About Pepsico

CHAPTER6
BUDGETING
P61:
SolutiontoCountryClub(10minutes)
[Budgetsdontmeasureopportunitycost]
Thisdeceptivelystraightforwardquestionisguaranteedtogeneratealotofclass
discussion.Thereasonforthedebateisthateachstudenthasaslightlydifferentconcept
ofcostinmind.Bylettingthediscussionrunforfiveminutes,itbecomesclearthat
whatpeoplemeanbycostisoftenintheeyeofthebeholderanddependsonwhat
decisiontheyarecontemplating.
Themostfrequentansweris$121,200.Thisistheamountofcashusedtooperate
theclub. Butthisexcludesactualphysicaldepreciation. Sincethestatementdoesn't
includeanyaccountingdepreciation,wecannotevenestimateifthetotalhistoricalcost
was$121,200. Moreover,themembersdidnotbearthefullcostof$121,200ifnon
memberguestspaidsomeoftheseexpenses.
Some students answer that the cost to the members includes their dues of
$62,500plusthenetoperatingsurplusof$6,000whichequals$68,500.
But applying the concept of opportunity cost from Chapter 2, we cannot
meaningfullyanswerthequestionposed. Wedon'tknowwhatopportunitiesfacedthe
Boardatthebeginningofthemonth.Forexample,supposetheBoardcouldhavehelda
national golf tournament in September, leasing the club to the Professional Golf
Association(PGA)for$250,000. Thetournamentwouldhaveclosedtheclubtothe
membersfortheentiremonth.The(opportunity)costofoperatingtheclubinSeptember
wouldnothavebeen$121,000butrather$250,000lessanyexpendituresassociatedwith
thetournament.
The operating statement looks backwards. It details the actual inflows and
outflowsthatoccurred,notwhatthe(opportunity)costswere.
P62:
SolutiontoShockerCompany(CMAadapted)(10minutes)
[Budgetedproductionandinventorylevels]
Quarter2sales
+EndingInventory:20%ofQuarter3sales(12,00020%)
BeginningInventory:20%ofQuarter2sales
(8,00020%)
Budgetedproduction
Chapter 6
Instructors Manual, Accounting for Decision Making and Control
8,000units
2,400units
(1,600)units
8,800units
The McGraw-Hill Companies, Inc., 2003

6-1
P63:
SolutiontoJungCorporation(CMAadapted)(10minutes)
[Budgetingdirectmaterials]
Directmaterialfor3rdquarterproduction(34,0003)
+EndingInventory:30%ofQuarter4production
(48,000330%)
BeginningInventory:30%ofQuarter3production
(34,000330%)
BudgeteddirectmaterialsforQuarter3
P64:
102,000lbs.
43,200lbs.
(30,600
lbs.)
114,600lbs.
SolutiontoG.BennettStewartonManagementIncentives(15minutes)
[Costsandbenefitsofbudgeting]
Thequotefailstorecognizethatbudgetingsystemshavesurvivedandthusin
generalmustbeyieldingbenefitsatleastaslargeastheircosts.WhileStewart'sanalysis
ofbudgetingsystemsoffersinsightsintothedysfunctionalaspectsofbudgeting,itdoes
notaddressthequestionofthebenefitssuchsystemsprovidethatallowthesesystemsto
survive.
Mr.Stewartscriticismofbudgetsfocusesontheirdecisioncontrolrole.When
usedasperformancemeasuresandlinkedtobonuses,budgetscausegaming.Thereisno
questionthatsuchgamingexists.Theimportantquestionsare:Whatisthemagnitudeof
thegaming?Ifbudgetsarenotusedtomeasureperformance,whatisanddoesitresultin
betterorworseincentives?
P65:
SolutiontoInvestmentBanks(15minutes)
[Zerobasedbudgeting]
a.
ZerobasedBudgeting(ZBB)isaformofbudgetinginwhicheachandeveryline
itemrequestineverybudgetmustbejustifiedbydemonstratingthatthebenefits
fromrequestingthisamountofmoneyexceedtheamountrequested.ZBBdiffers
fromthemoretypicalcaseofincrementalbudgeting,inwhichonlytheincrement
overlastyearsbudgetoneachlineitemisjustified. Presumably,ZBBbetter
rootsoutinefficienciesinthefirmbyforcingeachmanagertodemonstrateeach
yearthateachandeveryexpenditureproposedisinthebestinterestofthefirm.
However,ZBBismoretimeconsumingandthusmorecostlytooperate than
incrementalbudgeting.Moreover,ZBBtendstodeteriorateintoanincremental
type budgeting system whereby each year managers pull out last years
justificationsandmakeincrementalchangestolastyearsplan.
b.
All budgeting systems separate decision management from decision control.

Managerswhoproposenextyear'sbudgetsdonothavethedecisioncontrolrights
Chapter 6
6-2

toapprove(ratify)suchrequests.Thosewiththedecisionmonitoringrightsmust
havethespecificknowledgetoexercisetheratificationrights. WhileZBBis
morecostlytooperatethanincrementalbudgeting,itismoreusefulinthesense
that ittransfersmorespecific knowledge abouteachlineitem comprising the
budget.Inorganizationsthatexperiencehighturnoveramongthepeoplewiththe
decisionmonitoringrights,thebenefitsofZBBarehigherthaninfirmswithmore
stablemanagement.
Managerstendtobepromotedverticallywithinorganizations. Having
beeninlowerlevelpositions,theyhaveagreatdealofspecificknowledgeabout
theirsubordinatesbudgets. Therefore,thebenefitsofZBB(thevalueofthe
specific knowledge transferred) are lower in organizations with little external
turnoverofseniormanagementpositions.
GiventhehighexternalturnoverinCabots,Cabotsismorelikelytobe
usingZBBthanRogersPetersen.
P66:
a.
SolutiontoIceStorm(15minutes)
[Assigningresponsibilityandcontrollabilityofexpenses]
Thecovermemoforthesecondstatementis:
Asyoucanseefromtheenclosedoperatingstatementforthisyear,
our operating profits excluding the ice storm exceeded budget by
$107,000thusachieving105percentofourbudgetedprofit.Thisbetter
thanprojectedprofitresultsfromrevenues being1percenthigherthan
anticipated, and occupancy costs 3 percent lower than expected.
However,laborandmaterialsexceededbudget.
Takingintoaccounttheicestormdamagecostsof$653,000our
totalprofitswere$546,000belowbudget.
b.
Therearetwoissuesraisedbythisproblem:agendasettingandcontrollability.
How financial analyses are presented affects agendas. The second statement,
whichseparatesthestormcostsfromnormaloperations,focusesthediscussionon
theicestormandwhetherthecostsoftheicestormaremeasuredproperly.That
is, how were the costs of the ice storm computed? Dyes superiors might
concludethatthereasonforM&Psfavorableoperatingperformance(beforethe
icestormcostsareconsidered)isbecauseDyechargedsomenormaloperating
coststotheicestormtoimproveoperatingprofitsbeforetheicestorm.While
the second statement tries to remove the costs of the ice storm from Dyes
performanceevaluation,thesecondstatementalsoexposesDyetochargesthat
Dyedidnotdoenoughtoreducethecostsofpossiblestorms(e.g.,removingtree
limbsfromaroundthegreenhouses).
Chapter 6

6-3
Thesecondissueinvolveswhetherthemanagershouldbeheldresponsible
fortheicestorm.Whilethemanagercannotpreventsuchstorms,Dyecanreduce
theadverseconsequencesofsuchevents.Thesecondstatement,whichseparates
outtheicestorm,triestomakethecasethatthemanagershouldnotbeheld
accountablefortheicestorm.Theextenttowhichthisployworksdependson
whether Dye's boss focuses on the ice storm and blames Dye for not doing
enoughprevention.
P67:
a.
b.
c.
Solution to Budget Lapsing versus LineItem Budgets (15 minutes)

[Budgeting]
Budgetlapsingreferstopreventingthemanagerfromcarryingovertothenext
fiscal period any unspent budget funds from this fiscal period. Lineitem
budgetingreferstorestrictingthemanagersabilitytoshiftunspentfundsfrom
onelineitemtoanotherlineitem withinthesamefiscalperiod. Thus,budget
lapsingrestrictsmanagersdecisionrightsacrosstime,whereaslineitembudgets
restrictmanagersdecisionsrightswithinafiscalyear.
Budget lapsing occurs in most organizations, probably to reduce the horizon
problem of managers who build up large balances that are spent before they
changejobs.Italsoisusedtocontrolmanagersriskaversion.Ifitisoptimumto
spend$Xonacertainactivity,itisnotoptimumtohavethemanagersavea
portionof$Xbecausesheisriskaverse.
Lineitem budgets restrict managers decision rights. You would expect to
observesuchrestrictionswheretheagencycostsofmanagersdiscretionishigh
or where alternative monitoring devices such as incentive schemes and
competitionfromotherfirmsislow.Governmentagenciesandcertainnonprofit
organizationsfacelittleexternalcompetitionandareunabletoeffectivelyemploy
incentivecompensationschemes.Thus,theseorganizationsaremorelikelytouse
lineitembudgets.
P68:
SolutiontoEssay(20minutes)
[Theeffectofbudgetsonorganization]
Theorganizationproblemconsistsofpartitioningdecisionrightsandmeasuring
andrewardingperformance.Budgetshelpsolvetheorganizationproblembyprovidinga
measureofperformance,bylinkingknowledgeanddecisionrights,andbytransferring
specializedknowledgewithinthefirm.
Agencyproblemsexistinallmultipersonorganizations.Budgetsareanimportant
mechanismforcontrollingagencyproblems.Budgetsprovideaperformancemeasureby
comparingbudgetedamountstoactualamounts.
Chapter 6
6-4

Within organizations it is useful to try to link decision rights and specific

knowledge. Budgetsgivemanagersthedecisionrightstospendresourcesonspecific
functionsuptothedollarlimitinthebudget.Budgetspartitiondecisionrights,andby
giving budgets to managers with the specialized knowledge, decision rights and
knowledgearelinked.
Thebudgetingprocessseparatesdecisionmanagementfromdecisioncontrolvia
theinitiation,ratification,implementation,andmonitoringprocess.Amanagerdoesnot
have decision rights over all steps in the process. Through a bottomup budgeting
process,themanager'sbudgetingdecisionrightsarecontrolled.
Finally, budgeting does not solve all organization problems. There is the
remainingproblemofmanagersbiasingtheirbudgetforecastsifthesesamenumbersalso
areusedforperformanceevaluations.
P69:
SolutiontoGolfWorld(20minutes)
[Agencycostsandflexiblebudgetschangeincentives]
a.
Almostallofthedifferencebetweenactualoperatingprofitsandthestaticbudget
for April is due to the reduced cart rentals from 6,000 to 4,000. When the
variancesarecalculatedbasedontheflexiblebudget,Grimesoperationshows
onlya$1,100unfavorablevariance. Laborandgasandoilwereoverbudget.
The$200unfavorablevarianceinlaborisprobablyinsignificantandthe$900gas
&oildifferenceislikelyatimingdifferencebetweenwhenthegasandoilare
purchasedandwhentheyareactuallyused.
b.
Themajoradvantageofthecontroller'sflexiblebudgetschemeisthatitseparates
thoseitemsGrimescancontrolfromthosehecan'tcontrol.Theflexiblebudget
(andhencethevariances)areadjustedforvolumeeffectswhichpresumablyare
out of Grimes' control. But are they? Herein lies the disadvantage of the
controller'sscheme.ByremovingvolumeeffectsfromGrimes'variances,hehas
noincentivetoworryaboutcartrentals.Ifinfacttheonlyvariancesforwhichhe
is responsible are the operating costs, he can show favorable variances by
reducingthequalityofhisservices.Thecartswillnotbecleanedaswell,they
willbreakdownmoreonthecourse,andhewillnotchoosethecartfleetto
maximizehisprofitcenter'sprofitsbutrathertominimizecosts.
Also,Grimeshasspecializedknowledgeofthecustomers'demandcurves
forcarts.Ifheisheldresponsibleforrevenues(i.e.,thecontroller'sproposalis
not adopted), Grimes has more incentive to implement pricing policies that
maximizeprofits.Ifvolumeeffectsare"flexedout"ofGrimes'budget,hehasno
incentivetoofferspecialpricesinordertopricediscriminate.
c.
An agency problem exists between Sandy Green and Golf World under the
present organizational structure. Green receives the benefits of closing the
Chapter 6

6-5
coursestogolfcarts(thisreducesthemaintenancehercrewshavetoconduct)but
shedoesnotbearthefullcostsofthisaction(thereducedrevenuesfromgolf
carts).Byshuttingacoursebecauseofwetness,Greenkeepsthatcourselooking
goodanddoesnothavetorepaircartdamage. Intime,thistranslatestolower
maintenancecostsandhighergolfcourseprofits. Butthisdecisionimposesa
negativeexternalityonGrimesandthegolfcartprofitcenter.
Onewaytointernalize this externality is toinclude as partofGreen's
operating statement the difference between Grimes' actual and static budget
operatingprofits.
SomestudentsaretemptedtoconvertGolfCartstoacostcenterfroma
profitcenter.Thisquestioninvolveswhoshouldhavethedecisionrightstoset
the cart price. If Grimes can best set the price it should be a profit center,
otherwiseitshouldbeacostcenter.Whoshouldsetthepricedependsonwho
has the specialized knowledge and who has the comparative advantage in
acquiringtheknowledge.IfGolfCartsbecomesacostcenter,Grimeswillhave
noincentivetoacquiretheknowledgetosettheprofitmaximizingcartprice.
P610:
SolutiontoMinimumSpendingPlanatBayViewCountryClub (20
minutes)[Budgetsandcoercion]
Thetreasurerisconsideringaminimumspendingplanbecausemembersareno
longereatingattheclubwiththesamefrequencyasexpectedinthebudget.Something
haschanged.Eitherthemembershiphaschangedbecauseofnewmemberswithdifferent
tastes,ortheprice,quality,andserviceprovidedhavechanged.Notenoughinformation
isavailabletoassesswhathaschanged. Buttheminimumspendingplanproposesto
forcememberswhonormallywouldnoteatattheclubtoeatattheclub. Thisaction
makesthesemembersworseoff. Undoubtedly,therearesomememberswhonoware
closetothemarginofremainingintheclub(i.e.,totalbenefitsfromtheclubarejust
slightlylargerthantotalcosts).Theminimumplanraisesthenetcoststothesepeople
andsomewillquit.Ifthereisnotawaitinglistofoutsiderstotaketheplaceofthese
members,thenthehigherrevenuesgeneratedbytheminimumspendingplanwillhaveto
offsetthelostduesandotherchargesfromthosememberswhoquit.
Thus, in assessing the effect of a minimum spending plan, we should also
considertheeconomicimpactontheclubofreducingthemembership,unlessthereisa
waitinglist.Inadditiontocausingsomecurrentmemberstoquit,theminimumspending
planwillalsocausetheclubtobelessattractivetoprospectivemembers.Sincepeople
valuefreedomofchoice,prospectivememberswillprefertobelongtoaclubthatdoes
nothaveaminimumspendingplan.
Onecanquarrelwiththetreasurer'scomments.Inthefirstparagraph,thereare
options todealing withthe deficit otherthanpassingitthroughtothemembers and
raisingtheirduesthroughassessmentsoraspendingplan.Onecantrytounderstandwhy
Chapter 6
6-6

revenuesaredownandtakeactionstocorrecttheproblem.Also,ifrevenuesaredown,
expensesshouldfalltotheextentthattheyarevariable.
Inthesecondparagraph,theissueof"fairness"israised. It'snotclearwhya
spending plan is any more "fair" than the current scheme. It is not "fair" to those
memberswhojoinedtheclubnotwantingtospendmoneyintherestaurantandthinking
therewasnominimumspendingplantohaveoneimposedonthem.Finally,inthethird
paragraph,thetreasureriscorrectinsayingthatmoreaccuraterevenueforecastscanbe
generated,buttheargumentthatwastewillbereduceddoesnotfollow.Overthemonth,
eachmemberwillspendatleast$50,butitisstilldifficulttopredictdiningvolumeona
daybydaybasis,whichisrequiredtobeabletoorderfoodtoreducewaste.Moreover,
diningvolumewilltendtobehigherlateinthemonthasmembersseektouseuptheir
minimums,therebycausingpeakloadproblemsofstaffingandservicedeterioration.
P611:
a.
SolutiontoCoatingDepartment(20minutes)
[Identifyingfixedandvariablecostsforaflexiblebudget]
Thefirststepinidentifyingtheflexiblebudgetisdeterminingwhichaccountsare
fixedandwhicharevariable.Giventhedataintheproblem,onewaytoidentify
fixedandvariablecostsistocomputetheunitcostperyear(totalcostcoating
hours)andseeiftheunitcostisrelativelyconstantoverthewidevolumeswings
observedin20042006.Thefollowingtabletakesthetotalcostdataanddivides
thembymachinehours.
Coatingmaterials
Engineeringsupport
Maintenance
Occupancycosts(squarefootage)
Operatorlabor
Supervision
Utilities
2004
$4.11
$2.24
$2.87
$2.20
$9.26
$3.72
$1.03
2005
$4.10
$4.08
$4.28
$3.44
$9.33
$5.65
$1.05
2006
$4.12
$2.06
$2.38
$1.78
$9.69
$3.25
$1.06
Fromthistable,weseethatcoatingmaterials,operatorlabor,andutilitieshave
fairlyconstantunitcostsindicatingthattheseitemsareprobablyvariablecosts.
Fixed costs include engineering support, maintenance, occupancy costs, and
supervision. Basedontheprecedinganalysis,wecannowestimatefixedand
variablecostsfor2007byseparatingcostsintofixedandvariablecomponentsas
inthenexttable.
Chapter 6

6-7
Variablecosts:
Coatingmaterial
Operatorlabor
Utilities
Totalvariablecost
Fixedcosts:
Engineeringsupport
Maintenance
Occupancycosts
Supervision
Totalfixedcost
2004
2005
2006
Average
Random
Walk
$4.11
9.26
1.03
$4.10
9.33
1.05
$4.12
9.69
1.06
$4.11
9.43
1.05
$14.59
$4.12
9.69
1.06
$14.87
$27,962 $34,295 $31,300 $31,186

35,850 35,930 36,200
35,993
27,502 28,904 27,105
27,837
46,500 47,430 49,327 47,752
$142,768
$31,300
36,200
27,105
49,327
$143,932
In estimating 2007s costs, given we do not have specific data on expected

relativepricechanges,wecaneithertakeanaverageofthelastthreeyearsdata
foreachcostcategory,orwecanassumethat2007willlookmostlike2006.This
lastassumptioniscalledarandomwalkmodel:ourbestestimateofthefutureis
themostrecentobservationofthepast.Therefore,wehavetwoflexiblebudgets:
Expectedcosts=$142,768+$14.59permachinehour
Expectedcosts=$143,932+$14.87permachinehour
b.
Thefollowingtablecalculatesthecoatingdepartmentscostpermachinehourfor
2007usingbothanaverageoftheannualcostsandarandomwalk.
Variablecostpermachinehour
Times:Expected2007machinehours
Totalvariablecosts
Plus:Fixedcost
Budgetedcosts
Expected2007machinehours
Costperhourincoatingdepartment
Chapter 6
6-8
Average
$14.59
16,000
$233,333
142,768
$376,102
16,000
$23.51
Random
Walk
$14.87
16,000
$237,920
143,932
$381,852
16,000
$23.87

P612:
SolutiontoMarketingPlan(20minutes)
[Longrunversusshortrunbudgets]
Approvetheadvertisingcampaign,butonlythefirstyearoftheplan.Approving
theplaningeneralandspecifically authorizing theoneyearbudgetgivesJensenthe
flexibilitytomoveaheadontheprogram. Thereisnocompellingcaseforgrantinga
threeyearbudget forthis advertising campaign, while there aresome reasons not to
approveallthreeyearsnow.Thedisadvantagesofgrantingathreeyearbudgetinclude:
a.
b.
c.
d.
e.
Newinformationwillbecomeavailableoverthenextthreeyearsregardingthe
companysotherproducts,profitability,competition,etc.Byapprovingallthree
yearsnow,seniormanagementgivesupdecisionmonitoringrightsoverthenext
threeyears.Thismakesitmoredifficulttoassembleandtakeadvantageofnew
informationwhenitbecomesavailable.
Jensen can have the project approved for the first year. This is a tentative
approvalfortheentirethreeyears,butseniormanagersreservethedecisionrights
toreviewandmonitorperformanceoverthethreeyears.Ifsheisgivenathree
yearbudget,thereislessmonitoringofresultsthanifthreeoneyearbudgetsare
approved.
ThreeoneyearbudgetswillrequireJensentomakeapresentationeachyearof
theresultstodateandprojectedbenefitsofcontinuingtheprogram.Thus,three
oneyear budgets are more likely to force Jensen and senior managers to
communicate more information about the ad campaign, its results, and other
relatedaspectsofthebusiness.
Settingasinglethreeyearbudgetthatdoesnotlapseattheendofeachyearsetsa
precedentinthefirm. Othermanagerswillrequestsimilartreatment. Annual
budgets that lapse are a mechanism to control agency problems. Allowing
exceptionstoannualbudgetlapsingwillreducemonitoringandlikelyincrease
agencyproblems.
SettingasinglethreeyearbudgetproducesdifferentincentiveeffectsforJensen
thanthreeoneyearbudgets.Presumably,Jensenwillexertmoreeffortattheend
ofeachofthethreeyearspreparingforthebudgetreviewthanifthereisjustone
review at the end of three years. But this of course depends on how the
performance evaluation and reward systems operate in conjunction with the
budgetreviewprocess.
P613:
SolutiontoPotterBowen(20minutes)
[Topdownbudgetingandincentives]
PBs sales budgeting system is essentially a topdown approach. Senior

managementforecaststotalsalesandunitpricesatthefirmwidelevelanddistributesthis
plantothedivisions,andthentotheregions,andfinallytotheindividualsalespeople.
Chapter 6

6-9
Thetotalprojectedsalescascadesdownthroughthesalesforcebasedonhistoricalsales
patterns. Thisbudgetingproceduredoesnotprovidefortheassemblingofknowledge
fromlowerlevelsinthefirm,namelythesalesforce. Theyarenotaskedhowmany
6103seachcansell. Theyaretoldhowmanytheywillsell. Itisnotabottomup
budgetingprocess.Thus,thefirstpointtonoteisthebudgetsystemdoesnotassemble
knowledgefromlowerlevelsoftheorganization.
Whilethebudgetingsystemdoesnotassemblespecializedknowledgefromlower
levelsofPB,itdoessolvetheproblemofsalespeopleunderforecastingsalestomore
easily meet their sales quotas. Budgeting systems entail tradeoffs between decision
managementanddecisioncontrol.PBisusingthebudgettosetsalesquotastomotivate
and compensate its sales force. While PBs system does not emphasize decision
management,itreducesmanyoftheproblemswithdecisioncontrol.
PBs budgeting and compensation systems will lead to some dysfunctional
behavior.Growingregionsandsalesterritorieswithinaregionwillfinditeasiertomeet
theirtargetsandthusreceiveagreaterbonusthanshrinkingterritories.Therefore,itwill
bedifficultforPBtokeepitsbestsalespeopleindecliningterritories.Salespeoplewill
tendtogravitatetothoseterritoriesexpectedtohaveaboveaveragegrowth.
Salespeople have incentives to maximize dollar sales, not profits. Therefore,
individualsalespeoplehaveincentivestoofferpricediscountstogeneratesales.
AnotherproblemwiththePBsystemsisthatitratchetsupthebudgetbasedon
pastperformance.Salespeopleknowingthiswilltendtowithholdsalesiftheyarebelow
90percentorabove150percent. Ifsalesarebelow90percentorabove150percent,
additionalsaleswilljustincreasetheirnextyearstargetwithoutprovidinganycurrent
yearbonus.Thussalespeoplewilltrytodeferthesesalesintothenextfiscalyear.
Havingsuchwidebreakpoints(tenpercentagepoints)causessalespeopleatthe
endoftheyeartowithholdsalesifthesaledoesnotputthemintothenextcategory.For
example,supposeasalespersonhadachieved134percentofhis/hertargetfortheyear
anditisDecember14.Thepersonwilltrytodelayrecordingsalesbetweenthe14thand
the31stuntilthenextbudgetperiodunlessthesesalespushthepersonintothe140150
percentcategory.
Chapter 6
6-10

P614:
SolutiontoFederPurchasingDepartment(20minutes)
[Solvingforfixedandvariablecostgiventheflexiblebudget]
Actualspending
Unfavorablevariance
Flexiblebudget@9,300units
$1,175,000
41,400
$1,133,600
First,writedowntheflexible budgetsforthebeginningandendofFebruary.
Therearetwoequationsintwounknowns(FCandVC).Subtractoneequationfromthe
othertogetoneequationinoneunknown(VC).Thensolvefortheotherunknown(FC).
$1,133,600
1,076,400
57,200
VC
FC
P615:
=
=
=
=
FC + VC9,300 (EndofFebruaryflexiblebudget)
FC + VC8,200 (BeginningofFebruaryflexiblebudget)
1,100VC
$52
= $1,133,600$529,300
= $650,000
SolutiontoEcommerceCompanies(20minutes)
[Shortrunversuslongrunbudgets]
Oneyear (or shortterm) budgets are used as both decision management and
decisioncontrolmechanisms.Theyhelpassembleknowledgefordecisionmaking,and
arealsousedasbenchmarksinperformanceevaluation.Obviously,thesetwofunctions
involvetradeoffs.Threeyearbudgetsareusedalmostexclusivelyasplanningdocuments
tohelpassembleinformationfordecisionmaking.Theexecutivesinthecompanyusing
both one and threeyear budgets must believe that they (and their colleagues) have
substantialspecializedknowledgeoflongterm(threeyear)cashflowsandtrends;and
that the benefits of assembling this knowledge outweighs the costs of the budgeting
process.Thenatureoftheknowledgeheldbythemanagersintheothercompanymust
beofshorterduration.
Also,thecompanywiththethreeyearbudgetmightbeworriedthatonlyusinga
oneyearbudgetmaycreateshortrunincentivesformanagerstocutspendingonR&D
andadvertising.
Chapter 6

6-11
P616:
a.
SolutiontoAccess.Com(20minutes)
[Budgetratcheting]
Ifactual sales exceed budgeted sales in the year, next years target is raised.
However,ifactual salesfallshortofbudget,nextyearsbudgetdoesnotfall
much. LookingatA.C.Chensdatarevealsthat90percent ofChensgood
performance is added to the current budget whereas only 10 percent of any
shortfallsaresubtracted.
1999: 1.614=1.470+a(1.6301.470)
2000: 1.785=1.614+a(1.8041.614)
2001: 1.775=1.785+b(1.6851.785)
b.
=>
=>
=>
a=0.90
a=0.90
b=0.10
Advantagesofratcheting:
Budgetratchetingissimpleandinexpensivetoimplement.Nocostlymarket
researchorlongrunplanningstaffsarerequired.
Ratchetingisobjectiveandgeneratesminimuminfluencecosts.
Disadvantagesofratcheting:
Beingatopdownapproach,itdoesnotassembleknowledge.
It produces dysfunctional incentives when performance is above budget
salespeoplehaveadisincentivetomakeadditionalsalessinceadditionalsales
raisenextyearstarget.
Ratchetingdoesnotcontrolforvariationingrowthacrossdifferentmarkets.
Thisleadstoaselfselectionintheworkforce.Goodsalespeoplewilltendto
quit if they are in low growth markets and bad sales people will stay in
growingmarkets.
P617:
SolutiontoVidex(20minutes)
[BudgetRatcheting]
a.
VidexisratchetingMarthaRamerizsbudget.Whensheexceedsherbudget,next
yearsbudgetisincreasedby80percentofthedifference.Thebudgetinyear7
willbesetat$907,000,calculatedas:80%($908,000$901,000)+$901,000=
$906,600,whichroundsupto$907,000.Noticethatinsettingthebudget,Videx
isroundingupallcalculationstoeventhousands.
b.
WhenRamerizfallsshortofbudget,thebudgetfornextyearisthesameasthe
budgetforthecurrentyear. Ifhersalesinyear7are$900,000,herbudgetfor
year8remainsat$901,000.
Chapter 6
6-12

P618:
a.
SolutiontoAugustCompany(25minutes)
[Staticversusflexiblebudgettogaugeperformance]
Asampleperformancereportforthemonthisgivenbelow:
AugustCompany
PerformanceReport
CurrentMonth
I
Revenue
less:
Variablecosts
Contributionmargin
less:
Fixedcosts
Profits
II
III
Actual
$42,120
Variance
(III)
$2,120F
IV
Flexible
Budget
(at5,200)
$41,600a
Static
Budget
$40,000
V
Variance
(IIIV)
$520F
15,000
$25,000
17,160
$24,960
2,160U
$40U
15,600b
$26,000
1,560U
$1,040U
10,000
$15,000
12,000
$12,960
2,000U
$2,040U
10,000
$16,000
2,000U
$3,040U
5,200$8
5,200$3
b.
Thequestiontoaddressiswhetherperformanceshouldbegaugedagainstastatic
budgetoraflexiblebudget.ColumnIIIintheabovereportbenchmarkscurrent
performanceagainstthestaticbudgetandshowsthatwhilerevenueswerebetter
thanplanned,variablecostsmorethanconsumedthefavorablerevenuevariance.
Whentheunfavorablevarianceinfixedcostsisconsidered,profitswere$2,040
(13.6percent)belowbudget.
Thelasttwocolumnsinthetabletakeadifferentperspective. Herethe
benchmarkisnotthestaticbudgetat5,000unitsbutratherwhattheresultsshould
havebeengiventhevolumeof5,200units.Inthiscase,profitsfell$3,040(19
percent)shortoftheflexibleplan.Therewasafavorablepricevarianceof$520
[($8.10$8.00)5,200].Ifourcoststructurestayedthesame,thenavolumeof
5,200unitsshouldhavegeneratedprofitsof$16,000.Butvariablecostsperunit
rosemorethanprices,causinganunfavorablecontributionmarginvarianceof
$1,040.Whenthe$2,000unfavorablefixedcostvarianceisincluded,thereisan
unfavorablevarianceinprofitsfromtheflexiblebudgetof$3,040.
Therefore,thequestionis: shouldthemanagersbeheldaccountablefor
thevolumechangesornot?
Chapter 6

6-13
P619:
SolutiontoInternationalTelecon(25minutes)
[Budgetlapsing]
a.
Thepayrolldatadoesnotexhibitanystrongseasonaltimeseriespatternwithin
theyear.PayrollrisesslightlyinOctoberandNovemberinallthreeyears,but
Decemberislowerintwoofthethreeyears.Andtheincreaseinthelastthree
monthsisnotlargerelativetootherswingsduringtheyear.Sincepayrolldoes
notexhibitanystrongupsurgeattheendoftheyear,itisunlikelythatIThasa
majorseasonalcomponentinthelastquarterofitsfiscalyearthatwouldcause
suppliestorise.
However,thereisaverylargeandpersistentriseinthelastthreemonths
ineachofthelastthreeyearsforsupplies.Thispatternisconsistentwithrisk
aversecostcentermanagersholdingbacksomeoftheirsuppliesbudgetduringthe
yearandthenspendingtheremainingsuppliesbudgetinthelastthreemonths,
especiallyinDecember.ItishighlylikelythatITrequiresanyunspentsupplies
budgettobeforfeited(budgetlapsing).Largeunspentfundsinoneyearprobably
reducethenextyearssupplybudget.
b.
Budgetsthatlapsecausecostcentermanagerstodowastefulthingsattheendof
the year to spend any remaining funds. Wasteful activities include making
purchasesathigherthannormalprices,payingforrushdeliveries,andbuying
itemsvaluedbythefirmatlessthantheircost.
Itisimportanttonotethedifferenceinincentivesbetweencostandprofit
centermanagersregardingtheirsuppliesexpenditures.Profitcentermanagersdo
nothavethesameuseit orloseit mentality, becauseanyunspentsupplies
increaseprofits.Iftheprofitcentermanagerbudgets$100,000forsuppliesbut
onlyspends$85,000,the$15,000unspentbudgetcausestheprofitcentersprofits
tobehigherbythatamount.Costcentermanagers,ontheotherhand,haveless
incentivetoreducesuppliesspending.Savingsarenotdirectlyrewarded,unless
themanagersperformanceisevaluatedbycomparingactualsuppliesspendingto
budgetedsuppliesspending.
Onewaytoreducethespendingonsuppliesistochangethecostcenter
managers performance evaluation system. By placing more emphasis on
showing favorable budget variances (actual spending less than budget), cost
centermanagershaveincentivestoreturnunspentsuppliesbudgets.Theproblem
withthisschemeisthatitalsocreatesstrongincentivesformanagerstoinflatethe
suppliesbudgetestimateatthebeginningoftheyearsotheycanunderspendby
largeramounts.
Anothersolutiontoreducingwastefulendofyearsuppliesexpendituresis
toallowmanagerstocarryoversmallamountsofunspentbudgetstothenext
fiscalyearandnottoreducenextyearsbudgetbytheamountofanyunspent
funds.Forexample,ITcouldallow20percentofthebudgetnotspentinanyone
Chapter 6
6-14

yeartobecarriedovertothenextyear.Also,thecumulativecarryoverfromall
previousyearscannotexceed(say)40percentofthecurrentyear'sbudget.The
reason for this last constraint is to prevent successive year carryovers from
accumulatingtoaverylargeamount.
Budget lapsing is a frequently used policy in most firms to control
managersoverretentionoffunds. Ifbudgetsdidnotlapse,managersaboutto
retireormovetoanewassignmentcouldusetheaccumulatedfundsinwaysthat
enhancetheircareers,butnotthevalueofthefirm.
The benefits of allowing budget carryovers are the eliminated wasted
expendituresmadeattheendoftheyear. Thecostofthecarryoverpolicyis
whenmanagersleavetheirpositionandmakewastefulexpenditures. Also,the
policyasoutlinedaboverequiresadditional(costly)monitoringandbookkeeping
activitiestotracktheamountofcarryoverbudget.
P620:
a.
SolutiontoAdrianPower(30minutes)
[Flexiblebudgeting]
Thefirststepistoconvertthetotalvariablecostsintovariablecostsperunitof
outputandthentousetheseperunitamountstoconstructtheflexiblebudget.
AdrianPower
PlannedLevelofProductionforJanuary
Directmaterials
Directlabor
Indirectlabor
Indirectmaterials
Maintenance
Supervision
Othercosts
Total
b.
Variable
Costsper
unit
$10.00
16.00
1.50
0.75
0.45
Actual
Costs
Incurred
$142,400
259,800
27,900
12,200
9,800
28,000
83,500
$563,600
Flexible
Budget
@15,400
$154,000
246,400
23,100
11,550
6,930
24,700
83,500
$550,180
Variance
$11,600F
13,400U
4,800U
650U
2,870U
3,300U
0
$13,420U
Thedollarmagnitudeofthevariancesislargeenoughtowarrantinvestigation.
Productionlevelsexceededbudgetby10percent(15,400versus14,000units).
There was a very favorable materials variance of $11,600 but all the other
variances(exceptothercosts)wereunfavorable.Itappearsthatintheprocessof
securingalargersupplyofmaterialstomeettheincreasedproductionschedules,
Chapter 6

6-15
lowerqualitymaterialswereprocured,causingtheplanttousemoredirectand
indirectlabor,indirectmaterials,maintenance,andsupervision.Theunfavorable
variancesexceedthefavorablematerialvarianceby$13,420.
P621:
SolutiontoPanarudeAirfreight(30minutes)
[Budgetlapsing]
a.
Underthenewbudgetingscheme,budgetsnowlapsequarterly,asopposedto
annually.Inthisregime,profitandcostcentermanagerswillensurethatunspent
fundsarespentattheendofeachquarterasopposedtotheendoftheyear.This
occurs for two reasons: (i) future budgets are reduced by favorable quarterly
variancesand(ii)managerslosethebenefitsfromanycurrentunspentfundsin
thequarter.Inthissense,thenewbudgetingschemehasnotreallyeliminatedthe
hoardingandspendingbehaviorobservedunderthepreviousscheme,ithasonly
causedittooccurearlierinthefiscalyear.
b.
Thequarterlylapsingofbudgetsislikelyinferiortoannuallapsingforacoupleof
reasons.
(i)
Instead of endofyear spending, there is now endofquarter spending.
Thepresentvalueofthisendofquarterspendingishigherbecausethe
extradollarsthatwouldhavebeenspentinNovemberandDecemberare
nowspentinMarchandJune. Thiscausesthefirmtoloseintereston
thesefunds.
(ii)
Theincreasedmonitoringofquarterlybudgetsbythecentralizedbudget
officeandtheadditionaltimeoperatingmanagersspendattheendofeach
quarterarenotcostless.Managersandtheaccountingpersonnelcouldbe
spending this time in other activities. Thus, the quarterly lapsing of
budgetsgeneratesadditionalopportunitycosts.
(iii)
Thenewscheme imposes farmorecontrolontheoperating managers.
Theyhavelessflexibilitytoalterthetimingoftheirspendingthroughout
theyearascircumstanceschange.Thisisanotherexampleoftradingoff
decisionmanagementfordecisioncontrol.
Unlessthefirmrequiresextremelytightmonitoringofexpendituresonaquarterly
basis, the new budgeting scheme will likely generate costs in excess of the
benefits.
P622:
Chapter 6
6-16
SolutiontoVeriplex(30minutes)
[Budgetaryincentivestoshiftcoststonewstartupproduct]

a.
Analysisofbudgetvariances(euros):
Existinggauges
VTrap
Total
Actual
6.39
1.30
7.69
Chapter 6
Budget
6.60
0.92
7.52
Variance%
0.21F
0.38U
0.17U

6-17
b.
This problem is based on an actual large European multinational companys

experience, and occurs in other firms as well. The Gauge Department is
evaluated asacostcenter. Becauseseniormanagers aresointerested inthis
project, the Gauge Department manager knows they will tolerate a larger
unfavorablebudgetoverruninthenewgaugelinethanintheexistingline.Thus,
thegaugemanagerhasincentivetoshiftcoststonewproducts,therebymaking
theexistingproductslookbetter.
Forexample,supposetherearetwoequallyskilledmachinists,butonehas
beenwiththecompanylongerandreceivesahighersalary. Byassigningthe
oldermachinisttothenewgauges,thenewgaugelinebearsmorecostthanthe
oldgauges. Or,ifanexistingmachine,usedforbothnewandoldgauges,is
refurbishedandmostofthecostcanbejustifiedascausedbythenewgauges,
againtheoldgaugesbenefitandthenewgaugesarechargedthecost.
Thegaugemanagercaneasilyarguethenewgaugecostsareoverbudget
becauseofalltheengineeringchangeordersandtinkeringwiththeproduction
process. That is, the new gauge cost overruns are outside the Gauge
Departments control. The gauge manager has asymmetric information with
respecttohis/hersuperiorstomonitorthecostsofthenewgaugeprogram.Given
thestartupnatureoftheprogram,thereislittlehistorytobenchmarkthenew
gauge program. Thus, it is harder to monitor these expenditures by senior
managersandconsequentlyitiseasierforthegaugemanagertoshiftcostsfrom
theexistinggaugestothenewgauges.
Otherpossiblereasonsforthepatterninclude:
i.
TheGaugeDepartmentactuallydivertedrealresourcesfromthe
oldgaugelinetothenewline,andthisiswhatcausedthebudget
pattern.Seniormanagementwassofocusedonthenewlinethat
thegaugemanagershiftedrealproductionresourcesfromtheold
tothenewlines. Theproblemwiththisisthatifrealresources
wereshiftedfromtheoldgauges,howwastheGaugeDepartment
abletomeettheproductionquotasforbothlines?
ii.
Learningcurveeffectsnotbuiltintothebudgetcausetheexisting
products to be overbudgeted and new products to be under
budgeted.
iii.
Sincethebudgetnextyearisbasedinpartoncurrentspending,
newproductswillhaveoverrunsinearlyyearsasawaytobuildin
slackforlateryears.
Chapter 6
6-18

P623:
a.
SolutiontoMadiganModems(30minutes)
[Staticversusflexiblebudget]
Staticbudgetvariance:
Totalproductioncost
b.
Actual
Budget
$1,114,800
$1,120,000
Actual
Budget
Variance
$5,200F
Flexiblebudgetvariance:
Variablecosts(@$1601/unit)
Fixedcosts
Totalproductioncost
$631,800
483,0002
$1,114,800
$624,0003
480,000
$1,104,000
Variance
$7,800U
3,000U
$10,800U
$640,0004,000units
$1,114,800$631,800
3
3,900units$160
1
2
c.
Memobasedonstaticbudget: Theproductionmanagerdidwell. He/shewas

underbudgetedexpendituresby$5,200.
d.
Memo based on flexible budget: The production manager performed poorly.

Giventheactualvolumeof3,900units,variablecostswere$7,800overbudget.
Fixedcostswere$3,000overbudget.
e.
In this production setting, the flexible budget probably better reflects the
productionmanagersperformance.Sincethedecisiontodeviatefrombudgeted
volumeof4,000unitsisnotlikelyunderthecontroloftheproductionmanager,
thentheflexiblebudgetholdsthemanagerresponsibleforthevariablecostsper
unitproducedandallthefixedcosts.Iftheproductionmanagerisevaluatedon
thestaticbudget,he/shehasanincentivetoproducefewerunitsthanbudgetedto
savethevariablecosts.
P624:
a.
SolutiontoCityHospitalNursing(35minutes)
[Lineitembudgets,specializedknowledge,andcontrol]
ThemajortypeofspecializedknowledgeJonesacquiresinpreparingtheschedule
istheworkingpreferencesofherstaff.Nextmonthonenursewantstoworkonly
weekends,anotherwantsnightsbecausethekidsarehomefromschool,etc.
Chapter 6

6-19
b.
Giventhesetofconstraints onMaxineJonesstaffingdecisions (i.e.,shehas

fewerdecisionrightsthanhercounterpartsinprivatehospitals),sheislessableto
take advantage of her specific knowledge of nurse preferences. This has a
numberofconsequences:
c.
CityHospitalisoperatedunderalineitembudgetinwhicheachtypeofnurseisa
separatelineitem. MaxineJonesisunabletosubstituteacrossnursingtypes.
Lineitem budgets are very common in governmentowned andoperated
enterprises.Theyprovidemuchmorecontrolthanbudgetswherethesupervisor
can freely substitute among nurse types. They transfer the decision rights to
substituteamonglineitemstohigherlevelsintheorganization.
Giventheadverseconsequencesofsuchsystemsasidentifiedinpart(b),
the interesting question is why do such systems exist? What benefits are
achieved? Inaprivatehospital,presumablythereisclosermonitoringbythe
boardofdirectorsandhospitaladministrationthanintheCityHospital.Thereare
probablyfewerdemandsplacedonprivatehospitalsthancityhospitals.Private
hospitals havemore freedom todecide the niche theywishto fill. TheCity
Hospitalhaslessfreedomtodenypatientaccess. Ifaprivatehospitalfailsto
coveritsexpenses,thedisciplineofthemarketplacewillcloseitdown.Thereis
muchlessmarketdisciplineintheCityHospital.Governmentsareloathtodeny
healthservices. SincetheCityHospitalhaslessincentivetoberunefficiently,
agencyproblemsarelikelygreater.Andonewaytoreduceagencyproblemsisto
limitthedecisionrightsofagents. WhileMaxineJoneshaslessdiscretionto
Chapter 6
6-20
Theaveragequalityofnursingserviceswillbelowerornursingcostswillbe
highersinceJonesislessabletosubstituteamongalternatives. Jonescant
substitutetwonursepractitionersandaparttimeregisterednursefortwofull
timeregisterednurses,forexample.SinceJonesismoreconstrainedthanher
private counterparts in substituting among nursing types to meet schedule
requests,shewillnotbeabletocompeteaseffectivelyandthiswillcause
nursingcoststoriseornursingqualitytofall,orsomecombinationofthetwo.
TherewillbemoreturnoverofnursesatCityHospital.
TherewillbemoreforcedbedclosingsinCityHospitalthanotherhospitals.
SinceJonesislessabletocompetewithprivatehospitalsfornursesandwill
havemoreturnover,shewillviolateminimumstaffinglevelsmorefrequently.
Theseviolationswillcausebedstoclose,asnewpatientswillbeprevented
frombeingadmittedtoanunderstaffedunit.
SinceMaxineJoneshaslessflexibilityinusingthespecializedknowledgeshe
acquires of nursing schedule preferences, she will acquire less of this
specializedknowledge.Shewillappeartobecomeanuncaringgovernment
bureaucrat.

changestaffingmix,shehasmuchlessabilitytoimposeagencycostsonthecity
byoverstaffingtheunitorbygivinggoodworkschedulestoherfriends.
P625:
SolutiontoMaddenInternational(35minutes)
[Sharingofspecializedknowledgeviaintensivebudgetingandfinancial
reviews]
a.
(i)
Strengths:
constantinteractionandcommunicationamongallthemanagers
generatescollectionofspecificknowledgeaboutmarkets,products,
industry
encouragesvaluemaximization
stimulatessharingofspecializedknowledgeacrossmanagers
forcesmanagerstoplanforshort&longrun
better decision making helps separate the effects of
unforeseen/uncontrollablecosts
encourages localrisktakingwhichisdiversifiableatthecorporate
level
uniformity of procedures for evaluation across the firm (facilitates
knowledgetransfers)
not being evaluated on budget reduces the incentives to shade
estimates
(ii)
Weaknesses:
verytimeconsumingforseniorandcorporatemanagement
compensation is very subjective, not tied to meeting objective
performancecriteria
fiveyearplanshavelittle valueinrapidly changingworld(except
theyforcemanagerstothinkahead)
comparabilityacrosssubsidiariesdifficult
b.
GiventhecomplexityofthemarketsinwhichMaddenoperatesandtherateof
changeinthesemarkets,Maddenssuccessandvaluedependcriticallyonthe
generation, collection, and dissemination of specialized knowledge. A very
formal,structuredbudgetsystemforcesmanagerstocommunicatefrequently.In
the setting of the budget and in financial review committees, this specialized
knowledgeiscommunicated.
To illustrate the preceding point, consider the following analogy.
Elementaryschoolsholdschooldancesfor11and12yearolds.Usually,theboys
wouldbeononesideoftheroomandthegirlsontheother.Togettheboysand
girlstodance,theboyswouldbeplacedinonelineandthegirlsinasecondline
andthenthetwolineswouldbepairedupanddancepartnersassigned.
Chapter 6

6-21
Inmanyways,theveryformal,highlystructuredbudgetschemeislike
requiringpreteenagechildrentolineupatadance.Itisawaytoforcepeoplein
differentfunctionalareassuchasmarketing,manufacturing,andR&Dtoshare
theirspecializedknowledgewithdifferentpartsofthesubsidiaryandcorporate
headquarters.Normally,marketingpeoplewouldonlytalktomarketingpeople,
financepeopletofinancepeople,andsoforth.Becausetheworldischangingso
rapidly, crossfunctional meetings must be more frequent. Without such an
elaborate system, meetings would be less frequent and there would be less
communicationbetweenmarketing,manufacturing,andR&Dpeople.
Inordertoencouragepeopletoshareknowledge,verylittleweightshould
beplacedonusingbudgetsasaperformanceevaluationscheme. InMaddens
situation,tomaximizethevalueofthebudgetsystemfordecisionmanagement
(i.e.,sharingspecializedknowledge),verylittleweightisplacedonusingbudgets
fordecisioncontrol(i.e.,performanceevaluation).
Also,thehighuncertaintyintheenvironmentmakesitdifficulttoattribute
thesuccessofanewinnovationtoagivenmanagersactions.
P626:
SolutiontoCalenCo.(CMAadapted)(35minutes)
[Budgetingproductionandcontributionwithcapacityconstraints]
a.
Product
401
403
405
Totalrequired
Totalavailable
Excess(deficiency)
MachineHoursRequirements
Department
1
2
3
500
500
1,000
400
400
2,000
2,000
1,000
2,900
2,900
2,000
3,000
3,100
2,700
100
200
700
4
1,000
800
1,000
2,800
3,300
500
Product
401
403
405
Totalrequired
Totalavailable
Excess(deficiency)
DirectLaborHoursRequirements
Department
1
2
3
1,000
1,500
1,500
400
800
2,000
2,000
2,000
3,400
4,300
3,500
3,700
4,500
2,750
300
200
(750)
4
500
800
1,000
2,300
2,600
300
Chapter 6
6-22

Themonthlysalesdemandcannotbemetforallthreeproductsasaresultofthe
laborshortageinDepartment3.
b.
Thegoalistomaximizecontributionmargin.Fixedcostsarenotrelevant.The
scarceresourceisdirectlaborhours(DLH)inDepartment3.Calenshouldfirst
producetheproductthatmaximizescontributionmarginperthescarceresource
(DLH). Inthiscasetwoproducts,401and405,requiredirectlaborhoursin
Department3.
Salesprice
Variablecosts
Directmaterial
Directlabor
Variableoverhead
Selling
Totalvariablecosts
Contributionmargin
Product
401
405
MaximumDLH
Availablein
Department3
Produce405first
Produce401second
Product
401
403
405
$196
$123
$167
$7
66
27
3
$103
$93
$13
38
20
2
$73
$50
$17
51
25
4
$97
$70
Contribution
Margin
$93
$70
Department
3DLH
3
2
Contribution
Margin
PerDLH
$31
$35
Units
Department
3DLH
Required
Balance
1,000
250
Chapter 6
2,000
750
2,750
750
0

6-23
ResultingProductionSchedule
Product
401
403
400
405
1,000
Product
401
403
405
Total
c.
Units
250
Comments
Produceasmuchasconstraintallows
(7503DLH/unit).Reducedpro
ductionisbasedonitslowercontribution
marginperdirectlaborhour.
Produceuptomonthlysalesdemand;
unaffectedbyDepartment3.
Produceasmuchaspossibletomaximize
contributionmarginperDLH.
ContributiontoProfit
Contribution
Units
Margin/Unit
Produced
$93
250
$50
400
$70
1,000
Contribution
toProfit
$23,250
20,000
70,000
$113,250
Tosupplytheadditionalquantitiesof401thatarerequired,CalenCo.should
consider:
subcontractingtheadditionalunits.
operatingonanovertimebasis.
acquiringlaborfromoutsidethecommunity.
raisingtheprice(therebyloweringquantity)ofproducts405and401to
reducethelaborhourdeficiencyinDepartment3.
Inpartbsomestudentswillincorrectlyincludefixedoverheadinthecalculation
ofcontributionmarginasperthefollowing:
Chapter 6
6-24

Salesprice
Variablecosts
Directmaterial
Directlabor
Variableoverhead
Fixedoverhead
Selling
Totalvariablecosts
Contributionmargin
Product
401
405
MaximumDLH
Availablein
Department3
Produce401first
Produce405second
Product
401
403
405
Total
Product
401
403
405
$196
$123
$167
$7
66
27
15
3
$118
$78
$13
38
20
10
2
$83
$40
$17
51
25
32
4
$129
$38
Contribution
Margin
$78
$38
Department
3DLH
3
2
Contribution
Margin
PerDLH
$26
$19
Units
Department
3DLH
Required
Balance
500
625
1500
1250
ContributiontoProfit
Contribution
Units
Margin/Unit
Produced
$78
500
$40
400
$38
625
Chapter 6
2,750
1250
0
Contribution
toProfit
$39,000
16,000
23,750
$78,750

6-25
AdifferentallocationofDepartment3DLHoccursbecausedifferentcontribution
marginsresult. Itisimportanttorecognizethateachadditionalunitproduced
doesnotcausethefirmtoincuradditionaldollarsoffixedoverhead.
P627:
a.
SolutiontoRepublicInsurance(40minutes)
[Sovietstyleincentiveschemes]
Thefollowingtablecomputeshowtotalcompensationvarieswiththebudgeted
salesnumbers:
Actualsales,S
100
100
100
100
100
100
100
100
Reported
Budget,B
75
90
99
100
101
102
110
120
SB
25
10
1
0
(1)
(2)
(10)
(20)
BS
(25)
(10)
(1)
0
1
2
10
20
Comp.if
S>B
$28,000
$29,200
$29,920
$30,000
Comp.if
S<B
Change
$30,000
$29,700
$29,400
$27,000
$24,000
$1,200
$720
$80
($300)
($300)
($2,400)
($3,000)
Thesalespersonexpectingtosell100policieswillmaximizehisorher
compensationattheendoftheyearbyreportingtruthfullythattheywillsell100
policies.
Chapter 6
6-26

b.
Oneadvantageofthecompensationplanisthatitdoesinducetruthfulreporting
ofexpectedsales.Anotheradvantageisthatitrewardsthesalespersonforselling
morepolicies.Thatis,oncethebudgetisset.Eachadditionalpolicysoldeither
pays$20(ifS>B)or$400if(S<B).
Tobetterexaminethecompensationplan,rewritetheequations:
Totalcompensation=$20,000+$80B+$20S
$20,000$300B+$400S
ifSB
ifS<B
Youcanseefromtheseequationsthatoncethebudgethasbeensetat
somefixedB,thesalespersonhasanincentivetoselladditionalpolicies,evenif
theycauseS>B. Onemightquestiontheverylargechangeinthebonusper
policysoldatthepointwhereB=S.Supposethebudgetissetat100policies.
Sellingupto100policies,thesalespersonreceives$400perextrapolicy.After
sellingmorethan100policies,eachadditionalpolicyisworthonly$20.Doesthe
marginaldisutilityofsellinganadditionalpolicyafter100policiesdecreaseso
steeply? Moreover,suchalargedifferencewillcausesalespeopleabovetheir
targets to sell their extra policy sales to salespeople below their targets.
Alternatively,salespeopleabovetheirbudgetwilltrytodelaythesaleintothe
nextyear.
Thereisan$80penaltyforunderforecastingbuta$300penaltyforover
forecasting. Again,itisnotclearwhythetwopenaltiesshouldbesodifferent.
Thiscouldbiasariskaversesalespersontobiastheirforecastsdown.
P628:
SolutiontoOldRosebudFarms(40minutes)
[Flexiblebudgetsandperformanceevaluation]
Intermsofthestaticbudgetpresentedintheproblem,themanagementofRosebud
Farmshadlessvolume(boardingdays)thanexpected.Revenueswere$167,900under
the static budget. Likewise, expenses were under budget by $12,468 for variable
expensesand$11,000forfixedexpenses.Basedonthefavorableexpensevariancesin
Table1,oneistemptedtoconcludethatvolumefell,butoperationswerefinegiventhe
reducedvolume. However,the$12,468underbudgetvariableexpensesismisleading
because it is based on a much higher volume of boarding days than were actually
achieved.Therefore,onemustlookatvariableexpensevariancesusingaflexiblebudget
analysisperthefollowing:
Chapter 6

6-27
OldRosebudFarms
FlexibleBudgetIncomeStatement
YearEnded12/31
Budget
Formula
(permare
perday)
Numberofmares
Numberofboardingdays
Price
$25
Revenues
Lessvariableexpenses:
Feed&supplies
5.00
Veterinaryfees
3.00
Blacksmithfees
.30
Contributionmargin
$16
.70
Lessfixedexpenses:
Depreciation&insurance
Utilities
Repairs&maintenance
Labor
Netincome
Actual
Flexible
Budget
Variance
52
18,980
$20
52
18,980
$25
0
0
$5U
$379,600
$474,500
$94,900U
104,390
58,838
6,074
$210,298
94,900
56,940
5,694
$316,966
9,490U
1,898U
380U
$106,668
56,000
12,000
10,000
88,000
$44,298
56,000
14,000
11,000
96,000
$139,966
0
2,000F
1,000F
8,000F
$95,668U
Now all of the variable expense categories are showing unfavorable variances.
Insteadofshowinganunfavorablenetincomevarianceof$144,432usingastaticbudget
asinTable1,aflexiblebudgetanalysisshowsanunfavorablenetincomevarianceof
$95,668. Partofthisdifferenceisduetothevariableexpensesbeinghigherthanthey
shouldhavebeengiventheactualnumberofboardingdays.
Also,ananalysisofrevenuesrevealsthatnotonlywasthenumberofboardingdays
lessthanforecasted,thepriceactuallyrealizedperboardingdayturnedouttobe$20per
day instead of the budgeted $25 per day. Therefore, the static budget unfavorable
revenuevarianceof$167,900canbedecomposedintoanunfavorablepricevarianceof
$94,900 and an unfavorable quantity variance of $73,000 per below. (Chapter 12
describespriceandquantityvariancesinmoredetail).
Chapter 6
6-28

Actualprice(379,600/18,980)
Pricevariance[($2520)18,980]
Quantityvariance[(18,98021,900)$25]
Actualrevenuelessstaticbudget($379,600547,500)
$20
$94,900U
73,000U
$167,900U
U(F)denotesunfavorable(favorable)variance.
P629:
SolutiontoTroikaToys(40minutes)
[Flexiblebudgetingandperformanceevaluation]
ThefollowingtablereportsbothactualandbudgetedperformanceontheTroika
Toysaccount:
VarianceReport
TroikaToys
Actual
Amounts
Flexible
Budget
Variance
$26,400
$26,400
10,320
9,900
420U
4,350
4,120
230U
OfficeandOccupancyCosts
1,690
1,320
370U
TotalCosts
$16,360
$15,340
$1,020U
Profits
$10,040
$11,060
$1,020U
Revenue(220hours@$120)
DesignLabor
Artwork
MemotoExecutiveCommittee
Ms.Bentgeneratedmorebillablehours(220)thanwereinitiallybudgeted(150to
200)becauseofsuperiorperformanceandcustomeracceptance.However,theprofitson
thisprojectwere$1,020belowwhattheyshouldhavebeenhadshestayedwithinthe
budget. Sheusedmoreexpensivedesigners ($420),moreartwork($230),andmore
office and occupancy costs ($370) than budgeted. While she overran on costs, the
varianceisonly3percentoftotalrevenues.
Insummary,thecostvariancesarerelativelysmall. Ms.Bentgeneratedactual
profitsof$10,040which(evenafterthehighercosts)aresubstantiallyabovetheinitial
midpointofexpectedprofits(175hours)whichwereprojectedtobe$8,450whenthe
contractwassigned.
Chapter 6

6-29
P630:
a.
SolutiontoCellularFirst(40minutes)
[StaticversusFlexibleBudgets]
Thefollowingtablecalculatesthebudgetvarianceusingastaticbudgetbasedon
eightsalespeopleandnoovertime.
Salespeople
Hoursperpersonpermonth
Hourspersale
Averagesalaryperperson
Averagecommission/sale
Overtimewageperhour
Straighthours
Overtimehours
Hours
Sales
Revenue
Salaries
Straighthours
Overtime
Commissions
Profits
Static
Budget
8
160
2
$1,500
$20
$12
Actual
9
160
2
$1,500
$20
$12
1,2801
0
1,280
1,4402
140
1,580
6403
725
Static
Budget
Variance
$51,200
$58,000
$(6,800)
$12,000
0
12,000
12,800
$26,400
$13,500
1,680
15,180
14,500
$28,320
1,500
1,680
3,180
1,700
$(1,920)
()denotefavorablevariances
8salespeople160hourspersalesperson
3
budgetedhours2hourspersale
1
2
Chapter 6
6-30

b.
Thefollowingtablecalculatesthebudgetvarianceusingaflexiblebudgetbased
onninesalespeoplewhosell725newaccounts.
Flexible
Budget
(9salespeople,
salesof725)
Expectedhoursgivensales1
Expectedstraighthours2
Expectedovertime
Revenue
Salaries
Straighthours3
Overtime
Commissions
Profits
Actual
Flexible
Budget
Variance
$58,000
$58,000
$0
$13,500
120
$13,620
14,500
$29,880
$13,500
1,680
$15,180
14,500
$28,320
0
1,560
1,560
0
$1,560
1,450
1,440
10
()denotefavorablevariances
725sales2hourspersale
3
9salespeople@$1500each
1
2
c.
Thestaticbudgetinpartaisusedwhenthemanagerhascontroloverandhenceis
heldresponsibleforvolumechanges,asinthecaseofaprofitcenter. Flexible
budgetsasinpartbaremorelikelyusedwhenthemanagerdoesnothavecontrol
overandhenceisnotheldresponsibleforvolumechanges,asinthecaseofsome
costcenters. Aflexiblebudgetadjustsforvolumechangesandtherefore,does
notholdthemanageraccountableforvolumechanges.
P631:
a.
SolutiontoArtisansShirtcraft(50minutes)
[Preparingabudgetandanalyzingorganizationalissues]
Annualandmonthlyincomestatements:
BudgetedProductionandSalesQuantities
Chapter 6

6-31
FortypercentofallsalesoccurbetweenSeptemberandDecemberandsalesare
divided equally in these months. Given annual sales of 192,000, budgeted
monthlysalesquantitiesarebudgetedat:
Chapter 6
6-32

Sept.Dec.
1993
%ofSales
#ofMonths
%permonth
AnnualSales
SalesperMonth
Revenue($23/unit)
Jan.Aug.
1994
40%
4
10%
192,000
19,200
60%
8
7.5%
192,000
14,440
$441,600
$332,120
Since inventories are expected to be negligible, everything produced

duringaperiodisassumedsoldduringthatperiod.Therefore,monthlypurchase
quantitiesareequaltomonthlyproductionquantities,whichareequaltomonthly
salesquantities.
PurchasingDepartmentBudgetedCosts
ThecostsforwhichPurchasingisresponsiblearedirectmaterialscostsof$7per
shirtanddepartmentaloverheadcostsof$150,000.At192,000shirtsproduced
duringtheyear,theannualbudgetedcostsforPurchasingwouldbe:
192,000$7+$150,000=$1,494,000
Asstatedintheproblem,overheadcostsareincurreduniformlyoverthe
year.Therefore,foranygivenmonthduringtheyear,budgetedoverheadwould
be$150,000/12=$12,500.Purchasing'sbudgetedmonthlycostsare:
ShirtsPurchased
CostperShirt
MaterialsCost
+MonthlyOverhead
MonthlyBudget
Sept.Dec.
1993
Jan.Aug.
1994
19,200
$7
$134,400
12,500
$146,900
14,400
$7
$100,800
12,500
$113,300
ProductionDepartmentBudgetedCosts
As was the case with Purchasing, Production's costs consist of fixed
overhead costs and variable direct costs. For the Production Department,
however,thesevariabledirectcostsconsistnotofmaterialscosts,butsolelyof
laborcosts.Atonehalfhouroflaborpershirtandfixedoverheadof$240,000,
Production'sannualbudgetedcostis:
.5$6192,000+$240,000=$816,000
Chapter 6

6-33
BudgetedoverheadwouldbechargedtoProductionatarateof$240,000/12=
$20,000permonth.Directlaborwouldbeassignedatarateof$6perhour1/2
hourpershirt=$3pershirt.Budgetedmonthlycostsare:
Sept.Dec.
Jan.Aug.
1993
1994
ShirtsProduced
19,200
CostperShirt
$3
MaterialsCost
$57,600
+MonthlyOverhead 20,000
MonthlyBudget $77,600
14,400
$3
$43,200
20,000
$63,200
BudgetedIncomeStatementforArtisansShirtcraft
Budgetedrevenueforthefirmisequaltothebudgetednumberofshirts
timesthebudgetedpricepershirt:
192,000$23=$4,416,000.
Shirtcraft'sbudgetedCostofGoodsSoldwouldbemadeupofallcosts
assignedtoindividualshirts.CostofGoodsSoldconsistsofbothdirectcostsand
indirectcosts.Clearly,boththepricepaidbyPurchasingforrawmaterialsand
the cost of direct labor provided by Production should be assigned to the
individualshirts.Asstatedpreviously,budgeteddirectmaterialscostsanddirect
laborcostspershirtare$7and$3respectively. Thedirect costsassignedto
budgetedCostofGoodsSold,thereforeis($7+$3)192,000=$1,920,000.
Overheadcoststhatareincurredinthecreationofthefinishedproduct
mustalsobeincludedincalculatingbudgetedCostofGoodsSold.Thequestion
statesthatindirectcostsincurredboththroughtheprocessofbuyingrawmaterials
andasaconsequenceoftheproductionoffinishedgoodswillbepartofcorporate
CostofGoods Sold. These costs are budgetedforthe year at$150,000and
$240,000respectively.Sincetherearenoinventoryissues,Shirtcraft'sbudgeted
CostofGoodsSoldfortheyearissimply:
$1,920,000+$150,000+$240,000=$2,310,000
Administrative expenses consist of Sales and Administration overhead
plusexpectedbonuspay:
$750,000+$75,0003=$975,000
Givenbudgetedinterestexpensesof$550,000andexpectedtaxesof40
percent,Shirtcraft'sbudgetedannualandmonthlyincomestatementsare:
Chapter 6
6-34

Revenue
Shirtspurchased
Productioncosts
Costofgoodssold
Sales&
administration
Interest
Pretaxincome
Taxes(40%)
Netincome
b.
Sept.Dec.
1993
Jan.Aug.
1994
12months
ending
8/31/94
$441,600
146,900
77,600
$224,500
81,250
$331,200
113,300
63,200
$176,500
81,250
$4,416,000
1,494,000
816,000
$2,310,000
975,000
45,833
$90,017
36,007
$54,010
45,833
$27,617
11,047
$16,570
550,000
$581,000
232,400
$348,600
GrowthhasproducedtwofundamentalchangesinShirtcraft:
1.
Lendershavebeenaddedasstakeholders. Unabletofinanceitsgrowth
internally, Shirtcraft has relied on debt. This reliance increases the
bankers'powertoinfluenceShirtcraft'sbusinessdecisions. Thebankers
cannowpushthe Montgomery sisters toalign thecompany'sinterests
withthoseofitslenders.
2.
Aseparationbetweenownershipandmanagementhasbeguntodevelop.
As the company grows larger and responsibilities become more
specialized,thesisterswillcontinuetorelinquishcontrolofportionsofthe
business to professional managers. Agency problems increase and
systematic methods of addressing issues such as goal incongruence,
monitoringandinternalknowledgetransferneedtobedeveloped.
Responsibilities become more specialized, presumably, tolink decision

rights with specific knowledge. As this decentralization occurs at Shirtcraft,
control systems are developed to align the interests of managers, owners and
creditorsandfacilitatecommunicationofspecializedknowledgebetweenthese
majorstakeholders.Shirtcraftusesbudgetingandcostcenterstotrytomeetthese
aims.
Shirtcraft'sbudgetisthefoundationofthecompany'sfinancialcontrols.It
providesastandardagainstwhichadepartment'sperformancecanbemeasured
andaroundwhichincentivescanbebased.Also,byestablishinghowmuchcan
bespentonwhatsortofactivity,thebudgetexercisesformalcontrolovereach
departmentandtherebypartitionsdecisionrights.
Chapter 6

6-35
Thebudgetisalsousefulasameansofsharingspecializedknowledge
amongthemajorstakeholders.Informationthatisimportantforthecompanyasa
whole may reside in a specific part of the company. For example, some
knowledge of the company's anticipated cost structure is necessary for
determininghowmuchshouldbesoldatwhatprice. Throughtheprocessof
negotiations and consensus forging that are undertaken to make Shirtcraft's
budget, a mechanism exists, at least on an annual basis, to transfer this
informationbetweeninvolvedparties.
P632:
SolutiontoWielsonCompany(CMAadapted)(50minutes)
[Budgetingsellingexpensesandassigningresponsibility]
The central issue of this problem is whether performance should be measured

relativeto75salespersonsor80salespersons. Atthebeginningoftheyearthesales
forcewasprojectedtobe75people("onaverage").Theactualsalesforcewas80people
in November. The question becomes whether the five additional salespersons in
Novembershouldbetreatedasa"variance"or"flexedout"byincludingtheminthe
flexiblebudget.Analternativestatementofthecentralissueis:Shouldperformancebe
gaugedbasedonabenchmarkof75salespersonsor80salespersons?
Itdepends.Howarethereportedvariancesbeingusedasperformancemeasures?
Does the person being held responsible for the variance have the decision rights to
changethesalesforce? Iftheresponsiblepersonhasthedecisionrightstochangethe
number of salespersons and the increase from 75 to 80 was not approved, then the
benchmarkis75.Ifthepersonresponsibleforcontrollingthelineitem"Salessalaries"
doesnothavethedecisionrightsoverthenumberofsalespersons,thenthebenchmarkis
80.
TheCMAanswerpresentedascase(a)belowassumesthatthe"correct"benchmark
(budget)is80.Studentsmayquestionthelogicofthisassumption.Thesolutionincluded
ascase(b)belowassumesthecorrectbenchmarkis75salespersons.
a.
Fiveadditionalsalespersonsareincludedinthebudget
Chapter 6
6-36

WielsonCompany
SellingExpenseReport
November
MonthlyExpense
Budget
Advertisingand
promotion
Administrativesalaries
Salessalaries
Salescommissions
Salespersontravel
Total
Actual
Variance
$1,200,000
$1,350,000
$150,000U
57,000
80,0001
218,0002
183,2003
$1,738,200
57,000
80,000
218,000
185,000
$1,890,000
1,800U
$151,800U
U=unfavorable,oroverbudget.
F=favorable,orunderbudget
SupportingCalculations
$75, 000
80 $80, 000.
75
$200, 000
$10, 000, 000 $10,906, 000 $218, 000.
Changeincost:$175,000$170,000=$5,000.
Changeinsalesdollars:$10,625,000$10,000,000=$625,000.
Variablecostperdollarofsales=changeincostdividedbychangeinactivity
level:$5,000$625,000=$.008perdollarofsales.
Fixedcostat75personlevel:$170,000($10,000,000.008)=$90,000.
$90, 000
Fixedcostperpersonat80personlevel:
80 $96, 000.
75
Totaltravelbudget:$96,000fixed+($10,900,000.008)variable=$183,200.
b.
Fiveadditionalsalespersonsareexcludedfromthebudget
Chapter 6

6-37
WielsonCompany
SellingExpenseReport
November
MonthlyExpense
Budget
Advertisingand
promotion
Administrativesalaries
Salessalaries
Salescommissions
Salespersontravel
Total
Actual
Variance
$1,200,000
$1,350,000
$150,000U
57,000
75,0004
218,0005
177,2006
$1,727,200
57,000
80,000
218,000
185,000
$1,890,000
5,000U
7,800U
$162,800U
U=unfavorable,oroverbudget.
F=favorable,orunderbudget
SupportingCalculations
$75, 000
75 $75, 000.
75
$200, 000
$10, 000, 000 $10,900, 000 $218, 000.
Changeincost:$175,000$170,000=$5,000.
Changeinsalesdollars:$10,625,000$10,000,000=$625,000.
Variablecostperdollarofsales=changeincostdividedbychangeinactivity
level:$5,000$625,000=$.008perdollarofsales.
Fixedcostat75personlevel:$170,000($10,000,000.008)=$90,000.
$90, 000
Fixedcostat75personlevel:
75 $90, 000.
75
Totaltravelbudget:$90,000fixed+($10,900,000.008)variable=$177,200.
P633:
SolutiontoMageeInc.(60minutes)
[Tightversusloosebudgets]
This problem illustrates the type of analysis required in setting quotas when
bonusesandmanagerialeffortdependonthequota.Unlikethesituationdiscussedinthe
chapter,inthiscasethesalesmanagerdoesnothavethespecializedknowledgeofthe
futuresaleslevel.Thereisnoproblemwiththemanagerdistortingthequotaestimateas
Chapter 6
6-38

thequotaischosenbyseniormanagement. Thequotaisonlybeingsettoaffectthe
manager'sincentivestoworkhard.
Thepointofthisproblemistoillustratethatinsomecasesitisoptimumtosettight
quotasandinothercasesamediumtightorevenaloosequotamaximizesfirmvalue.
Thus,onecannotalwaysconcludethattightorloosequotasarealwaysbest.Itdepends
ontherelativecostsandbenefits.
Inthisproblem,dataareprovidedthatallowustoknowwhatthemanagerwilldo
(i.e.,choosehigh/loweffort).Ifaneasyquotaisset,theexpectedbenefittothefirmis
thetotalcontributionmargingeneratedbythesalesperson. Centralmanagementwants
thesalesmanagertoexertthehigheffortlevelaslongastheadditionalexpectedgross
marginexceedstheextrabonuspaid.
Themanagerwillexerthigheffortiftheexpectedpayoffsexceedthedisutilityof
theextraeffort.Thedisutilityoftheadditionaleffortis$1,500andletProbx$10,000
betheexpectedpayoff.Equatingthesetwo:
$1,500=Prob$10,000,
SolveforProb:
Prob=$1,500/$10,000=15%.
Theprobabilityofmakingthequotahastoincreaseby15percent.
Boththeloosequotaandmediumquotameetthecriteriathattheprobabilityof
makingthequotaincreasesby15percent.Thefollowingtablecalculatesthepayoffsto
themanageroftakingthehigheffortactionundereachquotascenarioandtheexpected
grossmarginundereachquota:
Chapter 6

6-39
VariousLevelsofQuotaTightness
Easy
Quota
Medium
Quota
Tight
Quota
ExpectedPayoffsto
Manager:Effort
Level
High
Low
$9,000
6,000
$6,000
4,000
$3,000
2,500
Differencein
expectedpayoffs
$3,000
$2,000
$500
Disutilityto
employeeof
selectinghigheffort
1,500
1,500
1,500
Gaintoemployeeof
selectinghigheffort
$1,500
$500
$1,000
Effortlevelexerted
High
High
Low
Expectedcosttothe
firmofmanager
exertingtheutility
maximizingeffort
$9,000
$6,000
$2,500
$45,000
$42,000
$18,250
2,000
16,000
32,250
$47,000
$58,000
$50,500
$9,000
$6,000
$2,500
$38,000
$52,000
$48,000
Expectedgross
marginof:
achievingquota
notachieving
quota
Expectedgross
margin
less:expectedbonus
tomanager
Expectednetpayoff
tofirmofsetting
quota
Chapter 6
6-40

Wecanseethatitisinthebestinterestofthesalesmanagertoexerthigheffort
underboththelooseandmediumquotas.
When the manager chooses the high effort action, the expected cost (expected
bonus) to the firm of the medium quota is only $6,000 (.6 $10,000) whereas the
expected cost of loose quota is $9,000. Given the numbers in the example, central
management should set the mediumtight quota over the tight quota because this
maximizestotalprofitsafterpayingthebonus.
However, it is easy to show by making small adjustments to the gross margin
numbersthatinsomecasesitisbesttosetaneasyquotaoratightquota.
P634:
SolutiontoKinkSales(70minutes)
[Incentiveschemestoinducetruthfulreportingofbudgets]
This problemillustrates thathowyouchoosethe performancerewardscheme

affectstruthfulreportingofbudgets.
a.
Graphsofequations(1)and(2)
Chapter 6

6-41
Theslopes($120and$80)ofthetwolinesegmentsarederivedas:
Bonus=100S20 BS
whereS=salesandB=budget
Bonus=100S20(BS)
forB>S
Bonus=100S20(SB)
forBS
Expandingtheselasttwoequationsyields:
b.
forB>S
Bonus=100S20S+20B=20B+80S
forBS
Thelocalmanagerwillreportbudgetedsalesthatmaximizetheexpectedbonus.
Foreachpossiblesaleslevel,thefollowingtablecalculatestheexpectedbonus.
Chapter 6
6-42
Bonus=100S20B+20S=20B+120S

Possible
Sales
Probability

100
.10
200
.20
300
.50
400
.20
Expectedbonus
ExpectedBonusforForecastedSales
100Units
200Units
Sales
Expected
Sales
Expected
100
Bonus
200
Bonus

0
$0
100
$0
100
2,000
0
0
200
10,000
100
5,000
300
6,000
200
4,000
$18,000
$9,000
Possible
Sales
Probability

100
.10
200
.20
300
.50
400
.20
Expectedbonus
ExpectedBonusforForecastedSales
300Units
400Units
Sales
Expected
Sales
Expected
300
Bonus
400
Bonus

200
$0
300
$0
100
0
200
0
0
0
100
0
100
2,000
0
0
$2,000
$0
Assumingthelocalmanagercannotbudgetsalesatzerounits,theexpectedbonus
ismaximizedunderbonusscheme#1byreportingaforecastedsaleslevelof100
units.Thus,thefirstbonusplancreatesincentivesformanagerstounderforecast
sales.
c.
The following table calculates the expected bonus for each budgeted sales
forecast.
Chapter 6

6-43
Budget=100
Possible
Sales
100
200
300
400
Probability
.10
.20
.50
.20
$100
Sales
$10,000
20,000
30,000
40,000
$20x
Budget
Actual
$0
2,000
4,000
6,000
Bonus
$10,000
18,000
26,000
34,000
Expected
Bonus
$1,000
3,600
13,000
6,800 $24,400
Budget=200
100
200
300
400
.10
.20
.50
.20
$10,000
20,000
30,000
40,000
$2,000
0
2,000
4,000
$8,000
20,000
28,000
36,000
$800
4,000
14,000
7,200
$26,000
Budget=280
100
200
300
400
.10
.20
.50
.20
$10,000
20,000
30,000
40,000
$3,600
1,600
400
2,400
$6,400
18,400
29,600
37,600
$640
3,680
14,800
7,520
$26,640
Budget=300
100
200
300
400
.10
.20
.50
.20
$10,000
20,000
30,000
40,000
$4,000
2,000
0
2,000
$6,000
18,000
30,000
38,000
600
3,600
15,000
7,600
$26,800
Budget=400
100
200
300
400
.10
.20
.50
.20
$10,000
20,000
30,000
40,000
$6,000
4,000
2,000
0
4,000
16,000
28,000
40,000
400
3,200
14,000
8,000
$25,600
Thisschemeinducesthelocalsalesmanagertoreporthermostlikelyforecasted
salesfigure,300units.Thereasonshedoesnotreportthemeanof280isbecause
theprobabilitiesarenotsymmetricaroundthemostlikelysalesamount.
d.
Clearly,withoutsomeadjustmentineitherthefixedwageorinthecommission
perunitsold($100)inscheme#2,thelocalmanagerwillbemakingalotmore
moneyunder#2than#1.Whilethesecondmethodinducesthelocalmanagerto
revealherprivateinformationregardingfuturesales,thesecondmethodisnot
unambiguouslythebest.Ifsalesareafunctionofthemanager'seffortlevel,the
secondmethodcausesthemanagertoworkharderuptomeetingthebudget,but
toslackoffabitoncethebudgetisachieved (i.e.,theslopeoftheincentive
Chapter 6
6-44

payoffissteeperuptothebudgetandthenisnotassteepafterthebudget).The
expectedpayoffsinpartcaboveareonlyvalidifthemanager'seffortleveldoes
notcausetheprobabilitiestochange.Butclearly,thelikelihoodofagivenlevel
ofsalesshoulddependontheamountofthemanager'seffort.Ifitdoesn't,there
isnoreasontobasethemanager'spayonsales.
Also, the manager is no longer compensated on units only above the
budgetbutforallunits. Thereasonforusingunitsabovethebudgetforbonus
compensation is to reduce the risk borne by the manager and to control for
differencesinthesizeofsalesterritoriesacrosssalespersons.Underthesecond
scheme,thesalesperson'sfixedpaymustbereducedbecauseofthebonusearned
onunitssolduptothebonus.Butthisimposesriskonthesalesperson.
Analternativebonusschemetotheonesintheproblemis:
Totalcompensation
=A0+B+(SB)ifSB
=A0+B(BS)ifS<B
where:
A0
B
S
,,
=
=
=
fixedwage
budgetrevealedbythemanager
actualsales
areparameterssetbyseniormanagerssuchthat0<<<
Inthisscheme,thelocalmanagerisrewardedforrevealinglargerbudgets,B>
0,andforexceedingthebudget,(SB)>0ifSB,butispenalizedfornot
achievingthebudget,(BS)<0ifS<B. Sovietplannershaveusedthis
schemeandhavedevelopedtheruleofthumbthat.3and.3.
P635:
SolutiontoJamesMarketingCampaign(70minutes)
[Differencesinrisksharingleadtoagencycosts]
This problem is designedtoillustrate that differences inrisksharing between

agentandprincipalwillcausetheagenttotakeactionswhichmaximizetheagent'sutility
butnottheprincipal'sutility.Inparticular,sincetheagentdoesnotshareproportionally
inthelosses,theagentmorereadilyacceptsprojectswherelossesaremorelikelyaslong
astheyalsopromisegreatergains.
a.
Thefollowingtablederivesthefirmprofitmaximizinglevelofspendingonthe
campaign.Ascanbeseenfromthetable,thefirmwillwanttheBuffalomanager
to spend $10,000 on the campaign, which will yield expected net profit of
$285,000(netofthemanagersexpectedbonusandsalary).
Chapter 6

6-45
(AllFiguresin000s)
NetProfit
Amount Probability
from
of
of
Spending
Spending Success(S) ifSuccessful
$10
.20
1390
$139.0
$9.0
Expected
NetProfit
afterBonus
andSalary1
$285.00
$25
.21
1375
137.5
7.5
283.20
$40
.22
1360
136.0
6.0
281.40
$55
.23
1345
134.5
4.5
279.60
$70
.24
1330
133.0
3.0
277.80
$85
.25
1315
131.5
1.5
276.00
$100
.26
1300
130.0
0.0
274.20
$115
.27
1285
128.5
0.0
271.31
$130
.28
1270
127.0
0.0
268.44
$145
.29
1255
125.5
0.0
265.61
Manager's
Bonusif
Successful
Manager's
BonusifNot
Successful
1Pr(S)(Netprofitsbonus)+[1Pr(S)]($100Advertisingbonus)$30
b.
Basedonthefollowingsetofcalculations,themanagerwillchoosetospendmore
ontheprojectthanprofitmaximizingshareholders. Themanagerwillseekto
spend$145,000ontheprojecttherebyreducingtheexpectedprofitsofthefirm
from$285,000to$265,610.
Chapter 6
6-46

(AllFiguresin000s)
Probabilityof
Success(S)
Manager's
Bonusand
Salaryif
Successful
Manager's
Bonusand
SalaryifNot
Successful
$10
.20
$169.00
$39.00
Expected
Bonusand
Salary2
$65.00
$25
.21
167.50
37.50
64.80
$40
.22
166.00
36.00
64.60
$55
.23
164.50
34.50
64.40
$70
.24
163.00
33.00
64.20
$85
.25
161.50
31.50
64.00
$100
.26
160.00
30.00
63.80
$115
.27
158.50
30.00
64.70
$130
.28
157.00
30.00
65.56
$145
.29
155.50
30.00
66.40
Amountof
Spending
(000s)
2Pr(S)(Salary+bonusifS)+[1Pr(S)](salary+bonusifnotS)
c.
For increases in advertising, the managers total compensation falls for both
successandunsuccessfuloutcomes. However,theexpectedcompensationrises
becausemoreweightisbeingplacedonthesuccessfulpayoffwhichisworthalot
morethantheunsuccessfuloutcome.Therefore,eventhoughcompensationfalls
forsuccessfulandunsuccessfuloutcomesasadvertisingisincreased,theexpected
compensationrises.
Thetwolevelsinpartsaandbabovedifferbecausethemanagerviews
riskdifferentlythanthefirm.Inparticular,themanagersbonusisboundedfrom
below at zero. Therefore, if the manager spends a lot on marketing but is
unsuccessful, the managers compensation does not fall below $30,000. The
manager is gambling withtheshareholders money,notthemanagers bonus.
Thisresultdoesnotdependonthemanagerbeingriskaverse. Boththeowner
andmanagervaluedollars.
Case61:
a.
SolutiontoEasternUniversityCatalog(70minutes)
[Assigningbudgetresponsibility]
The basic issue in this question involves linking the decision rights with the
specializedknowledge.Givingthecatalog'sbudgettoonecostcentereffectively
transfersthesedecisionrightstothatcostcenter.Buteachcostcenterhasitsown
specialized knowledge. Producing the catalog requires the assembly of very
Chapter 6

6-47
differentkindsofspecializedknowledgeheldbyindividualsindifferentpartsof
theUniversity. Admissionshasthespecializedknowledgeofwhathighschool
seniors are looking for in a college as well as knowledge of the University's
academicandnonacademicprograms.PublicRelations(PR)hasthespecialized
knowledge necessary to select the graphic artists, designers, and printers to
produce a high quality brochure, which portrays the desired image of the
University. Theproblembecomesoneofdesigninganorganizationalstructure
and thus a budget that causes these groups to assemble their specialized
knowledgeinatimelyandcosteffectivefashion.Ofcriticalimportanceishaving
the catalog ready in September. Being late causes the University to lose
prospectiveapplicants.
Theadvantagesanddisadvantagesofplacingthe Bulletin's costintothe
PublicRelationsversustheAdmissionsOfficebudgetarediscussedbelow:
(i)
(ii)
PlacetheentirecatalogcostintheAdmissionsbudget.TheAdmissions
budgetincludesmoniesforthedesignandprintingofthecatalog.They
contractwithPublicRelationsfordesignservicesandPRalsoisaskedto
recommendaprinterandsupervisetheprinting. PRreceivesrevenues
fromAdmissionsfortheirdesignwork.AdmissionsthenworkswithPR
aswithanyotheroutsidecontractor.IfPRfailstoperform,Admissions
cangooutsideforalldesignwork.Someoftheproblemsthatwillarise
underthisschemeare:
1.
IfAdmissionsisallowedtosubcontractoutsidetheUniversityfor
alldesignwork,theUniversitylosescontroloftheoverall"image"
ofitspublications.Ifsuchcoordinationisimportant,thengiving
the decision rights to PR to approve publications can create
internalmonopolyproblems.AnypublicationnotdesignedbyPR
willbedisapproved. Thatis,bygivingPRdecisionmonitoring
rights,theycanextractpayments fromAdmissionsinexcess of
theirtruecosts.
2.
DetermininghowPRiscompensatedforitsdesignworkrequiresa
transferpricetobeset. Thisraisesalltheusualtransferpricing
problems.
PlacetheentirecatalogcostinthePRbudget. Theadvantageofthis
method is that since the bulk of the $1 million cost is for outside
consultingandprinting,PRhasmuchmoreknowledgeofthesevendors
thantheAdmissionsOffice.Thismethodhasthefollowingproblems:
1.
Chapter 6
6-48
Whopaysforthecostofexpandingtheprintrun? Sincemore
catalogsmailedincreasestheexpectednumberofapplicantsand
thusadmissions,Admissionshasincentivestoaskforlargerprint
runs,especiallyiftheydonotpaythecost.
2.
b.
c.
ThecatalogisbutoneofPR'smanyresponsibilitiesbutiscritical
toAdmissions.PRislikelynottodevoteasmuchefforttoensure
itstimelyproductionasAdmissions.
Thereareseveralalternativewaysofhandlingthecatalog'sbudgetbesidesthe
twomentionedintheproblem.Eachoftheseisdiscussedbelow:
(i)
OnealternativeorganizationalchangeistomakePublicRelations(PR)a
partoftheAdmissionsoffice.Thisisunlikelytoproveusefulbecausethe
productionofthecatalogisjustonepartoftheentirepublicationsprogram
oftheUniversity.Alumnimagazines,placementbrochures,andbulletins
forothercollegesaresomeoftheotherpublicationsproducedbyPublic
Relations. Theproductionofeachpublicationproducesnewspecialized
knowledge in Public Relations regarding the skills of outside graphic
artistsandprinters.BreakingupPublicRelationsintodifferentoperating
units destroys this specialized knowledge. Therefore, the existing
organizationalstructureislikelytoremain.
(ii)
PlacetheprintingcostintheAdmissionsbudgetandthedesigncostinthe
PRbudget.Theproblemofsplittingthecostbetweenthetwobudgetsis
thatnogroupisthenresponsiblefortheentirecatalog. PRcanimpose
largecostsonAdmissionsbybeinglateinthedesign. Admissionscan
imposecostsonPRbysupplyingthecopylateandthenmakingfrequent
changesinthecopy,whichincreasesPR'scosts.Fixingblamefordelay
andcostoverrunsbecomesmoredifficultforseniorUniversityofficials
whenthetotalcostsaresplitandnosingleorganizationisresponsiblefor
thewholeproject."Fingerpointing"becomesmoreprevalent.
(iii)
Place the Bulletin's cost in the President's office. This alternative has
severalseriousdrawbacks.First,thePresidenthasnoneofthespecialized
knowledgetoproducethecatalog,andsecond,overseeingthisactivityis
likelynotthebestuseofthePresident'stime.
(iv)
MakeAdmissionsand/orPRaprofitcenter. Thisdoesnotaddressthe
fundamental question of how to assemble the specialized knowledge
currentlydiffuselyheldinthetwogroups.
Clearly,allthealternativesinvolvesomeproblems.The"best"solutionrequires
selectingthealternativewiththegreatestbenefits,netofitsproblems.Whileitis
difficulttoquantifythecostsofeachalternative,placingtheBulletin'sentirecost
Chapter 6

6-49
intotheAdmissionsOfficebudgetislikelytheleastcostlyalternative.Sincethe
catalogismore"important"toAdmission'smissionthantoPR'smission,allof
the decision rights, and hence budget for the catalog should be assigned to
Admissions. This also enhances the ability of senior officers to monitor the
performanceofbothgroupsandoftheBulletin.
Case62:
SolutiontoScionCorp.(75minutes)
[Selectingthenextyearsbudgettarget]
Thiscaseallowstheinstructortointroducetheconceptofstandardcostsearlierin
thecourseinsteadofhavingtowaituntilthedetaileddiscussionofstandardcostingin
Chapter 9. Introducing standard costs here completes the topic of budgeting for a
manufacturing plant. Since standard costs are really part of the budgeting process,
deferringalldiscussionofstandardcostsuntilChapter9isabitdisjointed.
Theissuetobeaddressedinvolvesthedifferentincentivescreatedbythetwo
methodsofarrivingatthebudgettargetsforthenextyear.Adjustinglastyear'sbudget
bytheproductivityimprovementfactorgeneratesadifferentsetofincentivesthanusing
thesameproductivityimprovementfactor(PIF)toadjustlastyear'sactuals. Thetwo
alternativesarediscussedbelow:
Advantages&disadvantagesapplyingtobothschemes
Advantages:
Thebudgeteddirectlabortimesaredevelopedoverseveralyearsandshouldbe
fairlyaccurate.
Bothsystemsdrivecostsdownovertime.
Disadvantages:
An acrosstheboard PIF does not take advantage of individual managers
specializedknowledgeofhowtoreducecosts. Byapplyinganacrossthe
boardreduction,bothschemescancausediscretionarycoststobereducedtoa
pointthat theplanthas noresources torespondtoemergencies. Another
problemcommontobothisthatonewaytomeetthePIFtargetandreduce
laborinputisbyreducingproductquality.
Adjustingthebudgetscheme
Advantages:
Itissimpleanditallowsmanagersindownstreamdepartments whouseparts
fromdepartmentA303toknowwithmorecertaintythelongrunbudgeted
costsofpartsfromdepartmentA303.
Chapter 6
6-50

Managershavetheincentivetotrytoreduceactualcostsbelowthisyearsbudget
withoutthefearofhavingnextyearsbudgetfurtherreducedbythisyears
costsavings.
Disadvantages:
Department managers, knowing that next years PIF will further reduce the
standarddirectlaborhoursperunit,willholdbacksomeoftheirimprovement
thisyear.Thatis,ifthePIFis5percent,butaparticularmanagerknowshow
tosave8percentnextyear,he/shewillimplementaprogramtosave5percent
nextyearandsavetheremaining3percentsavingsuntilthefollowingyear.
Anyinefficiencies orinaccuracies inthe budget arecarried forwardinto next
yearsbudget.
Adjustingtheactualscheme
Advantages:
Nextyearsbudgetisbasedonthemorerecentoperatingresultsandthusnext
yearsbudgetismoreaccurate(assumingcurrentoperatingperformanceisa
betterindicationofactualoperatingperformancethanlastyearsbudget).
Disadvantages:
Ifmanagersarehavinganoutstandingyearintermsofmeetingthecostreduction
targets,theyhaveincentivetoholdbacksomeofthesavingssothatnext
yearsbudgetisntreducedevenfurther. Forexample,ifthebudgetis2.5
directlaborhoursperbatch,butthemanagercangetitdownto2.4hoursthis
year,he/shehasincentivetojustmeetthetargetof2.5hoursthisyear,andnot
implement the other .1 hour savings until next year when the budget is
reduced again. The decision to save productivity improvements or take
advantageofthemthisyeardependsonwhethertherewardsforexceeding
thisyears targetarebiggerthanthepenalties fornotmeeting nextyears
targets.
Ifthemanagersresultsarepoor(belowbudget),incentivesexisttofurtherreduce
performancetherebygeneratingaveryeasytargetfornextyear.Forexample,
thebudgetfordirectlaborsalariedis2.5hours. Supposethereisamajor
labordisputeoutsidethecontrolofthemanagerthatcausesthisnumbertorise
to2.8hours. Themanagerhaslittleincentivetotrytoreducethisbackto,
say,2.7hoursbytheendoftheyear.Adjusting2.8hoursusingthePIFgives
alooserbudgetfornextyearthanadjusting2.7hoursusingthesamePIF.
Useofactualstosetnextyearsbudgetresultsinamorevariablebudgetnumber
overtime.Downstreamusersofthebudgetedcostswillhavemoredifficulty
projectinglongtermcosts.
Chapter 6

6-51
Case63:
SolutiontoLaserFlo(90minutes)
[Budgetedfixedandvariablecostchangeswithvolume]
Thiscaseprovidesthefollowingtopicstoberaisedanddiscussed:
howchangesinvolumeaffectaverageunitcosts
howaccountingcostscanbeusedtosupportpricediscrimination
howbudgetsformpartoftheinternalcontractingprocess
how managers deal with other people in the organization surrounding
budgetnegotiations
mutualmonitoring
evaluatingjointproductsofsalesandtieinservice
Oneinteresting aspectofthis caseisusingtheannuityfactortocalculate the
presentvalueofserviceprofitsaspartoftheproductstotalprofits.Thisillustratesthe
jointproductsofsalesandservice.
Anotherinterestingaspectofthiscaseinvolvespricediscrimination.
a.
Table1calculatesthecostoftheprojectedfiveyearprofitsofanAP2000using
firstthe$35.05andthenthe$38.25servicecost.
Profits perAP2000from service are lower by about $350per year or
about$1,100overfiveyears(discounted)duetothehigherservicecost.Based
onplacementsof120unitsthisyear,theAP2000programisprojectedtohave
fiveyearprofitsthisyearthatarelowerbyabout$130,000.
FieldServiceshourlycostincreasedfrom$35.05to$38.25fortworeasons:(i)
variablecostsperhourwentup,primarilyduetotheshifttoahigherfractionof
moreexpensiveTech2s,and(ii)averagefixedcostsperunitwentupbecause
fewerhoursarebeingworked.
Thefirststepistocalculatethefixedandvariablecostsfor2005.Table2
providesthedetailsofthecomputation.In2005thevariablecostperhourwas
$29.63andthefixedcostperhourwas$5.42.
Table3calculatesthehourlyserviceratesandfixedandvariablecostsper
hourin2005and2006.FromTable3weseethat,whiletotaltechnicianhours
fell13.0percent,variablecostsonlyfell4.8percent.Fixedcostsalsofell,butby
lessthanthedecreaseinhours.Thustheservicerateperhourincreasedbecause
althoughthenumerator(fixedplusvariablecost)fell,thedenominator(hours)fell
more,causingtheratio(costperhour)torise.
It is also instructive to decompose the overall rate change into its
components:
Chapter 6
6-52

2006totalhourlyrate
2005totalhourlyrate
Increase
2006variablecost
2005variablecost
Variablecostincrease
2006fixedcost
2005fixedcost
Fixedcostchange
Totalrateincrease
$38.25
35.05
$3.20
$32.44
29.63
$5.81
5.42
$2.81
$0.39
$3.20
Mostoftheincreaseiscausedbyvariablecostsnotdroppingasmuchasvolume.
ThereasonforthisistheshiftfromlowercostTech1stohighercostTech2s.
c.
Table4calculateswhatthecostofservicingtheAP2000wouldhavebeenin
2006 had the reorganization not occurred. If the number of Tech1s and 2s
remainedattheir2005levelinto2006,thehourlyratewouldhavebeen$36.54,
buttherewouldhavebeenmoreserviceperAP2000.Ascanbeseen,theannual
servicecostsavings fromthe reorganization foranAP2000is$144peryear.
Whilethesavingsarepositive,itisnotverylarge,onlyabout3percentofthe
2005staffingcost.
d.
WhatcanorshouldMartiMeyersdoabouttheservicecostincrease?First,list
thevariousoptions:
1.
2.
3.
4.
5.
6.
Donothingandabsorbthecostincreasebyshowinglowerprofits.
Raisetheservicepriceof$85andhopetheprofitsfromthelostsalesare
smallerthantheadditionalserviceprofitsfromthehigherprice.
TrytogetPhilHansentochangehisbudgetfornextyearinsuchaway
thatMeyersischargedlessperhourthan$38.25.
Gotoherbossandraisetheissue.ThismightinvolvechargesthatField
Serviceisfatormismanaged.Thisoptionwouldseektobringpressure
fromhigherlevelmanagerstoreviewFieldServicesbudgetandreduce
therate.
Trytochangetheorganizationalstructure.Severalpossibilitiesinclude:
a.
Setthecostfortechnicians atthecorporatelevel,notbasedon
Hansensbudget.
b.
Make Hansen a profit center and let Meyers purchase service
outside.
LowerthesellingpriceoftheAP2000andraisetheservicingprice.
Chapter 6

6-53
Beforeevaluatingthefiveoptions,noticethattheissueinLaserFloisa
transferpricedispute.Marketingsperformanceevaluationisbasedinpartonthe
transferpricetheyarechargedforfieldservice. FieldServiceisamonopoly
supplierofservice.Asacostcenter,FieldServicehastodeliverserviceatthe
budgetedcost,nextyearat$38.25.Theyhaveanincentivetopadthisfigurein
theirbudgetsotheyhaveroomtobeatit.Marketing,beingaprofitcenter,pays
the Field Service costs. Thus,Marketing (Marti Meyers)has anincentive to
monitorthesecharges. Andthisiswhatsheisdoingnow. Hansendoesnot
report directly to Meyers. But by creating this transfer pricing scheme and
treatingMarketingasaprofitcenter,thecompanygivesMeyersanincentiveto
monitor these charges. This case illustrates how accounting, performance
evaluationsystems,anddecisionrightspartitioningaresointertwined.
Evaluatethesixoptions.
1.
Donothing. Thisoptionlooksprettygood,especiallyifMeyerslacks
power in the organization to lower the Field Service charge. Meyers
profitsarelowerbyabout$130,000withthehighercost.Thisisabout1
percentoftotalAP2000salesinthefirstyear,andtheimpactonMeyersis
actually less. The$130,000profit reduction is basedonfiveyears of
serviceprofitsdiscounted.Inthefirstyearonly,theprofitlossis$41,472
($346120). IfMeyersisnotexpectingtobeinthejobforlong,she
doesnotbearalltheprofitloss.
SinceMeyersisheadofallofMarketing,andallsixprogramsare
charged for maintenance, her total evaluation will be affected by the
higherservicecosts. SheultimatelyischargedalloftheFieldService
costs. Assuming 780,000 service hours next year at a higher cost of
$38.25 per hour, the total impact on Marketing profits is almost $2.5
million,iftheservicecostisraisedfrom$35.05to$38.25.Thus,while
the impact on the AP2000 program is small, the overall effect on
Marketingislarge.
However,itisimportanttorecognizethatthetotalcostofservice
actuallyfallsbetween2005and2006:
FieldServiceCosts(millions)
FixedCost
VariableCost
Totaloperatingbudget
Chapter 6
6-54
2005
$26.6
4.9
$31.5
2006
$25.3
4.5
$29.8

WhileMeyers(andMarketing)wouldbebetteroffiftheratehadstayedat
$35.05,sheisstillbetteroffacrossallsixprogramsbecauseMarketingis
chargedabout$1.7millionfewerdollarsin2006thanin2005.
2.
Raise the price of service. Depending on the price elasticity of the

demandcurve,thismaybebetterthanoption1. However,sheshould
reviewthepricesonalltheotherprogramsmaintenancecontracts.Part
ofthereasonwhyservicecostshaverisenisduetothehigherfractionof
Tech2sneededtoservicethemorecomplicatedprinters. Thissuggests
thatmarginalcostshaverisenandthatapriceincreasetothecustomerof
above$85perhouriswarranted,notjustontheAP2000butforallthe
printers.
3.
TrytoconvinceHansentolowerhiscostestimates.IfHansenhasbuilt
slackintohisbudget,thenthreateningabigfightwithcorporateoverhis
budgetmightinducehimtocutbackonthebudgetedcostestimate.
4.
Gotocorporatewithchargesofslack.Suchchargesaresuretosetoffa
firestormwithinLaserFlo. Thequestionis:canMeyerswinsucha
fight. Hansenhasthedetailedspecializedknowledgeofhisoperations.
Hecanarguewithmoreevidenceastowhyhiscostperhourisincreasing:
themachinesaremorecomplicatedandproportionatelymoreTech2sare
needed.
Thisisobviouslyariskystrategy,onethatcouldbackfireonher.
PartofherdecisiontopursuethisstrategyistherelativepowerofHansen
in the organization. If senior managers view Hansen as weak or
vulnerable,thisoptionbecomesmoreattractive.
5.
Makesomeorganizationalchange.Bydecentralizingthefirmandgiving
Marketingdecisionrightsoverservicepricing,Meyershasincentivesto
monitor Hansen. However,asacostcenter,Hansenhasincentives to
build slack into the budget. Thus, while the organizations structure
appearsirrationalandcallsforchange,LaserFlomightbeworkingfine.
Afterall,LaserFloisthelargestfirminitsindustry(recall:marmotsand
bears). Alltheprofits frombothsalesandservice areinMarketings
performancemeasure.Thus,marketinghasincentivestojointlysetboth
thesalesandservicepricestomaximizecombinedprofits.Bycreatingthe
mutualmonitoringincentives,corporatemanagementlearnswhenMeyers
thinksFieldServicecostsgetoutoflinewiththoseofthecompetition.
Without a lot more evidence that something is terribly wrong in the
organizationsstructure,thereisnocompellingreasontoredesignit.
Chapter 6

6-55
6.
e.
AtfirstitappearsoddthatmostofLaserFlosprofitsarecomingfromservicing
the AP2000 versus selling it. But remember the economics of price
discrimination.Underpricediscrimination,afirmwithmarketpowerwouldlike
tochargeconsumerswhovaluetheproductahigherpricethanthosewhovalueit
lower.Insettingasingleprice,thepersonwhovaluestheproductatthispriceis
indifferentbetweenpurchasingandnotpurchasing. Thosewhovaluethegood
higherwillpurchaseandreceivesomeconsumersurplus(thedifferencebetween
thepriceandtheirvalue).Supposethepriceofanappleis$0.25.Ifsomeone
valuesitat$0.30,theybuyitandgetasurplusof$0.05.Theapplesellerwould
liketochargethisperson$0.2999. Heorshewouldstillbuyit,buttheseller
wouldcapturetheconsumersurplus.Theproblemwithmostpricediscrimination
schemesishowtopreventresale.Howdoyoupreventthepersonwhojustvalues
theappleat$0.25andwhobuysitfor$0.25fromresellingittothepersonwho
values it at $0.30 for $0.2999? Many price discrimination schemes unravel
becauseofreselling.
LaserFlopricediscriminatesonitsprinters. Somecustomersvaluethe
AP2000atnearthe$74,500priceplusmaintenance.Othersvalueithigher.One
factor that is probably highly associated with a customers valuation is print
volume;customersvaluetheprintersbasedonthevolumestheyexpect.Higher
volumecustomersaremorelikelytovaluetheAP2000higherthancustomers
withlowervolumes. Andthehighervaluationcustomerismorelikelytobe
willingtopayahigherprice.ThewaythatLaserFlochargesthehigherpriceis
throughamaintenancecontractthatisafunctionofprintvolume.Iftheycharged
ahigherpurchaseprice,eveniftheycoulddiscriminatebetweenhighandlow
volumeusersatthetimeofsale,nothingwouldpreventthelowvolume,lowprice
userfromresellingtheAP2000toahighervolumeuseratapricejustbelow
AP2000s price. But maintenance cannot be resold, because it is tied to the
machine.Therefore,LaserFlosetsarelativelylowpriceontheinitialsaletojust
covermarginal costandthenahighpriceonits servicetopricediscriminate
betweenthehighandlowvolumeusers.
Chapter 6
6-56
Decrease the purchase price of the printer and increase the price of
maintenancetoreachthe60percenttargetmarkup. Thetotalrealized
increaseinmaintenancerevenuewillhavetobehigherthanthedecrease
insalesrevenuesduetothelowerprice.
It is in LaserFlos best interest to maintain our level of printer
sales, especially given the lucrative servicing portion of the business.
Oncetheprinterissold,serviceandmaintenanceiseminent.Theoption
of getting service from someone other than LaserFlo for a LaserFlor
printer are almost nonexistent, since the technological changes are so
rapidthatanoutsidecompanycannotkeepitsworkforcetrainedtoservice
thelatestmodels.SoLaserFlowcanchargeapremiumfortheservice.

Thismethodofpricediscriminationiswellknown.Inthe1940sand50s
Gilletterazorsweregivenaway,andtheuserpaidfortheblades.Bladeprices
weresetatabovemarginalcost. IBMrequiredtheircustomerstobuyblank
punchedcardsfromIBMtobeusedintheircardbasedaccountingmachines
priortocomputers.Themachinesweresoldatlowprices,andthecardswere
soldatabovemarginalcost. Copiers,printers,andcomputersallhavetiein
maintenancecontractsaspricediscriminationschemes.
ItmakesalotofsenseforLaserFlotomakemoremoneyonservicingthan
onsales.Yetthisonlyworksaslongasthereisnoreselling.Resellingwould
occurifthirdpartyserviceprovidersenterthemarketandofferservicecontracts
lowerthanLaserFlosprices,butthisisunlikelygiventherateoftechnological
change in the industry. Knowledge of LaserFlos printers gives them a
comparativeadvantageoverwouldbeserviceentrants.
It is somewhat of a misstatement to say they are making more on
servicingprintersthanonsales. Theyarejointproducts. Youcannothavea
servicecontractuntilyouhaveasale.Toallocatethetotalprofitsinthiswayis
alsoabitmisleadingandwouldseemtosuggestthat,sincemostoftheprofitsare
comingfromservice,itsacceptableifLaserFlosservicecostsareoutofline.
Table1
ProjectedFiveYearProfitson
AP2000
ExpectedservicehoursperAP2000:
Pagesperyear
Pagesperservicing
Servicingsperyear
Techhoursperservicing
Normalservicehoursperyear
Unscheduledservicehours(50%)
Projectedservicehoursperyear
Salesprice
less
Hardware
Selling&administrativecosts(33%)
Incomeonsale
Revenueonservice(@$85/hour)
Servicecosts
Serviceincomeperyear
12,000,000
500,000
24
3
72
36
108
$35.05
Cost
$74,500
$38.25
Cost
$74,500
$46,295
24,585
$3,620
$46,295
24,585
$3,620
$9,180
3,785
$5,395
$9,180
4,131
$5,049
Chapter 6

6-57
Chapter 6
6-58
Fiveyearannuityfactor@18%
Fiveyearserviceincome
3.127
3.127
$16,869
$15,788
Totalfiveyearincomeonsale
$20,489
$19,408

Table2
CalculateFixedandVariableServiceCostsfor2005
Tech1
number
salary,benefits,etc.
TotalvariablecostofTech1
300
$40,100
$12,030,000
Tech2
Number
Salary,benefits,etc.
TotalvariablecostofTech2
Totalvariablecost
275
$52,900
$14,547,500
$26,577,500
TotalnumberofTechs
Numberoftechmonthsperyear
Numberoftechmonths
Billablehourspertechpermonth
Totalbillablehours
Variablecostperhour
Totalhourlycost
Totalhours
Totalcostofservice
Less:Totalvariablecost
Fixedcost
Totalhours
Fixedcostperhour
575
12
6900
130
897,000
$29.63
$35.05
x897,000
Chapter 6
$31,439,850
26,577,500
$4,862,350
897,000
$5.42

6-59
Table3
Comparisonof2005and2006
Hours,Fixed,andVariableCosts
Totalhours
Variablecost
Fixedcost
Totalcost
2005
897,000
$26,577,500
4,862,350
$31,439,850
2006
780,000
$25,300,000
4,535,000
$29,835,000
Costperhour
$35.05
$38.25
Variablecostperhour
Fixedcostperhour
$29.63
$5.42
$32.44
$5.81
%Change
13.0%
4.8%
6.7%
5.1%
9.1%
9.5%
7.3%
Table4
CostSavingsofServicinganAP2000
fromFieldServiceReorganization
Number
300
275
Tech1
Tech2
Totalvariablecost
Totalfixedcost
Totalcost
Totalhours
Projectedhourlyratefor2006
Normalservicings/year
Techhoursperservicing
Techhourspernormalservicing
Unscheduledservicehours(50%)
Totalservicehoursperyear
Servicingcost/year(2005staffing)
Servicingcostperyear(after
reorganization)
Costsavingsfromreorganization
Chapter 6
6-60
Variable
Cost
$42,800
$54,800
24
3.25
78
+39
Total
$12,840,000
15,070,000
$27,910,000
4,862,350
$32,772,350
897,000
$36.54
117
$4,275
$4,131
$144

Chapter 6

6-61

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CHAPTER6

The McGraw-Hill Companies, Inc., 2003

All budgeting systems separate decision management from decision control.

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

Solution to Budget Lapsing versus LineItem Budgets (15 minutes)

The McGraw-Hill Companies, Inc., 2003

Within organizations it is useful to try to link decision rights and specific

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

$27,962 $34,295 $31,300 $31,186

In estimating 2007s costs, given we do not have specific data on expected

The McGraw-Hill Companies, Inc., 2003

PBs sales budgeting system is essentially a topdown approach. Senior

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

This problem is based on an actual large European multinational companys

The McGraw-Hill Companies, Inc., 2003

Memobasedonstaticbudget: Theproductionmanagerdidwell. He/shewas

Memo based on flexible budget: The production manager performed poorly.

The McGraw-Hill Companies, Inc., 2003

Giventhesetofconstraints onMaxineJonesstaffingdecisions (i.e.,shehas

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

Since inventories are expected to be negligible, everything produced

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

Responsibilities become more specialized, presumably, tolink decision

The McGraw-Hill Companies, Inc., 2003

The central issue of this problem is whether performance should be measured

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

This problemillustrates thathowyouchoosethe performancerewardscheme

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

This problem is designedtoillustrate that differences inrisksharing between

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003

The McGraw-Hill Companies, Inc., 2003