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CHAPTER 7
COST MANAGEMENT
INTRODUCTION
Chapter 6 discussed the concept of establishing prices to help achieve a particular desired return
on investment. However, there is often a limit to how high prices can be pushed before customer
resistance occurs and reduced demand for the product or service occurs. To avoid constantly
raising prices, concentrating on controlling costs may be required without which costs could
escalate out of proportion to sales revenue. In Chapter 5, we saw how the use of standard cost
control can assist in controling the cost of food and beverages. This chapter continues the
discussion on cost control and discusses the importance of cost management and decision–
making.
TRUE OR FALSE QUESTIONS
(Correct answer indicated by T for True and F for False)
1. Knowledge of the identity and classification of a specific cost is essential when
making business decisions.
T
2. An indirect cost is normally controllable by an operating department head.
F
3. A joint cost is one that is partly direct and partly indirect.
F
4. A sunk cost is one that is not normally relevant to future decisions.
T
5. A fixed cost is one that never changes, even in the long run.
F
6. A semivariable cost is one that is partly fixed and partly variable.
T
7. A variable cost is one that varies in linear fashion with sales revenue.
T
8. A standard cost is what the cost should be for a given level of sales revenue.
T
9. An opportunity cost is one that is recorded on the income statement.
F
10. A discretionary cost is one that can either be incurred or not incurred.
T
11. Allocation of indirect costs to operating departments should be done with caution.
T
12. One should never sell below total cost.
F
13. In making decisions about costs, no other factors need to be considered other than the
relevant costs.
F
14. An operation is considering closing for a certain period during which it has been
losing money. If by closing, the remaining fixed costs would be greater than the
previous losses, then normally the decision will be to close.
F
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15. If at an equivalent sales revenue level, Business A has higher fixed costs than
Business B, then Business B will make more net income than Business A from each
additional sales revenue dollar above the current level.
F
16. A business with high fixed costs relative to variable costs is said to have high
operating leverage.
T
17. Given two comparable business situations, the one with the lower fixed costs will
have a higher break-even sales revenue level.
F
18. The equation for calculating the indifference point when deciding to pay a fixed rent
amount or rent based on a percent of sales revenue is: Fixed rent costs divided by the
variable rate percent.
T
19. The high-low method of separating semivariable costs into their two elements is the
most accurate method.
F
20. On a multipoint graph, the information about the independent variable is plotted on
the vertical axis.
F
21. On a multipoint graph, only one “correct” straight line can be drawn.
F
22. On a multipoint graph, the point at which the sloped straight line intersects the
vertical axis gives the amount of total variable costs.
F
23. Regression analysis is a mathematical technique for separating the two elements in
semivariable costs.
T
24. In regression analysis, the information about the independent variable is given the
symbol X.
T
25. Regression analysis gives the least exact results for fixed and variable costs.
F
26. Standard portion sizes are an integral part of food cost control.
T
27. A standard recipe for each menu item is essential for effective cost control.
T
28. The fixed cost of labor is not a factor in labor cost control.
F
MULTIPLE CHOICE QUESTIONS
(Correct answer indicated by asterisk)
1. A sunk cost is one that is:
(c) Controllable in the future
(d) The same as an opportunity cost
2. Which of the following costs is primarily fixed?
(c) Labor cost
(d) Operating supplies
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3. Variable costs:
(a) Decrease 10% if sales revenue increases 10%.
4. Standard costs:
(c) Are the same as variable costs
(d) Must be broken down into their fixed and variable elements
5. Indirect costs should be allocated to operating departments:
(a) Because otherwise the departmental income after deducting direct costs will be incorrect
(b) To insure that each department has a net income after deducting both direct and indirect
costs
6. One can sell below cost when the sales revenue:
(c) Covers fixed costs but not necessarily all variable costs
(d) Covers all direct costs
7. An operation should close during the off season when:
(a) Variable costs are higher than fixed costs
(b) The lost sales revenue would be higher than total costs
8. A restaurant with high operating leverage has:
(a) Low fixed costs relative to variable costs
(b) A high net income in relation to sales revenue
9. A company with low operating leverage:
(a) Is better off than one with high operating leverage
(b) Is not going to be as successful as one with high operating leverage
10. In times of rising sales revenue, it would be better to:
(c) Try and convert some of the fixed costs into variable ones
(d) Change direct costs into indirect costs
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11. The equation for calculating the indifference point when deciding to pay a fixed rent amount
versus rent based on a percent of sales revenue is:
(a) Sales revenue divided by the variable rent percentage
(b) Fixed rent cost multiplied by the variable rent percentage
12. Using the high-low method, what are the fixed and variable costs if the high sales revenue is
$160,000 with total costs of $90,000, and the low sales revenue is $96,000 with total costs of
$58,000. What is the fixed cost and the variable percentage per dollar of sales revenue?
(c) $ 6,750 fixed and 32.5% per dollar of sales revenue
(d) $ 4,240 fixed and 56.0% per dollar of sales revenue
13. The intersect point of the vertical and sloped lines on a multi-point graph:
(c) Gives the total cost
(d) Gives the total units
14. In making a decision about which piece of equipment to buy, two types of costs are
considered. They are relevant and:
(a) Sunk
15. Which is the best concept for allocating indirect costs?
(c) Based on contributory income
(d) Based on square footage
EXERCISE SOLUTIONS
E7.1 Find variable cost %.
E7.2 Find contribution margin: [SR – VC = CM]
111
E7.3 Find the contribution margin and operating income; accept or reject?
Sales Revenue [70 × $18]
$1,260
Variable costs [$1,260 × 68%]
( 857)
Contribution Margin
$ 403
Fixed costs
( 100)
Operating Income
$ 303
* Accept the proposal
E7.4 Allocation of indirect costs based on square footage.
E7.5 Find variable cost per guest and total fixed costs.
Guests
Labor Cost
High data
18,000
$25,500
Low data
(12,000)
(18,000)
▲
6,000
▲
$ 7,500
▲ Cost / ▲ Guests = VC per guest = $7,500 / 6,000 = $1.25
High labor cost
$25,500
High VC [18,000 × $1.25]
(22,500)
Fixed cost
$ 3,000
Low labor cost
$18,000
Low VC [12,000 × $1.25]
( 15,000)
Fixed cost
$ 3,000
E7.6 Find variable cost per dollar of sales revenue and total fixed costs.
S.R.
Operating Cost
High data
$28,000
$20,000
Low data
( 23,000)
( 17,000)
▲
$ 5,000
▲
$ 3,000
▲ Cost / ▲ Guests = VC per SR dollar = $3,000 / 5,000 = 60%
High operating cost
$20,000
High VC [28,000 × 60%]
(16,800)
Fixed cost
$ 3,200
Low operating cost
$17,000
Low VC [23,000 × 60%]
( 13,800)
Fixed cost
$ 3,200
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E7.7 Calculate the contribution margin and operating income. Justify your decision to accept
or not accept the booking.
Sales Revenue [40 × $10.50]
$420
* Accept the function. By selling below
total cost of $423 ($273 + 150), we offset
FC costs by $147 of $150 that is incurred
with or without the function.
* Accept the offer!
Variable costs [$420 × 65%]
( 273)
Contribution Margin
$147
Fixed costs (per day)
( 150)
Operating loss
($ 3)
E7.8 Find the indifference point (the breakeven point of sales revenue at which the fixed rent
and variable rent for a year are the same). Explain which option you recommend?
E7.9 Given the information, do you recommend they close or stay open for the last three
months.
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PROBLEM SOLUTIONS
P7.1 Objective evaluation made to determine the best investment considering only relevant
costs of the alternatives. Identify which model would be the best investment.
(Primary) Unique costs Year 1
Model 1
Model 2
Model 3
New equipment cost
$5,000
$5,500
$5,300
Initial installation costs
80
100
100
Initial training costs
350
300
325
First year costs
$5,430
$5,900
$5,725
Recurring inclusive costs Years 1-5
Maintenance [$275 x 5 ] [$300 x 5] [$250 x 5]
$1,375
$1,500
$1,250
Cost of supplies [$175 x 5] [$225 x 5] [$200 x 5]
875
1,125
1,000
Less: Equipment residual value
( 1,000)
( 1,200)
( 800)
Total recurring inclusive costs Years 1-5
$1,250
$1,425
$1,450
Total first year costs
$5,430
$5,900
$5,725
Total first year & Recurring inclusive costs
$6,680
$7,325
$7,175
(Alternative) Unique costs Year 1
Model 1
Model 2
Model 3
Initial installation costs
$ 80
$ 100
$ 100
Initial training costs
350
300
325
First year costs
$ 430
$ 400
$ 425
Recurring inclusive costs Years 1-5
Depreciation [$800 x 5] [$860 x 5] [$900 x 5]
$4,000
$4,300
$4,500
Maintenance [$275 x 5 ] [$300 x 5] [$250 x 5]
1,375
1,500
1,250
Cost of supplies [$175 x 5] [$225 x 5] [$200 x 5]
875
1,125
1,000
Total recurring inclusive costs Years 1 to 5
$6,250
$6,925
$6,750
Total first year costs
$ 430
$ 400
$ 425
Total first year & Recurring inclusive costs
$6,680
$7,325
$7,175
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P7.2 Consideration of selling below cost can be made if an objective analysis indicates
variable costs are covered and a contribution towards fixed costs.
a. The total variable cost plus the allocated fixed cost per person determines the total
cost on a per person basis:
Cost per person evaluation
Food cost of sales
$ 6.50
Wage cost
2.75
Other costs
1.25
Total variable cost per person
$10.50
Fixed cost per person [$350 / 100]
3.50
Total cost per person
$14.00
b. If 100% is the unknown selling price, contributory income wanted is 20%. Then
100% − 20% = 80% represents the total cost. If total cost per person is $14.00 or
c. With the per person selling price, variable cost, fixed cost, and contributory income
known, evaluate the position of accepting or not accepting the offer.
Accepted
Yes
No
Sales revenue [100 × $13.75]
$1,375
-0-
Variable costs [100 × $10.50]
(1,050)
-0-
Function gross margin
$ 325
-0-
Fixed costs
( 350)
( 350)
Operating loss
($ 25)
($350)
Accept the function if there is no chance of accepting another offer. Variable costs
are covered and a contribution of $325 is made towards fixed costs, thus the loss is
minimized to $25 instead of $350 if the function is not accepted.
Allocated indirect costs
( 12,480)
( 52,000)
Operating income
P7.3 a. Allocate indirect costs (IDC) to each division based on square footage.
Division
IDC
Allocated
Dining Room
2,200 sq. ft.
/
4,000
=
55.0%
×
$52,000
=
$28,600
Coffee Shop
840 sq. ft.
/
4,000
=
21.0%
×
$52,000
=
$10,920
Lounge
960 sq. ft.
/
4,000
=
24.0%
×
$52,000
=
$12,480
Total Sq. Ft.
4,000 sq. ft.
100.0%
$52,000
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P7.4 Annual operating income:
1st qtr.
+
2nd qtr.
+
3rd qtr.
−
4th qtr.
=
Operating Income
$7,100
+
$10,100
+
$8,600
−
($2,650)
=
$23,150
Operating income for 9 months; closed Quarter 4:
1st qtr.
+
2nd qtr.
+
3rd qtr.
=
Operating Income
$7,100
+
$10,100
+
$8,600
=
$25,800
Less 4th quarter expenses to be paid if closed:
Operating income for 3 quarters
$25,800
Wages
$3,000
Advertising [600 × 50%]
300
Utilities [$100 × 3 mo.]
300
Maintenance [stated]
200
Insurance [$1,200 × 40%]
480
Interest [stated @ $750 per qtr.]
750
Depreciation [$700 × 25%]
175
Rent [stated @ $6,000 per qtr.]
6,000
( 11,205)
Adjusted operating income; 3 qtrs.
$ 14,595
Do not close. Known costs to be incurred if 4th quarter operations are closed is $11,205
and adjusts operating income from $23,150 to $14,595, or an additional loss of $8,555
($23,150 – $14,595).
P7.5 a. If Motel A is closed, overall net loss will be:
Motel A Fixed costs
($110,000)
Motel B Operating income
8,000
Motel C Operating income
30,000
Net operating loss
($ 72,000)
If Motel B is closed, overall net loss will be:
Motel A Operating Loss
($ 5,000)
Motel B Fixed costs
( 167,000)
Motel C Operating income
30,000
Net operating loss
($142,000)
If Motel C is closed, overall net loss will be:
Motel A Operating Loss
($ 5,000)
Motel B Operating income
8,000
Motel C Fixed costs
( 260,000)
Net operating loss
($257,000)
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Thus, closing Motel A which will minimize the overall loss. Leaving Motel’s B and
C open with operating income of $8,000 and $30,000 respectively, they will provide
b. If Motel A is closed overall net loss will be:
Motel A Fixed costs
($110,000)
Motel B Operating income
45,000
Motel C Operating income
63,000
Net operating loss
($ 2,000)
If Motel B is closed overall net income will be:
Motel A Operating income
$ 55,000
Motel B Fixed costs
(113,000)
Motel C Operating income
63,000
Net operating income
$ 5,000
If Motel C is closed overall net loss will be:
Motel A Operating income
$ 55,000
Motel B Operating income
45,000
Motel C Fixed costs
(112,000)
Net operating loss
($ 12,000)
Thus, close Motel B because the company overall will have a net operating income
rather than an operating loss. Motel’s A and C will provide a total net operating
income of $5,000 after absorbing the fixed costs Motel B, ($55,000 + $63,000 –
$113,000).
Note: This time Motel B is closed despite the fact it has the highest fixed costs. The
same discussion applies to this situation as it does to Part a. However, in Part b.
there is little leeway with increasing additional labor costs.
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P7.6 Determine the present operating income of each motel and recommend which should be
purchased.
Jack’s
Jock’s
Sales revenue
$550,000
$550,000
Variable costs
$302,500
$330,000
Fixed costs
212,500
(515,000)
185,000
(515,000)
Operating income
$ 35,000
$ 35,000
Stated assumptions: (1) Sales revenue can be increased by 25% in both of the motels.
(2) A saving of $12,000 on interest expense (FC) is possible in Jack’s Motel. (3) A cost
savings of 6% reducing variable wage costs to 54% (60% − 6%) for Jock’s Motel. If
these assumptions were achieved, the operating income would be:
Jack’s
Jock’s
Sales revenue
$687,500
$687,500
Variable costs
$378,125
$371,250
Fixed costs
200,500
185,000
Total operating costs
(578,625)
(556,250)
Operating income
$108,875
$131,250
Calculations of stated assumptions:
Sales revenue: Jacks and Jocks = $550,000 x 125% = $687,500
Jack’s
Jock’s
VC: $687,500 x 55% = $378,125
VC: $687,500 x 54% = $371,250
FC: $212,500 – $12,000 = $200,500
FC: $185,000 no change
Based on the assumptions being achieved, Jock’s Motel would be a better proposition
since its operating income would be higher than Jack’s Motel. The entrepreneurs should
be advised that this would only be true if all the assumptions are correct. For example:
reduction of variable cost from 60% to 55%.
P7.7 a. Fixed lease cost / Variable lease % (or FC / VC%)
$2,800 × 12 months = $33,600
b. Assuming the average sales revenue forecast for the coming year is correct at
$525,000, the anticipated fixed and variable cost would be:
(1) Fixed lease cost remains at $33,600
P7.8 a. Calculate the variable cost per room, total variable cost and, using the High-Low
method, find the fixed cost per month.
VC per room unit (person):
b. Using the highest month, total variable cost is: 2,800 rooms × $0.70 = $1,960
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P7.10 Regression analysis:
SR
Wage Cost
XY
X²
X
Y
(X × Y)
(X × Y)
1
$ 11,200
$ 5,300
$ 59,360,000
$ 125,440,000
2
13,000
6,100
79,300,000
169,000,000
3
14,900
6,200
92,380,000
222,010,000
4
19,100
7,000
133,700,000
364,810,000
5
22,000
9,000
198,000,000
484,000,000
6
24,200
9,600
232,320,000
585,640,000
7
26,300
9,700
255,110,000
691,690,000
8
27,400
10,100
276,740,000
750,760,000
9
23,500
8,300
195,050,000
552,250,000
10
20,100
7,600
152,760,000
404,010,000
11
18,200
8,000
145,600,000
331,240,000
12
16,000
7,100
113,606,000
256,000,000
Totals
$235,900
$94,000
$1,933,920,000
$4,936,850,000
X
Y
XY
X²
Fixed costs = (Y)( X2) – (X)( XY)
n(X2) – (X)2
Total annual wages
$94,000
Less: Fixed costs [$2,185.17 x 12]
( 26,222)
Variable wages
$67,642
P7.11 Additional data will require adjustments to high July data and low December data.
July Adjustments: (Wage costs) Retroactive wage increase of $1,800 must be deducted:
$21,600 − $1,800 = $19,800 July wage cost.
Dec. Adjustments: (Sales revenue) The special $3,400 sales revenue must be deducted:
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CASE 7 SOLUTION
Additional sales revenue
Food Sales revenue: [15 × $5.25 × 6 ×52]
$24,570
Beverage Sales revenue: [15 × $0.92 × 6
×52]
4,306
Total sales revenue
$28,876
Cost of sales:
Food [39.5% × $24,570]
$ 9,705
Beverages [21.8% × $4,306]
939
Total cost of sales
( 10,644)
Gross Margin
$18,232
Increase in expenses
Wages: [4 × $5.50 × 6 × 52]
$ 6,864
Laundry: 2.6%
China and tableware: 1.9%
Glassware: 0.3%
Other operating costs: 0.6%
5.4%
Total Variable Expenses [5.4% × $28,876]
$ 1,559
Total Increase in Expenses
( 8,423)
Operating Income
$ 9,809
Less: Cost of advertising
( 3,000)
Operating Income (Increase)
$ 6,908
The advertising should be carried out.