PPM 2-3

1. BOTTLE CO

The Bottle Co produces three products, X, Y and Z, all made from the same material. Until now, it has used traditional absorption costing to allocate overheads to its products. The company is now considering an activity based costing system in the hope that it will improve profitability. Information for the three products for the last year is as follows:

The price for raw materials remained constant throughout the year at $1.20 per kg. Similarly, the direct labour cost for the whole workforce was $14.80 per hour. The annual overhead costs were as follows:

$

Machine set up costs                                  26,550

Machine running costs                               66,400

Procurement costs                                      48,000

Delivery costs                                               54,320

Required:

A. Calculate the full cost per unit for products X, Y and Z under traditional absorption costing, using direct labour hours as the basis for apportionment.

B. Calculate the full cost per unit of each product using activity based costing.

C. Using your calculation from (a) and (b) above, explain how activity based costing may help The Bottle Co improve the profitability of each product.

2. LIFECYCLE COSTING

‘Companies operating in an advanced manufacturing environment are finding that about 90% of a product’s life cycle cost is determined by decisions made early in the cycle. Management accounting systems should therefore be developed that aid the planning and control of product life-cycle costs and monitor spending at the early stages of the life cycle.’

Required:

Having regard to the above statement:

A. Explain the nature of the product life cycle concept and its impact on businesses operating in an advanced manufacturing environment.

B. Explain life cycle costing and state what distinguishes it from more traditional management accounting practices.

C. Explain briefly the concept of activity based management and TWO benefits that its adoption could bring for a business.

3. AKY PLC

AKY plc assembles three types of motorcycle at the same factory: the 50cc Star; the 250cc Rooster and the 1000cc Bullet. It sells the motorcycles throughout the world. In response to market pressures AKY plc has invested heavily in new manufacturing technology in recent years and, as a result, has significantly reduced the size of its workforce.

Historically, the company has allocated all overhead costs using total direct labour hours, but is now considering introducing Activity Based Costing (ABC). AKY plc’s accountant has produced the following analysis.

The three cost drivers that generate overheads are:

• Deliveries to retailers – the number of deliveries of motorcycles to retail showrooms.
• Set-ups – the number of times the assembly line process is re-set to accommodate a production run of a different type of motorcycle.
• Purchase orders – the number of purchase orders.

The annual cost driver volumes relating to each activity and for each type of motorcycle are as follows:

The annual overhead costs relating to these activities are as follows:

$

Deliveries to retailers                         2,400,000

Set-up costs                                         6,000,000

Purchase orders                                  3,600,000

All direct labour is paid at $5 per hour. The company holds no inventories.

At a board meeting there was some concern over the introduction of activity based costing.

The finance director argued: ‘I very much doubt whether selling the Bullet is viable but I am not convinced that activity based costing would tell us any more than the use of labour hours in assessing the viability of each product.’

The marketing director argued: ‘I am in the process of negotiating a major new contract with a motorcycle rental company for the Star model. For such a big order they will not pay our normal prices, but we need to at least cover our incremental costs. I am not convinced that activity based costing would achieve this as it merely averages costs for our entire production’.

The managing director argued: ‘I believe that activity based costing would be an improvement but it still has its problems. For instance, if we carry out an activity many times surely we get better at it and costs fall rather than remain constant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.’

The chairman argued: ‘I cannot see the problem. The overall profit for the company is the same no matter which method of allocating overheads we use. It seems to make no difference to me.’

Required:

A. Calculate the total profit on each of AKY plc’s three types of product using each of the following methods to attribute overheads:

i) The existing method based upon labour hours

ii) Activity based costing.

B. Explain the implications of activity based costing for AKY plc, and is so doing evaluate the issues raised by each of the directors.

4. PH CO

PH Co is a pharmaceutical company trying to decide whether to continue with the production of one of its drugs. On economic grounds, the decision to continue manufacture is marginal; However, in the light or recent high–profile corporate scandals linked to environmental disasters, PH Co is particularly anxious to make an informed decision based mainly on the environmental effects of continued production.

Following up on a review of its operations and various reports from its Operations Director, PH Co’s management accountant has identified the company’s main environmental costs as follows:

• Waste disposal
• Water consumption
• Energy consumption
• Transport and travel.

Required:

A. Explain how the costs listed above arise and what control measures could be implemented by PH Co in order to manage them.

B. Briefly describe four management accounting techniques for the identification and allocation of environmental costs.

5. BUILDING CO

Building Co is a building business that provides a range of building services to the public. Recently they have been asked to quote for garage conversions (GC) and extensions to properties (EX) and have found that they are winning fewer GC contracts than expected.

Building Co has a policy to price all jobs at budgeted total cost plus 50%. Overheads are currently absorbed on a labour hour basis. Building Co thinks that a switch to activity based costing (ABC) to absorb overheads would reduce the cost associated to GC and hence make them more competitive.

You are provided with the following data:

 A typical GC costs $3,500 in materials and takes 300 labour hours to complete. A GC requires only one site visit by a supervisor and needs only one planning document to be raised. The typical EX costs $8,000 in materials and takes 500 hours to complete. An EX requires six site visits and five planning documents. In all cases labour is paid $15 per hour.

Required:

A. Calculate the cost and quoted price of a GC and of an EX using labour hours to absorb the overheads.

B. Calculate the cost and the quoted price of a GC and of an EX using ABC to absorb the overheads.

C. Assuming that the cost of a GC falls by nearly 7% and the price of an EX rises by about 2% as a result of the change to ABC, suggest possible pricing strategies for the two products that Building Co sells and suggest two reasons other than high prices for the current poor sales of the GC.

D. One Building Co manager has suggested that only marginal cost should be included in budget cost calculations as this would avoid the need for arbitrary overhead allocations to products. Briefly discuss this point of view and comment on the implication for the amount of mark-up that would be applied to budget costs when producing quotes for jobs.

6. GIPSTER

NQ Company, a manufacturer of computer games, has developed a new game called the GIPSTER. This is an interactive 3D game and is the first of its kind to be introduced to the market. NQ Company is due to launch the GIPSTER in time for the peak selling season.

Traditionally NQ Company has priced its games based on standard manufacturing cost plus selling and administration cost plus a profit margin. However, the management team of NQ Company has recently attended a computer games conference where everyone was talking about life cycle costing, target costing and market-based pricing approaches. The team has returned from the conference and would like more details on the topics they heard about and how they could have been applied to the GIPSTER.

Required:

As management accountant of NQ Company:

A. Discuss how the following techniques could have been applied to GIPSTER:

• Life cycle costing
• Target costing.

B. Discuss the market-based pricing strategies that should have been considered for the launch of the GIPSTER and recommend a strategy that should have been chosen.

C. Explain briefly each stage in the product life cycle of the GIPSTER and consider ONE issue that the management team will need to consider at each stage.

7. VIJAYA PUBLISHING CO

Vijaya Publishing Co publishes two forms of book.

The company publishes a children’s book (CB), which is sold in large quantities to government controlled schools. The book is produced in only four large production runs but goes through frequent government inspections and quality assurance checks.

The paper used is strong, designed to resist the damage that can be caused by the young children it is produced for. The book has only a few words and relies on pictures to convey meaning.

The second book is a comprehensive technical journal (TJ). It is produced in monthly production runs, 12 times a year. The paper used is of relatively poor quality and is not subject to any governmental controls and consequently only a small number of inspections are carried out. The TJ uses far more machine hours than the CB in its production.

The directors are concerned about the performance of the two books and are wondering what the impact would be of a switch to an activity based costing (ABC) approach to accounting for overheads. They currently use absorption costing, based on machine hours for all overhead calculations. They have accurately produced an analysis for the accounting year just completed as follows:

CB                          TJ

$ per unit             $ per unit

Direct production costs:

Paper                                                       0.75                      0.08

Printing ink                                             1.45                      4.47

Machine costs                                        1.15                      1.95

Overheads                                              2.30                      3.95

–––––                   –––––

Total cost                                                5.65                     10.45

–––––                   –––––

Selling price                                            9.05                     13.85

–––––                   –––––

Margin                                                     3.40                      3.40

–––––                   –––––

The main overheads involved are:

Overhead                                     % of total overhead                      Activity driver

Property costs                                         75.0%                                 Machine hours

Quality control                                        23.0%                          Number of inspections

Production set up costs                          2.0%                               Number of set ups

If the overheads above were re-allocated under ABC principles, then the results would be that the overhead allocation to CB would be $0.05 higher and the overhead allocated to TJ would be $0.30 lower than previously.

Required:

A. Explain why the overhead allocations have changed in the way indicated above.

The directors are keen to introduce ABC for the coming year and have provided the following cost and selling price data:

• The paper used costs $2 per kg for a CB but the TJ paper costs only $1 per kg. The CB uses 400g of paper for each book, four times as much as the TJ uses.
• Printing ink costs $30 per litre. The CB uses one third of the printing ink of the larger TJ. The TJ uses 150 ml of printing ink per book.
• The CB needs six minutes of machine time to produce each book, whereas the TJ needs 10 minutes per book. The machines cost $12 per hour to run.
• The sales prices are to be $9.30 for the CB and $14.00 for the TJ.

As mentioned above there are three main overheads, the data for these are:

Overhead                                                       Annual cost for the coming year ($)

Property costs                                                                   2,160,000

Quality control                                                                    668,000

Production set up costs                                                      52,000

––––––––

Total                                                                                   2,880,000

––––––––

The CB will be inspected on 180 occasions next year, whereas the TJ will be inspected just 20 times.

Vijaya Publishing will produce its annual output of 1,000,000 CBs in four production runs and approximately 10,000 TJs per month in each of 12 production runs.

Required:

B. Calculate the cost per unit and the margin for the CB and the TJ using machine hours to absorb the overheads.

C. Calculate the cost per unit and the margin for the CB and the TJ using activity based costing principles to absorb the overheads.

8. TM LTD

As the exams are tested as CBE, candidates will not have to draw a graph. However, it is good practice to attempt a question such as this as part of a robust revision programme. In the exam, graphs will be part of the question scenario and candidates may be asked to provide further calculation or analysis.

TM Ltd produces and sells the following two products throughout the year in a constant mix:

Product X                          Product Y

Variable cost per $ of sales                    $0.45                                 $0.60

Fixed costs                                                       $1,212,000 per period

The management of TM has stated that total sales revenue will reach a maximum of $4,000,000, and is generated by the two products in the following proportions:

Product X                          Product Y

70%                                    30%

Required:

A. Calculate the breakeven sales revenue required per period, based on the sales mix assumed above.

B. Prepare a profit-volume chart of the above situation for the maximum sales revenue. Show on the same chart the effect of a change in the sales mix to product X 50%, product Y 50%, and clearly indicate on the chart the breakeven point for each situation.

C. $455,000 of the total fixed costs are attributable to Product X.

Calculate the sales revenue required on Product X in order to recover the attributable fixed costs and provide a net contribution of $700,000 towards general fixed costs and profit.

9. ARY CO

A. Ary Co makes and sells two products A and B, each of which passes through the same automated production operations. The following estimated information is available for period 1:

(i) Product unit data:                                                         A                         B

Direct material cost ($)                                                2                        40

Variable production overhead cost ($)                    28                        4

Overall hours per product unit (hours)                  0.25                    0.15

(ii) Production/sales of products A and B are 120,000 units and 45,000 units with

selling prices per unit $60 and $70 respectively.

(iii) Maximum demand for each product is 20% above the estimated sales levels.

(iv) Total fixed production overhead cost is $1,470,000. This is absorbed at an

average rate per hour based on the estimated production levels.

Required:

Using net profit as the decision measure, show why the management of Ary Co argues that it is indifferent on financial grounds as to the mix of products A and B which should be produced and sold.

B. One of the production operations has a maximum capacity of 3,075 hours which has been identified as a bottleneck which limits the overall production/sales of products A and B. The bottleneck hours required per product unit for products A and B are 0.02 and 0.015 respectively.

Ary Co has decided to determine the profit maximising mix of products A and B based on the Throughput Accounting principle of maximising the throughput return per production hour of the bottleneck resources. This may be measured as throughput return per production hour = (selling price – material cost)/bottleneck hours per unit.

Required:

i) Calculate the mix (units) of products A and B which will maximise net profit and the value of that net profit.

ii) Calculate the throughput ratio for product B.

iii) Discuss how a throughput accounting ratio can be used as a control measure. You should refer to the ratio for product B in your answer.

10. CITY CO

City Co designs, develops and sells many PC games. Games have a short lifecycle lasting around three years only. Performance of the games is measured by reference to the profits made in each of the expected three years of popularity. City Co accepts a net profit of 35% of turnover as reasonable. A rate of contribution (sales price less variable cost) of 75% is also considered acceptable.

City Co has a large, centralised development department which carries out all the design work before it passes the completed game to the sales and distribution department to market and distribute the product.

City Co has developed a brand new game called Kezo and this has the following budgeted performance figures.

The selling price of Kezo will be a constant $30 per game. Analysis of the costs show that at a volume of 10,000 units a total cost of $130,000 is expected. However, at a volume of 14,000 units a total cost of $150,000 is expected. If volumes exceed 15,000 units, the fixed costs will increase by 50%.

Kezo’s budgeted volumes are as follows:

Year 1                               Year 2                              Year 3

Sales volume               8,000 units                     16,000 units                     4,000 units

In addition, marketing costs for Kezo will be $60,000 in year one and $40,000 in year two. Design and development costs are all incurred before the game is launched and has cost $300,000 for Kezo. These costs are written off to the income statement as incurred (i.e., before year 1 above).

Required:

A. Explain the principles behind lifecycle costing and briefly state why City Co in particular should consider these lifecycle principles.

B. Produce the budgeted results for the game ‘Kezo’ and briefly assess the game’s expected performance, taking into account the whole lifecycle of the game.

C. Explain why incremental budgeting is a common method of budgeting and outline the main problems with such an approach.

11. CHOCO LOVE (CL)

As the exams are tested as CBE, candidates will not have to draw a graph. However, it is good practice to attempt a question such as this as part of a robust revision programme. In the exam, graphs will be part of the question scenario and candidates may be asked to provide further calculation or analysis.

CL Ltd produces a single large item of confectionary, Product S, which is sold for $12 per unit. You have been provided with the following information about the ‘S’ for the forthcoming year:

Sales                             6,000 units

Variable costs             $7 per unit

CL’s overheads are budgeted to amount to $20,000. CL’s Financial Director has asked you to prepare some documents for a presentation to the Board of Directors.

Required:

A. Calculate, and briefly explain the significance of, CL’s breakeven point and margin of safety, expressed as a percentage.

B. Based on CL’s information above, construct and explain the purpose of the three following charts:

i) A breakeven chart

ii) A contribution graph

iii) A profit – volume chart.

C. Briefly outline the limitations of breakeven analysis.

12. W LTD

W Ltd has presented you with its break-even chart:

Required:

A. Identify the components of the breakeven chart labelled p, q, r, s, t, u, v, w, x and y.

B. Suggest what events are represented at the values of x that are labelled m and n on the chart.

C. Briefly comment on the usefulness of breakeven analysis to senior management of a small company.

13. LOOP LEATHER

As the exams are tested as CBE, candidates will not have to draw a graph. However, it is good practice to attempt a question such as this as part of a robust revision programme. In the exam, graphs will be part of the question scenario and candidates may be asked to provide further calculation or analysis.

Loop has been in the clothing market for the last 3 years and operates in an industry which is very competitive and volatile. Loop’s management accountant has heard that break even analysis could be used to assess the risks of the business and helps decision making.

The following information on Loop and its product portfolio is also available – figures are per annum:

Leather is regularly used in the production of all the products above. The company has recently discovered that there is likely to be a shortage of leather on the market for the coming year. Leather used in production is bought from a supplier on a JIT basis for $60 per meter. For now, enough material can be sourced from the supplier to satisfy the production requirement. Fixed cost per annum is $580,000.

Required:

A. Calculate the break-even sales revenue.

B. Draw a profit volume chart by clearly showing all the workings to arrive at the graph.

C. Explain how the unavailability of leather and the rise in its price affect the profitability and breakeven point of Loop. No calculation is required.

D. Explain how breakeven analysis could be used in decision making, and outline the limitations of the technique.

14. FIN CO

Fin Co is involved in the processing of sheet metal into products A, B and C using three processes, pressing, stretching and rolling. Like many businesses Fin faces tough price competition in what is a mature world market.

The factory has 50 production lines each of which contain the three processes: Raw material for the sheet metal is first pressed then stretched and finally rolled. The processing capacity varies for each process and the factory manager has provided the following data:

Processing time per metre in hours

Product A                   Product B                   Product C

Pressing                                 0.50                             0.50                             0.40

Stretching                              0.25                             0.40                             0.25

Rolling                                    0.40                             0.25                             0.25

The factory operates for 18 hours each day for five days per week. It is closed for only two weeks of the year for holidays when maintenance is carried out. On average one hour of labour is needed for each of the 225,000 hours of factory time. Labour is paid $10 per hour.

The raw materials cost per metre is $3.00 for product A, $2.50 for product B and $1.80 for product C. Other factory costs (excluding labour and raw materials) are $18,000,000 per year. Selling prices per metre are $70 for product A, $60 for product B and $27 for product C.

Fin carries very little inventory.

Required:

A. Identify the bottleneck process and briefly explain why this process is described as a ‘bottleneck’.

B. Calculate the throughput accounting ratio (TPAR) for each product assuming that the bottleneck process is fully utilised.

C. Assuming that the TPAR of product C is less than 1:

i) Explain how Fin could improve the TPAR of product C.

ii) Briefly discuss whether this supports the suggestion to cease the production of product C and briefly outline three other factors that Fin should consider before a cessation decision is taken.