Solution Manual for Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven Finkler, Thad Calabrese

SOLUTION MANUAL FOR FINANCIAL MANAGEMENT FOR PUBLIC HEALTH, AND NOT-FOR-PROFIT ORGANIZATIONS 7TH EDITION BY STEVEN FINKLER, THAD CALABRESE 4-1 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations Chapter 4 UNDERSTANDING COSTS QUESTIONS FOR DISCUSSION 4-1. Anything in particular for which a measurement of cost is desired. This could be a unit of service, a program, department, or organization. For example, one might be interested in the cost of plowing snow from the roads of the Town of Millbridge. The most basic point in costing is to clearly define and communicate the cost objective. Communication is critical, and data only become useful information if they are communicated in a way that everyone understands. 4.2. Full cost refers to the total of all costs associated with a cost objective. This includes direct and indirect costs. Direct costs are the costs incurred within the organizational unit for which the manager has responsibility, or the costs of resources for direct production of a good or service. Indirect costs are costs that are assigned to an organizational unit from elsewhere in the organization, or costs of resources that are not used for direct production of a good or service. Direct and indirect costs are particularly difficult to understand because their definitions relate to the object of the analysis. If one is interested in the direct cost of the public works department, it is appropriate to include department supervisory personnel in that cost. In contrast, if one is interested in the direct cost per mile of road plowed, that would include the plow, the driver, and the cost of the salt spread on the road, but not the cost of supervisory personnel. In that example, the supervisors are direct costs of the public works department (i.e., what it costs to operate the public works department) but indirect costs of plowing the road (i.e., what it costs to plow the roads). The various scheduling and other administrative activities carried out by supervisory personnel are essential to running the department, but they are not a direct cost of plowing snow. 4.3. Average cost is the full cost of any cost objective divided by the number of units of service provided. Fixed costs: those costs that do not change in total as the volume of service units changes over a relevant range of activity. Variable costs: those costs that vary directly with changes in the volume of service units over a relevant range of activity. If all of the costs of plowing snow, both direct and indirect, are added and the total is divided by the number of units, the result is the cost per unit or the average cost. So, the total cost could be divided by the number of miles to find the cost per mile plowed. Once Meals for the Homeless (Meals) rents space for a soup kitchen, the rent will not change from day to day, even if the number of meals provided varies by a substantial amount. Perhaps Meals is serving 300 people a day at a given soup kitchen. If Meals were to feed another person, the rent would stay the same. Therefore, it is a fixed cost. In contrast, the amount of food that Meals must purchase represents a variable cost. If more people are served, meals will need more food. Activity represents the volume of services provided. 4.4. Marginal costs are the extra costs incurred as a result of providing one more service unit (such as one more meal). At first, marginal costs would appear to be identical to variable costs. In both cases, if there is one more unit of activity, there will be an increase only in variable costs. Marginal costs, however, more broadly look at all costs that might change as a result of a Chapter 4: Understanding Costs 4-2 decision. Suppose that HOS has an x-ray machine that can take 5,000 x-rays per year. What is the cost of doing one more x-ray? If HOS has to buy another machine to do the 5,001st x-ray, then on the margin, the costs of the additional patient are the variable cost of one more patient plus the cost of acquiring another machine. 4-5. Cost per unit depends on volume. If volume is low, the cost per unit is higher than if volume is high. This is because as volume rises, fixed costs get shared resulting in less fixed cost per unit. Furthermore, for historical purposes measuring the average cost may be adequate. For prospective decision making, we are often interested in the marginal costs. Therefore the appropriate measure of cost depends in part on the reason we want to know the cost. 4-6. Suppose the activity is the cost of educating students. One could argue that the teacher and supplies used in the classroom are direct costs and that the principal and secretaries in the school office and the superintendent at the central office are indirect costs. Alternatively, if the activity is the cost of running each of the school district’s elementary schools, then the direct costs would include the principal, secretary, and heat, in addition to the teacher and classroom supplies. However, it would not include the district superintendent, who would be an indirect, or overhead, cost. The superintendent only becomes a direct cost when the activity is the cost of running the school district. 4-7. For changes in activity volume within the relevant range, marginal costs are the same as variable costs. If a proposed change is beyond the relevant range of some fixed cost, then the marginal costs will include the change in fixed cost as well as the variable costs. 4-8. In order to assign costs from one objective to another, a base is needed. For example, we could choose to allocate costs based on patient days. In that case, the number of patient days would be the base. Alternatively, costs could be allocated based on hours. It is common to allocate housekeeping costs based on hours of service provided. The total number of hours of housekeeping service becomes the base. If this base is divided into the total cost for providing housekeeping services, the result is an overhead application rate, in this case, a cost per hour of service. 4.9. Activity-based costing (ABC) considers that volume is not the only generator of cost. Often activities with low volume may generate significant amounts of cost. If indirect costs are allocated based on volume, they will be overassigned to some units of service and underassigned to others. A more accurate approach would be to allocate indirect costs based on the activities that drive them. INSTRUCTOR’S NOTE Activity Based Costing One could contend that if you perform cost measurement correctly to begin with, there is no need for ABC. The problem is that a model T Ford was mostly direct cost and very little overhead, but a modern Ford is mostly overhead and very little direct cost. Why? Because we got sloppy and started allocating direct costs as if they were indirect because it is easier to allocate on broad bases rather than to actually try to track the costs. So, ABC is sold as an approach to allocate indirect costs more accurately. But that is a contradiction. There is no accurate way to allocate costs that 4-3 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, are really indirect. ABC is really a movement toward treating more of our direct costs as being direct. If there is a cause-and-effect relationship, it can be hidden by broad allocation approaches. Cost accounting has long taught that it was necessary to focus on direct costs and to use multiple cost bases when you do have to allocate costs in order to incorporate as much of the cause and effect as possible. On the other hand, ABC does serve a role because organizations have become so confused by their cost allocations that they often don’t know which of their costs are truly direct costs nor to which specific cost objective they relate. 4.10. The decision of whether to “make or buy” is one that is best addressed using an approach called marginal cost analysis. This approach is sometimes referred to as incremental analysis or outof-pocket analysis. The essence of the approach is that decisions such as whether to provide a service or to change the volume of a service should be based on marginal rather than average costs. 4.11. If a particular program, service, or activity is expected to have a volume of activity that is too low to break even, the activity may not be feasible. However, sometimes changes in the activity can be made to achieve a break-even status. One approach is to lower the volume needed to break even. There are three ways to reduce the required break-even level. One can lower the fixed costs by getting by with less expensive or fewer fixed resources. That may or may not be possible, depending on the specific circumstances. A second way to lower the break-even point is to increase prices. Price increases would increase the contribution margin per unit. That would have the effect of lowering the break-even point. However, based on the principles of supply and demand, price increases might reduce the expected volume for many activities or services. In that case, the price increases may be defeating their purpose. Also, prices are sometimes regulated and beyond the control of the organization. Finally, one could try to reduce the variable cost per unit. This might be accomplished by increased efforts toward improved efficiency. If it is not feasible to change the fixed costs, price, or variable costs, an organization can try to increase the number of units of activity through marketing activities, focused on services or customers that have a particularly high contribution margin. PROBLEMS 4-12. a. Fixed: depreciation, doctor, nurse, cooks and camp director b. Step-Fixed or Semi-Variable costs: counselors c. Variable: food and transportation d. Not included in the camp’s cash budget: depreciation 4-13. b. the number of children that will be added to the program d. the impact of adding the children to the existing facility 4-14. b. there is a change in fixed costs 4-15. 1. BEQ = FC/(VR – VC) = ($5,000 per week/5 days per week)/((15-5)) = 1000/10 Chapter 4: Understanding Costs 4-4 = 100 per day 2. b. decreases 4-16. 1. a. Direct Country staff, clinic staff and supplies b. Indirect DWB’s central staff c. Fixed all staff expenses d. Variable supplies 2. The country director and country-wide staff 4-17. d. Who is measuring the cost e. Whether the person asking the question is inside or outside the organization 4-18. 1. a. Direct faculty researcher, research assistants, laboratory costs and supplies b. Indirect administrative staff, building expenses, research director c. Fixed building and laboratory expenses, administrative expenses, faculty researcher and research assistants d. Variable supplies 2. cost objective 4-19. a. The relevant time period b. The relevant range of volume 4-20. 1. Full Cost. 2. Average Cost. 3. Marginal Cost. 4-21. 1. b. Indirect cost 2. a. Direct cost 4-22. 1. d. Unit variable cost remains constant and unit fixed cost decrease 2. d. Relevant range 4-23. 1. flexible 2. operating 3. zero-based 4-24. a. increases 4-5 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 4-25. c. total revenues = total costs 4-26. 1. ___total revenue__ equals __total expense____ 2. ___price or variable revenue___ minus __variable cost_____. 3. b. decreases 4-27. 1. price per unit or marginal revenue __ and __ variable cost per unit or marginal cost. 2. a. increase 4-28. b. reduce the contribution margin per unit of service. 4-29. 1. contribution margin or marginal contribution 2. a. a loss or deficit 4-30. 1. $2,000,000-$1,600,000 = $400,000 2. 400,000 x 1.10 = 440,000 Total costs = 1,600,000 + 440,000 = $2,040,000 4-31. Relevant Costs = $120,000 - $25,000 = $95,000 4-32. 1. variable salary expenses of $570,000 ($650,000 - $80,000) variable benefit expenses of $570,000*30% = $171,000 printing costs of $150,000 These costs will change (will be eliminated) if Hudson accepts the contract. All of the other costs are fixed or sunk. 2. YES the cost of the contract is $750,000 and the savings are $570,000 + $171,000 + $150,000 = $891,000 Chapter 4: Understanding Costs 4-6 4-33. FC: $30,000 + 13,000 + 5,000 = $48,000 P per day = $12*300 = $3,600 per day VC per day = $1,600 BEQ = ___$48,000____ = 24 days (3,600-1,600) 4-34. Weighted Average Price .30 * $100 = 30 .70*.80*$100 = 56 $86 FC = $210,000 VC = $65 per exam P = $86 per exam BEQ = $210,000 / (86 – 65) = 10,000 exams 4-35. 1. BEQ = FC / (P – VC) = 10000/(275 – 75) = 50 people 2. $300 - $75 = $225 3. TR – TE = Profit Q*P – (FC + VC * Q) = Profit Q*P = Profit + (FC + VC * Q) P = (Profit + (FC + VC * Q))/Q P = (100,000 + 10,000 + 500 * 75)/500 = 147,500/500 = $295 per ticket 4-7 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 4-36. 1. Breakeven Number of = Total Fixed Expenses/Unit Contribution Margin People = ($5,000 + $1,000) / ($150 - $50) = 60 people 2. Average cost = Total cost / volume TC= 6,000 + (50*100) = 11,000 AC= 11,000 / 100 = $110 per person 4-37. 1. Fixed costs = $180 VC= 5 Q=12 Q = FC/(P – VC) 12=180/(P-5) 12(P-5)=180 12P-60=180 12P=240 P=$20 2. Fixed costs = $180+300 = $480 treat profit as a fixed cost VC= 5 Q=12 Q = FC/(P – VC) 12=480/(P-5) 12(P-5)=480 12P-60=480 12P=540 P=$45 4-38. Q = FC/P-VC Q = 30 days P = 2,000*$10 = $20,000 per day VC = $1,000 per day 30 = FC/(20,000-1,000) 30 x 19,000 = FC FC = $570,000 Chapter 4: Understanding Costs 4-8 4-39. 1. BEQ = FC/(VR – VC) = ($18,000)/((300-30)) = 18,000/270 = 67 2. a. increases 4-40. 1. BEQ = (FC-City revenue)/(Weighted VR – Weighted VC) or BEQ = (FC-City revenue)/(Weighted CM) Base Reading Daily Price $10.00 $3.00 Daily VC $3.00 $5.00 Days per week 5 Fixed Costs $36,000 City Contract $30,000 Weekly Weekly Weekly Weekly Mix Price VC CM Weighted CM non reading 70.0% $50.00 $15.00 $35.00 $24.50 reading 30.0% $65.00 $40.00 $25.00 $7.50 Total Weighted CM $32.00 Break Even 188 2. a. increases 4-41. 1. BEQ = (FC-grant)/(total VR – total VC) Fixed Cost $100,000 Less Grant $25,000 Net Fixed Costs $75,000 Variable Costs Tee Shirt $5.00 Refreshments $10.00 Total Variable Cost $15.00 Variable Revenue Registration Fee $5.00 Miles 10 Contribution/mile $0.50 Number of sponsors 15 Sponsors Payment $75.00 contribution/mile * sponsors * miles Variable Revenue $80.00 BEQ 1,153.85 fc /(vr-ve) Nearest Whole Person 1,154 2. increases 4-9 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 4-42. 1. New visit contribution margin: $50 - $40 = $10 * 20% = $ 2 Follow up visit contribution margin: $50 - $30 = $20 * 80% = $16 Weighted average contribution margin: = $18 Breakeven volume = Total Fixed Cost/Weighted Average Contribution Margin = ($12,000 + $6,000)/$18 = 1,000 visits 2. Total Contribution Margin = $18/visit*12 visits/day*21 days/physician*5 physicians = $22,680 Profit = Total Contribution Margin – Monthly Fixed Cost = $22,680 – 18,000 = $4,680 4-43. 1. Fixed Cost = $750 + 600 + 400 = $1,750; Unit Variable Cost = $20; BEQ = 250 students 250 = 1,750/ (p – 20) p = $27 2. Contribution margin on student tickets = $25 – $20 = $5 Contribution margin on student tickets = $75 – $20 = $55 Weighted average contribution margin = $5 * 75% + $55 * 25% = $17.50 BEQ = $1,750 / $17.50 = 100: 75 students and 25 alumni 4-44. Case 1 Case 2 Fixed Cost $25,000 $25,000 Marginal Revenue $75 $65 Marginal Cost $35 $40 Contribution Margin $40 $25 Break Even - FC / (MR - MC) 625 1,000 Increase in BE Quantity 375 Chapter 4: Understanding Costs 4-10 4-45. BREAK EVEN PROBLEM Variable Costs vet expenses $42.00 # visits * cost per visit spay./neuter $45.00 cost per spay/neuter & transport food $9.00 #days * cost of food per day Total Variable Cost $96.00 Variable Revenue Adoption fee $225.00 adoption fee Average Additional Donation $30.00 % making donation * average donation Total Variable Revenue $255.00 Contribution Margin $159.00 variable revenue - variable cost Fixed Costs Salaries $95,000 Benefits $23,750 Depreciation $15,000 Less: Donations ($40,000) Net Fixed Cost $93,750 Break Even 589.62 590 dogs 4-46. a. Fixed: Rent, Nurse and Secretary or staff b. Step-Fixed or Semi-Variable costs: Doctors c. Variable: exam supplies and vaccines 4-47. 1. a. the cost objective 2. b. indirect and fixed 4-48. 1. weighted average; 2. either profit or break even 3. b. decreases 4-49. (Marginal Cost Analysis) a. Volume Fixed Variable Total Average 100 $300,000 $25,000 $325,000 $3,250 500 300,000 125,000 425,000 850 1,500 300,000 375,000 675,000 450 2,500 300,000 625,000 925,000 370 3,000 300,000 750,000 1,050,000 350 4-11 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, b. Cost $850 450 370 350 500 1,500 2,500 3,000 Volume c. Cost at 2,500 = $370/patient Cost at 3,000 = $350/patient Revenue = $300/patient Accept business because marginal revenue of $300 > marginal cost of $250. Discuss issues such as potential fixed cost increases, push by other customers to get the discounted price, excess industry capacity, and accrual accounting losses versus cash flow losses. 4-50. (Break-Even Analysis) Fixed cost = $2,400,000 Variable costs = $5/ticket Price = $75/ticket FC $2,400,000 Q = ------------------ = ------------------- = 34,286 tickets must be sold to break even P – VC/Ticket $75 - $5 Note: The actual calculation yields the result 34,285.714. However, it is important to round up. If we sold only 34,286 tickets, the Symphony would lose money because it would be below its breakeven point. Even if the value had been 34,285.15 we would have to round up to avoid a loss. Discussion: What if price falls, variable costs rise, etc.? What if we expect demand for only 33,000 tickets? Chapter 4: Understanding Costs 4-12 4-51. (Break-Even Analysis—Multiple Products) Price – VC = CM ´ Mix = Weighted Pool $70 $3 $67 40% $26.80 Tennis $50 $3 $47 35% 16.45 Golf $30 $3 $27 25% 6.75 Weighted Average Contribution Margin $50.00 or Price Mix Weighted Pool $70 40% $28.00 Tennis $50 35% 17.50 Golf $30 25% 7.50 Weighted Average Price $53.00 Variable Cost Mix Weighted Pool $3 40% $1.20 Tennis $3 35% 1.05 Golf $3 25% .75 Weighted Average Variable Cost $3.00 FC FC $250,000 $250,000 BEQ = -------------- = ------ = ------------------- = ---------------- = 5,000 total passes P - VC/Unit CM $53.00 - $3.00 $50 40% x 5,000 = 2,000 pool passes. 4-52. (Break-Even Analysis—Step-Fixed Costs) Revenue $1,400,000 total Variable costs $40/arrest Fixed cost $100,000 payroll Semivariable cost ??? 4-13 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, Budgeted Volume of Arrests 1,000 2,000 3,000 4,000 Revenue $1,400,000 $1,400,000 $1,400,000 $1,400,000 Payroll $ 100,000 $ 100,000 $ 100,000 $ 100,000 Police 594,000 648,000 648,000 702,000 Desk 354,000 354,000 413,000 472,000 Supervisor 137,000 137,000 137,000 205,500 Food 40,000 80,000 120,000 160,000 Total Expense $1,225,000 $1,319,000 $1,418,000 $1,639,000 Surplus $ 175,000 $ 81,000 $ (18,000) $(239,000) We can do more than 2,000 but less than 3,000. What costs rise when we go above 2,000? Staff and food. If we start to back away from 3,000, what costs go down on the margin? Only the food. They go down at a rate of $40 per arrest. If we lose $18,000 at 3,000, then we could break even at 2,550. Divide the loss by the variable cost. Reduce volume by the result to arrive at a break-even point. 18 000 40 450 ,  = 3 000 450 2 550 ,  = , Budgeted Volume of Arrests: 2550 Revenue $1,400,000 Payroll $ 100,000 Police 648,000 Desk 413,000 Supervisor 137,000 Food 102,000 Total Expense $1,400,000 Surplus $0 Chapter 4: Understanding Costs 4-14 4-53. (Break-Even) Price $ 2,500 Charge + 250 Fundraising – 75 Uncollectible $ 2,675 Variable Costs: Airfare $ 600 Hotel 600 Food 600 Admissions 125 Entertainment 300 Other 200 Total Variable $ 2,425 Contribution Margin $ 250 Fixed Cost Guide $ 3,000 Bus 2,500 Contingency 2,500 Airfare, food, admissions, entertainment, other for 4 chaperones 4 ´ (600 + 600 + 125 + 300 +200) 7,300 Total Fixed $15,300 Fc $15, 300 Break-even Quantity =  =  P VC $2, 675 $2, 425 = = 15 300 250 612 , . ,  , Break-even with Subsidy = = = , . 15 300 10 000 250 5 300 250 212 Is the hotel cost variable per teen, or per group of four teens? Will the cost go up $160 per night for the first extra teen over 4, and then be fixed for the next three? If so, the breakeven will be higher. What about the fact that the budget is for 50 teens? That is not divisible by 4. Is there an extra room cost that hasn’t been accounted for? It is unclear. Is the hotel cost really $160 per room per night, or has the travel agent given a total room cost that works out on average to $160 per room per night? 4-15 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, If there are only 20 teens, how many chaperones will be needed? We can reduce the break- even point by going to two chaperones. It is important to note that in many cases, budgets are approximations. For example, while the airfare may be known with certainty, the food cost is likely to be approximate, depending on the specific restaurants that are actually used. 4-54. (Flexible Budgets and Break-Even Analysis) FC $70,000 Q = ---------- = ----------------- = 36,459 riders P – VC $2.00 - $.08 The New City Subway makes money if it has more than 36,459 riders. Flexible budget Price $ 1.50 $ 2.00 $ 2.50 Volume per day ´ 50,000 ´ 40,000 ´ 30,000 Revenue per day $ 75,000 $80,000 $75,000 Less fixed cost 70,000 70,000 70,000 Less variable cost $.08 ´ volume 4,000 3,200 2,400 Surplus $ 1,000 $ 6,800 $ 2,600 Here we see that the subway makes money at all volumes shown. How can that be, given the 36,459 in the break-even calculation? Note that in the flexible budget we did not just change volume. The price also changed. The increase in the price lowers the break-even point. Intuitively we would expect higher profits for 50,000 riders per day than for 30,000, yet the flex budget shows that the profits are lower at the higher rider volume. This is because the higher volume was accompanied by a lower price. That lower price raised the break-even point. In fact, it turns out that the current $2 price results in a higher profit than would occur if the price were to rise or fall! Breakeven analysis often makes the somewhat unrealistic assumption that price is constant over a range of volumes. We can see that if volume changes are accompanied by price changes, higher volume does not necessarily increase profits. 4-55. (Relevant Costs) Rent 20,000 marginal Repairs and maintenance 10,000 marginal Supplies 5,000 marginal Marginal $35,000 marginal Keep the location open. There will be savings of only $35,000 and they will lose a $40,000 grant, so they will be $5,000 worse off. What qualitative issues of relevant here? If it made financial sense to close the location we would still have to consider the impact on the mission of the organization. Chapter 4: Understanding Costs 4-16 4-56. (Allocation Base and Overhead Rates) One base is the number of tax bills. The rate would be $32,000/8,000 = $4 per bill. A second possible base would be tax collector department clerical hours consumed in processing bills. The rate would be $32,000/1,000 = $32 per hour. 4-57. (Cost Allocation and Overhead Rates) a. Calculation of overhead rate on direct-labor-hour basis: Cost Overhead rate = = Direct labor hours hours per hour $810, , $9 000 90 000 = = Overhead applied to Mr. Robbins Direct labor hours rate hours ´ = 20 ´ $9 per hour = $180 b. Calculation of overhead rate on direct-labor-dollar basis: Cost $810,000 Overhead rate = ------------------------- = ------------ Direct labor dollars $1,350,000 = $.60 per direct labor dollar Overhead applied to Mr. Robbins = Direct labor dollars ´ rate = 380 direct labor dollars ´ .60 = $228 The results differed under the two different bases. The probable reason for this difference is that some patients consume labor hours from more highly skilled, highly paid workers. A direct-labor-hour basis system will assign a patient just as much overhead for having consumed an hour of licensed practical nurse (L.P.N.) labor as it will for having consumed an hour of registered nurse (R.N.) labor. A system that assigns overhead on the basis of direct labor cost will assign more overhead for the consumption of an hour of a more highly paid worker’s time. Which basis is preferable? That depends on whether the overhead items in question are more closely related to the amount of labor an individual patient consumes or to the type of labor consumed. 4-58. (Cost Allocation—Direct Distribution) Direct distribution. Allocation 4-17 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, Direct Costs Purchasing Purch. Orders Administration Total Salaries Total Costs Support cost centers Purchasing $ 80,000 $(80,000) $ 0 Administration 40,000 $(40,000) 0 Mission cost centers Soup kitchens 900,000 37,647 37,895 975,542 Counseling 300,000 42,353 2,105 344,458 Total cost $1,320,000 $ 0 $ 0 $1,320,000 4-59. (Cost Allocation—Step-Down) Step-down distribution Allocation Direct Costs Purchasing Purch. Orders Sub-total Administration Total Salaries Total Costs Support cost centers Purchasing $ 80,000 $(80,000) $ 0 Administration 40,000 12,000 $ 52,000 $(52,000) 0 Mission cost centers Soup Kitchens 900,000 32,000 932,000 49,263 981,263 Counseling 300,000 36,000 336,000 2,737 338,737 Total cost $1,320,000 $ 0 $1,320,000 $ 0 $1,320,000 Chapter 4: Understanding Costs 4-18 4-60. (Cost Allocation—Step-Down) Step-down distribution—changed order of allocation. Allocation Direct Costs Administration Total Salaries Sub-total Purchasing Purch. Orders Total Costs Support cost centers Purchasing $ 80,000 $ 2,000 $ 82,000 $(82,000) $ 0 Administration 40,000 (40,000) 0 0 Mission cost centers Soup kitchens 900,000 36,000 936,000 38,588 974,588 Counseling 300,000 2,000 302,000 43,412 345,412 Total cost $1,320,000 $ 0 $1,320,000 $ 0 $1,320,000 It is clear that the order of step-down does matter! 4-61. (Activity Based Costing) The first step would be to determine the total costs of the maintenance department. These consist of the $100,000 spent on supplies, the $15,000 spent on administration, and the labor cost of $192,000 (i.e., 10,000 hours @ $12 plus 4,000 hours @ $18, or 14,000 hours @ $13.71 per hour). This is a total cost of $307,000. The traditional application rate would be as follows: $307, 000 = $3. 07 square foot 100 000 , square feet That rate would cover both routine maintenance and repairs. Because the pharmacy has 2,000 square feet, it would be assigned a cost of $6,140. Alternatively, because the pharmacy is 2% of the total square feet (2,000/100,000 ´ 100%), we could simply multiply the total maintenance department cost of $307,000 by 2% to get the $6,140 in the traditional step-down approach. What allocation would an ABC approach yield? First, we must make some choices about allocation bases. Given that administration is supervising personnel, we can allocate the administrative cost based on direct labor hours. What about the labor cost? First consider labor for repairs. The cost could be allocated based on square feet, or on the number of repairs, or on the length of the repair. The cost for labor is driven by the number of hours the workers work. It is not the volume of repairs, but rather how long they take that is critical to an accurate allocation. Therefore, repair labor should be allocated based on direct labor hours. It could be argued that routine labor should also be allocated in that fashion. However, is it worthwhile to gather that information? In the example, hours spent on routine maintenance in the pharmacy department were not supplied. Therefore, routine labor must be allocated based on square feet. However, consider whether the extra accuracy would justify the collection of additional data on where workers spend their time. Similarly, supplies used for routine maintenance will have to be allocated based on square feet. Supplies for repairs could be allocated based on the number of repairs, how long they take, or the specific supplies used. In actuality, it is likely that major supplies (repair parts) could be 4-19 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, assigned specifically to each repair based on actual costs. Other supplies (nuts, nails, etc.) would probably be assigned based on direct labor hours, assuming that workers use supplies fairly evenly over the time they work. In this case, we have been given actual costs for supplies used. The actual allocation becomes somewhat tricky, because routine maintenance is being allocated using different cost drivers from repairs. First, consider administration. The total cost is $15,000. There were 14,000 labor hours, so the rate would be $1.071 per hour. The pharmacy had 6 hours of repairs and would be charged $6.43. Repairs in other departments took 3,994 hours and would be charged $4,279.29. However, what about the remaining $10,714.28 of administrative cost? The administration related to routine work cannot be charged based on hours because we do not know the hours for each department, as discussed above. The pharmacy is 2% of the square feet, so it will be allocated 2% of this remaining administrative cost, or $214.29, with the balance of $10,499.99 being charged to other departments. The pharmacy department consumed repairs that required 6 hours of labor at $18 per hour, or a total of $108. The other departments consumed 3,994 hours at $18 per hour, or $71,892. The remaining 10,000 hours at $12 per hour, or $120,000, are allocated based on square feet; 2% of $120,000 is $2,400, and 98% of $120,000 is $117,600. The supplies used for repairs can be allocated directly, as given in the solution below; $200 for pharmacy and $79,800 for other departments, based on actual costs incurred and assigned to repair projects directly. The remaining $20,000 of routine supplies would be allocated based on square feet; 2% of $20,000 is $400, and the remaining 98% is $19,600. In sum, the total pharmacy costs under the ABC approach are as follows: Pharmacy Total Routine $3,014 Repairs 314 Total $3,328 This total of $3,328 is only a little more than half the original allocation of $6,140. Clearly, the more accurate costing approach does have a significant impact in this instance. The solution table is as follows: Pharmacy Routine Repairs Administration $ 214 $ 6 Labor 2,400 108 Supplies 400 200 Total $3,014 $314 All Other Departments Pharmacy & All Other Routine Repairs Total Administration $ 10,500 $ 4,279 $ 15,000 Labor 117,600 71,892 192,000 Supplies 19,600 79,800 100,000 Total $147,700 $155,971 $307,000 Chapter 4: Understanding Costs 4-20 CASE STUDY: MEAD MEALS ON WHEELS CENTER 1 Problem 1 is a variation on the break-even problem. It asks you to calculate the maximum amount that MMWC can spend per person per week on food. In other words, what is the largest variable cost that MMWC can afford to pay and still cover all of its fixed costs? From the problem set you know the Unit Revenue (P) is $32 per week. To find out how many people MMWC can feed in a week (Q), you have to do a little work. The problem set says that MMWC can prepare 9,600 meals per day. But its contract calls for it to deliver two meals per day per person. This means that MMWC can feed 4,800 people on any given day. Note that each person eats 14 meals per week, so MMWC can feed only 4,800 people per week. Fixed costs (FC) are $36,000 per week. The base break-even formula is: Fixed Cost FC   Break - even Quantity Q   =  Unit Revenue Variable Unit Cost P   VC   Q P FC VC = = = = 4 800 , 000 $32 $36, ? we need to solve for the variable unit cost FC Q =  P VC multiplying both sides of the equation by P VC  , we get: ´  = Q P VC FC   expanding the terms on the left side, we get: Q P Q VC FC ´  ´ = subtracting Q R´ from both sides, we get:  ´ =  ´  ´  = Q VC FC Q P VC FC Q P Q 1 Mead Meals on Wheels Center and its solution were written by Robert Purtell, Robert F. Wagner Graduate School of Public Service, New York University. Used with permission. 4-21 Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, multiplying both sides by –1, we get: VC Q P FC Q = ´  substituting the values above, we get: ´  = 4800 32 36000 VC = $24. 50 4800 $24.50 PER PERSON WEEK is the maximum amount that MMWC can spend for food. Problem 2 asks you to take the information from problem 1 along with some additional data on the seasonality of MMWC’s fixed costs and add the fact that the lowest food supply bid was $.50 below the break-even level that was calculated in problem 1. The budget below was derived from the problem-set facts as follows. Quarterly revenue equals the number of people served per week (4,800) times the number of weeks in a quarter (13) times the amount that Millbridge pays MMWC for each person-week ($32). Thus quarterly revenue = $1,996,800 Quarterly fixed expenses: The problem set tells us that fixed costs vary by quarter. They are $38,000 per week in the winter (1 st quarter), $34,000 per week in the second quarter, $35,000 in the third quarter and $37,000 in the fourth quarter. The calculations for quarterly fixed costs involves multiplying the weekly fixed costs per quarter by the number of weeks in a quarter. For the first quarter that is $38,000 ´ 13, or $494,000. Quarterly variable food costs are calculated by multiplying the number of people fed (4,800) by the number of weeks in a quarter (13) by the cost of the food ($24.50 – $.50 = $24.00). This is equal to $1,497,000. Chapter 4: Understanding Costs 4-22 Budget Quarter One Quarter Two Quarter Three Quarter Four Annual Total Revenue $1,996,800 $1,996,800 $1,996,800 $1,996,800 $7,987,200 Fixed Costs 494,000 442,000 455,000 481,000 1,872,000 VC Food 1,497,600 1,497,600 1,497,600 1,497,600 5,990,400 Total Cost $1,991,600 $1,939,600 $1,952,600 $1,978,600 $7,862,400 Profit/(Loss) $ 5,200 $ 57,200 $ 44,200 $ 18,200 $ 124,800