Accounting for Non-Financial Managers
Accounting for Non-Financial Managers
Chapter 7: Cost Behaviour, Breakeven and Activity Based Costing
Discussion Questions & Problems: SOLUTIONS
Discussion Questions
7.1
Describe how fixed costs and variable costs behave with respect to activity.
When activities increase or decrease, variable costs increase or decrease in proportion, while fixed costs do not change. Fixed costs will change as a result of the passage of time, or as the result of a management decision.
7.2
How is the contribution margin useful in decision making?
The contribution margin (selling price less variable cost) measures the effect of selling one additional unit, it is the net benefit of marginal activity
7.3
Is the breakeven model a realistic description of real world organizations?
While the breakeven model gives some insights into simple situations and decisions, it is too crude for complex situations, and fails to adequately represent the type of diverse multi-product organization that is typical of modern business. Activity based costing is a more realistic model for these.
7.4
Is it possible to change one variable in a breakeven calculation without affecting any of the others?
It is unlikely that this could be done in a beneficial way. For example, you might be able to reduce costs, but this will probably compromise quality, and hence sales volume.
7.5
Give two examples of batch related costs and describe what causes them to behave the way they do.
Set-up costs: the costs associated with configuring machines to make products are incurred once at the start of each batch;
Inspection cost: the costs associated with quality control may occur once when the batch is inspected.
7.6
Give two examples of product sustaining costs and describe what causes them to behave the way they do.
Engineering: costs associated with design and redesign of the product: they exist if the product exists, they are avoided if the product is deleted.
Advertising: costs associated with advertising and promotion of the product: they exist if the product exists, they are avoided if the product is deleted.
7.7
Do unit variable costs occur in activity based costing?
Yes, unit variable costs, such as materials, do not disappear with ABC; ABC is more relevant to analysis of overhead costs.
7.8
How would you treat research and development costs in an activity based costing analysis of a company?
Research & development is a discretionary cost, it is caused by a management decision rather than any product or work related activity.
7.9
What are the main features of a situation where activity based costing will give a better understanding of product cost that traditional cost allocation?
There should be a high level of complexity, with different products or customers making different resource demands on the system.
7.10
Which is more precise, breakeven or activity based costing?
Break-even analysis only uses one cost driver (volume), ABC is more precise, as it analyses costs according to a larger list of cost drivers.
Problems
7.1
Kloster Chemical makes ethical pharmaceuticals. Classify the following costs it incurred as variable, fixed or mixed:
a) raw materials;
variable;
b) direct labour;
variable (could be fixed e.g. guaranteed hours conbtract);
c) supervisory labour;
fixed;
d) utilities;
mixed;
e) administrative overhead;
mixed;
f) depreciation of plant;
fixed (probably);
g) depreciation of office equipment;
fixed;
h) production manager’s salary;
fixed;
i) the annual audit;
fixed;
j) research and development.
fixed.
7.2
Maria Egger has decided to go into business making pizzas. Ingredient cost will be $3 per pizza; delivery will cost $1 per pizza. The pizzas will sell for $9 each. Fixed costs will be rent $500 per month, and phone, $50 per month. All the work will be done by Maria herself, so no wages will be paid.
Required:
a) how many pizzas must she sell to break even?
Contribution margin = $9 – ($3 + $1) = $5
Fixed cost = ($500 + $50) = $550
Break-even = fixed cost/contribution margin = 110 pizzas.
b) if Maria wants a $2,000 per month for her work, how many pizzas must she sell?
Fixed cost + required profit = $2,000 + $550 = $2,550
$2,550/$5 contribution margin = 510 pizzas.
c) Maria’s brother Tim wants to come and work for her. If he did so output could be increased. His salary would be $1,600 per month. How many additional pizzas must Maria sell to justify hiring Tim?
Additional fixed cost = $1,600/$5 contribution margin = 320 additional.
d) what would be the effect on the decision to hire him of paying Tim on a “per pizza” rate, rather than $1,600 per month?
Paying Tim on a “per pizza” rate makes his cost a variable cost instead of a fixed cost. It reduces the risk for Maria, as no Pizzas, no cost.
7.3
The Training Department of Ace Chemicals runs regular courses on health & safety at work. Each course has an instructor and 50 participants. The following costs were incurred in 2001, when 8 courses were offered: The courses are paid for by the divisions the participants work for, at a rate of $250 per person.
a) publicity: $ 2,000;
b) administration: $16,000
c) instructors’ fees: $40,000;
d) refreshment: $ 2,000;
e) course related photocopying: $ 2,400;
f) room hire (6 @ $500, 2 @ $1,300): $ 5,600;
g) depreciation (educational computers): $ 9,000,
h) software licence ($5,000 + $1,000 per course) $13,000.
Required:
a) classify each cost as variable, fixed or mixed, in relation to courses;
publicity: $ 2,000; fixed
administration: $16,000; fixed
instructors’ fees: $40,000; variable
refreshment: $ 2,000; variable
course related photocopying: $ 2,400; variable
room hire (6 @ $500, 2 @ $1,300): $ 5,600; variable
depreciation (educational computers): $ 9,000, fixed
software licence
($5,000 + $1,000 per course) $13,000; mixed
b) calculate the variable cost per course and the total variable cost.
Variable costs:
instructors’ fees: $40,000; variable
refreshment: $ 2,000; variable
course related photocopying: $ 2,400; variable
room hire (6 @ $500, 2 @ $1,300): $ 5,600; variable
software licence $ 8,000; variable part
Total $58,000
# courses: 8
Variable cost per course $ 7,250
c) calculate the total fixed cost and the fixed cost per course,
publicity: $ 2,000; fixed
administration: $16,000; fixed
depreciation (educational computers): $ 9,000, fixed
software licence $ 5,000 fixed part
Total: $32,000
# courses: 8
Fixed cost per course: $ 4,000
d) calculate the contribution margin per course;
Contribution margin =
selling price ($250 * 50 participants) – variable cost ($7,250) = $5,250
e) calculate the breakeven point in number courses;
B/E = Fixed cost/contribution margin = $32,000/$5,250 = 6.09 courses
f) calculate the budgeted profit;
Contribution margin: 8 * $5,250 = $42,000 – fixed cost ($32,000) = $10,000
g) calculate the total cost per course;
Variable cost ($7,250) + fixed cost ($4,000) = $11,250
h) if they run one additional course, by how much will profit increase?
$5,250 (= unit contribution margin)
i) if they have one additional student on one of the courses, what is the effect?
Probably negligible effect on costs (photocopying + refreshments);
Increases revenue by $250.
j) the manager of the Nuclear Fuels divisional has asked the Training Division to run a specialized course for them. The Nuclear Fuels Division would provide the room, the refreshments and the photocopying. The Training Department would provide the instructor, the computers and the computer software. How much should the Training Division charge the Nuclear Fuels Division for this course?
Instructor: $5,000 ($40,000/8 courses)
Computers: nil
Computer software 1,000 (variable part)
Minimum: $6,000 they must charge this to break even
A good argument can also be made for adding the following cost of fixed expenses:
publicity: 250 $ 2,000/8 courses
administration: 2,000 $16,000/8 courses
depreciation 1,125 $ 9,000/8 courses
software licence 625 $ 5,000/8 courses
$4,000
(an interesting debate can occur as to whether 8 courses or 9 courses should be used as the divisor)
A slightly less good argument can also be made for adding their “normal” profit margin of $1,250.
k) should the Training Department be making a profit at the expense of the operating divisions it services with courses?
That depends on how the organization perceives the Training Department: is it a profit centre or a cost centre?
l) is the breakeven model a good description of the Training Department’s activities?
Mostly, yes, as it is a simple situation, with a single product. However, we know some courses have different costs (room hire), which means that they will have different contribution margins.
7.4
Classify the following costs incurred by Kloster Chemical as unit variable, batch level, product sustaining or business sustaining:
a) raw materials;
unit variable;
b) direct production labour;
unit variable (probably);
c) supervisory labour (used to check production settings when a new production run is started);
batch level;
d) cost of operating forklift trucks to move goods in the plant;
batch level;
e) utilities;
mix of product sustaining & business sustaining;
f) laboratory costs (used to monitor product specifications);
product sustaining;
g) administrative overhead;
business sustaining;
h) sales personnel (sales persons specialise in one product each);
product sustaining;
i) cataloguing products;
product sustaining;
j) depreciation of plant;
product sustaining;
k) depreciation of office equipment;
business sustaining;
l) production manager’s salary;
product sustaining or business sustaining;
m) the annual audit;
business sustaining;
n) research and development.
business sustaining.
7.5
Identify a cost driver for each of the following activities:
a) ordering raw materials;
number of orders placed;
b) moving raw materials from inventory to production;
number of material move orders;
c) raw materials used;
raw material cost;
d) production scheduling;
number of production runs;
e) machine setup costs;
number of production runs;
f) quality control;
number of inspections;
g) plant depreciation;
quantity/cost of plant;
h) depreciation of office computers;
quantity/cost of computers;
i) office cleaning and maintenance;
number of offices;
j) sales personnel salaries;
number of sales personnel;
k) sales personnel bonuses;
sales $;
l) advertising products;
number of products;
m) corporate public relations.
fixed cost.
7.6
The Vision Co has calculated the following cost drivers and cost driver rates:
Maintenance: $ 2 per machine hour;
Materials handling: $10 per material move;
Machine setup: $50 per setup hour;
Inspection: $ 5 per inspection.
Product 55Y requires the following:
100 machine hours;
25 material moves;
15 setup hours;
3 inspections.
Required:
calculate the overhead to be allocated to product 55Y
100 machine hours * $2 = $ 200
25 material moves * $10 = 250
15 setup hours * $50 = 750
3 inspections * $5 = 15
Total $1,215
7.7
KL Co has analysed its budgeted overhead costs into four cost pools, as follows:
Production run setup costs: $480,000
Materials ordering and handling: 120,000
Utilities: 300,000
Maintenance 160,000
Total $960,000
They have also identified the following cost drivers:
for production run setup the cost driver is setup hours: there are 1,200 setup hours budgeted;
for materials handling the cost driver is the weight of materials handled. Budgeted material weight is 200 tonnes;
for utilities the cost driver is the rated wattage of machines. Total is budgeted at 100,000 kilowatt hours;
maintenance has no cost driver as it is a business sustaining cost.
The following information refers to Product B27:
Number of units produced: 1,000
Direct materials: $24,000
Direct labour: $15,000
Setup hours: 200
Weight: 20 tonnes
Kilowatt hours: 8,000
Required:
calculate the cost per unit for product B27
Production run set-up costs: $480,000/1,200 = $400/set-up hour
Materials ordering and handling:120,000/200 tonnes = $600/tonne
Utilities: 300,000/100,000 = $3/kilowatt hour
Maintenance 160,000
Total $960,000
Product B27:
Raw materials: $ 24,000
Labour: 15,000
Set-up: 200 * $400 80,000
Materials handling: 20 * $600 12,000
Utilities: 8,000 * 3 24,000
Total $155,000
# units 1,000
Cost per unit $ 155
7.8
Verona Inc has established the following cost pools:
Pool Budgeted Cost Cost Driver Budgeted Level
Setups: $50,000 Number of setups 100 setups
Materials handling: $98,000 Number of moves 245 moves
Maintenance: $42,000 Machine hours 4,200 hours
Inspection: $10,000 Inspection hours 1,000 hours
Labour hours: 10,000 hours
The following data refers to two jobs completed during July 2002:
Job 7/234 Job 7/235
Direct material cost: $12,500 $ 6,000
Direct labour cost: 24,000 4,000
Direct labour hours: 1,000 150
Machine hours: 100 75
Number of setups: 1 1
Material moves: 25 20
Inspection hours: 125 80
Required:
a) using labour hours as the allocation base, calculate a plant-wide overhead recovery rate;
Budgeted overhead cost:
Set-ups: $ 50,000
Materials handling: 98,000
Maintenance: 42,000
Inspection: 10,000
Total $200,000
Budgeted labour hours: 10,000
Overhead recovery rate $ 20 per labour hour
b) using the plant-wide overhead recovery rate calculate the cost of each job;
c)
Job 7/234 Job 7/235
Direct material cost: $12,500 $ 6,000
Direct labour cost: 24,000 4,000
Overhead: 1,000 * $20 20,000
Overhead: 150 * $20 3,000
Total: $56,500 $13,000
d) using activity based costing calculate the cost of each job;
e)
Pool Budgeted Cost Driver Budgeted Level Rate
Setups: $50,000 Number of set-ups 100 set-ups $500
Materials handling:$98,000 Number of moves 245 moves $400
Maintenance: $42,000 Machine hours 4,200 hours $ 10
Inspection: $10,000 Inspection hours 1,000 hours $ 10
Job 7/234 Job 7/235
Direct material cost: $12,500 $ 6,000
Direct labour cost: 24,000 4,000
Machine hours: 100 * $10 1,000 75 * $10 750
Number of set-ups:1 * $500 500 1 * $500 500
Material moves: 25 * $400 10,000 20 * $400 8,000
Inspection hours:125 * $10 1,250 80 * $10 800
Total: $49,250 $20,050
e) what are the advantages and disadvantages of using plant-wide overhead recovery rates and activity based costing to calculate job costs?
Plant-wide overhead rates are easier to calculate and apply, but less precise, particularly where jobs use factor inputs differentially;