238 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISIONS
238 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISIONS
C5-4 COST A LLOCATION A N D CON TRIBUTION MA RGIN . (R. An derson , adapted) An an alogy h elps to u n derstan d th e treatm en t of costs in ciden t to variou s types of operation s. Con sider th e followin g con versation between a restau ran t own er (Joe) an d h is Accou n tan t-Efficien cy-Expert (Eff Ex) abou t addin g a rack of pean u ts to th e cou n ter in an effort to pick u p addition al profit in th e u su al cou rse of bu sin ess. Som e people m ay con sider th is con versation an oversim plification , bu t th e an al- ogy h igh ligh ts som e cen tral issu es in cost allocation .
Eff Ex:
Joe, you said you pu t in th ese pean u ts becau se som e people ask for th em , bu t do you realize wh at th is rack of pean u ts is costing you ?
Joe:
It isn ’t goin g to cost. It’s goin g to be a profit. Su re, I h ad to pay $250 for a fan cy rack to h old th e bags, bu t th e pean u ts cost $.60 a bag an d
I will sell th em for $1. I figu re if I sell 50 bags a week to start, it’ll take 121/ 2 weeks to cover th e cost of th e rack. After th at I am goin g to clear a profit of $.40 a bag. Th e m ore I sell, th e m ore I m ake.
Eff Ex:
Th at is an an tiqu ated an d com pletely u n realistic approach , Joe. Fortu n ately, m odern accou n tin g procedu res perm it a m ore accu rate pictu re, wh ich reveals th e com plexities in volved.
Joe: Hu h ? Eff Ex:
To be precise, th ose pean u ts m u st be in tegrated in to you r en tire oper- ation an d be allocated th eir appropriate sh are of bu sin ess overh ead. Th ey m u st sh are a proportion ate part of you r expen ditu re for ren t,
h eat, ligh t, equ ipm en t am ortization , decoratin g, salaries for you r wait- resses, cook ——
Joe:
Th e cook ? Wh at does h e h ave to do with th e pean u ts? He doesn ’t even
h ave th em !
Eff Ex:
Look Joe, th e cook is in th e kitch en , th e kitch en prepares th e food, th e food is wh at brin gs people in h ere, an d th e people ask to bu y pean u ts. Th at’s wh y you m u st ch arge a portion of th e cook’s wages as well as part of you r own salary to pean u t sales. Th is sh eet con tain s a carefu lly calcu lated cost an alysis, wh ich in dicates th at th e pean u t operation sh ou ld pay exactly $12,780 per year toward th ese gen eral overh ead costs.
Joe:
Th e pean u ts? $12,780 a year for overh ead? Th e n u ts?
Eff Ex:
It’s really a little m ore th an th at. You also spen d m on ey each week to
h ave th e win dows wash ed, h ave th e place swept ou t in th e m orn in gs, keep soap in th e wash room , an d provide free soft drin ks to th e police. Th at raises th e total to $13,130 per year.
Joe:
[Th ou gh tfu lly] Bu t th e pean u t salesm an said th at I wou ld m ake m on ey . . . pu t th em on th e en d of th e cou n ter, h e said . . . an d get $.40 a bag profit . . .
Eff Ex:
[With a sn iff] He’s n ot an accou n tan t. Do you actu ally kn ow wh at th e portion of th e cou n ter occu pied by th e pean u t rack is worth to you ?
Joe:
It’s n ot worth an yth in g . . . n o stool th ere . . . ju st a dead spot at th e en d.
Chapter 5 Cost Allocation and Activity-Based Costing Systems
Eff Ex:
Th e m odern cost pictu re perm its n o dead spots. You r cou n ter con tain s
20 squ are m etres an d you r cou n ter bu sin ess grosses $150,000 a year. Con sequ en tly, th e squ are m etres of space occu pied by th e pean u t rack is w orth $2,500 per year. Sin ce you h ave taken th at area aw ay from gen eral cou n ter u se, you m u st ch arge th e valu e of th e space to th e occu pan t.
Joe:
You m ean I h ave to add $2,500 a year m ore to th e pean u ts?
Eff Ex:
Righ t. Th at raises th eir sh are of th e gen eral operatin g costs to a gran d total of $15,630 per year. Now th en , if you sell 50 bags of pean u ts per week for 52 weeks, th ese allocated costs will am ou n t to approxim ately $6 per bag.
Obviou sly, to th at m u st be added you r pu rch ase price of $.60 per bag, wh ich brin gs th e total to $6.60. So you see by sellin g pean u ts at $1 per bag, you are losin g $5.60 on every sale.
Joe:
Som eth in g is crazy!
Eff Ex:
Not at all! Here are th e figures . Th ey prove you r pean u ts operation can - n ot stan d on its own feet.
Joe:
[Brigh ten in g] Su ppose I sell lots of pean u ts . . . say a th ou san d bags a week in stead of fifty.
Eff Ex:
[Toleran tly] Joe, you don ’t u n derstan d th e problem . If th e volu m e of pean u ts sales in creases, ou r operatin g costs will go u p . . . you ’ll h ave to h an dle m ore bags with m ore tim e, m ore am ortization , m ore every- th in g. Th e basic prin ciple of accou n tin g is firm on th at su bject: “Th e Bigger th e Operation , th e More Gen eral Overh ead Costs Th at Mu st Be Allocated.” No, in creasin g th e volu m e of sales won ’t h elp.
Joe:
Okay, if you ’re so sm art, you tell me wh at I h ave to do.
Eff Ex:
[Con descen din gly] Well . . . you cou ld first redu ce operatin g costs. Joe: How? Eff Ex:
Move to a bu ildin g with ch eaper ren t. Cu t salaries. Wash th e win dows bi-weekly. Have th e floor swept on ly on Th u rsday. Rem ove th e soap from th e wash room s. Decrease th e squ are-m etre valu e of you r cou n ter. For exam ple, if you can cu t you r costs 50 percen t, th at will redu ce th e am ou n t allocated to pean u ts from $15,630 to $7,815 per year, redu cin g th e cost to $3.60 per bag.
Joe:
[Slowly] Th at’s better?
Eff Ex:
Mu ch , m u ch better. However, even th en you wou ld lose $2.60 per bag if you ch arge on ly $1. Th erefore, you m u st also raise you r sellin g price. If you wan t an in com e of $.40 per bag you wou ld h ave to
ch arge $4.00.
Joe:
[Flabbergasted] You m ean even after I cu t operatin g costs by 50 per- cen t I still h ave to ch arge $4 for a $1 bag of pean u ts? Nobody’s th at n u ts abou t n u ts! Wh o wou ld bu y th em ?