ACC 333 Lecture Notes - Negative Number, Marginal Revenue, Cubic Function
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A paper published in the Harvard Business Review points out a new way to calculate economic profit that could be more appropriate for service firms and other âpeople-intensiveâ companies. Instead of focusing on investment and return on investment, the focus is on employee productivity, both in terms of generating revenues and reducing costs. |
The approach is to first determine economic profit in the conventional way, except that we ignore taxes, so that economic profit is before tax, as follows: |
Economic profit = Operating profit â Capital charge |
Assume the following information for a hotel chain that wishes to adopt the new method. The firm has $100 million in operating profit, $1 billion in investment, and uses a cost of capital rate of 5%, so the capital charge is $50 million and the economic profit is $50 million. Relevant calculations are contained in Part 1 of the following schedule. Use the following information in the table on the bottom. |
Part 1: Economic Profit (in thousands, except cost of capital rate) | |||
Revenue | $500,000 | ||
Operating costs: | |||
Personnel costs | 300,000 | ||
Other costs | 100,000 | ||
Operating profit | $100,000 | ||
Operating profit before personnel costs (OPBP) | $400,000 | ||
Investment (capital) | $ | 1,000,000 | |
Cost of capital, rate | 0.05 | ||
Capital charge | $50,000 | ||
Economic profit = Operating profit â Capital charge | $50,000 | ||
Part 2: Economic Profit Calculated Using Employee Productivity | |||
Number of employees | 10,000 | ||
Employee productivity: | |||
Operating profit before personnel cost per employee ($400,000/10,000) | $40 | ||
Capital charge per employee ($50,000/10,000) | 5 | ||
Employee productivity | $35 | ||
Less personnel cost per employee | 30 | ||
Economic profit per employee = Productivity â Cost | $5 | ||
Total economic profit, all employees | $50,000 | ||
Note: All numbers in thousands except for number of employees | |||
The next step is to decompose economic profit using employee productivity. To do this we first determine operating profit before personnel costs (OPBP): |
OPBP | = Operating profit + Personnel costs |
$400,000 | = $100,000 + $300,000 |
Employee productivity can be determined by calculating OPBP less capital charge, per employee. For this example, since there are 10,000 employees, OPBP is $40,000 per employee and the capital charge is $5,000 per employee, so that productivity is $35,000 per employee. The next step is to determine personnel cost per employee, $30,000, and subtract that from employee productivity to obtain economic profit per employee, $5,000 (i.e., $35,000 â $30,000). Total economic profit for all employees is thus $5,000 Ã 10,000, or $50 million, the same amount as determined in the conventional way. The value of the decomposition of economic profit into employee productivity and personnel costs per employee is that it provides measures that the hotel chain can benchmark to other hotel chains. It also provides a direct measure of the profit that is being generated per employee relative to the average personnel cost for each employee. Measures of revenue per employee and personnel cost per employee are widely used in the hospital, health and human services, and other people-oriented service industries. |
Source: Felix Barber and Rainer Strack, âThe Surprising Economics of the People Business,â Harvard Business Review, June 2005, pp. 81â90. |
Required: |
Use the above approach and assume a chain of residential care facilities employs 10,000 people, has a cost of capital of 6%, and has the following information (000s). |
Revenue | $ | 660,000 | |
Operating costs | |||
Personnel costs | 370,000 | ||
Other costs | 180,000 | ||
Operating profit | $ | 110,000 | |
Investment | $ | 1,500,000 | |
Determine the productivity per employee, personnel costs per employee, and economic profit per employee. (Enter your answers in thousands.) |
#1 | Which of the following correctly describes fixed and variable cost behavior as total volume increases? | ||
A. | Unit fixed costs stay the same and unit variable costs increase. | ||
B. | Total fixed costs stay the same and total variable costs increase. | ||
C. | Unit fixed costs decrease and total variable costs decrease. | ||
D. | Unit fixed costs decrease and unit variable costs decrease. | ||
#2 | The incremental profit generated by the sale of one additional unit is equal to the | ||
A. | contribution margin per unit. | ||
B. | selling price. | ||
C. | margin of safety. | ||
D. | incremental cost. | ||
#3 | Clipper Office Furniture uses cost-plus pricing with a 40% mark-up on total cost at capacity. The company is currently selling 40,000 units at $19.60 per unit. Each unit has a variable cost of $9. In addition, the company incurs $200,000 in fixed costs annually. If demand falls to 32,000 units and the company wants to continue to earn a 40% return, what price should the company charge? | ||
A. | $15.25 | ||
B. | $21.35 | ||
C. | $19.60 | ||
D. | $27.44 | ||
#4 | ABC company has $6.50 per unit in variable costs and $2.20 per unit in fixed costs at a volume of 40,000 units. If the company uses cost-plus 20% for pricing, which of the following should the company use to determine the price? | ||
A. | The company should use a unit cost of $8.70 per unit only at a volume of 40,000 units. | ||
B. | The company should use a unit cost of $8.70 at any volume level. | ||
C. | The company should use a unit price of $10.44 at any volume level. | ||
D. | The company should ignore fixed costs for cost-plus pricing. | ||
#5 | Which of the following is a grouping of overhead costs whose total is allocated using one allocation base? | ||
A. | Cost objective | ||
B. | Cost pool | ||
C. | Direct cost | ||
D. | Cost driver | ||
#6 | Which one of the following is the preferred alternative when deciding between two options? | ||
A. | Incremental profit is greater than under the other alternatives. | ||
B. | Revenues are greater than under the other alternatives. | ||
C. | Expenses are less than under the other alternatives. | ||
D. | No opportunity or sunk costs exist. |
#7 | The required rate of return used to calculate an investmentâs net present value is related to the firmâs | |||
A. | contribution margin. | |||
B. | cost of capital. | |||
C. | total assets. | |||
D. | Price/Earnings ratio. | |||
#8 | A company is trying to decide whether to keep or drop the organic foods department in its grocery store. If organic foods are dropped, the manager will be laid off. What is the manager's salary in relation to the decision to keep or drop the department? | |||
A. | A variable cost and therefore relevant | |||
B. | Avoidable and therefore incremental | |||
C. | Sunk and therefore not relevant | |||
D. | A fixed cost and therefore not relevant | |||
#9 | The following information relates to Ajax Widgets during the year. There was no beginning inventory. | |||
Units produced | 11,000 | |||
Units sold | 10,000 | |||
Units in ending inventory | 1,000 | |||
Fixed manufacturing overhead | $220,000 | |||
How much fixed manufacturing overhead will be expensed during the year (included in Cost of Goods Sold) using full costing? | ||||
A. | $220,000 | |||
B. | $200,000 | |||
C. | $20,000 | |||
D. | $10,000 | |||
#10 | If the required rate of return is greater than the internal rate of return of a potential investment, the company should judge the investment as acceptable. | |||
A. | This is a True statement | |||
B. | This is a False statement | |||
C. | Not enough information provided. | |||
#11 | The basic concept involved in time value of money calculations is that | |||
A. | it is better to receive a dollar in the future than to receive a dollar today | |||
B. | incremental revenues must exceed incremental costs. | |||
C. | it is better to receive a dollar today than to receive a dollar in the future. | |||
D. | it can only be applied to positive cash flows |
#12 | Hanson Sports has three product lines: footballs, basketballs, and bats. Common costs are allocated based on relative sales. A product line income statement for the year ended December 31, 2016 follows: | ||||
Footballs | Basketballs | Bats | Total | ||
Sales | $600,000 | $800,000 | $400,000 | $1,800,000 | |
Cost of goods sold | 260,000 | 400,000 | 230,000 | 890,000 | |
Gross margin | 340,000 | 400,000 | 170,000 | 910,000 | |
Less other variable costs | 85,000 | 120,000 | 80,000 | 285,000 | |
Contribution margin | 255,000 | 280,000 | 90,000 | 625,000 | |
Less direct salaries | 50,000 | 60,000 | 45,000 | 155,000 | |
Less common fixed costs | 85,000 | 100,000 | 55,000 | 240,000 | |
Net income | $120,000 | $120,000 | -$10,000 | $230,000 | |
Since the profit for bats is a net loss, the company is considering dropping this product line. What is the incremental $ effect on total net income of dropping the Bats line? | |||||
#13 | Right Air Supply sells a specialized air filter that has a variable cost of $10 each. | ||||
Fixed costs are estimated to be $700,000 across all levels of sales shown below. | |||||
Units Sold | Unit Price | CM per unit x Qty | Fixed Costs | Profit | |
90,000 | $33 | 700,000 | |||
100,000 | $31 | 700,000 | |||
110,000 | $30 | 700,000 | |||
120,000 | $28 | 700,000 | |||
Which price should Right Air Supply charge to maximize profits? | |||||
#14 | Randolph Corporation sells a single product at a price of $275 per unit. Variable cost per unit is $135 and fixed costs total $356,860. If sales are expected to be $825,000, what is the companyâs margin of safety? | ||||
#15 | Roger Excavating Company experienced the following costs in 2016: | ||||
Direct materials | $1.75 per unit | ||||
Direct labor | $2.00 per unit | ||||
Variable manufacturing overhead | $2.50 per unit | ||||
Variable selling | $0.75 per unit | ||||
Fixed manufacturing overhead | $50,000 | ||||
Fixed selling | $15,000 | ||||
Fixed administrative | $5,000 | ||||
During 2016, the company manufactured 100,000 units and sold 80,000 units. If the average selling price per unit was $22.65, what is the amount of the companyâs contribution margin per unit? |