January 12

1. January 12 • Review Solutions to the Entrance Exam • Relevant Cost Concepts and Terminology • The Jennie Mae Frog Farm • Break • Relevant Cost Exercise

2. January 12 • Review Solutions to the Entrance Exam • Relevant Cost Concepts and Terminology • The Jennie Mae Frog Farm • Break • Relevant Cost Exercise

3. Entrance Exam Question #1 The owner of a barber shop pays each hair stylist in the shop $10 for each customer. The owner is not currently seeing customers himself. Out of the $10, each stylist must pay for all disposable supplies such as hair gel, hair spray, and shaving cream. When the annual costs of the lease on the building, insurance, depreciation, advertising, etc. are averaged over all customers, these costs average $3 per customer. Hence, at the current level of customer traffic, the total cost to the owner per customer is $13. If the owner can increase demand by 50%, using the same equipment and facilities as before, what will be the new average cost per customer (i.e., per haircut)?

4. Entrance Exam Question #1 The $3 per customer represents the allocation of a large lump sum averaged over all customers. Let that lump sum equal X, and the number of customers equal Y. X ÷ Y = 3 When the number of customers increases by 50%, the lump-sum X does not change. Therefore, we need to know the answer to: X ÷ 1.5Y Since we know from above that X = 3Y, we get 3Y ÷ 1.5Y = 2 The $10 per customer does not change, so the total cost would now be $10 + $2 = $12.

5. Entrance Exam Question #2 Nate sells beer at the State Fair for $3 per glass. Nate’s cost for the beer is $1.20 per glass. He pays $280 per day to rent the booth and equipment. How many beers will Nate have to sell to generate profits of $80 per day?

6. Entrance Exam Question #2 Nate sells beer at the State Fair for $3 per glass. Nate’s cost for the beer is $1.20 per glass. He pays $280 per day to rent the booth and equipment. How many beers will Nate have to sell to generate profits of $80 per day? Nate makes a profit (contribution margin) of $1.80 per glass ($3.00  $1.20) He needs to generate $360 to cover his fixed costs and his desired profit ($280 + $80). Therefore, he must sell $360 ÷ $1.80 = 200 glasses.

7. Entrance Exam Question #3 Kaypro has ten desktop computers that cost $410 each to make. The computers are obsolete, and can only be sold for $100 each. They can be turned into pre-school toys at a cost of $50 per computer, and sold for $140 each. Alternatively, they can be donated to a museum, resulting in a charitable tax contribution worth $90 per computer (i.e., a reduction in the company’s income tax expense and liability of $90 per computer). What should Kaypro do?

8. Entrance Exam Question #3 Kaypro has ten desktop computers that cost $410 each to make. The computers are obsolete, and can only be sold for $100 each. They can be turned into pre-school toys at a cost of $50 per computer, and sold for $140 each. Alternatively, they can be donated to a museum, resulting in a charitable tax contribution worth $90 per computer (i.e., a reduction in the company’s income tax expense and liability of $90 per computer). What should Kaypro do? The cost of $410 is a sunk cost, and is irrelevant. The future net cash flow from selling the computers is $100 per computer. This exceeds the net cash flow of $90 ($140 $50) from selling them as pre-school toys or the net cash flow of $90 from the charitable donation.

9. Entrance Exam Question #4 Due to a kitchen fire, the Albuquerque Baking Company has only one working oven for the next several weeks. The company makes pies and cookies. The oven can hold four pies or two dozen cookies. The pies require 60 minutes to bake. The cookies require 12 minutes to bake. Since the pies and cookies bake at different temperatures, they cannot be baked at the same time. Pies sell for $9 each. A dozen cookies sell for $5. The ingredients to make each pie cost $3. The ingredients to make a dozencookies cost $2. Should the Albuquerque Baking Company use its one functional oven to make cookies, pies, or some combination? Why?

10. Entrance Exam Question #4 In one hour, making only pies, profits are: 4 pies x ($9 sales price  $3 cost) = $24 In one hour, making only cookies, profits are: 2 dozen per batch x 5 batches per hour x ($5 sales price  $2 cost) = $30 Therefore, make cookies.

11. Entrance Exam Question #5 Explain the difference between revenue and income on an income statement prepared in accordance with Generally Accepted Accounting Principles. Also, explain the difference between operating income and net income.

12. Entrance Exam Question #5 Explain the difference between revenue and income on an income statement prepared in accordance with Generally Accepted Accounting Principles. Also, explain the difference between operating income and net income. Revenue represents sales. It does not consider the costs associated with generating those sales. Revenue is usually the first line on an income statement. Income is sales minus costs. Operating income is sales minus the costs associated with the company’s recurring operations. Net income is operating income minus other costs, such as income tax expense and restructuring charges.

13. Entrance Exam Question #6 Cat Company has sales of $50,000 in March, $60,000 in April, $70,000 in May, and $65,000 in June. 50% of sales are cash sales, for which Cat receives the cash at the time the customer makes the purchase. The other 50% are credit sales, for which Cat receives the cash in the month following the purchase. Calculate the balance in Accounts Receivable on May 31.

14. Entrance Exam Question #6 Cat Company has sales of $50,000 in March, $60,000 in April, $70,000 in May, and $65,000 in June. 50% of sales are cash sales, for which Cat receives the cash at the time the customer makes the purchase. The other 50% are credit sales, for which Cat receives the cash in the month following the purchase. Calculate the balance in Accounts Receivable on May 31. $70,000 x 50% = $35,000

15. Entrance Exam Question #7 Following is information about the Concord Merchandising Company: Calculate Cost of Goods Sold for 2005, using LIFO (last-in, first-out). What is the cost of ending inventory at the end of 2005 under LIFO?

16. Entrance Exam Question #7 Calculate Cost of Goods Sold for 2005, using LIFO (last-in, first-out). What is the cost of ending inventory at the end of 2005 under LIFO? COGS: $20 per unit x 800 units sold = $16,000 Ending inventory: (100 units x $15 per unit) + (100 units x $20 per unit) = $3,500

17. Entrance Exam Question #8 Following is information about the Concord Merchandising Company: Calculate Cost of Goods Sold for 2005, using FIFO (first-in, first-out). What is the cost of ending inventory at the end of 2005 under FIFO?

18. Entrance Exam Question #8 Calculate Cost of Goods Sold for 2005, using FIFO (first-in, first-out). What is the cost of ending inventory at the end of 2005 under FIFO? COGS: ($15 per unit x 100 units) + ($20 per unit x 700 units) = $15,500 Ending inventory: 200 units x $20 per unit = $4,000

19. Entrance Exam Question #9 A machine is purchased for $50,000. The machine has an estimated life of five years. The machine is anticipated to have a salvage value of $10,000 at the end of its useful life. If the machine is depreciated using the straight-line method, and if the salvage value reduces the total amount of depreciation expense, what will be the depreciation expense recorded on the income statement in year 4, and what will be the net balance in the balance sheet account (historical cost less accumulated depreciation) at the end of year 4?

20. Entrance Exam Question #9 Annual depreciation expense: ($50,000  $10,000) ÷ 5 years = $8,000 per year. Net balance on the Balance Sheet at the end of Year 4: Four years’ worth of depreciation expense will have been charged to the accumulated depreciation account. Hence: $50,000  ($8,000 x 4) = $18,000

21. Entrance Exam Question #10 Precisely what is the matching principle, as that term is used in accounting? Explain why it is a principle of financial accounting.

22. Entrance Exam Question #10 Precisely what is the matching principle, as that term is used in accounting? Explain why it is a principle of financial accounting. Match against revenue the expenses incurred to generate those revenues. The matching principle attempts to provide a measure of profitability in each period. However, the matching principle is not followed for all expenses.

23. January 12 • Review Solutions to the Entrance Exam • Relevant Cost Concepts and Terminology • The Jennie Mae Frog Farm • Break • Relevant Cost Exercise

24. Terminology Sunk Costs: Costs that have already been incurred. Sunk costs are irrelevant for all decisions, because they cannot be changed.

25. Terminology Opportunity Costs: The profit foregone by selecting one alternative instead of another; the net return that could be realized if a resource were put to its best alternative use.

26. Terminology Relevant Costs: Also sometimes called Differential Costs or Incremental Costs A differential cost for a particular decision is one that changes if an alternative decision is chosen.

27. When are Costs and Revenues Relevant? Answer: The relevant costs and revenues are those which, as between the alternatives being considered, are expected to be different in the future.

28. When are Costs and Revenues Relevant? Hence, variable costs may be relevant, or not, depending on whether the variable costs will differ in the future, as between the alternatives under consideration. Also, fixed costs may be relevant, or not, depending on whether the fixed costs will differ in the future, as between the alternatives under consideration.

29. January 12 • Review Solutions to the Entrance Exam • Relevant Cost Concepts and Terminology • The Jennie Mae Frog Farm • Break • Relevant Cost Exercise

30. The Jennie Mae Frog Farm Jennie Mae’s Frog Farm has fixed costs of $5,000 per month and variable costs of $2 per frog. All fixed costs are avoidable, in the sense that Jennie Mae could close the farm tomorrow, and not incur any fixed costs next month. However, she doesn’t want to do that because times are good in the frog business: she is operating at capacity, making and selling 1,000 frogs per month. Jennie Mae’s usual sales price is $9 per frog. The U.S. Army has approached Jennie Mae and proposed a one-time purchase of 300 frogs for $7 per frog. The sale would occur next month. Jennie Mae’s $2 per frog variable cost includes $0.25 of product packaging that would be unnecessary for frogs designated for the Army.

31. The Jennie Mae Frog Farm Question #1:With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost?

32. The Jennie Mae Frog Farm Question #1:With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost? Since Jennie Mae is operating at capacity, her opportunity cost is her profit foregone from the regular sales that are displaced by the sales to the Army. These profits are calculated either as $9 sales price minus $2 variable costs = $7 per frog, multiplied by 300 frogs = $2,100; or as the difference between this $7 per frog contribution margin and her contribution margin from sales to the Army of the $7 sales price less $1.75 in variable costs = $5.25 per frog. This difference is $7 minus $5.25 = $1.75, multiplied by 300 frogs = $525.

33. The Jennie Mae Frog Farm Question #2:With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision?

34. The Jennie Mae Frog Farm Question #2:With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision? No costs are sunk. Even the fixed costs are avoidable. Hence, although the fixed costs are irrelevant to Jennie Mae’s decision, they are not sunk.

35. The Jennie Mae Frog Farm Question #3:With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)?

36. The Jennie Mae Frog Farm Question #3:With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)? The differential costs are the $0.25 product packaging costs. Nothing else is differential, because whether or not Jennie Mae sells to the Army, she will produce at capacity.

37. The Jennie Mae Frog Farm Question #4:Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one-time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog?

38. The Jennie Mae Frog Farm Question #4:Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one-time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog? $1.75 per frog, the variable cost of production, assuming Jennie Mae was going to continue operations. However, with only 500 customers, she is not covering her costs, and the price to the Army that will allow her to break even is $6.75, as follows: Revenues: from the Army: $6.75 x 300 = 2,025 from normal customers: $9 x 500 = 4,500 Costs: Variable costs (500 x $2) + (300 x $1.75) = 1,525 Fixed costs 5,000 Income $ 0

39. The Jennie Mae Frog Farm Question #5:Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Annie should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost?

40. The Jennie Mae Frog Farm Question #5:Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Annie should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost? Jenny should accept any price above zero. Her opportunity cost is zero.

41. January 12 • Review Solutions to the Entrance Exam • Relevant Cost Concepts and Terminology • The Jennie Mae Frog Farm • Break • Relevant Cost Exercise

42. January 12 • Review Solutions to the Entrance Exam • Relevant Cost Concepts and Terminology • The Jennie Mae Frog Farm • Break • Relevant Cost Exercise

43. You are a big fan of rock musician Billy Joel. (There’s no accounting for taste.) You decide to spend $200 for you and your fiancé to go to an upcoming Billy Joel concert, and you buy a pair of tickets. On your way to the concert, you realize that you have lost the tickets! At first, you panic. Then you realize that, most probably, your little sister put the tickets down the kitchen disposal the other day when she was mad at you. Anyhow, she put something down the disposal, and seemed to derive great satisfaction from it. You make a mental note to kidnap her beanie baby collection. In the meantime, at the box office, you learn that seats are still available, and you can buy new tickets for $200 that are comparable to the ones you lost. Evaluate the logic, in terms of the relevant cost concepts of incremental cost, sunk cost and/or opportunity cost, with respect to each of the following responses to the question of “What should you do?”

44. a. You should forego the concert, because although the concert was worth $200 to attend, it’s not worth $400 to attend. b. You should buy the tickets, even though you never would have spent $400 to attend, because at this point, the incremental cost is only $200. c. You should buy the tickets, even though you never would have spent $400 to attend, because at this point, if you don’t, your fiancé will be disappointed.

45. You decide its not worth another $200 to attend the concert, and you and your fiancé decide to go bowling. On the way out of the lobby, a wealthy and happy (and intoxicated) looking couple whom you have never seen before confront you, tell you they have decided to fly to Paris tonight, and ask if you want their tickets. You say “yes,” of course, and “thank you.” A bystander standing in line to buy tickets sees this happening, and offers to buy the tickets from you for $200. Evaluate the logic, in terms of relevant cost concepts, with respect to each of the following responses to the question of “What should you do now?”

46. a. You should attend the concert, since you are now in exactly the same situation you were in when you were driving to the concert and thought you had the original tickets. b. You should sell the tickets for $200, since you had already decided, only a few minutes ago, that you didn’t want to spend another $200 to buy the tickets.