Exhibit 1: Prior Income Statements 20x2 20x1 Revenues Expenses $2,500,000 $2,000,000 150,000 150,000 270,000 200,000 130,000 231,000 Consultant salaries... Sales representative commissions. 180,000 Other general and administrative salaris. 135,000 Payroll taxes and employee benefits.. 252,000 Survey labor, printing, photocopying, and other direct job costs. Rent, heat, and lights 900,000 51,000 700,000 45,00050,000 40,000 Total expenses .. Pretax income. 497,000 99.400 229,000 income tax expense @ 20% Project Pricing and Sales Commissions All sales reps were responsible for writing their own proposals, although they could ask the consultants for technical assistance as needed. The sales reps were responsible for calculating the estimated cost and for setting the price for projects. After a proposal was accepted, the sales reps turned each project over to a consultant to do the actual work. The sales reps usually set the price at 320% of the estimated direct consulting labor cost plus 125% of the other direct costs (such as survey labor and photocopying). The estimated direct consulting labor cost was calculated by multiplying the estimated consulting hours by a standard labor rate. A stand rate of $25 per hour wa s used for senior consultants, and a $20 rate was used for junior consultants. The sales force was paid on straight sales commission. The commission was equal to 24% of the erence between the price paid for a project by the client and the actual total direct costs of the diff project. After a project was complete, the actual labor hours were totaled and the actual direct consultant labor cost was calculated by multiplying actual hours times the labor rate. Other direct ere also acumulated for the job. Then the sales rep)'s commission was calculatd and puid. were Exhibit 2 provides estimated cost, price, and commission information for a potential new job Exhibit 2: Potential New Job One of the sales representatives developed the following information for a potential new consulting engagement. Estimated consultant cost: Senior consultant Junior consultant s 250 10 hours@ $25 per hour 20 hours @ $20 per hour S 650 Total Estimated other direct job costs: $1,000 Survey labor (outsourced) Photocopying of final report (outsourced) $1,050 Total Estimated price: $2,080 1.313 $3,393 $650 x 320% $1,050 x 125% Consultant cost Other direct costs Total ($3,393-S650-$1,050) x 24% S 406 Estimated sales commission Consultants and Time Records Unlike the sales reps, the consultants were all paid a straight salary with no overtime and no bonus. Paukovich Consulting used a job costing system that required consultants to record their time in 0.25 hour (15-minute) increments. Each project was assigned a job code and each task (survey design, data collection, report writing, proofreading, and copying and binding) was assigned a task code. The standard consultant labor rate was equal to the average consultants' annual salaries divided by theoretical capacity of 2,080 hours per year (standard work week of 40 hours times 52 weeks per year). Exhibit 3 provides average consultant time records from 20x2. Exhibit 3: Average Consultant Time During 20x2 Senior 1,500 410 110 Junior 1,000 960 100 Time charged to jobs Time charged to internal marketing Holidays and sick leave Vacation Total hours 2,080 (52 weeks x 40 hours per week- 2,080 hours) VP of Finance Concerns Randall Smith, the vice president of finance, had two major concerns about the current system for sales representatives and consultants First, Randall noticed that some of the sales reps often brought in relatively small jobs. He wondered whether these small jobs were worth the resources devoted to them. He decided to talk with Richard about setting a minimum price on all jobs. Second, Randall found that the consultants billed nearly half of their time to job code 0001 "Internal Marketing" (see Exhibit 3). This job code was used for all marketing activities, including time spent helping the sales reps on proposals. However, he suspected that the senior and junior consultants did not assign equivalent work to this job code. Specifically, he believed that the sales reps preferred to ask the senior consultants for help when writing proposals, to increase the chance of winning the bi He also suspected that the sales reps had been pressuring the junior consultants to bill some of the time spent on projects as "Internal Marketing" to avoid exceeding the time budget on projects. Junior consultants often took longer to complete a project than the senior consultants. Since consultant performance was evaluated based on meeting budgets, the junior consultants generally complied with a sales rep's request. Randall planned to recommend a revised time reporting system. Under the new system, consultants would not be permitted to charge time to "internal marketing." Instead, they would charge their time separately to "job proposals" and to "unbillable time." The "unbillable time" category would include time spent in departmental meetings, training courses, and other activities that cannot jobs. In addition, each consultant's time records would be submitted to a new consulting managen who would review and approve them. The consultants their time is spent. Randall estimated Exhibit 4. be traced to the average consultant time under the new system as shown in Exhibit 4: Estimated Average Consultant Time Under Proposed Time Reporting System Junior 1,720 40 200 100 Senior 1,500 330 80 110 Time charged to jobs Time charged to job proposals Unbillable time Holidays and sick leave Vacation 2.080 2.080 Total hours Questions Cost Behavior and Cost Function 1. Refer to the prior year income statements shown in Exhibit I. Classify each of the following costs as fixed, variable, or mixed. Briefly explain how you classified each item. a. Sales representative commissions b. Payroll taxes and employee benefits: c. S urvey labor, printing, photocopying, and other direct job costs: Rent, heat, and lights: d. 2. Create a cost function for Paukovich Consulting. Use the financial statement information in Exhibit 1 and your cost classifications from question #1 . Assume that miscellaneous office costs are mixed. For simplicity, use revenues as the cost driver (Hint: Because only two years' data are available, use the two-point method to estimate the cost function for mixed costs.) Cost-Volume-Profit Analvsis 3. Given your answer to question #2, what amount of revenue must the company generate to achieve net income (after-tax) of $500,000? Given your answer to question #2, calculate the company's 20x2 operating leverage. Should Richard Paukovich be concerned about the company's degree of operating leverage? Explain. 4. Given your answer to question #2, calculate the company's 20x2 margin of safety in revenue, and briefly explain what it means. 5. Job Costing Systenm 6. The consultants were paid on salary. Why would the company have them fill out time sheets? Was it a problem that so much consulting time was charged to "Internal Marketing"? Why or 7. why not? Would management capture better information if the sales reps also completed time sheets? 8. Explain. Should the sales reps be responsible for estimating job costs? Why or why not? under-applied labor cost? Who would be affected by any misapplication? How might you change 9. 10. Critique the method used to calculate the standard consulting labor rate. Will it result in over- or the standard cost system? Overhead/Support Cost Allocation 11. What types of overhead costs did the company incur? Should the accounting system be modified to allocate overhead to individual jobs? As you answer this question, consider how allocated overhead cost information might be used. 12. Suppose the owner decides that overhead costs should be allocated to ench job. Recommend a support cost allocation method (textbook Chapter 8). Explain your choice 13. Discuss whether activity-based costing (ABC) would be useful for Paukovich. Job Pricing 15. Discuss whether the company's pricing policy should be changed. In your discussion, consider the basis that should be used to set prices and who should be responsible for pricing decisions 16. Consider the VP of Finance's idea that a minimum price should be established for all jobs. Discuss the pros and cons of this idea. Internal Reporting Format 17. Would a variable costing income statement provide useful information to the management of Paukovich Consulting? Explain Employee Incentives 18. What were the incentives and likely behavior of the sales reps under the existing accounting system? 19. Should the sales rep commissions be based on the difference between the price and the ex-post (i.e., actual) consulting labor cost? 20. What factors should be considered when evaluating the consultants' performance? Exhibit 1: Prior Income Statements 20x2 20x1 Revenues Expenses $2,500,000 $2,000,000 150,000 150,000 270,000 200,000 130,000 231,000 Consultant salaries... Sales representative commissions. 180,000 Other general and administrative salaris. 135,000 Payroll taxes and employee benefits.. 252,000 Survey labor, printing, photocopying, and other direct job costs. Rent, heat, and lights 900,000 51,000 700,000 45,00050,000 40,000 Total expenses .. Pretax income. 497,000 99.400 229,000 income tax expense @ 20% Project Pricing and Sales Commissions All sales reps were responsible for writing their own proposals, although they could ask the consultants for technical assistance as needed. The sales reps were responsible for calculating the estimated cost and for setting the price for projects. After a proposal was accepted, the sales reps turned each project over to a consultant to do the actual work. The sales reps usually set the price at 320% of the estimated direct consulting labor cost plus 125% of the other direct costs (such as survey labor and photocopying). The estimated direct consulting labor cost was calculated by multiplying the estimated consulting hours by a standard labor rate. A stand rate of $25 per hour wa s used for senior consultants, and a $20 rate was used for junior consultants. The sales force was paid on straight sales commission. The commission was equal to 24% of the erence between the price paid for a project by the client and the actual total direct costs of the diff project. After a project was complete, the actual labor hours were totaled and the actual direct consultant labor cost was calculated by multiplying actual hours times the labor rate. Other direct ere also acumulated for the job. Then the sales rep)'s commission was calculatd and puid. were Exhibit 2 provides estimated cost, price, and commission information for a potential new job Exhibit 2: Potential New Job One of the sales representatives developed the following information for a potential new consulting engagement. Estimated consultant cost: Senior consultant Junior consultant s 250 10 hours@ $25 per hour 20 hours @ $20 per hour S 650 Total Estimated other direct job costs: $1,000 Survey labor (outsourced) Photocopying of final report (outsourced) $1,050 Total Estimated price: $2,080 1.313 $3,393 $650 x 320% $1,050 x 125% Consultant cost Other direct costs Total ($3,393-S650-$1,050) x 24% S 406 Estimated sales commission Consultants and Time Records Unlike the sales reps, the consultants were all paid a straight salary with no overtime and no bonus. Paukovich Consulting used a job costing system that required consultants to record their time in 0.25 hour (15-minute) increments. Each project was assigned a job code and each task (survey design, data collection, report writing, proofreading, and copying and binding) was assigned a task code. The standard consultant labor rate was equal to the average consultants' annual salaries divided by theoretical capacity of 2,080 hours per year (standard work week of 40 hours times 52 weeks per year). Exhibit 3 provides average consultant time records from 20x2. Exhibit 3: Average Consultant Time During 20x2 Senior 1,500 410 110 Junior 1,000 960 100 Time charged to jobs Time charged to internal marketing Holidays and sick leave Vacation Total hours 2,080 (52 weeks x 40 hours per week- 2,080 hours) VP of Finance Concerns Randall Smith, the vice president of finance, had two major concerns about the current system for sales representatives and consultants First, Randall noticed that some of the sales reps often brought in relatively small jobs. He wondered whether these small jobs were worth the resources devoted to them. He decided to talk with Richard about setting a minimum price on all jobs. Second, Randall found that the consultants billed nearly half of their time to job code 0001 "Internal Marketing" (see Exhibit 3). This job code was used for all marketing activities, including time spent helping the sales reps on proposals. However, he suspected that the senior and junior consultants did not assign equivalent work to this job code. Specifically, he believed that the sales reps preferred to ask the senior consultants for help when writing proposals, to increase the chance of winning the bi He also suspected that the sales reps had been pressuring the junior consultants to bill some of the time spent on projects as "Internal Marketing" to avoid exceeding the time budget on projects. Junior consultants often took longer to complete a project than the senior consultants. Since consultant performance was evaluated based on meeting budgets, the junior consultants generally complied with a sales rep's request. Randall planned to recommend a revised time reporting system. Under the new system, consultants would not be permitted to charge time to "internal marketing." Instead, they would charge their time separately to "job proposals" and to "unbillable time." The "unbillable time" category would include time spent in departmental meetings, training courses, and other activities that cannot jobs. In addition, each consultant's time records would be submitted to a new consulting managen who would review and approve them. The consultants their time is spent. Randall estimated Exhibit 4. be traced to the average consultant time under the new system as shown in Exhibit 4: Estimated Average Consultant Time Under Proposed Time Reporting System Junior 1,720 40 200 100 Senior 1,500 330 80 110 Time charged to jobs Time charged to job proposals Unbillable time Holidays and sick leave Vacation 2.080 2.080 Total hours Questions Cost Behavior and Cost Function 1. Refer to the prior year income statements shown in Exhibit I. Classify each of the following costs as fixed, variable, or mixed. Briefly explain how you classified each item. a. Sales representative commissions b. Payroll taxes and employee benefits: c. S urvey labor, printing, photocopying, and other direct job costs: Rent, heat, and lights: d. 2. Create a cost function for Paukovich Consulting. Use the financial statement information in Exhibit 1 and your cost classifications from question #1 . Assume that miscellaneous office costs are mixed. For simplicity, use revenues as the cost driver (Hint: Because only two years' data are available, use the two-point method to estimate the cost function for mixed costs.) Cost-Volume-Profit Analvsis 3. Given your answer to question #2, what amount of revenue must the company generate to achieve net income (after-tax) of $500,000? Given your answer to question #2, calculate the company's 20x2 operating leverage. Should Richard Paukovich be concerned about the company's degree of operating leverage? Explain. 4. Given your answer to question #2, calculate the company's 20x2 margin of safety in revenue, and briefly explain what it means. 5. Job Costing Systenm 6. The consultants were paid on salary. Why would the company have them fill out time sheets? Was it a problem that so much consulting time was charged to "Internal Marketing"? Why or 7. why not? Would management capture better information if the sales reps also completed time sheets? 8. Explain. Should the sales reps be responsible for estimating job costs? Why or why not? under-applied labor cost? Who would be affected by any misapplication? How might you change 9. 10. Critique the method used to calculate the standard consulting labor rate. Will it result in over- or the standard cost system? Overhead/Support Cost Allocation 11. What types of overhead costs did the company incur? Should the accounting system be modified to allocate overhead to individual jobs? As you answer this question, consider how allocated overhead cost information might be used. 12. Suppose the owner decides that overhead costs should be allocated to ench job. Recommend a support cost allocation method (textbook Chapter 8). Explain your choice 13. Discuss whether activity-based costing (ABC) would be useful for Paukovich. Job Pricing 15. Discuss whether the company's pricing policy should be changed. In your discussion, consider the basis that should be used to set prices and who should be responsible for pricing decisions 16. Consider the VP of Finance's idea that a minimum price should be established for all jobs. Discuss the pros and cons of this idea. Internal Reporting Format 17. Would a variable costing income statement provide useful information to the management of Paukovich Consulting? Explain Employee Incentives 18. What were the incentives and likely behavior of the sales reps under the existing accounting system? 19. Should the sales rep commissions be based on the difference between the price and the ex-post (i.e., actual) consulting labor cost? 20. What factors should be considered when evaluating the consultants' performance