Richard Johnson worked at packaging and assembly department at National Auto Accessories Ltd, a large Canadian automotive accessory distribution company. He and his brother, Ken planned to invest in a firm Protect-a-plate, which manufactured licensed plate protector for car plates. Due to the five-year licensed plate policy, both believed that there was a market for this product. They each planned to invest $18,000 and take a bank loan of $30,000. They drew attention of the sales manager at National about the product. They faced competition from an American company who quoted a price of $1.63. Hence, they aimed to offer a 10 to 15 percent lower price to National. There is presented the analysis of the profitability of the venture.
Classify costs as either product costs (DM, DL, MOH) or period costs; variable or fixed costs and Opportunity costs and Sunk costs. You need to identify at least two opportunity and sunk costs for this situation. A spreadsheet with dollar amounts (yearly $ for MOH, period costs, fixed costs and per unit for DM, DL and variable costs) Using DL hours as the activity base, calculate the OH rate. (Hint: MOH should be calculated for the year) Assume that you will sell 200,000 units for the year.
Exhibit 1 shows the classification of costs. It is assumed that the mould produces one million units. Hence, if 200,000 units are produced each year, the mould would last for five years. Mould is treated like a fixed asset and depreciated based on the unit produced. Hence, mould depreciation would be a variable cost. Other variable costs include packaging, hardware cost and shipping cost. Operators’ wages are treated as direct labor expenses. Hence, the Operators’ wages are also variable costs. Additionally, the oil based resin cost is also included in variable cost as they vary with the number of units produced.
Fixed cost is the monthly expenses that do not relate to units produced. Rent and Utilities, Maintenance Expenses, administrative cost and supervisor salary are fixed cost. The 15% interest on $30,000 bank loan adds the monthly interest expense of $375.
From the variable costs, the product cost includes the mould depreciation cost, the oil based resin cost, the packaging cost and the hardware cost. The shipping cost will be a period cost. From the fixed cost, rent and utilities cost, and the supervisor salaries are assumed to be indirectly related to the product. Thus, these are product costs. All other fixed costs are period costs.
The opportunity cost for the ventures are the 15% interests receipt on investments by Ken and Richard. Therefore, by investing in Protect-a-plate, they each lose annual interest on savings of $2700. Furthermore, as Richard will resign from his job to supervise the salary, Richard’s forgone salary will also be an opportunity cost.
The mould of $12000, buffing machines of $9,000 and the moulding machine of $15,000 would be bought when the operations start. This investment will be irrecoverable. Hence, this will be classified as the sunk cost.
Exhibit 2 shows the calculation of overhead rate. Manufacturing overheads, including rent and utilities expense and supervisor salary, are $31,200. As the operators produce 40 units in 1 hour, the per unit labor hour would be 0.025 hours. Hence, for 200,000 units, 5000 labor hours will be used. The overhead rate per labor hour would be $6.24 per hour.
Determine the cost of producing one protector for National.
Exhibit 3 shows the product cost of the protector for National. It is assumed that there is no depreciation of equipment in the first year. Material cost of mould and oil-based resin is added to the Operators’ wages and other variables cost like hardware and packaging cost. The manufacturing overhead per unit are calculated by multiplying overhead rate with the labor hours per unit. Hence, the product cost is $1.33.
Record any three journal entries for this company.
Exhibit 4 show three main journal entries, required at the start of the business.
- First is the investment of Ken and Richard into the business in a form of cash. Therefore, cash of $36,000 is debited and capital of each partner, credited.
- Second would be to use the cash to buy assets. Hence, $36,000 is spent in purchasing mould and equipments. Equipment and mould are debited, and the cash is credited.
- Finally, the bank loan journal entry is passed, where the bank loan is credited, and cash is debited by $30,000.
Prepare three CVP Income Statements using the range of purchase levels given by National. Explain how the owners can use these numbers to understand changes to their business. Why are CVP Income Statements important to a new business?
Exhibit 5 shows the CVP income statement for 120,000, 160,000 and 200,000 units. The calculations show that for each level of production, the firm will be making a loss. However, the loss decreases as the quantity produced increases. The lowest loss is $9,600 for 200,000 units. This is because as units produced increase, the contribution rises but fixed cost remains constant. This causes the loss to decrease.
CVP income statement is important for new ventures because it helps in decision making. By using different volumes to calculate costs and profits, the manager can determine the optimal volume for production.
Calculate Break-even in units and sales $ for the company; units and sales $ if the company wants a profit of $25,000; contribution margin per unit; and variable cost per unit.
The variable cost per unit for the venture is $1.22. With the selling price of $1.39, the contribution per unit for Protect-a-Plate is $0.16. The total fixed cost is $42,300. If the Richard and Ken want to make a profit of $25,000, they need to be able to produce and sale 411,621 units. This would mean a sale of $570,301 (Exhibit 6).
Prepare a traditional Income Statement for the 200,000 unit volume.
The traditional income statement is shown in Exhibit 7. When 200,000 units are produced, the firm incurs a loss of $9,600.
If the following changes were to be made, calculate a new CVP Income Statement: variable costs decrease by 6%; fixed costs increase by 12% and sales price would increase by 2%. Assume you are selling 160,000 units. Should the company consider these changes? Give some examples of cost increases or decreases that could implement these changes for the business.
A few changes are made to the revenue and expenses of the CVP statement in Exhibit 5. The sale revenue is increased by 2%. The variable cost is decreased by 6%, and the fixed costs are increased by 12%. The revised CVP income statement is shown in Exhibit 8. The changes subsequently result into profits of $5,530 for 200,000 units. As Richard is planning to produce 200,000 units, the changes will be advantageous for the firm. Hence, these changes should be implemented.
Explain what will happen to the MOH costs on a per unit basis if only 120,000 units are sold. Does it impact the per unit cost? Fully discuss all pertinent points and show any calculations needed.
Manufacturing overheads (MOH) are fixed cost. Hence, traditionally, to allocate MOH in the product cost, absorption costing is used. In absorption costing, the MOH is linked to a driver, and MOH rate is calculated. For Instance, if labor hours are cost drivers, MOH per labor hour is calculated using total labor hours. As units produced fall from 200,000 to 120,000, the total labor hours will fall from 5000 to 3000 hours. Hence, the MOH per labor hour rises, labor cost per unit rises and the product cost also rises. Exhibit 9 shows that the product cost for 120,000 units is $1.43. This is because the MOH rate rose from $6.24 per labor hour to $10.4 per labor hour.
If the product can be sold for $1.39 to National, what would you recommend to the owners? Should they try this new venture? What areas represent potential problems for a new company? Are there costs that are not being considered currently that need to be included in these calculations? How can Ken and Richard increase revenue and/or control costs? Give a minimum of two suggestions each. A full discussion on the information and calculations completed should be considered in this discussion.
The profitability of this venture can only be determined when more information is provided. A lot of information is missing. Firstly, the useful life of the buffing, routing and moulding equipments should be given to determine the depreciation of the equipment. This depreciation is a part of manufacturing overheads and would be added to the product cost.
Only the data for one year is given. Information is required for the sales and costs estimate of at least five years. Using five year data, the profitability of the product can be judged in the long run. The net present value of the investment must be calculated to see if venture gives positive returns in five years. Richard’s salary should also be stated to determine the opportunity cost of investment. Similarly, the principal payment plan is required for the construction of amortization schedule. Amortization schedule is necessary to determine the flow of cash for the firm.
The reason for the losses shown by the Exhibit 5 and Exhibit 7 is the low selling price. If the selling price is increased, the firm will be able to earn profits. Exhibit 10 show three recommended scenario based on the given costs.
- In the first scenario, the firm charges the same price as the American competitor. Even if the firm sells 120,000 units, it will be able to make a profit of $6,660. The firm can get the contract based Richard’s 14 years experience with the firm.
- Another scenario is if the price charged is 5% lower than the American competitor. At a lower price of $1.55, the firm might be able to get National’s contract of $120,000. However, due to lower price, it is assumed that as much as 160,000 units can be sold. The firm will make a profit of $9,940.
- Finally, if the price is lowered to $1.47 i.e. 10% lower than competitor prices, the firm will be expected to get National’s contact and make up to 200,000 unit sales. Hence, the profit in this scenario would be $6,700.
The three scenarios illustrate that the price charged by Richard and Ken is too low. For this reason, the firm will be facing a loss. If Richard and Ken want to make profits at a price of $1.39, they would either have to increase the units produced and sold or reduce the fixed and variable costs.
Based on the current plan, the project is not feasible as it shows a loss. If Richard and Ken have a profit target of $25,000, they should try to increase the selling price and number of units sold. In addition, they can also decrease the costs of the firm.