Problem 7-20 Evaluating the Profitability of Services [LO7-2, LO7-3, LO7-4, LO7-5]

Gallatin Carpet Cleaning is a small, family-owned business operating out of Bozeman, Montana. For its services, the company has always charged a flat fee per hundred square feet of carpet cleaned. The current fee is $23.75 per hundred square feet. However, there is some question about whether the company is actually making any money on jobs for some customers—particularly those located on remote ranches that require considerable travel time. The owner’s daughter, home for the summer from college, has suggested investigating this question using activity-based costing. After some discussion, she designed a simple system consisting of four activity cost pools. The activity cost pools and their activity measures appear below:

The total cost of operating the company for the year is $368,000 which includes the following costs:

Resource consumption is distributed across the activities as follows:

Job support consists of receiving calls from potential customers at the home office, scheduling jobs, billing, resolving issues, and so on.

Required:

1. Prepare the first-stage allocation of costs to the activity cost pools.

2. Compute the activity rates for the activity cost pools.

3. The company recently completed a 600 square foot carpet-cleaning job at the Flying N Ranch—a 55-mile round-trip journey from the company’s offices in Bozeman. Compute the cost of this job using the activity-based costing system.

4. The revenue from the Flying N Ranch was $142.50 (600 square feet @ $23.75 per hundred square feet). Calculate the customer margin earned on this job.

You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $2.1 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $2.3 million on an after-tax basis. In four years, the land could be sold for $2.4 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. An excerpt of the marketing report is as follows: The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 3,600, 4,300, 5,200, and 3,900 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $750 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued. PUTZ believes that fixed costs for the project will be $415,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.5 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $350,000. Networking capital of $125,000 will be required immediately. PUTZ has a 38% tax rate, and the required rate of return on the project is 13%.

Now please provide a detailed explanation for the following:

• Explain how you determine the initial cash flows

• Discuss the notion of sunk costs and identify the sunk cost in this project

• Verify how you determine the annual operating cash flows

• Explain how you determine the terminal cash flows at the end of the project’s life

• Calculate the NPV and IRR of the project and decide if the project is acceptable

• If the company that is implementing this project is a publicly-traded company, explain and justify how this project will impact the market price of the company’s stock

Carter v Indianapolis Power & Light Company and Indiana Bell Telephone Company, Inc 2005: Carter sued as personal representative for the estate of Jacobs. Jacobs was speeding and “jumping hills” when he crashed into a utility pole, spun out and crashed into another pole starting a fire in which he died. Carter sued saying companies were negligent in where they placed the poles. The court gave summary judgement to the defendants. Another odd one to be sure but can you make an argument in favor of liability to a utility company based on the placement of utility poles?

Deflation refers to the phenomenon of a negative inflation rate. (In 2004, the inflation rate was negative in Hong Kong and we say Hong Kong suffered deflation in 2004.) Many people regard deflation as bad. Can you explain why? Is deflation sometimes good (at least for some people)? (400 words)

Target Corporation prepares its financial statements according to U.S. GAAP. Target's financial statements and disclosure notes for the year ended February 3, 2018, are - This material also is available under the Investor Relations link at the company's website.
1. On what line of Target's income statement is revenue reported? What was the amount of revenue Target reported for the fiscal year ended February 3, 2018? 2. Disclosure Note 2 indicates that Target generally records revenue in retail stores at the point of sale. Does that suggest that Target generally records revenue at a point in time or over a period of time? Explain. 3. Disclosure Note 2 indicates that customers ("guests") can return some merchandise within 90 days of purchase and can return other merchandise within a year of purchase. How is Target's revenue and net income affected by returns, given that it does not know at the time a sale is made which items will be returned? 4. Disclosure Note 2 indicates that "Commissions earned on sales generated by leased departments are included within sales and were $44 million ... in 2017." Do you think it likely that Target is accounting for those sales as a principal or an agent? Explain.
5. Disclosure Note 2 discusses Target's accounting for gift card sales. Does Target recognize revenue when it sells a gift card to a customer? If not, when does it recognize revenue? Explain. 6. Disclosure Note 4 discussed how Target accounts for consideration received from vendors, which they call "vendor income." Does that consideration produce revenue for Target? Does that consideration produce revenue for Target's vendors? Explain.

Shamsud Ltd. operates on a calendar-year basis. At the beginning of December 2016, the company had the following current liabilities on its books:

In December, the following events occurred:

1.Shamsud purchased a new computer system on account at a cost of $28,000, payable on January 15, 2017. In addition to this, $4,000 was paid in cash to have the new system installed and customized to the company's requirements.

2.The company purchased inventory for $93,000 on account and made payments of $86,000 to its suppliers.

3.The rent that was payable at the beginning of December represented the payment that should have been made in November. In December, Shamsud paid the past rent owed, as well as the rent for December and January.

4.By December 31, the company had earned $5,000 of the service revenue that was received in advance from customers.

5.Shamsud's employees are paid a total of $2,000 per day. Three work days elapsed between the last payday and the end of the fiscal year. (Ignore deductions for income tax, CPP, and EI.)

6.The company's products are sold with a two-year warranty. Shamsud estimates its warranty expense for the year (not previously recorded) as $16,000. During December, it paid $1,200 in warranty claims.

Required:

a.  

Prepare the journal entries to record the December transactions and adjustments. (Ignore the amounts that the company pays for its share of CPP and EI.)

b.  

Prepare the current liability section of Shamsud's statement of financial position on December 31, 2016.

Herr Fenderbender considers himself a great driver. He has just received a Mercedes sports car as a gift from his uncle. His car is worth $90 000, but will have a scrap value of $10 000 in the event of a collision, an event that will occur with a probability of 0.4. He is offered the following insurance policy: In the event of a collision the insurance company will pay Herr Fenderbender $80 000. The insurance company is asking a premium of R = $27 500 which Fenderbender has to pay if the policy is accepted, whether or not there is a collision. Herr Fenderbender has a (von-Neumann Morgenstern) utility function of wealth given by: U = W ^ 1/2

1.Should Herr Fenderbender purchase this insurance? Explain carefully.

2.Should the insurance company be offering him this insurance (the insurance company has a lot of customers and hence is risk neutral; i.e. it has utility function U= x.

3.Repeat 1 and 2 for the case where the insurance premium is R = $37 100.

4.Find the range of values of the insurance premium, R, which will be accepted by Fenderbender AND which the insurance company would be willing to offer.

5.Suppose now that the insurance company knows that Herr Fenderbender is a good driver but believes that due to the moral hazard problem, after the insurance policy has been purchased the probability that there will be a collision will rise to 0.5. What does the insurance company believe its expected profit from sale of the policy is, and should the insurance company sell Fenderbender that policy? (R = $37 100)

True or False

Indirect costs are usually included in the costs that are allocated to activity cost pools in an activity-based costing system

In the first-stage allocation in an ABC system, some costs may be allocated to a special cost pool that are not subsequently allocated to products or customers.

The activity variance for revenue is favorable if the revenue in the flexible budget exceeds the revenue in the static planning budget.

A favorable spending variance occurs when the cost in the flexible budget exceeds the amount of that actual cost (i.e. the corresponding cost in the actual results).

If the required rate of return is 15% and the internal rate of return of a potential investment 10%, the company should deem the investment acceptable.

When cash flows are uneven and vary from year to year, the net present value method is harder to calculate than the internal rate of return method.

In capital budgeting computations, discounted cash flow methods assume that all cash flows occur at the beginning of a period.

Use the following to answer questions 20-21:

LeGrand Co. sells office supplies and equipment to law firms and other high-end clients. Their accountant has provided you with the following Balance Sheet for the company for 2005.

The company's loan is not due for 3 more years. However, they are required to pay off 20% of their mortgage each year. The company has decided that they should list their PPE accounts at historical cost, rather than as net amounts. They have also decided to combine all of the accumulated depreciation into one account on the balance sheet. LeGrand issued their $650,000 bond at face value on October 1st. The bond is semi-annual (i.e. LeGrand must pay interest every 6 months) with an 8% annual interest rate. When the auditor checked the numbers given above, they found that LeGrand had yet not recognized any interest expense on the bond.