The following is an interesting juxtaposition of a traditional accounting view of a decision and a view supported by relevant costing. On the discussion board for this week, discuss the points of view of Joe and the expert. Who do you agree with? Why? Have you ever run across a similar situation in your professional or personal life in which the traditional accounting view conflicted with a relevant costing view? (I have made some changes to the original to remove stereotypical language, however, the costs/pricing of earlier remains.) An Accounting Accounting: A Tragedy in One Act by Rex H. Anderson The Scene: A small store deep in the jungle of accounting logic The Time: Today - and tomorrow, if you aren't careful The Cast: Joe, owner and operator of a small store-restaurant An Accounting - Efficiency Expert. As the curtain rises, we find Joe dusting his counter and casting admiring glances at a shiny new rack holding brightly colored bags of peanuts. The rack sits at the end of the counter. The store itself is like all small store-restaurants in the jungle of accounting logic. It is a clean, well-lighted joint patronized by the neighborhood residents and an occasional juvenile delinquent. As Joe dusts and admires his new peanut rack, he listens almost uncomprehendingly to the earnest speeches of the Accounting - Efficiency Expert. Expert: Joe, you said you put in these peanuts because some people ask for them, but do you realize what this rack of peanuts is costing you? Joe: It's not going to cost - it'll be a profit. Sure, I had to pay $25 for a fancy rack to hold the bags, but the peanuts cost $.06 a bad, and I sell 'em for $.10. I figure I'll sell 50 bags a week to start. It'll take 12 weeks to cover the cost of the rack. After that, I'm going to clear a profit of $.04 per bag. The more I sell, the more I make. Expert: That is an antiquated and completely unrealistic approach, Joe. Fortunately, modern accounting procedures permit a more accurate picture that reveals the complexities involved. Joe: Huh? Expert: To be precise, those peanuts must be integrated into your entire operation and be allocated their appropriate share of business overhead. They must share a proportionate part of your expenditures for rent, heat, light, equipment, depreciation, decorating, salaries for waitresses, the cook... Joe: The cook? What's he got to do with the peanuts? He doesn't even know I got 'em. Expert: Look, Joe, the cook is in the kitchen, the kitchen prepares the food, the food is what brings people in, and while they're in, they ask to buy peanuts. That's why you must charge a portion of the cook's wages, as well as your own salary, to peanut sales. This sheet contains a carefully calculated cost analysis that indicates the peanut operation should pay exactly $1,278 per year toward these general overhead costs. Joe: The peanuts? $1,278 a year for overhead? That's nuts! Expert: It's really a little more than that. You also spend money each week to have the windows washed, to have the place swept out each morning, to keep soap in the washroom, and to provide free colas to the police. That raises the total to $1,313 per year. Joe: (Thoughtfully) But the peanut salesman said I'd make money - put them on the end of the counter, he said, and get $.04 per bag profit. Expert: (With a sniff!) He's not an accountant. Do you actually know what the portion of the counter occupied by the peanut rack is worth to you? Joe: It's worth nothing - there's no stool there - just a dead spot at the end. Expert: The modern cost picture permits no dead spots. Your counter contains 60 square feet, and your counter business grosses $15,000 per year. Consequently, the square foot of space occupied by the peanut rack is worth $250 per year. Since you have taken that area away from the general counter use, you must charge the value of the space to the occupant. Joe: You mean I've got to add $250 a year more to the peanuts? Expert: Right. That raises their share of the general operating costs to a grand total of $1,563 per year. Now then, if you sell 50 bags of peanuts per week, these allocated costs will amount to $.60 per bag. Joe: (Incredulously) What? Expert: Obviously, to that must be added your purchase price of $.06 per bag, which brings the total to $.66. So you see, by selling the peanuts at $.10 per bag, you are losing $.56 on every sale. Joe: Something's crazy! Expert: Not at all! Here are the figures. They prove that your peanut operation cannot stand on its own feet. Joe: (Brightening) Suppose I sell lots of peanuts - a thousand bags a week instead of 50? Expert: (Tolerantly) You don't understand the problem. If the volume of peanut sales increases, your operating cost will go up. You'll have to handle more bags, with more time, more general overhead, everything. The basic principle of accounting is firm on that subject: "The bigger the operation, the more general overhead must be allocated." No, increasing the volume of sales won't help. Joe: Okay. You're so smart, you tell me what I have to do. Expert: (Condescendingly) Well, you could first reduce operating expenses. Joe: How? Expert: Take smaller space in an older building with cheaper rent. Cut salaries. Wash the windows only biweekly. Have the floor swept only on Thursday. Remove the soap from the washrooms. Cut out the colas for the cops. This will also help you decrease the square-foot value of your counter. For example, if you can cut your expenses 50%, that will reduce the amount allocated to the peanuts from $1,563 down to $781.50 per year, reducing the cost to $.36 per bag. Joe: (Slowly) That's better? Expert: Much, much better. However, even then you would lose $.26 per bag if you charge only $.10. Therefore, you must also raise your selling price. If you want a net profit of $.04 per bag, you will have to charge $.40. Joe: (Flabbergasted) You mean even after I cut operating costs 50%, I still have to charge $.40 for a $.10 bag of peanuts? Nobody's that nuts about nuts! Who'd buy them? Expert: That's a secondary consideration. The point is, at $.40, you'd be selling at a price based on a true and proper evaluation of your then-reduced costs. Joe: (Eagerly) Look! I've got a better idea. Why don't I just throw the nuts out - put 'em in the trashcan? Expert: Can you afford it? Joe: Sure, all I've got is about 50 bags of peanuts that cost about 3 bucks. So what if I lose $25 on the rack, at least I'm out of this nutsy business and no more grief. Expert: (Shaking head) Joe, it isn't quite that simple. You are already in the peanut business. The minute you throw those peanuts out, you are adding $1,563 of annual overhead to the rest of your operation. Joe, be realistic! Can you afford to do that? Joe: (Completely crushed) It's unbelievable. Las week I was going to make money. Now I'm in trouble - just because I think peanuts on the counter's going to bring in some extra profit - just because I believe 50 bags of peanuts a week is easy. Expert: (With raised eyebrows) That is the reason for modern cost studies, Joe, to dispel those false illusions