Herrestad Company managerial accounting
Introduction
Module 1-SLP
Question One responses
(A) Contribution margins
Contribution Margin refers to the accounting concept that a firm uses to determine the profitability of individual products. It is normally obtained by finding the discrepancy between total sales revenue and total sales variable cost. The contribution margin is also referred to as gross profit (Davis & Davis, 2012). From the above situation, contribution margin may be computed as follows:
Computation for contribution margin
Sales (8,000units×$ 250) $ 2,000,000
Less variable expenses
Direct materials (8,000 units * $100) $800,000
Direct labor (8,000 units * $50) $400,000
Variable overheads (8,000 units * $30) $240,000
Variable selling and administrative (8,000 unit * $10) $80,000 ($1,520,000)
Contribution Margin $ 480,000
Less fixed expenses
Fixed manufacturing overheads $200,000
Fixed selling and administrative $100,000 ($300,000)
Net operating Income $180,000
Contribution margin as a percentage is computed as = (contribution margin ÷ sale price) * 100
Contribution Margin as a percentage = ($480,000 ÷ $ 2000, 000) * 100
=$ 24%
Additionally, the contribution margin ratio (CR ratio) may be calculated as follows:
Contribution Margin Ratio = (Unit Contribution margin ÷ Unit selling price) * 100
Unit contribution margin = revenue per unit – variable expenses per unit
= $250 – $190
= $60
Unit selling price = $250
Therefore, contribution Margin ratio CR (ratio) = ($60 ÷ $250) * 100
=24%
Interpretation
Based on the above computation, after subtracting total variable cost from the sales, we obtained an annual contribution ratio of 24%. This means that 24% of sales revenue is reserved as a direct contribution towards expenses and profits. Additionally, the contribution margin of 24% will help towards covering the variable cost and will also give a net operating income. In connection to the above, the 24% margin will enable decision makers to compute the break-even points for the product. This will be important because managers will know the number of units that the company should sell and produce in order to make profits.
Second version whereby selling price per unit is 280
Cost of goods sold = (opening stock inventory + purchases) – closing stock
Cost of goods sold = $1,600,000
Selling and administrative expenses = fixed selling and administrative expenses + unit sold * variable selling and administrative cost
Selling and administrative expense = $100,000 + (8,000 * $10)
=$180,000
Herrestad Company
Adjusted Absorption Income Statement
For the year ending 31st December, 2011
Sales (8,000 * $280) $2240000
Cost of goods sold $1600000
Gross Profit (Margin) $640000
Less selling and administrative expenses (180000)
Net Income $460000
After the adjustment whereby the selling price per unit changed from $ 250 to $ 280. The net operating income increased from $220,000 to $460,000. This leads to a difference of $240,000. The above situation indicates that when the selling price is increased, the company can meet the cost of sale, as well as the selling and administrative charges. Therefore, huge profits will be made.
Contribution margin when unit selling price is $280 will be as follows:
Sales (8,000 units * $ 280) $ 2240000
Less variable expenses
Direct materials (8,000 units * $100) $800000
Direct labor (8,000 units * $50) $400000
Variable overheads (8,000 units * $30) $240000
Variable selling and administrative (8,000 unit * $10) $80000 ($1520000)
Contribution Margin $ 720000
Less fixed expenses
Fixed manufacturing overheads $200000
Fixed selling and administrative $100000 ($300000)
Net operating Income $420000
Contribution margin as a percentage is computed as = (contribution margin ÷ sale price) * 100
Contribution Margin as a percentage = ($720000 ÷ $ 2240000) * 100
=$ 32.14%
Additionally, the contribution margin ratio (CR ratio) may be calculated as follows:
Contribution Margin Ratio= (Unit Contribution margin ÷ Unit selling price) * 100
Unit contribution margin = revenue per unit – variable expenses per unit
=$280 – $190
=$90
Unit selling price =$280
Therefore, contribution Margin ratio CR (ratio) = ($90 ÷ $280) * 100
= 32.14%
An interpretation for the above Contribution Margin Ratio
From the above computation, after subtracting total variable cost from the sales, an annual contribution of 32.14% will be obtained. In this case, for every dollar gotten from sales, there is 32.14% that is left to contribute towards direct cost and profits. Additionally, after an increment in unit selling cost, the percentage contribution margin increased from 24% to 32.14%. This indicates that the company’s power to offset variable cost is increasing substantially. Therefore, the contribution margin is a vital tool. This is because it can help corporate managers in making decisions regarding the keeping or dropping of given elements of the company. In this respect, if there is a positive contribution margin, the margin should be maintained even if it leads to negative profits. On the contrary, if the contribution margin is undesirable, it should be left alone. This will help the company to avoid incurring losses associated with the production of individual units (Hermanson, Edwards & Invacevich, 2011). Therefore, in the above case, the contribution margin should be maintained. This is because it results into profits for each unit produced by the company. In above connection, the managers of Herrestad Company can compute the break-even point easily. The company aims at the revenue from sales to establish enhanced choices regarding the addition or subtraction of the unit to be produced.
(A) Computation of the number of units the company must sell to break-even for the year
A break-even point refers to the number of units that should be put on sale to enable the company meet its operational costs. At a break-even point, a company is only able to meet its operating cost without making profits or losses. At any point above the break-even point, the company starts making profits. On the contrary, at any point below the break-even point, the company starts making losses (Maher, Stickney & Weil, 2012).
At break-even, total revenues (sales) – total cost =zero profits
The formula for computing break-even points is as follows:
Break-Even Point = Fixed Cost ÷ (Selling price-Variable Cost).
Break Even Computation when selling price is $250
Fixed cost
Fixed manufacturing overheads $200000
Fixed selling and administrative Cost $100,000
Total fixed cost $300000
Variable Cost
Direct material $100
Direct labor $50
Variable Overheads $30
Variable selling and administrative cost $10
Total Variable Cost $190
Therefore, break even point = $300,000 ÷ ($250–$190)
= 5000 Units
Herrestad Company
Annual Profit and Loss Statement
Year Ended 31st December 2011
Sales
Gross Sales ($250 * 5000) $1250000
Less Cost of goods Sold ($190 * 5000) $950000
Net Sales $300000
Less Expenses
Fixed manufacturing Overheads $200000
Fixed and Administrative expenses $100000 ($300000)
Net Profit $0
An analysis for the above Break-even Point
To break-even, the company must sell 5000 Units per annum. In this connection, the annual financial statement of Herrestad Company clearly indicate that, at break even point, the company will be making zero profits. This means that the company is neither making profits nor losses. Therefore, the company is only able to meet its operating cost without making profits or losses (Davis & Davis, 2012). Additionally, if the Herrestad Company starts producing any units above 5000 units, the company will start making profits. On the contrary, if the Herrestad Company starts making any units below 5000 units, the company will start operating at a loss. Therefore, the break-even point plays a very vital role as it acts as an important tool that helps decision makers to know the measures to adopt so that the company can continue making profits. In this case, the company will take on the available chances for investment. Additionally, managers will know the point at which the company started operating at a loss. Therefore, the necessary measures shall be established to arrest the adverse situation that may occur.
(C) Computation of Break-even Points given the assumption that, direct material cost increased from $ 100 to $ 120
Break Even Computation when selling price is $250
Fixed cost
Fixed manufacturing overheads $200000
Fixed selling and administrative Cost $100000
Total fixed cost $300000
Variable Cost
Direct material $120
Direct labor $50
Variable Overheads $30
Variable selling and administrative cost $10
Total Variable Cost $ 210
Therefore, break even point = $300,000 ÷ ($250–$210)
= 7500 Units
Herrestad Company
Annual Profit and Loss Statement
Year Ended 31st December 2011
Sales
Gross Sales ($250 * 7500) $1875000
Less (-) Cost of goods Sold ($210 * 7500) ($1575000)
Net Sales $300000
Less Expenses
Fixed manufacturing Overheads $200000
Fixed and Administrative expenses $100000 ($300000)
Net Profit $0
Interpretation
After the direct material cost increased from $100 to $120, the company must produce 7500 units to attain the break-even point. At this juncture, the company is neither making profits nor losses. However, if this company tends to lower its production units below 7500 units, the company will start operating at a loss. Additionally, if this company tends to produce above 7500 units, it will start making profits. The above change indicates that, if the cost of direct, material cost is increased, the company must produce significant units so as to attain the break-even point. In addition, if the company managers think that the company may not make substantial profits when producing 7500 units, the managers should reduce the fixed cost. This may be done by trying to carry out necessary reduction on both fixed manufacturing overheads and administrative expenses. On the same note, corporate managers may try to identify how they can reduce variable cost by finding less expensive suppliers who can supply direct materials at a subsidized price (Warren, Reeve & Duchac, 2012). Finally, the corporate managers may further increase the selling price of products A and B. Nonetheless, prior to the increment in selling prices of the two products, the managers should analyze other prices within the same market in which they are operating. This will be important because it will help in avoiding losses arising from lack of customers who may be willing to purchase the products at predetermined prices.
Module 2-SLP
Activity based costing asserts that costs emanates from actions. Also, it is believed that demand is generated by cost objects. On the contrary, the traditional costing systems assert that the cost is as a result of the units produced. There had been controversies on whether activity based costing have been able to overcome deficiencies of tradition costing. Some of those deficiencies include inability to successfully incorporate capital intensive methods of production and rather fully relying on labor intensive activities. There are three major discrepancies between activity based costing and traditional costing. In conventional costing, cost objects were often seen to use a lot of resources. On the other hand, activity based costing assumes that cost objects consume activities. Also, the conventional cost accounting makes use of allocation that is based on the volume. On the other hand, the activity based costing relies on drivers at different points. Additionally, traditional costing is structure directed while activity based costing is process oriented (Bradtke, 2007). Therefore, because of important insight that activity based costing delivers, this costing is going to be applied in the allocation of cost to products A and B. There are several advantages of using activity based costing in cost allocation. It eliminates product cross subsidies inherent in cost accounting. This also facilitates the revelation of the causes of losses that lead to a fall in profitability of a company. Finally, it acts like an enzyme or catalyst for the decision affecting profitability of the firm (Bradtke, 2007).
Herrestad Company
Segmented Income Statement
Year ended 31st December 2011
Product A Product B Totals
Sales $920000 $1080000 $2000000
Less Variable Cost
Direct Material $560000 $240000 $800000
Direct labor $100000 $300000 $400000
Variable overhead $90000 $150000 $240000
Variable selling &
Admin.Expenses $26000 ($776000) $54000 ($744,000) $80000 ($152000)
Contribution Margin $144000 $336000 $1848000
Less Fixed Costs
Fixed manufacturing
Overheads $200000 $200000 $200000
Fixed selling and
Admin Overheads $100,000 $100000 $100000
Production runs $130000 ($430000) $210000 ($510000) $800000 ($1100000)
Net operating Income/loss $(286000) ($174,000) $748000
Comments
The above results indicate that the company is doing well. This is irrespective of having recorded a negative net operating income for individual products. This is because the contribution margin is positive (Bradtke, 2007). Therefore, the company should continue producing the product, but increase the production units for product B. The above results further indicate that more losses are incurred to produce and sell product A than the losses incurred on product B. In order for this company to reduce the above losses, the company has to take an action. In this respect, the company should reduce abnormal losses. This can be achieved by reducing unit losses, as well as the value losses that the company is susceptible to incur.
Module 3-SLP
Relevant Costs are costs used in decision making. These costs are critical when establishing certain managerial judgments. For a cost to affect a decision, the cost must have the following attributes: incremental, future, and cash flows. Incremental refers to the spending that is experienced or circumvented when a judgment is made. The costs experienced irrespective of the judgment being made or not cannot be argued to be incremental in respect to the choices made. The future attribute means that the previous costs lack relevance since they cannot be affected by the present judgments. Such costs are usually common to all the alternatives that may be chosen (Warren, Reeve & Duchac, 2012). Finally, the cash flow attribute in this context excludes some expenses like depreciation. Such expenses are perceived to lack relevance. Also, the book value for the present assets is said to lack importance. However, disposal value is relevant. Therefore, relevant cost will be the sum of avoidable cost outlay and opportunity cost. Avoidable cost outlay refers to the expenses that are experienced when the projected value is accepted. On the contrary, opportunity costs are benefits foregone for choosing a certain alternative instead of another. In this case, there are assumptions of relevant cost behavior. This means that, if a department is closed down, the associated cost savings will be known. The short term profits are the major objectives for decision making in this scenario (Davis & Davis, 2012).
(a) List of expenses and amount that are relevant
Direct Material
Direct labor
Variable Overheads
Below is the computation for relevant cost for product C in Herrestad Company
Product C
Selling price per unit $150
Direct Material (40-12) $28
Direct labor $50
Variable Overheads $25
Total relevant Cost ($106)
Contribution Margin $44
Units produced 1000 units
Total Contribution margin $44000
Relevant cost refers to the variable selling and administrative costs. However, these costs shall not be incurred in this case. The other variable costs are sunk. This is because the production of the units has already been attained. In this respect, the relevance of the fixed costs will not be necessary. This is because there will be no impact after selling the leftover units. Sunk cost is an already incurred cost whose recovery is impossible. Unlike other costs, sunk cost is independent of any event that may happen in the future because such costs had already been incurred (Hansen, Mowen & Hansen, 2006). In this case, the sunk cost will refer to direct material, direct labor, and variable overheads.
(b) If the company only pays $140 per unit, the following will happen
Selling price $150
Total relevant cost per unit ($140)
Contribution margin $10
Units produced 1000 units
Total Contribution margin $10000
The total contribution margin will substantially fall by $33,000 as a result of increase in variable cost. This trend will be unsuitable for the company, and thus there will be the need to change decision with regard to production. This further means that, if the company continues with this trend, substantial losses will be made. In turn, this will make the company to collapse.
(c)
If I am the manager for Herrestad Company, in the short run, I will accept the order. This is because my company’s contribution margin will still be positive. This means that my company will be able to meet its operating cost even if it is not able to make enough profits. However, in the long run, I would not accept the order. This is because even if my company makes some profits, the contribution margin is compromised. This means that in the long run, my company will have a negative contribution margin, and it will start operating at a loss (Maher, Stickney & Weil, 2012). Therefore, as a portfolio manager, I will accept the order in the short run. In the mean time, I will look for other investment portfolios to diversify the anticipated risk that might accrue in the long run.
Conclusion
This paper has captured the computation of contribution margin in the first module. In this case, the contribution margin and contribution margin ratios have been computed, and necessary interpretations for the outcomes have been made. This has been with regard to how they affect the profitability derived from each product. Additionally, the paper has captured the computation of adjusted income statements of Herrestad Company, as well as calculations and interpretation of break-even points. In the second module, the activity based costing has been applied to allocate cost to products A and B. Finally, the last module captured the computation and analysis of relevant cost for the Herrestad Company.
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