What does integrated planning accomplish?

A. Participation of stakeholders and affected departments

B. The creation of strategic planning

C. Electronic commerce

D. Business process design

A. Participation of stakeholders and affected departments

Integrated planning provides for the participation of stakeholders with affected departments within an organization. This participation helps the organization to examine costs and benefits of a plan of action.

Based on potential sales of 500 units per year, a new product has estimated traceable costs of $990,000. What is the target price per unit to obtain a 15% profit margin on sales using the traditional markup calculation?

A. $2,329

B. $2,277

C. $1,980

D. $1,935

A. $2,329 =(990,000/500)/0.85

Traceable costs per unit = $990,000 / 500 = $1,980

This $1,980 represents 85% (i.e., 100% - 15%) of the target price.

Target price per unit = $1,980 / .85 = $2,329.41

Which of the following may be used to estimate how inventory warehouse costs are affected by both the number of shipments and the weight of materials handled?

A. Economic order quantity analysis

B. Probability analysis

C. Correlation analysis

D. Multiple regression analysis

D. Multiple regression analysis

The purpose of regression analysis is to use an independent variable to predict the value of another variable. Multiple regression involves the analysis of more than two variables. In this situation, we can use multiple regression analysis with the number of shipments and the weight of materials as the independent variables to predict inventory warehouse costs.

Economic order quantity (EOQ) is the quantity of inventory that should be ordered at one time in order to minimize the associated costs of carrying and ordering inventory, such as purchase-order processing, transportation, and insurance. EOQ is an inventory decision model that reflects a fixed quantity system. It would not provide a method to predict warehouse costs.

Probability theory is a branch of mathematics that studies the likelihood of occurrence of random events in order to predict behavior. Probability is the measure of how likely an event is. It would not allow us to predict warehouse costs based on weight and number of orders.

Correlation analysis is a measure of the extent to which the independent variable accounts for the variation of the dependent variable (i.e., the amount of variation in y that is explained by x). It is the measure of how well the regression line fits the actual data points. It would not permit the prediction of warehouse costs from independent variables, although it could be used to measure how good the predictions are.

Which of the following changes would cause a company’s breakeven point in sales to increase?

A. The company’s contribution-margin rate increases.

B. The company’s variable cost per unit decreases.

C. The company’s total fixed costs increases.

D. The company’s selling price per unit increases.

C. The company’s total fixed costs increases.

Breakeven units are computed by dividing fixed costs by contribution margin. This amount is then multiplied by the sales price per unit. Breakeven would increase if the numerator increased or the denominator decreased. (If fixed costs increase, more units will need to be sold to cover the additional cost.)

A company reported a significant material efficiency variance for the month of January. All of the following are possible explanations for this variance, except:

A. cutbacks in preventive maintenance.

B. an inadequately trained and supervised labor force.

C. processing a large number of rush orders.

D. producing more units than planned for in the master budget.

D. producing more units than planned for in the master budget.

Producing more units than planned in the master budget will not affect the efficiency of the materials used for each unit.

Poorly functioning machines will have more material waste and spoilage.

An inadequately trained and supervised labor force will have more material waste and spoilage than an adequately trained and supervised labor force.

Rush orders disrupt the manufacturing process by interfering with normal work routines, practices, and procedures. These disruptions will adversely affect each of the manufacturing processes, including the efficient use of material, labor, and overhead.

Johnson Co., distributor of candles, has reported the following budget assumptions for Year 1: No change in candles inventory level; cash disbursement to candle manufacturer, $300,000; target accounts payable ending balance for year 1 is 150% of accounts payable beginning balance; and sales price is set at a markup of 20% of candle purchase price. The candle manufacturer is Johnson’s only vendor, and all purchases are made on credit. The accounts payable has a balance of $100,000 at the beginning of Year 1. What is the budgeted gross margin for Year 1?

A. $60,000

B. $70,000

C. $75,000

D. $87,500

B. $70,000

(300,000+(100,000*150%-100,000))=*350,000

*350,000*120%-350,000*=$70,000

(300,000+(100,000*150%-100,000))*120%-(300,000+(100,000*150%-100,000))

Accounts payable increased from $100,000 at the beginning of the year to $150,000 at the end of the year (the 150% increase). Purchases of candles include the $300,000 paid in cash plus the $50,000 increase in payables for total purchases of $350,000. Since inventory does not change, the cost of goods sold equals the cost of purchases.

Sales price is 120% times purchase cost, so sales are budgeted at 1.20 × $350,000, or $420,000. Gross margin is sales revenue of $420,000 less cost of sales of $350,000, or $70,000.

A ceramics manufacturer sold cups last year for $7.50 each. Variable costs of manufacturing were $2.25 per unit. The company needed to sell 20,000 cups to break even. Net income was $5,040. This year, the company expects the following changes: sales price per cup to be $9.00; variable manufacturing costs to increase 33.3%; fixed costs to increase 10%; and the income tax rate to remain at 40%. Sales in the coming year are expected to exceed last year’s sales by 1,000 units. How many units does the company expect to sell this year?

A. 21,000

B. 21,600

C. 21,960

D. 22,600

D. 22,600 =(1,000+ *21,600)$CM= (7.50-2.25)*20,000=105,000

$CM+NI+ (105,000+ 5,040/60%)=105,000+8400=113,000

113,000/5.25(CM)=21,600* Units sold last year.

Last year the company had a contribution margin of $5.25 (price of $7.50 less variable costs of $2.25). Breakeven in units (20,000) equals fixed costs divided by the unit contribution margin ($5.25), so fixed costs must have been 20,000 × $5.25, or $105,000.

Net income last year was $5,040. Before-tax income must have been $8,400 ($5,040 ÷ 0.60, the part of income that is not tax). If pre-tax income was $8,400 and fixed costs were $105,000, then the sum, $113,400, was the contribution margin last year.

If the contribution margin per unit was $5.25, then 21,600 units were sold last year. Sales this year are expected to increase by 1,000 units to 22,600 units. The information given about changes to the sales and cost structure for this year is not relevant since the problem states that sales exceed last year’s sales by 1,000 units.

Mien Co. is budgeting sales of 53,000 units of product Nous for October. The manufacture of one unit of Nous requires four kilos of chemical Loire. During October, Mien plans to reduce the inventory of Loire by 50,000 kilos and increase the finished goods inventory of Nous by 6,000 units. There is no Nous work-in-process inventory. How many kilos of Loire is Mien budgeting to purchase in October?

A. 138,000

B. 162,000

C. 186,000

D. 238,000

C. 186,000 (53,000+6,000)*4-50,000

Units produced = Unit sales + Increase in inventory

= 53,000 + 6,000

= 59,000 units of Nous

Purchases of Loire = Production requirement - Decrease in inventory

= (59,000 x 4) - 50,000

= 236,000 - 50,000

= 186,000 kilos of Loire

The following information for a company is given:

Fixed cost per month $2,500

Unit selling price 100

Variable cost as a percentage of sales 60%

What amount of annual sales must the company achieve to break even?

A. $100,000

B. $75,000

C. $50,000

D. $30,000

B. $75,000=(2500*12)/(100-60)*$100

The contribution margin is sales price minus variable cost, or $100 less $60. So the unit contribution margin is $40.

Breakeven units equal annual fixed costs divided by the contribution margin or ($2,500 × 12) ÷ 40, which equals $30,000 ÷ 40, or 750 units. At a selling price of $100 per unit the annual sales revenue must be $75,000.

A company’s standard costs for direct labor are as follows:

Direct Labor Standard Quantity Standard Price 1 hour per unit $15 per hour

Last month, the company produced and sold 100 units of its product, using 110 direct labor hours at a rate of $16 per hour. What amount is the company’s direct labor efficiency variance for last month?

A. $260

B. $160

C. $150

D. $110

C. $150 = $15*(1hr/unit-(110 hr/100 units)

The company’s direct labor efficiency variance for last month is $150, calculated as follows:

Direct labor efficiency variance (DLEV) = Standard price × (Standard hours – Actual hours)

DLEV = $15/hour × [(1 hour/unit – (110 hours ÷ 100 units)]

= $15/hour × 0.10 hours/unit

= $1.50 per unit, or $150 total for 100 units

Selected costs associated with a product are as follows:

Total standard hours for units produced 5,000

Total actual direct labor cost $111,625.00

Actual per hour labor rate $23.50

Standard per hour labor rate $24.00

What amount is the total direct labor price variance?

A. $2,375 unfavorable

B. $2,375 favorable

C. $2,500 unfavorable

D. $2,500 favorable

B. $2,375 favorable 111,625-(24*4,750)

The actual hours worked is the actual labor cost of $111,625 divided by the actual rate per hour of $23.50, or 4,750 hours.

The labor price (rate) variance is the difference between the actual labor cost ($111,625) and the budgeted cost of actual hours worked ($24 × 4,750 hours, or $114,000). This difference is $2,375. The actual rate paid of $23.50 is less than the standard rate of $24.00, so the variance is favorable.

Quick Co. was analyzing variances for one of its operations. The initial budget forecasted production of 20,000 units during the year with a variable manufacturing overhead rate of $10 per unit. Quick produced 19,000 units during the year. Actual variable manufacturing costs were $210,000. What amount would be Quick’s flexible budget variance for the year?

A. $10,000 favorable

B. $20,000 favorable

C. $10,000 unfavorable

D. $20,000 unfavorable

D. $20,000 unfavorable

Flexible budget variance = Actual cost compared to Flexible budget cost

= $210,000 - ($10 x 19,000 units)

= $210,000 - $190,000

= $20,000 unfavorable

The variance is unfavorable since more was spent than anticipated.

The four components of time series data are secular trend, cyclical variation, seasonality, and random variation. The seasonality in the data can be removed by:

A. multiplying the data by a seasonality factor.

B. taking the weighted average over four time periods.

C. subtracting a seasonality factor from the data.

D. adding a seasonality factor to the data.

B. taking the weighted average over four time periods.

Seasonality in data may be removed by calculating a weighted average of the data for the four seasonal (quarterly) time periods. This provides a representative annual value which is free of seasonal influence.

The economic order quantity formula assumes that:

A. purchase costs per unit differ due to quantity discounts.

B. costs of placing an order vary with quantity ordered.

C. periodic demand for the good is known.

D. erratic usage rates are cushioned by safety stocks.

C. periodic demand for the good is known.

Economic order quantity seeks to identify an optimum order quantity by equating order cost with carrying cost.

In order to do this, the following values must be known or assumed:

Cost of placing an order

Cost of carrying inventory

Periodic demand for product

Augusta, Inc., expects manufacturing and sales of 70,000 units of product Maggie, its only product, to occur evenly over a 10-week period. Augusta pays for materials in the week following use. The balance of accounts payable for materials at the beginning of the 10-week period is $40,000. There are no beginning inventories. The following information pertains to product Maggie for the 10-week period:

Sales price $11 per unit

Materials $3 per unit

Manufacturing conversion costs—Fixed $210,000

Variable $2 per unit

Selling and administrative costs—Fixed $45,000

Variable $1 per unit

What amount should Augusta budget for cash payments to material suppliers during the period?

A. $189,000

B. $229,000

C. $210,000

D. $214,000

B. $229,000 (40,000+70,000/10*9)

Manufacturing and sales occur evenly over the period, so each week has the same production and sales. At 70,000 units, that is 7,000 units per week. Cash payments for materials are $3 per unit, so payments for material for one week’s production is $21,000.

They will pay $40,000 at the beginning of the period for beginning accounts payable in addition to paying for 70,000 units at $3 per unit, or $210,000, for a total of $250,000. However, the materials used during the last week, 7,000 units at $3, or $21,000, will not be paid until the first week after the end of the period, reducing cash payments during the period down to $229,000.

Which of the following inputs would be most beneficial to consider when management is developing the capital budget?

A. Supply/demand for the company’s products

B. Current product sales prices and costs

C. Wage trends

D. Profit center equipment requests

D. Profit center equipment requests

Capital budgeting involves management making decisions about spending money on long-term assets. In order to make these decisions, management must first know what each profit center’s equipment needs are.

Supply and demand for the company’s products, current sales prices and costs, and wage trends would be helpful in order to determine future cash flows as they relate to implementing various capital projects, but these are not the best answers.

Del Co. has fixed costs of $100,000 and breakeven sales of $800,000. What is its projected profit at $1,200,000 sales?

A. $50,000

B. $150,000

C. $200,000

D. $400,000

A. $50,000=

(1,200,000-(1,200,000*(700,000/800,000*)100,000)

Breakeven sales = Variable costs + Fixed costs

Or:

Variable costs = Breakeven sales - Fixed costs

= $800,000 - $100,000 = $700,000

*Variable cost rate = Variable Costs / Breakeven Sales

= $700,000 / $800,000 = .875

Projected profit = Sales - Variable costs - Fixed costs

= $1,200,000 - .875(1,200,000) - $100,000

= $1,200,000 - $1,050,000 - $100,000

= $50,000

Trendy Co. produced and sold 30,000 backpacks during the last year at an average price of $25 per unit. Unit variable costs were the following:

Variable manufacturing costs $ 9

Variable selling and administrative costs 6

Total $15

Total fixed costs were $250,000. There was no year-end work-in-process inventory. If Trendy had spent an additional $15,000 on advertising, then sales would have increased by $30,000. If Trendy had made this investment, what change would have occurred in Trendy’s pretax profit?

A. $3,000 increase

B. $4,200 increase

C. $3,000 decrease

D. $4,200 decrease

C. $3,000 decrease

Contribution margin per unit was $10 ($25 sales price less variable costs of $9 and $6). The contribution margin ratio was 40% ($10 contribution per unit divided by $25 sales revenue per unit).

Additional sales of $30,000 would have increased the contribution margin by $12,000 ($30,000 × 0.40). The increased contribution margin of $12,000 fails to cover the advertising costs of $15,000, leaving a decrease of $3,000 in pretax profit.

The correlation coefficient that indicates the weakest linear association between two variables is:

A. - 0.73.

B. - 0.11.

C. 0.12.

D. 0.35.

B. - 0.11.

The correlation coefficient is a measure of the closeness of data points to the regression line. The closer to zero, the poorer the fit. Hence, - 0.11 is the closest to zero and thus the weakest association to the regression line. (Note: Correlation can be positive or negative. Thus, the best answer choice is the smallest absolute number.)

A company has gathered the following information from a recent production run:

Standard variable overhead rate $10 Actual variable overhead rate 8 Standard process hours 20 Actual process hours 25 What is the company's variable overhead spending variance?

A. $50 unfavorable

B. $50 favorable

C. $40 unfavorable

D. $40 favorable

B. $50 favorable(10-8)*25

The variable overhead spending variance is the difference between the actual amount paid ($8) and standard overhead ($10) for the 25 actual hours. The difference of $2 multiplied by 25 actual hours gives $50. The variance is favorable because the actual cost ($8) was less than the standard cost ($10).

On June 30, 20X1, a company is preparing the cash budget for the third quarter. The collection pattern for credit sales has been 60% in the month of sale, 30% in the first month after sale, and the rest in the second month after sales. Uncollectible accounts are negligible. There are cash sales each month equal to 25% of total sales. The total sales for the quarter are estimated as follows: July, $30,000; August, $15,000; and September, $35,000. Accounts receivable on June 30, 20X1, were $10,000. What amount would be the projected cash collections for September?

A. $21,375

B. $28,500

C. $30,125

D. $37,250

C. $30,125

Credit Sales:

July: $30,000 x 0.75 = $22,500

Aug.: $15,000 x 0.75 = 11,250

Sept.: $35,000 x 0.75 = 26,250

September Cash Collection:

Sept. Cash Sales $35,000 x 0.25 = $ 8,750

Sept. Credit Sales $26,250 x 0.60 = 15,750

Aug. Credit Sales $11,250 x 0.30 = 3,375

July Credit Sales $22,500 x 0.10 = 2,250

Total Collection $30,125

Which of the following options lists the correct sequence for preparing budgets?

A. Cost of goods sold budget, sales budget, budgeted income statement, budgeted balance sheet

B. Material purchases budget, production budget, cost of goods sold budget, cash receipts budget

C. Sales budget, production budget, budgeted balance sheet, budgeted income statement

D. Production budget, material purchases budget, budgeted income statement, budgeted balance sheet

D. Production budget, material purchases budget, budgeted income statement, budgeted balance sheet

The sequence “production budget, material purchases budget, budgeted income statement, budgeted balance sheet” is correct because you cannot budget material purchases until you know the expected production. Once you have the production and material purchases budget, you can prepare the budgeted income statement, which leads to the budgeted balance sheet.

The sequence “cost of goods sold budget, sales budget, budgeted income statement, budgeted balance sheet” is incorrect because you cannot determine the cost of goods sold until you know your budgeted sales level.

The sequence “material purchases budget, production budget, cost of goods sold budget, cash receipts budget” is incorrect because you cannot determine your material purchases until you know your expected production.

The sequence “sales budget, production budget, budgeted balance sheet, budgeted income statement” is incorrect because your budgeted income statement amounts are combined with the prior balance sheet to give the budgeted balance sheet.

State College is using cost-volume-profit analysis to determine tuition rates for the upcoming school year. Projected costs for the year are as follows:

Contribution margin per student $ 1,800

Variable expenses per student 1,000

Total fixed expenses 360,000

Based on these estimates, what is the approximate breakeven point in number of students?

A. 129

B. 200

C. 360

D. 450

B. 200 (360,000/1,800)

Breakeven in units is fixed costs ($360,000) divided by contribution margin per unit ($1,800) for a breakeven point of 200 students. The amount of variable cost is irrelevant for this solution because it has already been taken into account in calculating contribution margin per student.

The following information is taken from Wampler Co.’s contribution income statement:

Sales $200,000

Contribution margin 120,000

Fixed costs 90,000

Income taxes 12,000

What was Wampler’s margin of safety?

A. $50,000

B. $150,000

C. $168,000

D. $182,000

A. $50,000=200,000- 90,000/ (120,000/200,000)

Margin of safety is the excess of actual or budgeted sales over breakeven point sales. It is the amount by which sales could decrease before losses occur. At breakeven there would be no income tax, so we can ignore the income tax information.

To find breakeven sales, first find the contribution margin ratio (contribution margin divided by sales) of $120,000 ÷ $200,000, or 60%. Then divide fixed costs by the contribution margin ratio ($90,000 ÷ 0.6 = $150,000 breakeven sales).

The margin of safety is the current sales ($200,000) less breakeven sales ($150,000), or $50,000.

What is strategic planning?

A. It establishes the general direction of the organization.

B. It establishes the resources that the plan will require.

C. It establishes the budget for the organization.

D. It consists of decisions to use parts of the organization’s resources in specified ways.

A. It establishes the general direction of the organization.

Strategic planning answers questions such as the following:

What product or service do we supply?

Who are our customers?

How can we perform well?

The answers to these questions provide a general direction for the organization.

A company uses a standard costing system. The production budget for year 1 was based on 200,000 units of output. Each unit requires two standard hours of manufacturing labor for completion. Total overhead was budgeted at $900,000 for the year, and the budgeted fixed overhead rate was $1.50 per direct manufacturing labor hour. Both variable and fixed overheads are allocated to the product based on direct manufacturing labor hours. The actual data for year 1 are as follows:

Actual production in units 198,000

Actual direct manufacturing labor hours 425,000

Actual variable overhead $352,000

Actual fixed overhead $575,000

What is the amount of unfavorable variable overhead efficiency variance?

A. $21,750

B. $33,250

C. $43,500

D. $55,000

A. $21,750=(425,000 hours × $0.75), or $297,000 − $318,750(425,000*0.75)

An efficiency variance is the difference between the budgeted overhead costs at the actual volume and the budgeted costs at the earned volume.

Total budgeted fixed overhead was 200,000 units × 2 hours per unit × $1.50 per hour, or $600,000. Since total budgeted overhead was $900,000, total budgeted variable overhead must be $300,000, or $0.75 per hour. (Remember, overhead is always calculated in terms of hours.)

The variable overhead efficiency variance is the difference between the budgeted overhead costs at the actual volume (198,000 units × 2 hours × $0.75) and the budgeted costs at the earned volume (425,000 hours × $0.75), or $297,000 − $318,750 = $(21,750).

Which of the following is a disadvantage of participative budgeting?

A. It is more time consuming.

B. It decreases motivation.

C. It decreases acceptance.

D. It is less accurate.

A. It is more time consuming.

Participative budgeting is a bottom-up budgeting process where budgets are developed after lower-level managers have provided input in the development of the numbers. The thought is that lower-level managers will feel an ownership of the budget if they have had a hand in developing the budget, and this ownership is hoped to lead to a greater motivation and goal congruence. Some of the disadvantages are the fact that the numbers provided by the lower-level managers often contain budgetary slack, leading to negative motivation and the fact that it is more time consuming to involve additional people in the budgeting process.

Sago Co. uses regression analysis to develop a model for predicting overhead costs. Two different cost drivers (machine hours and direct materials weight) are under consideration as the independent variable. Relevant data were run on a computer using one of the standard regression programs, with the following results:

Machine Direct Materials Hours Weight Y intercept coefficient 2,500 4,600 B coefficient 5.0 2.6 R2 0.70 0.50

Which regression equation should be used?

A. Y = 2,500 + 5.0X

B. Y = 2,500 + 3.5X

C. Y = 4,600 + 2.6X

D. Y = 4,600 + 1.3X

A. Y = 2,500 + 5.0X

Coefficient of determination is a measure of the extent to which the independent variable accounts for the variation of the dependent variable (i.e., the amount of variation in y that is explained by x). It is the measure of how well the regression line fits the actual data points. The symbol for the correlation coefficient is R and the coefficient of determination is r squared (R2). Values of R range between -1 and 1. The closer the value is to 1, the greater the association (correlation) between the two variables.

Since the coefficient of determination (R2) is greater for machine hours than for direct materials weight (0.7 instead of 0.5), there is a stronger relationship between machine hours (the independent variable) and the resulting cost than there is between the resulting cost and direct materials weight. Thus, the resulting cost can be best estimated by substituting machine hours for X in the equation Y = 2,500 + 5.0X.

To assist in an investment decision, Gift Co. selected the most likely sales volume from several possible outcomes. Which of the following attributes would selected sales volume reflect?

A. The midpoint of the range

B. The median

C. The greatest probability

D. The expected value

C. The greatest probability

“Most likely” is another way of saying the question is looking for the outcome with the greatest probability of occurrence.

Measures of central tendency include mean (average), mode (most common value), and median (the amount with half the values above and half below). Expected value is the weighted average of all the outcomes weighted by probability of occurrence.

The midpoint, median, and expected value may not have the greatest probability of occurrence, so none of those are necessarily the most likely to occur.

Older data is weighted less than newer or more recent data when using the statistical tool known as which of the following?

A. Exponential smoothing

B. Seasonal variation

C. Trend analysis

D. None of the answer choices are correct.

A. Exponential smoothing

Exponential smoothing weights current data heavier than older data. It is used to smooth forecast variation.

Exponential smoothing is a statistical method that is useful as a sales forecasting technique. This forecasting procedure is a special type of weighted moving average: it is reverse geometric progression in which the effect of past events (in this case sales) is discounted based on some multiple so that the effect which the past event has on current projections decreases as the time since the event increases.

Merry Co. has two major categories of factory overhead: material handling and quality control. The costs expected for these categories for the coming year are as follows:

Material handling $120,000 Quality inspection 200,000 The plant currently applies overhead based on direct labor hours. The estimated direct labor hours are 80,000 per year. The plant manager is asked to submit a bid and assembles the following data on a proposed job: Direct materials $4,000 Direct labor (2,000 hours) 6,000

What amount is the estimated product cost on the proposed job?

A. $8,000

B. $10,000

C. $14,000

D. $18,000

D. $18,000(4,000+6,000+2,000*1.5+2,000*2.5)

The first step in this problem is to calculate the two factory overhead rates:

Material handling and Quality control

This is accomplished by dividing the expected annual costs by the estimated direct labor hours (DLH) for the coming year.

Material handling overhead rate = $120,000 ÷ 80,000 DLH hours = $1.50 per DLH

Quality control overhead rate = $200,000 ÷ 80,000 DLH hours = $2.50 per DLH

The estimated cost of the proposed job can then be determined assuming that 2,000 hours of direct labor will be needed to complete the job.

Direct materials $ 4,000

Direct labor 6,000

Applied material handling (2,000 hours x $1.50 per DLH) 3,000

Applied quality inspection (2,000 hours x $2.50 per DLH) 5,000

Estimated product cost for proposed job $18,000

The standard direct labor cost to produce one pound of output for a company is presented below. Related data regarding the planned and actual production activities for the current month for the company are also given below.

Direct Labor Standard:

.40 DLH at $12.00 per DLH = $4.80

Planned production 15,000 pounds

Actual production 15,500 pounds

Actual direct labor costs (6,250 DLH) $75,250

The company’s direct labor rate variance for the current month would be:

A. $10 unfavorable.

B. $240 unfavorable.

C. $248 unfavorable.

D. $250 unfavorable.

D. $250 unfavorable.

$250 unfavorable derives from the actual direct labor hours (6,250) times the difference between the standard direct labor rate ($12.00) and the actual direct labor rate ($75,250 ÷ 6,250 = $12.04). Therefore, 6,250 × ($12.00 - $12.04) = $250.

$10 unfavorable derives from the difference between the planned direct labor hours (15,000 × .4 = 6,000) and the actual direct labor hours (6,250) times the difference between the standard direct labor rate ($12.00) and the actual direct labor rate ($75,250 ÷ 6,250 = $12.04) producing ((6,000 - 6,250) × ($12.00 - 12.04) = $10).

$240 unfavorable derives from the planned direct labor hours (15,000 × .4 = 6,000) times the difference between the standard direct labor rate ($12.00) and the actual direct labor rate ($75,250 ÷ 6,250 = $12.04) producing ((6,000) × ($12.00 - 12.04) = $240).

$248 unfavorable derives from the direct labor hours allowed for actual production (15,500 × .4 = 6,200) times the difference between the standard direct labor rate ($12.00) and the actual direct labor rate ($75,250 ÷ 6,250 = $12.04) resulting in ((6,200) × ($12.00 - 12.04) = $248).

Which of the following is not an integrating mechanism?

A. General personnel systems

B. General management systems

C. Increasing coordination potential

D. Reducing the need for coordination

A. General personnel systems

Integrating mechanisms connect the information, tasks, and resources with the work groups in the organization. The major integrating mechanisms include:

general management systems, increasing coordination potential, and reducing the need for coordination.

A delivery company is implementing a system to compare the costs of purchasing and operating different vehicles in its fleet. Truck 415 is driven 125,000 miles per year at a variable cost of $0.13 per mile. Truck 415 has a capacity of 28,000 pounds and delivers 250 full loads per year. What amount is the truck’s delivery cost per pound?

A. $0.00163 per pound

B. $0.00232 per pound

C. $0.58036 per pound

D. $1.72000 per pound

B. $0.00232 per pound

(0.13*125,000)/(28000*250)

The truck has a variable cost of $0.13 per mile × 125,000 miles, or $16,250 per year. It delivers 28,000 pounds × 250 loads, or 7,000,000 pounds a year.

Dividing the annual cost of $16,250 by 7,000,000 pounds delivered each year gives a cost of $0.00232 per pound delivered.

Which tool would most likely be used to determine the best course of action under conditions of uncertainty?

A. Cost-volume-profit analysis

B. Expected value (EV)

C. Program evaluation and review technique (PERT)

D. Scattergraph method

B. Expected value (EV)

Cost-volume-profit (CVP) analysis uses sales price and cost numbers that are assumed to be known in the short run.

Program evaluation and review technique (PERT) is used to plan and control the resources consumed in completing large and complex projects. PERT does use a probabilistic approach in identifying a “critical path,” but it is not applicable in situations other than those involving critical path identification.

The scattergraph approach is a graphical method for separating fixed and variable costs. Historical cost data is used as input in this process.

Expected value (EV) applies estimated percentages of occurrence to estimated values such as sales or costs. For example, assume that in preparing next month’s sales budget we think that there is a 60% chance that sales will be $200,000 and a 40% chance that sales will be $160,000. The expected value of sales is computed:

Sales x Probability = Expected Value $200,000 x .60 = $120,000 $160,000 x .40 = 64,000 -------- Total expected value for sales = $184,000 Expected value can be used to determine the best estimate or course of action under uncertainty.

The following information data pertains to a manufacturing company:

Total sales $80,000

Total variable costs 20,000

Total fixed costs 30,000

What is the breakeven level in sales dollars?

A. $30,000

B. $40,000

C. $50,000

D. $80,000

B. $40,000 (80,000-20,000)/80,000=0.75

30,000/0.75=40,000

The contribution margin ratio is the contribution margin (sales of $80,000 less variable costs of $20,000, or $60,000) divided by the sales revenue of $80,000, or 0.75.

Breakeven revenue is found by dividing the fixed costs of $30,000 by the contribution margin ratio of 0.75, for breakeven sales revenue of $40,000.

Black Co.’s breakeven sales were $780,000. Variable expenses averaged 60% of sales, and the margin of safety was $130,000. What was Black’s contribution margin?

A. $364,000

B. $546,000

C. $910,000

D. $1,300,000

A. $364,000=(780+130)-(780+130)*0.60=910-546

Margin of safety is sales above the breakeven sales, so sales were $910,000 (breakeven sales of $780,000 plus the margin of safety of $130,000). Since variable expenses were 60% of sales, the variable expenses were $546,000 ($910,000 × 0.60). Contribution margin equals sales ($910,000) less variable expenses ($546,000), or $364,000.

Since contribution margin is sales minus variable costs, this answer could also be calculated as the remaining 40% of the $910,000 in sales. (780+130)*(1-60%)

In calculating the breakeven point for a multi-product company, which of the following assumptions are commonly made when variable costing is used?

Sales volume equals production volume.

Variable costs are constant per unit.

A given sales mix is maintained for all volume changes.

A. I and II

B. I and III

C. II and III

D. I, II, and III

C. II and III

When performing cost-volume-profit (CVP) analysis, a standard assumption is that variable costs are constant per unit. In addition, if multiple products are involved, it becomes necessary to assume that the sales product mix will remain constant. Thus II, variable costs are constant per unit, and III, a given sales mix is maintained for all volume changes, must occur. There is no reason that sales volume must equal production volume (I).

The inherent simplifying assumptions used in CVP analysis are the following:

Costs and revenues are predictable and are linear over the relevant range.

Total variable costs change proportionally with the activity level. Variable costs per unit are constant.

Changes in inventory are insignificant.

Total fixed costs are constant over the relevant range of volume.

Production equals sales or units produced equals units sold.

The product mix is constant, or the firm has only one product.

A relevant range exists in which the various relationships are true.

All costs are either fixed or variable; i.e., costs can be separated into fixed and variable elements.

Productivity and efficiency are constant.

The sales mix remains constant.

Selling prices and unit variable costs are constant. Selling price does not change with the activity level.

The breakeven point is directly related to costs and indirectly related to the budgeted margin of safety and the contribution margin.

Breakeven analysis is based upon several simplified assumptions. Included in these assumptions is that variable costs are constant per unit and, for a multi-product company, that a given sales mix is maintained for all volume changes. When absorption costing is used, operating income is a function of both production volume and sales volume. This is because an increase in inventory levels causes fixed costs to be held in inventory while a decrease in inventory levels causes fixed costs to be charged to cost of goods sold. These fluctuations can dramatically affect income and the breakeven point. On the other hand, when variable costing is used, the same amount of fixed costs will be deducted from income whether or not inventory levels fluctuate. As a result, the breakeven point will be the same even if production does not equal sales. Hence, operating income under variable costing is a function only of sales, and assumption I is incorrect.

Seacraft, Inc., received a request for a competitive bid for the sale of one of its unique boating products with a desired modification. Seacraft is now in the process of manufacturing this product but with a slightly different modification for another customer. These unique products are labor intensive and both will have long production runs. Which one of the following methods should Seacraft use to estimate the cost of the new competitive bid?

A. Expected value analysis

B. Learning curve analysis

C. Regression analysis

D. Exponential distribution analysis

B. Learning curve analysis

Since the manufacturing processes for these unique products are new, are labor intensive and have long production runs, labor becomes more skilled, and hence more efficient, over time as the new processes are learned. This increased efficiency reduces the cost. Thus, the method that should be used to estimate the cost of the second process is learning curve analysis.

Brewster Co. has the following financial information:

Fixed costs $20,000

Variable costs 60%

Sales price $50

What amount of sales is required for Brewster to achieve a 15% return on sales?

A. $33,333

B. $50,000

C. $80,000

D. $133,333

C. $80,000 (X-0.6X-20,000=0.15X)

To achieve a 15% return on sales, $80,000 is required:

Net income = 0.15 x Sales

Sales - Variable costs - Fixed costs = Net income

Sales - (0.60 x Sales) - $20,000 = 0.15 x Sales

(0.85 x Sales) - (0.60 x Sales) = $20,000

0.25 x Sales = $20,000

Sales = $80,000

A company produces and sells two products. The first product accounts for 75% of units sold and the second product accounts for the remaining 25% of units sold. The first product has a selling price of $10 per unit, variable costs of $6 per unit, and allocated fixed costs of $100,000. The second product has a selling price of $25 per unit, variable costs of $13 per unit, and allocated fixed costs of $212,000. At the breakeven point, what number of units of the first product will have been sold?

A. 52,000

B. 39,000

C. 25,000

D. 14,625

B. 39,000=13,000*3312(212+100)/$24*=13,000 PACKEAGE

(3

*10+25)-(3*6+13)=24*

Total fixed costs of $312,000 ($100,000 from Product 1 and $212,000 from Product 2) must be covered by the contribution margin of the two products combined.

We know three times as many Product 1 units are sold as Product 2 units because 75% of unit sales is from Product 1. If we imagine a product package of 3 units of Product 1 and 1 unit of Product 2, it would be sold for (3 × $10) + $25, or $55. The variable cost of the package would be 3 × $6, or $18 for Product 1, plus $13 for Product 2, a total variable cost of $31. The contribution margin of the package would be $24 ($55 - $31).

Breakeven package units = Fixed costs ÷ Contribution margin per package = $312,000 ÷ $24 = 13,000 package units

Since there are 3 units of Product 1 in each package, sales of Product 1 will be 3 × 13,000 packages, or 39,000 units of Product 1.

The forecasting technique most relevant for analyzing data prior to creation of a flexible budget is:

A. exponential smoothing.

B. learning curves.

C. regression analysis.

D. time series analysis.

C. regression analysis.

Flexible budgets are prepared (or can be prepared) for different levels of activity. In doing this, it is necessary to identify and separate variable costs and fixed costs.

Regression analysis can be used to develop simple regression equations of the type y = a + b(x), where a represents the constant (i.e., fixed) cost and b represents the variable rate. This is what is needed for preparation of flexible budgets.

Strategic planning addresses both internal and external environment factors. Which of the following is not a component of the internal environment?

A. Competitive advantages

B. Opportunities

C. Strengths

D. Weaknesses

B. Opportunities

Opportunities and threats make up the external environment. The internal environment consists of strengths, weaknesses, and competitive advantages.

Crisper, Inc., plans to sell 80,000 bags of potato chips in June, and each of these bags requires five potatoes. Pertinent data includes the following:

Bags of Potato Chips Potatoes Actual June 1 inventory 15,000 bags 27,000 Desired June 30 inventory 18,000 bags 23,000

What number of units of raw material should Crisper plan to purchase?

A. 381,000

B. 389,000

C. 411,000

D. 419,000

C. 411,000

Chip production = Sales + Desired ending inventory -

Beginning inventory

= 80,000 + 18,000 - 15,000

= 83,000 bags

Potato purchases = Production needs + Desired ending inventory -

Beginning inventory

= (83,000 x 5) + 23,000 - 27,000

= 411,000 potatoes

A company that annually reviews its investment opportunities and selects appropriate capital expenditures for the coming year is presented with two projects, called Project A and Project B. Best estimates indicate that the investment outlay for Project A is $30,000 and for Project B is $1 million. The projects are considered to be equally risky. Project A is expected to generate cash inflows of $40,000 at the end of each year for two years. Project B is expected to generate cash inflows of $700,000 at the end of the first year and $500,000 at the end of the second year. The company has a cost of capital of 8%. What is the net present value (NPV) of each project when the cost of capital is zero?

A. Project A: $30,000; Project B: $1,000,000

B. Project A: $50,000; Project B: $200,000

C. Project A: $80,000; Project B: $1,200,000

D. Project A: $110,000; Project B: $2,200,000

B. Project A: $50,000; Project B: $200,000

When the cost of capital is zero, the NPV is simply the sum of a project’s un-discounted cash flows:

NPV = Cash inflows - Initial outlay

NPV for A = $ 40,000 + $ 40,000 - $ 30,000 = $50,000 NPV for B = $700,000 + $500,000 - $1,000,000 = $200,000

The amounts, $30,000 and $1,000,000, are the initial investment outlays and do not incorporate the cash inflows from the projects.

The amounts, $80,000 and $1,200,000, are the sums of cash inflows without deducting the initial investment outlays.

The amounts, $110,000 and $2,200,000, are calculated by adding, rather than subtracting, the initial outlays to the sum of the cash inflows.

How many levels of interdependence are included in integrated planning?

A. Three levels

B. One level

C. Five levels

D. Ten levels

A. Three levels

There are three levels of interdependence in integrated planning:

Pooled

Sequential

Reciprocal

Rolling Wheels purchases bicycle components in the month prior to assembling them into bicycles. Assembly is scheduled one month prior to budgeted sales. Rolling pays 75% of component costs in the month of purchase and 25% of the costs in the following month. Component costs included in budgeted cost of sales are as follows:

April May June July August

—— —— —— —— ——

$5,000 $6,000 $7,000 $8,000 $8,000

What is Rolling’s budgeted cash payments for components in May?

A. $5,750

B. $6,750

C. $7,750

D. $8,000

C. $7,750 (8,000*0.75+7,000*0.25)

Assembly is scheduled one month before the sale, and components are purchased the month before assembly. Cash payments are budgeted at 75% of the cost in the month following purchase and 25% in the next month.

Components for July sales ($8,000) would have been purchased in May and assembled in June; 75% of that $8,000 would have been paid in May, the month of purchase. This is a May payment of $6,000.

Components for June sales ($7,000) would have been purchased in April and assembled in May; 25% of that $7,000 would have been paid in May, the month following the month of purchase. This is a May payment of $1,750. Combining the $6,000 paid in May for July sales and the $1,750 paid in May for June sales gives total May cash payments of $7,750.

Cuff Caterers quotes a price of $60 per person for a dinner party. This price includes the 6% sales tax and the 15% service charge. Sales tax is computed on the food plus the service charge. The service charge is computed on the food only. At what amount does Cuff price the food?

A. $56.40

B. $51.00

C. $49.22

D. $47.40

C. $49.22 Cuff prices the food at $49.22, determined as follows:

Q = Quoted price ($60) P = Price for food ST = Sales tax (.06 × Price plus service charges

Q = P + ST + SC $60 = P + .06 (P + .15P) + .15P $60 = P + .06P + .009P + .15P $60 = 1.219P $60 / 1.219 = P $49.22 = P

Proof: Price of Food $49.22 Service charge (49.22 x .15) 7.38 Tax ((49.22 + 7.38) x.06) 3.40 Total Charge $60.00

A company is evaluating two investment proposals. Project A costs $700,000 and Project B costs $500,000. Expected cash inflows for the two projects are as follows:

Cash Inflow Cash Inflow At End of Year: At End of Year: Year Project A Project B ---- --------------- --------------- 1 $400,000 $250,000 2 $300,000 $250,000 3 $600,000 $250,000 Both projects are assessed as being equally risky and having an appropriate cost of capital of 10%.

For a 10% cost of capital, the following present value factors apply:

Number Present Value of Present Value of an Annuity of

of $1 Received at $1 Received at End of Each Year

Years End of Year N (PVIF) for N Years (PVIFA)

—— ——————– ——————————-

1 .9091 .9091

2 .8264 1.7355

3 .7513 2.4873

For a 3-year annuity, the following present value factors apply: Discount Present Value of a 3-Year Rate Annuity of $1 (PVIFA) -------- ------------------------- 16% 2.2459 20% 2.1065 24% 1.9813 28% 1.8684

Which of the following most closely approximates the internal rate of return of Project B?

A.16%

B.20%

C.24%

D.28%

C.24%

The internal rate of return is the discount rate that sets the net present value of a project equal to zero. At a discount rate of 24%, the net present value of Project B is: - $500,000 + $250,000 (PVIFA (3 years, 24%)) = - $500,000 + $250,000 (1.9813) = $4,675 Of the discount rates given, this one most closely approximates the internal rate of return on Project B.

At a discount rate of 16%, the net present value of Project B is:

-$500,000 + $250,000 (PVIFA (3 years, 16%))

= -$500,000 + $250,000 (2.2459)

= $61,475

At a discount rate of 20%, the net present value of Project B is:

-$500,000 + $250,000 (PVIFA (3 years, 20%))

= -$500,000 + $250,000 (2.1065) = $ 26,625

At a discount rate of 28%, the net present value of Project B is:

-$500,000 + $250,000 (PVIFA (3 years, 28%))

= -$500,000 + $250,000 (1.8684)

= -$32,900

Through the use of decision models, managers thoroughly analyze many alternatives and decide on the “best” alternative for the company. Often the actual results achieved from a particular decision are not what were expected when the decision was made. In addition, an alternative that was not selected may have actually been the best decision for the company. The appropriate technique to analyze the alternatives by using expected inputs and then altering them before a decision is made is:

A. expected value analysis.

B. Program Evaluation Review Technique (PERT).

C. sensitivity analysis.

D. regression analysis.

C. sensitivity analysis.

Sensitivity analysis is any process that measures the impact of a change in a single variable or a combination of variables on profits or on some other decision variable. That is, it is a technique to analyze the alternatives before the decision is made by measuring how changes in the critical assumptions will influence the results.

Sensitivity analysis asks “what if?” Expected value analysis is used to determine the mean value of a random variable over an infinite number of outcomes.

PERT is a network model used for planning and managing the system with well-defined activities and events (i.e., a start and a finish of activity). Regression analysis is a statistical tool that measures the average amount of change in the dependent variable that is associated with a unit change in the amount of one or more independent variables.

Relevant information for Product A follows:

Actual variable overhead cost per hour $8.00

Standard variable overhead cost per hour $7.50

Actual hours 4,500

Standard hours 5,000

What was the variable overhead spending variance for Product A?

A. $2,250 favorable

B. $4,000 favorable

C. $2,250 unfavorable

D. $4,000 unfavorable

C. $2,250 unfavorable

The variable overhead spending variance (VOHSV) is the comparison of what was actually spent with what was expected to have been spent for the actual amount used:

VOHSV = (Actual price - Standard price) × Actualquantity

Remember that for overhead variances, the “quantity” refers to the cost driver usage. So, for our example:

VOHSV = ($8.00 - $7.50) x 4,500 hours

= $0.50 x 4,500 hours

= $2,250 U

The variance is unfavorable (U) since more was spent than expected for the given activity level.

A company’s controller is adjusting next year’s budget to reflect the impact of an expected 5% inflation rate. Listed below are selected items from next year’s budget before the adjustment:

Total salaries expense $250,000

Health costs 100,000

Depreciation expense 65,000

Interest expense on 10-year, fixed-rate notes 37,750

After adjusting for the 5% inflation rate, what is the company’s total budget for the selected items before taxes for next year?

A. $470,250

B. $472,138

C. $473,500

D. $475,388

A. $470,250= ((250+100)*1.05+65+37.75

The expected inflation rate of 5% will affect items where the costs are being incurred due to activities taking place during the year, as opposed to being related to past actions or decisions. For example, the depreciation expense is based upon the systematic expensing of prior capital purchases. The interest expense is based upon a contract entered into sometime in the past.

The total budget before taxes for the items listed would be as follows:

Total salaries expense ($250,000 x 1.05 (105%)) $262,500

Health costs ($100,000 x 1.05) 105,000

Depreciation expense 65,000

Interest expense on 10-year, fixed-rate notes 37,750

Adjusted budget $470,250

A company manufactures a product using one material per unit. The following information for the upcoming budget year is available:

Number of units sold 14,500

Budgeted beginning FG inventory units 1,500

Budgeted ending FG inventory units 3,000

Budgeted beginning DM inventory units 2,000

Budgeted ending DM inventory units 1,500

Direct manufacturing material cost per unit $5

What amount is the total direct materials purchasing budget?

A. $67,500

B. $72,500

C. $77,500

D.$80,000

C. $77,500=((14,500+(3000-1500))-(2000-1500))*5

The company would produce 16,000 finished units, 14,500 to sell and 1,500 more to increase the finished goods inventory from 1,500 to 3,000 units. They would have to purchase 16,000 units of material, except that the raw material inventory declines by 500 units, from 2,000 units to 1,500 units; therefore, they will only purchase 15,500 units. At a cost of $5 per unit, the 15,500 units will cost $77,500.

A company is considering outsourcing one of the component parts for its product. The company currently makes 10,000 parts per month. Current costs are as follows:

Per Unit Total

Direct materials $4 $40,000

Direct labor 3 30,000

Fixed plant facility cost 2 20,000

The company decides to purchase the part for $8 per unit from another supplier and rents its idle capacity for $5,000/month. How will the company’s monthly costs change?

A. Decrease $15,000

B. Decrease $10,000

C. Increase $5,000

D. Increase $10,000

C. Increase $5,000

The product should be produced if the incremental cost to produce the product, including any opportunity cost of idle facilities, is less than the purchase price.

Since the fixed plant charge will not change due to this decision, it is irrelevant and should not be considered. The direct materials and direct labor costs ($40,000 + $30,000 = $70,000) are relevant costs. These incremental costs total $70,000 per month to make the product, while they can buy the part for $80,000 per month, an increase in monthly costs of $10,000.

However, the rental income from renting the idle capacity of $5,000 reduces the monthly cost of purchasing the parts, for a net increase in monthly costs of $5,000.

Sensitivity analysis in an investment project proposal:

A. calculates the change in the result due to a potential change in the project’s cash flows.

B. provides management with a linear equation of trend information from the projected cash flows.

C. develops probabilities for a variety of results.

D. develops the discount rate to be used in project evaluation.

A. calculates the change in the result due to a potential change in the project’s cash flows.

Sensitivity analysis is a “what if?” technique that asks how a result will change if the original predicted data changes or if an underlying assumption changes. Estimates and predictions are subject to varying degrees of uncertainty (defined here as the possibility that an actual amount will deviate from an expected amount). In investment projects, cash flows and interest rates are particularly subject to change.

Which of the following types of budgets is the last budget to be produced during the budgeting process?

A. Cash

B. Capital

C. Cost of goods sold

D. Marketing

A. Cash

A cash budget is the last budget to be prepared in the budgeting process because the other steps must be completed before the effects of each part on cash can be estimated.

The steps to prepare a master budget are:

develop a sales forecast,

determine the desired level of finished goods inventory,

prepare a purchases or production budget,

estimate selling, administrative, and other general expenses,

organize the preceding information into an income statement, and

prepare a cash forecast.

A disadvantage of the net present value method of capital expenditure evaluation is that it:

A. is calculated using sensitivity analysis.

B. computes the true interest rate.

C. does not provide the true rate of return on investment.

D. is difficult to adapt for risk.

C. does not provide the true rate of return on investment.

The net present value method of capital expenditure evaluation seeks to determine whether the present value of estimated future cash inflows at a desired rate of return will be greater or lesser than the cost of the proposed investment. The present value of the cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if its net present value is positive; that is, if the present value of the cash inflows exceeds the investment. The cash inflows, initial investment and desired rate of return are givens.

The net present value method does not calculate the true rate of return of the investment, only whether or not it meets, exceeds or falls short of the desired rate of return. This may be considered a disadvantage of the net present value method of capital expenditure evaluation.

The accountant for Champion Brake, Inc., applies overhead based on machine hours. The budgeted overhead and machine hours for the year are $260,000 and 16,000, respectively. The actual overhead and machine hours incurred were $275,000 and 20,000. The cost of goods sold (COGS) and inventory data compiled for the year is as follows:

Direct materials $ 50,000

COGS 450,000

Work-in-process (WIP) (units) 100,000

Finished goods (units) 150,000

What is the amount of over/underapplied overhead for the year?

A. $15,000

B. $50,000

C. $65,000

D. $67,000

B. $50,000=(260/16)*20HRs-275

The overhead application rate is $16.25 per machine hour (budgeted overhead of $260,000 divided by budgeted machine hours of 16,000). Multiplying that rate by actual hours of 20,000 gives $325,000 for overhead applied. Subtracting that from the $275,000 actual overhead gives a variance of $50,000. The overhead is over-applied since more overhead was applied to work-in-process than the actual overhead.

A ceramics manufacturer sold cups last year for $7.50 each. Variable costs of manufacturing were $2.25 per unit. The company needed to sell 20,000 cups to break even. Net income was $5,040. This year, the company expects the price per cup to be $9.00, variable manufacturing costs to increase 33.3%, and fixed costs to increase 10%. How many cups (rounded) does the company need to sell this year to break even?

A. 17,111

B. 17,500

C. 19,250

D. 25,667

C. 19,250

The breakeven point is where total revenue equals total cost. Another way to express this specific condition is that contribution margin equals fixed costs. In order to solve this problem, the following items must be determined:

Revenue per unit (P)

Variable cost per unit (V)

Total fixed costs (FC)

Projected revenue per unit is given in the problem as $9.00 per unit. Projected variable costs are as follows:

Prior variable cost per unit x (1 + 33.33)% = $2.25 per unit x 1 = $3.00 per unit

Total fixed costs were not given directly in the problem; however, they can be determined by first calculating the fixed costs for the prior year. Last year, the company needed to sell 20,000 cups in order to break even; therefore:

Last year’s fixed costs = 20,000 units x ($7.50 - $2.25)

= $105,000

The projected fixed costs are 10% more than the prior year. Projected fixed costs = $105,000 x 1.10

= $115,500

Breakeven in units = FC ÷ (P - V) = $115,500 ÷ ($9 - $3) = 19,250 units

Asta, Inc., is a medical laboratory that performs tests for physicians. Asta anticipates performing between 5,000 and 12,000 tests during the month of April. Compared to industry averages, at the low range of activity Asta has a lower sales price per test, higher fixed costs, and the same breakeven point in number of tests performed. At the high range of activity, Asta’s sales price per test and fixed costs are the same as industry averages, and Asta’s variable costs are lower. At the low range of activity (0 to 4,999 tests performed) fixed costs are $160,000. At the high range of activity (5,000 to 14,999 tests performed) fixed costs are $200,000.

Sales price per test $60

Variable costs per test 20

Are Asta’s contribution margin and breakeven point greater or lower than the industry average at the high activity range?

A. Contribution margin, greater; Breakeven point, greater

B. Contribution margin, greater; Breakeven point, lower

C. Contribution margin, lower; Breakeven point, greater

D. Contribution margin, lower; Breakeven point, lower

B. Contribution margin, greater; Breakeven point, lower

At the high range of activity, Asta’s sales price per test and fixed costs are the same as industry averages, and Asta’s variable costs are lower.

If Asta’s sales price per test is the same as the average but their variable costs are lower, that leaves a greater contribution margin per unit than the average.

If Asta’s contribution margin is greater than average and fixed costs are the same as average, then fewer units will cover those fixed costs, so their breakeven point is lower than average.

At annual sales of $900,000, the Ebo product has the following unit sales price and costs:

Sales price $20

Prime cost 6

Manufacturing overhead:

Variable 1

Fixed 7

Selling and admin. costs:

Variable 1

Fixed 3

18

Profit $ 2

What is Ebo’s breakeven point in units?

A. 25,000

B. 31,500

C. 37,500

D. 45,000

C. 37,500

Prime cost consists of direct material and direct labor. Both of these are variable costs, so total variable cost is $8 per unit ($6 + $1 + $1).

Current unit sales = $900,000 / $20 per unit = 45,000

Total fixed costs = (45,000 x $7) + (45,000 x $3)

= $315,000 + $135,000

= $450,000

Breakeven units = Total fixed costs / (Selling price - Variable cost)

= $450,000 / ($20 - $8)

= $450,000 / $12

= 37,500 units

Mat Co. estimated its material handling costs at two activity levels as follows: Kilos Handled Cost ------------- -------- 80,000 $160,000 60,000 132,000

What is the estimated cost for handling 75,000 kilos?

A.$150,000

B. $153,000

C. $157,500

D. $165,000

B. $153,000

Assuming that materials handling costs are variable costs, the change in volume of 20,000 units (80,000 – 60,000) causes a change in cost of $28,000 ($160,000 – $132,000). Therefore, variable costs per unit are $1.40 ($28,000 ÷ 20,000). Total variable costs at 60,000 units would be $84,000 (60,000 × $1.40), leaving the remaining $48,000 as fixed costs.

Since fixed costs do not change, the total cost at 75,000 units would be the variable costs of $105,000 (75,000 × $1.40) plus the fixed costs of $48,000, for a total cost of $153,000.

Card Bicycle Co. has prepared production and raw materials budgets for next year. At the end of this year, the finished product inventory is expected to include 2,000 bicycles and raw material inventory is expected to include 3,000 bicycle tires. Each finished bicycle requires two tires. The marketing department provided the following data from the sales budget for the first quarter:

January February March Expected Bicycle Sales (units) 12,000 16,000 18,000 The company inventory policy is to have finished product inventory equal to 20% of the following month's sales requirements and raw material equal to 10% of the following month's production requirements. In the January budget for raw materials, how many tires are expected to be purchased?

A. 24,200

B. 26,120

C. 26,600

D. 26,680

D. 26,680

January production = Jan. sales + Desired ending inventory - Beginning inventory

= 12,000 + (0.20 x 16,000) - 2,000 = 13,200 bicycles

February production = Feb. sales + Desired ending inventory - Beginning inventory

=16,000 + (0.20 x 18,000) - (0.20 x 16,000) = 16,400 bicycles

January purchases = Production needs + Desired ending inventory- Beginning inventory

= (2 x 13,200) + (0.10 x 2 x 16,400) - 3,000 =26,680 tires

Which one of the following is a sales forecasting technique?

A. Linear programming

B. Exponential smoothing

C. Queuing theory

D. Cost-volume-profit analysis

B. Exponential smoothing

Exponential smoothing is a statistical method that is useful as a sales forecasting technique. This forecasting procedure is a special type of weighted moving average: it is reverse geometric progression in which the effect of past events (in this case sales) is discounted based on some multiple so that the effect which the past event has on current projections decreases as the time since the event increases.

The other methods are not useful in forecasting sales:

Linear programming is a model for the allocation of scarce resources.

Queuing theory relates to the balancing of the cost of waiting with the cost of service; for example, the cost of lost sales resulting from long lines at the cash register versus the cost of opening another cash register.

Cost-volume-profit analysis is a model used to aid decision making relating to product lines, pricing of products, marketing strategy, and utilization of production facilities.

A company has had the following production experience over the last 10 quarters for product P1:

Quarterly Production Frequency 1,000 units 2 1,500 units 3 2,000 units 4 2,500 units 1 10 Additional information for P1: Unit variable costs $ 7 Quarterly unavoidable allocated fixed costs 40,000

A unit of P1 can be purchased from an outside supplier for $8.75. If P1 is purchased the plant facilities now used for its manufacture can be used to produce another product that will generate a quarterly contribution margin of $5,500. Assuming that P1 is to be produced internally, what is the expected quarterly production?

A. 700

B. 1,000

C. 1,700

D. 2,000

C. 1,700

The correct expected sales is 1,700 units, computed as follows:

Sales Probability Expected Value (Units)

1,000 .2 200

1,500 .3 450

2,000 .4 800

2,500 .1 250

1,700

700 is incorrect because it relies on the computed simple average of the past quarters: (1,000 + 1,500 + 2,000 + 2,500) ÷ 10 = 700. This does not take into account the associated probabilities of the outcomes.

1,000 is the minimum number of P1 manufactured during the past quarters; it does not represent expected requirements for P1 for the following quarter.

2,000 represents the quantity of P1 sold that occurred with the greatest frequency; it does not represent expected requirements of P1 in the following quarter.

Box Co. uses regression analysis to estimate the functional relationship between an independent variable (cost driver) and overhead cost. Assume that the following equation is being used:

y = A + Bx

What is the symbol for the independent variable?

A. y

B. x

C. Bx

D. A

B. x

A is the y intercept.

B is the slope of the line. (Linear means a straight line, so the slope of the line is the same at any point on the line.)

y is the dependent variable since it is determined based on the other three terms.

x is the independent variable since it is an input to the equation, not based on the other terms.

When estimating a cost function (y), x is the cost driver that determines the value of y.

In year 1, a company’s cash is 15% of sales, accounts receivable is 10% of sales, inventory is 20% of sales, accounts payable is 30% of sales, and long-term debt is 5% of sales. The company is preparing its forecasts and anticipates that sales will increase from $50,000 in year 1 to $55,000 in year 2. The company uses the percentage-of-sales method. What amount would be the required net working capital in year 2?

A. $(2,750)

B. $5,500

C. $7,500

D. $8,250

D. $8,250

Net working capital is Cash + Accounts Receivable (A/R) + Inventory – Accounts Payable (A/P), so net working capital is 15% + 10% + 20% – 30%, or 15% of sales.

Sales is forecast to be $55,000 in year 2, so net working capital would be $8,250 ($55,000 × 0.15).

The operating results in summarized form for a retail computer store for 20X1 are:

Revenue:

Hardware sales $4,800,000

Software sales 2,000,000

Maintenance contracts 1,200,000

Total revenue $8,000,000

Costs and expenses:

Cost of hardware sales $3,360,000

Cost of software sales 1,200,000

Marketing expenses 600,000

Customer maintenance costs 640,000

Administrative expenses 1,120,000

Total costs and expenses $6,920,000

Operating income $1,080,000

The computer store is in the process of formulating its operating budget for 20X2 and has made the following assumptions:

The selling prices of hardware are expected to increase 10% but there will be no selling price increases for software or maintenance contracts.

Hardware unit sales are expected to increase 5% with a corresponding 5% growth in the number of maintenance contracts; growth in software unit sales is estimated at 8%.

The cost of hardware and software is expected to increase 4%.

Marketing expenses will be increased 5% in the coming year.

Three technicians will be added to the customer maintenance operations in the coming year, increasing the customer maintenance costs by $120,000.

Administrative costs will be held at the same level.

The retail computer store’s budgeted total revenue for 20X2 would be:

A. $8,804,000.

B. $8,460,000.

C. $8,904,000.

D.$8,964,000.

D.$8,964,000.

Hardware sales = $4,800,000 x 1.05 x 1.10 = $5,544,000

Software sales = $2,000,000 x 1.08 = $2,160,000

Maintenance contracts = $1,200,000 x 1.05 = $1,260,000

Total budgeted revenue for 20X2 $8,964,000

The following is selected information from the records of Ray, Inc.:

Purchases of raw materials $ 6,000 Raw materials, beginning 500 Raw materials, ending 800 Work-in-process, beginning 0 Work-in-process, ending 0 Cost of goods sold (COGS) 12,000 Finished goods, beginning 1,200 Finished goods, ending 1,400 What is the total amount of conversion costs?

A. $5,500

B. $5,900

C. $6,100

D. $6,500

D. $6,500

Raw materials used = Purchases + Beginning raw material inventory - Ending raw material inventory

= $6,000 + $500 - $800

= $5,700

Current production costs = COGS + Ending finished goods inventory - Beginning finished goods inventory

= $12,000 + $1,400 - $1,200

= $12,200

Conversion cost = Direct labor + Overhead

= Production costs - Raw materials used

= $12,200 - $5,700

= $6,500

The proper discount rate to use in calculating certainty equivalent net present value is the:

A. risk-adjusted discount rate.

B. risk-free rate.

C. cost of equity capital.

D. cost of debt.

B. risk-free rate.

Normally, investment projects are perceived to be subject to some degree of risk with regards to amount and timing of future cash flows. This risk is incorporated into the analysis by using a discount rate higher than the risk-free rate. If there is no risk (i.e., the cash flows are certain), the appropriate discount rate is the risk-free rate.

In using regression analysis, which measure indicates the extent to which a change in the independent variable explains a change in the dependent variable?

A. p-value

B. r-squared

C. Standard error

D. t-statistic

B. r-squared

The coefficient of determination (r2) is a ratio that indicates the proportion of variance in the dependent variable determined by the independent variable using the regression equation.

Augusta, Inc., expects manufacturing and sales of 70,000 units of product Maggie, its only product, to occur evenly over a 10-week period. Augusta pays for materials in the week following use. The balance of accounts payable for materials at the beginning of the 10-week period is $40,000. There are no beginning inventories. The following information pertains to product Maggie for the 10-week period:

Sales price $11 per unit

Materials $3 per unit

Manufacturing conversion costs—Fixed $210,000

Variable $2 per unit

Selling and administrative costs—Fixed $45,000

Variable $1 per unit

A special order for 4,000 units would cause a loss of 1,000 regular sales. All cost relationships are unchanged. If the special order is accepted, what minimum amount of revenue must be generated from the special order so that net income is not reduced?

A. $29,000

B. $31,000

C. $38,000

D. $41,000

A. $29,000

Variable cost per unit is $3 for materials, $2 for other manufacturing costs, and $1 for selling and administrative, for a total of $6. Since the sales price is $11, the unit contribution margin ($11 − $6) is $5 per unit.

The loss of 1,000 units of regular sales would decrease total contribution margin by 1,000 × $5, or $5,000. The special order would need to generate $5,000 of contribution margin to replace the contribution of the regular units. If we let P equal the price per new unit, this equation is true, where P − 6 is the contribution margin per new unit:

4,000(P − 6) = 5,000

4,000P − 24,000 = 5,000

4,000P = 29,000

P = 29 ÷ 4 = $7.25

If the new units are sold for $7.25 each, and there are 4,000 units, the revenue from the new order will be 4,000 × $7.25, or $29,000.

A company uses a standard costing system. At the end of the current year, the company provides the following overhead information:

Actual overhead incurred:

Variable $90,000

Fixed $62,000

Budgeted fixed overhead $65,000

Variable overhead rate (per direct labor hour (DLH)) $8

Standard hours allowed for actual production 12,000

Actual labor hours used 11,000

What amount is the variable overhead efficiency variance?

A. $8,000 favorable

B. $8,000 unfavorable

C. $6,000 favorable

D. $2,000 unfavorable

A. $8,000 favorable

Variable overhead efficiency variance (VOHEV) = (Actual quantity × Standard price) - (Standard quantity × Standard price)

Remember that for overhead variances, the “quantity” refers to the cost driver usage. So, for the problem:

VOHEV = (11,000 DLH x $8 per hour) - (12,000 DLH x $8 per hour)

= $88,000 - $96,000

= $8,000 F

The variance is favorable (F) since less cost driver activity than expected was used for the units produced.

A manufacturing company that produces trivets has established the following standards for the current year:

Standard price per pound $3.00

Standard material usage per trivet 2.00

During April, the company purchased 10,000 pounds of material for $33,000 and used 9,400 pounds to produce 4,500 trivets. Four thousand trivets were sold during April. What amount should be reported as the materials’ quantity (usage) variance?

A. $1,200 unfavorable

B. $1,320 unfavorable

C. $3,000 unfavorable

D. $4,200 unfavorable

A. $1,200 unfavorable ($3*9400)-($3*2*4500)=28200-27000

The material efficiency (usage) variance of $1,200 is the difference between the budgeted cost of actual materials used of $28,200 ($3 × 9,400 pounds) and the budgeted cost of standard materials that should have been used for the units produced of $27,000 ($3 × 2 pounds per trivet × 4,500 trivets). The variance is unfavorable because the company actually used more material (9,400 pounds) than the standard amount (9,000 pounds).

The external environment, in a strategic planning context, includes:

A. limitations.

B. opportunities.

C. threats.

D. All of the answer choices are correct.

D. All of the answer choices are correct.

The external environment of a business is the environment within which that business resides. It is influenced and controlled by outside factors which do not depend in any way on that firm’s strengths and weaknesses. It includes limitations, opportunities, and threats coming from competitors, governmental agencies, and other external sources.

e following information pertains to Clove Co. for the year ending December 31:

Budgeted sales $1,000,000

Breakeven sales 700,000

Budgeted contribution margin 600,000

Cashflow breakeven 200,000

Clove’s margin of safety is:

A. $300,000.

B. $400,000.

C. $500,000.

D. $800,000.

A. $300,000.

Margin of safety = Budgeted sales - Breakeven sales

= $1,000,000 - $700,000 = $300,000

In preparing the annual profit plan for the coming year, Wilkens Company wants to determine the cost behavior pattern of the maintenance costs. Wilkens has decided to use linear regression by employing the equation y = a + bx for maintenance costs. The prior year’s data regarding maintenance hours and costs, and the results of the regression analysis are given here.

Hours Maintenance

of Activity Costs

Sum 4,480 $43,200

Average 400 3,600

Average cost per hour = $9.00; a = 684.65; b = 7.2884; Standard error of a = 49.515; Standard error of b = .12126; Standard error of the estimate = 34.469; r2 = .99724.

Based upon the data derived from the regression analysis, 420 maintenance hours in a month would mean the maintenance costs (rounded to the nearest dollar) would be budgeted at:

A. $3,780.

B. $3,790.

C. $3,746.

D. $3,756.

D. $3,756.

In this problem, hours of activity is the independent variable (x) with maintenance costs (y) being dependent upon the level of activity achieved. Using the standard simple regression equation and the other information given:

y = a + bx

y = 684.65 + 7.2884x

If maintenance activity (x) in a month is 420 hours, then maintenance costs for the month would be:

y = 684.65 + 7.2884(420)

= 684.65 + 3061.13

= 3745.78

= $3,746

Operational budgets are used by a retail company for planning and controlling its business activities. Data regarding the company’s monthly sales for the last six months of the year and its projected collection patterns are:

Forecasted Sales:

July $775,000

August 750,000

September 825,000

October 800,000

November 850,000

December 900,000

Types of Sales:

Cash sales 20%

Credit sales 80%

Collection Pattern for Credit Sales:

In the month of sale 40%

In the first month following the sale 57%

Uncollectible 3%

The cost of merchandise averages 40% of its selling price. The company’s policy is to maintain an inventory equal to 25% of the next month’s forecasted sales. The inventory balance at cost is $80,000 as of June 30.

The company’s total cash receipts from sales and collections on account that would be budgeted for the month of September would be:

A. $757,500.

B. $771,000.

C. $793,800.

D. $856,500.

B. $771,000.

The company’s total cash receipts from sales and collections on account that would be budgeted for the month of September would be $771,000. This response recognizes that 20% of the September sales are cash sales that would be collected in the month and 40% of the September credit sales (80% of the total sales) would be collected in the month, and 57% of the August credit sales (80% of the total sales) would be collected in September ($165,000 + $264,000 + $342,000 = $771,000).

Cash Receipts for September Sept. Cash Sales $825,000 x .2 $165,000 Sept. Credit Sales $825,000 x .8 x .4 264,000 Aug. Credit Sales $750,000 x .8 x .57 342,000 Budgeted Cash Receipts $771,000

A company that produces 10,000 units has fixed costs of $300,000, variable costs of $50 per unit, and a sales price of $85 per unit. After learning that its variable costs will increase by 20%, the company is considering an increase in production to 12,000 units. Which of the following statements is correct regarding the company’s next steps?

A. If production is increased to 12,000 units, profits will increase by $50,000.

B. If production is increased to 12,000 units, profits will increase by $100,000.

C. If production remains at 10,000 units, profits will decrease by $50,000.

D. If production remains at 10,000 units, profits will decrease by $100,000.

D. If production remains at 10,000 units, profits will decrease by $100,000.

The new contribution margin will be sales price less variable cost, or $85 − (120% × $50) = $25 per unit.

If production increases to 12,000 units, the contribution margin will be 12,000 × $25, or $300,000. Subtracting fixed costs of $300,000 from a contribution margin of $300,000 leaves no profit.

If production remains at 10,000 units, the contribution margin will be 10,000 × $25, or $250,000. Before the increase in variable costs, the contribution margin was 10,000 × $35 ($85 − $50), or $350,000. With no change in fixed costs, a decrease in the contribution margin from $350,000 to $250,000 will reduce profits by $100,000.

Asta, Inc., is a medical laboratory that performs tests for physicians. Asta anticipates performing between 5,000 and 12,000 tests during the month of April. Compared to industry averages, at the low range of activity Asta has a lower sales price per test, higher fixed costs, and the same breakeven point in number of tests performed. At the high range of activity, Asta’s sales price per test and fixed costs are the same as industry averages, and Asta’s variable costs are lower. At the low range of activity (0 to 4,999 tests performed) fixed costs are $160,000. At the high range of activity (5,000 to 14,999 tests performed) fixed costs are $200,000.

Sales price per test $60

Variable costs per test 20

Are Asta’s contribution margin and variable costs greater or lower than the industry average at the low activity range?

A. Contribution margin, greater; Variable costs, greater

B. Contribution margin, greater; Variable costs, lower

C. Contribution margin, lower; Variable costs, greater

D. Contribution margin, lower; Variable costs, lower

B. Contribution margin, greater; Variable costs, lower

Compared to industry averages, at the low range of activity Asta has a lower sales price per test, higher fixed costs, and the same breakeven point in number of tests performed.

If Asta has the same breakeven point as the averages but with higher fixed costs, it must have a greater contribution margin per unit to cover those higher fixed costs.

If Asta has the same breakeven point as the averages but with a lower sales price per test, it must have lower variable costs to generate that higher contribution margin to cover the higher fixed costs.

A vendor offered Wyatt Co. $25,000 compensation for losses resulting from faulty raw materials. Alternately, a lawyer offered to represent Wyatt in a lawsuit against the vendor for a $12,000 retainer and 50% of any award over $35,000. Possible court awards with their associated probabilities are as follows:

Award Probability

$75,000 0.6

0 0.4

Compared to accepting the vendor’s offer, the expected value for Wyatt to litigate the matter to verdict provides a:

A. $4,000 loss.

B. $18,200 gain.

C. $21,000 gain.

D. $38,000 gain.

A. $4,000 loss.

Here there are two possible outcomes: collecting $25,000, or accepting the lawyer’s offer to represent Wyatt in the lawsuit. We will need to compare the expected value of $25,000 (fixed at $25,000) with the expected value if the lawsuit alternative is chosen.

If the lawsuit is chosen, Wyatt will lose the $12,000 retainer, but have a 60% probability of winning $75,000 less the lawyer’s contingent fee of 50% of the award above $35,000. The contingent fee would be 50% times ($75,000 − $35,000) which is 0.50 × $40,000, or $20,000.

The value of winning the lawsuit is $75,000 less the contingent fee of $20,000, or $55,000. The expected value of winning the lawsuit is the probability of winning (60%) multiplied by the value of winning ($55,000), or $33,000. However, Wyatt will have to pay the retainer of $12,000, leaving a net expected value of $21,000.

Comparing a gain of $25,000 from accepting the vendor’s offer with an expected value of $21,000 of filing the lawsuit leaves a loss of $4,000 to file the lawsuit, as compared to accepting the vendor’s offer.

Cook Co.’s total costs of operating five sales offices last year was $500,000, of which $70,000 represented fixed costs. Cook has determined that total costs are significantly influenced by the number of sales offices operated. Last year’s costs and number of sales offices can be used as the basis for predicting annual costs. What would be the budgeted costs for the coming year if Cook were to operate seven sales offices?

A. $700,000

B. $672,000

C. $614,000

D. $586,000

B. $672,000

Total cost last year $500,000

Less fixed cost -70,000

Variable cost for five offices $430,000

Variable cost per office = $430,000 / 5 = $86,000

Variable cost for seven offices = 7 x 86,000 = $602,000

Add fixed costs 70,000

Total cost of operating seven offices = $672,000

Probability (risk) analysis is:

A. used only for situations involving five or fewer possible outcomes.

B. used only for situations in which the summation of probability weights is greater than one.

C. an extension of sensitivity analysis.

D. incompatible with sensitivity analysis.

C. an extension of sensitivity analysis.

Sensitivity analysis determines how the results will change if the original data or the underlying assumptions change. It is the process of identifying the data changes that alter optimal solutions and the decisions made based on that solution. Probability analysis combines the likelihood of various outcomes with sensitivity analysis.

Probability analysis can be used with an infinite number of outcomes, and 1.00 is the largest possible probability. It is helpful to combine probability analysis with sensitivity analysis to evaluate the sensitivity of various outcomes to risk.

If there is a strong statistical relationship between the sales and customers’ income levels, which of the following numbers best represents the correlation coefficient for this relationship?

A. -9.00

B. -0.93

C. +0.93

D. +9.00

B. -0.93

A negative correlation coefficient means that as one variable increases, the other decreases, so +0.93 and +9.00, which are positive, are incorrect. The answer choices -9.00 and +9.00 are incorrect because the correlation coefficient must be between -1.0 and 1.0.

The only answer choice that has not been eliminated is -0.93.

At the end of a company’s first year of operations, 2,000 units of inventory are on hand. Variable costs are $100 per unit and fixed manufacturing costs are $30 per unit. The use of absorption costing, rather than variable costing, would result in a higher net income of what amount?

A. $60,000

B. $140,000

C. $200,000

D. $260,000

A. $60,000

Absorption costing assigns the fixed (overhead) costs as product costs. Variable costing considers the fixed costs as expense in the period incurred.

The net income, therefore, would increase using absorption costing by the amount of overhead allocable to the units which are in inventory on hand at the end of the year. This is because those fixed costs are not considered an expense in absorption costing, but are considered one in variable costing.

The fixed manufacturing costs allocable to the 2,000 units on hand at the end of the year would be $60,000 (2,000 × $30 per unit).

An investor uses risk analysis to measure the probability of the variability of future returns from a proposed investment. What is the approach that is based upon utility theory and compels the decision maker to choose at what point he or she is indifferent to the choice between a certain amount of money and the expected value of a risky amount?

A. Capital Asset Pricing Model

B. Certainty equivalent adjustments

C. Risk-adjusted discount rates

D. Sensitivity analysis

B. Certainty equivalent adjustments

Certainty equivalent adjustments is a risk analysis technique that is based upon utility theory. The “utility” is how much a certain sum of money is worth to the investor. It makes the decision maker stipulate at what point he or she is indifferent to the choice between a certain amount of money and the expected value of a risky amount.

The amount of payoff (e.g., money or utility) that an investor would have to receive between that payoff and a given risk or gamble is called that gamble’s “certainty equivalent.” For a risk-averse investor, the certainty equivalent is less than the expected value of the gamble because the investor prefers to reduce uncertainty.

A certainty equivalent represents the maximum amount one is willing to pay for some gamble. It is also the minimum premium one is willing to pay to insure against some risk.