis (Chapter 6).
2. Budgeting (Chapter 9).
3. Segmented reporting of profit data (Chapter 12).
4. Special decisions such as pricing and make-or-buy analysis (Chapter 13).

Comparison of the Contribution Income Statement


with the Traditional Income Statement
Traditional Approach Contribution Approach
(costs organized by function) (costs organized by behavior)
Sales $ 100,000 Sales $ 100,000
Less cost of goods sold 70,000 Less variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating expenses 20,000 Less fixed expenses 30,000
Net operating income $ 10,000 Net operating income $ 10,000

Used primarily for Used primarily by


external reporting. management.

Appendix 5A
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Master Program Advanced Managerial accounting 12/20/2010 last update

Least-Squares Regression Using Microsoft Excel.

Simple Regression Analysis Example


Matrix, Inc. wants to know its average fixed cost and variable cost per unit.
Using the data to the right, let’s see how to do a regression using Microsoft Excel.

Simple Regression Using Excel


You will need three pieces of information from your regression analysis:
1. Estimated Variable Cost per Unit (line slope)
2. Estimated Fixed Costs (line intercept)
3. Goodness of fit, or R2

To get these three pieces information we will need to use three different Excel functions.
LINEST, INTERCEPT, & RSQ
we will determine the “goodness of fit”, or R2, by using the RSQ function.

End of Chapter 5

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Cost-Volume-Profit Relationships Chapter Six

Basics of Cost-Volume-Profit Analysis


Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses
have been deducted.
CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income
Example -

The Contribution Approach


Sales, variable expenses, and contribution margin can also be expressed on a per unit
basis. If Racing sells an additional bicycle, $200 additional CM will be generated to
cover fixed expenses and profit.

The Contribution Approach


Each month Racing must generate at least $80,000 in total CM to break even.

If Racing sells 400 units in a month, it will be operating at the break-even point.

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If Racing sells one more bike (401 bikes), net operating income will increase by $200.

We do not need to prepare an income statement to estimate profits at a particular sales volume.
Simply multiply the number of units sold above break-even by the contribution margin per unit.
If Racing sells 430 bikes, its net income will be $6,000.
CVP Relationships in Graphic Form

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The relationship among revenue, cost, profit and volume can be expressed graphically by preparing a
CVP graph. Racing developed contribution margin income statements at 300, 400, and 500 units sold.
We will use this information to prepare the CVP graph.

Income Income Income


300 units 400 units 500 units
Sales $ 150,000 $ 200,000 $ 250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $ 100,000
Less: fixed expenses 80,000 80,000 80,000
Net operating income $ (20,000) $ - $ 20,000

CVP Graph

In a CVP graph, unit volume is usually


represented on the horizontal (X) axis and
dollars on the vertical (Y) axis.
axis.

rea
Total Sales fit A
Pro

450,000
Total Expenses
oll
ar
D

Fixed Expenses
400,000
Units
r ea
Lo ssA 350,000

300,000 Units

250,000

200,000

150,000
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100,000
Master Program Advanced Managerial accounting 12/20/2010 last update

Contribution Margin Ratio


Total CM
CM Ratio = Total
sales
$80,000
= 40%
$200,000
Each $1.00 increase in sales results in a total
contribution margin increase of 40¢.

Or, in terms of units, the contribution margin ratio is:


Unit CM
CM Ratio =
Unit selling price

For Racing Bicycle Company the ratio is:

$200 = 40%
$500

400 Bikes Per Unit 500 Bikes Per Unit


Sales $ 200,000 $ 250,000 $ 500
Less: variable expenses 120,000 150,000 300
Contribution margin 80,000 100,000 $ 200
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000

A $50,000 increase in sales revenue


results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)

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Changes in Fixed Costs and Sales Volume


What is the profit impact if Racing can increase unit sales from 500 to 540 by increasing the monthly
advertising budget by $10,000?

$80,000 + $10,000 advertising = $90,000


Sales increased by $20,000, but net operating income decreased by $2,000.
The Shortcut Solution
Increase in CM (40 units X $200) $ 8,000
Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)

Change in Variable Costs and Sales Volume


What is the profit impact if Racing can use higher quality raw materials, thus increasing variable costs
per unit by $10, to generate an increase in unit sales from 500 to 580?
580 units × $310 variable cost/unit = $179,800
Sales increase by $40,000, and net operating income increases by $10,200.

Change in Fixed Cost, Sales Price and Volume


What is the profit impact if Racing (1) cuts its selling price $20 per unit, (2) increases its advertising
budget by $15,000 per month, and (3) increases unit sales from 500 to 650 units per month?

Sales increase by $62,000, fixed costs increase by $15,000, and net operating income increases
by $2,000.

Change in Regular Sales Price


What is the profit impact if Racing (1) pays a $15 sales commission per bike sold instead of paying
salespersons flat salaries that currently total $6,000 per month, and (2) increases unit sales from 500 to
575 bikes?

Sales increase by $37,500, variable costs increase by $31,125, but fixed expenses decrease by
$6,000.

Change in Regular Sales Price


If Racing has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers
or fixed expenses, what price would it quote to the wholesaler if it wants to increase monthly profits by
$3,000?

$ 3,000 ÷ 150 bikes = $ 20 per bike


Variable cost per bike = 300 per bike
Selling price required = $ 320 per bike
150 bikes × $320 per bike = $ 48,000

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Master Program Advanced Managerial accounting 12/20/2010 last update

Total variable costs = 45,000


Increase in net income = $ 3,000

Quick Check ü
Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month
is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139 ,b,

Unit contribution margin


CM Ratio =
Unit selling price
($1.49-$0.36)
= $1.49
$1.13
= = 0.758
$1.49

Break-Even Analysis
Break-even analysis can be approached in two ways:

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1. Equation method
2. Contribution margin method

Equation Method
Profits = (Sales – Variable expenses) – Fixed expenses
OR
Sales = Variable expenses + Fixed expenses + Profits

At the break-even point


profits equal zero

Break-Even Analysis
Here is the information from Racing Bicycle Company:
Total Per Unit Percent
Sales (500 bikes) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net operating income $ 20,000

Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $0

Where:
Q = Number of bikes sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense
$500Q = $300Q + $80,000 + $0
$200Q = $80,000
Q = $80,000 ÷ $200 per bike
Q = 400 bikes

The equation can be modified to calculate the break-even point in sales


dollars.
Sales = Variable expenses + Fixed expenses + Profits

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Master Program Advanced Managerial accounting 12/20/2010 last update

X = 0.60X + $80,000 + $0

X = 0.60X + $80,000 + $0

Where:
X = Total sales dollars
0.60 = Variable expenses as a % of sales
$80,000 = Total fixed expenses

The equation can be modified to calculate the break-even point in


sales dollars.
Sales = Variable expenses + Fixed expenses + Profits
X = 0.60X + $80,000 + $0
0.40X = $80,000
X = $80,000 ÷ 0.40
X = $200,000

Contribution Margin Method


The contribution margin method has two key equations.

Break-even point Fixed expenses


=
in units sold Unit contribution margin

Break-even point in Fixed expenses


total sales dollars = CM ratio

Let’s use the contribution margin method to calculate the break-even point in total sales dollars at
Racing

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Master Program Advanced Managerial accounting 12/20/2010 last update
Fixed
Break-even point in expense
total sales dollars = s
CM
Quick Check ü ratio
Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month
is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in units?
a. 872 cups
b. b. 3,611 cups
c. c. 1,200 cups
d. d. 1,150 cups ,d,

Fixed expenses
Break-even = Unit CM
$1,300
= $1.49/cup - $0.36/cup
$1,300
=
$1.13/cup

= 1,150 cups

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