Costs and Net Operating Income

Exchange Corp. is a company that acts as a facilitator in tax-favored real estate swaps. Such swaps, know as 1031 exchanges, permit participants to avoid some or all of the capital gains taxes that would otherwise be due. The bookkeeper for the company has been asked to prepare a report for the company to help its owner/manager analyze performance. The first such report appears below: Note that the revenues and costs in the above report are unit revenues and costs. For example, the average office expense is $135 per exchange completed on the planning budget; whereas, the average actual office expense is $112 per exchange completed.

Legal and search fees is a variable cost; office expenses is a mixed cost; and equipment depreciation, rent, and insurance are fixed costs. In the planning budget, the fixed component of office expenses was $5,200. All of the company’s revenues come from fees collected when an exchange is completed. Required: 1. Evaluate the report prepared by the bookkeeper. 2. Prepare a performance report that would help the owner/manager assess the performance of the company in May. 3. Using the report you created, evaluate the performance of the company in May.

SOLUTION: 1. The report prepared by the bookkeeper compares average budgeted per unit revenues and costs to average actual per unit revenues and costs. This approach implicitly assumes that all costs are strictly variable; only variable costs should be constant on a per unit basis. The average fixed cost should decrease as the level of activity increases and should increase as the level of activity decreases. In this case, the actual level of activity was greater than the budgeted level of activity.

As a consequence, the average cost per unit for any cost that is fixed or mixed (such as office expenses, equipment depreciation, rent, and insurance) should decline and show a favorable variance. This makes it difficult to interpret the variance for a mixed or fixed cost. For example, was the favorable $9 variance per exchange for rent due simply to the increased volume or did the company actually save any money on its rent? Because of this ambiguity, the report prepared by the bookkeeper is not as useful as a performance report prepared using a flexible budget.

2. A flexible budget performance report would be much more helpful in assessing the performance of the company than the report prepared by the bookkeeper. To construct such a report, we first need to determine the cost formulas as follows, where q is the number of exchanges completed: Revenue $395q The revenue all comes from fees. Legal and search fees $165q Variable cost Office expenses $5,200 + $5q $5,200 is fixed; $5 = ($135 ? 40 ? $5,200)/40 Equipment depreciation $400 $400 = $10 ? 40 Rent $1,800 $1,800 = $45 ? 40 Insurance $200 $200 = $5 ?

40 Exchange Corp Flexible Budget Performance Report For the Month Ended May 31 Planning Budget Activity Variances Flexible Budget Spending Variances Actual Results Exchanges completed (q) 40 50 50 Revenue ($395q) $15,800 $3,950 F $19,750 $ 500 U $19,250 Expenses: Legal and search fees ($165q) 6,600 1,650 U 8,250 950 U 9,200 Office expenses ($5,200 + $5q) 5,400 50 U 5,450 150 U 5,600 Equipment depreciation ($400) 400 0 400 0 400 Rent ($1,800) 1,800 0 1,800 0 1,800 Insurance ($200) 200 0 200 0 200 Total expense 14,400 1,700 U 16,100 1,100

U 17,200 Net operating income $ 1,400 $2,250 F $ 3,650 $1,600 U $ 2,050 3. On the one hand, the increase in the number of exchanges completed was positive. The overall favorable activity of $2,250 indicates that the net operating income should have increased by that amount because of the increase in activity. However, the net operating income did not actually increase by nearly that much. This was due to the unfavorable revenue variance and a number of unfavorable spending variances, all of which should be investigated by the owner.

A limited
time offer!
Save Time On Research and Writing. Hire a Professional to Get Your 100% Plagiarism Free Paper