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)
b)
c)
d)
e)
f)
g)
h)
publicity:
administration:
instructors’ fees:
refreshment:
course related photocopying:
room hire (6 @ $500, 2 @ $1,300):
depreciation (educational computers):
software licence ($5,000 + $1,000 per course)
$ 2,000;
$16,000
$40,000;
$ 2,000;
$ 2,400;
$ 5,600;
$ 9,000,
$13,000.
Required:
a) classify each cost as variable, fixed or mixed, in relation to courses;
publicity:
administration:
instructors’ fees:
refreshment:
course related photocopying:
room hire (6 @ $500, 2 @ $1,300):
depreciation (educational computers):
software licence
($5,000 + $1,000 per course)
$ 2,000;
$16,000;
$40,000;
$ 2,000;
$ 2,400;
$ 5,600;
$ 9,000,
fixed
fixed
variable
variable
variable
variable
fixed
$13,000;
mixed
b) calculate the variable cost per course and the total variable cost.
Variable costs:
instructors’ fees:
refreshment:
course related photocopying:
$40,000;
$ 2,000;
$ 2,400;
variable
variable
variable
room hire (6 @ $500, 2 @ $1,300):
software licence
Total
# courses:
Variable cost per course
$ 5,600;
$ 8,000;
$58,000
8
$ 7,250
variable
variable part
c) calculate the total fixed cost and the fixed cost per course,
publicity:
administration:
depreciation (educational computers):
software licence
Total:
# courses:
Fixed cost per course:
$ 2,000;
$16,000;
$ 9,000,
$ 5,000
$32,000
8
$ 4,000
fixed
fixed
fixed
fixed part
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:
Materials handling:
Machine setup:
Inspection:
$ 2 per machine hour;
$10 per material move;
$50 per setup hour;
$ 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 =
25 material moves * $10 =
15 setup hours * $50 =
3 inspections * $5 =
Total
$ 200
250
750
15
$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:
Direct materials:
Direct labour:
Setup hours:
Weight:
Kilowatt hours:
1,000
$24,000
$15,000
200
20 tonnes
8,000
Required:
calculate the cost per unit for product B27
Production run set-up costs: $480,000/1,200
Materials ordering and handling:120,000/200 tonnes
Utilities:
300,000/100,000
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
= $400/set-up hour
= $600/tonne
= $3/kilowatt hour
7.8
Verona Inc has established the following cost pools:
Pool
Setups:
Materials handling:
Maintenance:
Inspection:
Budgeted Cost
$50,000
$98,000
$42,000
$10,000
Cost Driver
Number of setups
Number of moves
Machine hours
Inspection hours
Labour hours:
Budgeted Level
100 setups
245 moves
4,200 hours
1,000 hours
10,000 hours
The following data refers to two jobs completed during July 2002:
Direct material cost:
Direct labour cost:
Direct labour hours:
Machine hours:
Number of setups:
Material moves:
Inspection hours:
Job 7/234
$12,500
24,000
1,000
100
1
25
125
Job 7/235
$ 6,000
4,000
150
75
1
20
80
Required:
a) using labour hours as the allocation base, calculate a plant-wide overhead
recovery rate;
Budgeted overhead cost:
Set-ups:
Materials handling:
Maintenance:
Inspection:
Total
Budgeted labour hours:
Overhead recovery rate
$ 50,000
98,000
42,000
10,000
$200,000
10,000
$
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
Materials handling:$98,000
Maintenance:
$42,000
Inspection:
$10,000
Direct material cost:
Direct labour cost:
Machine hours: 100 * $10
Number of set-ups:1 * $500
Material moves: 25 * $400
Inspection hours:125 * $10
Total:
Number of set-ups 100 set-ups
$500
Number of moves 245 moves
$400
Machine hours
4,200 hours
$ 10
Inspection hours 1,000 hours
$ 10
Job 7/234
Job 7/235
$12,500
$ 6,000
24,000
4,000
1,000
75 * $10
750
500
1 * $500
500
10,000
20 * $400
8,000
1,250
80 * $10
800
$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;
ABC is more precise, but is more troublesome to calculate.
Where product cost is a key factor (e.g. when quoting for jobs) it is
better to use ABC.
7.9
The Bank of Bozen has calculated the following cost drivers for customer related
activities on chequing accounts:
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
cheque payment:
automated teller payment:
teller payment:
direct deposit:
automated teller deposit:
teller deposit:
monthly statement:
pass book:
manager interview:
average balance of less than $1,000:
overdrawn cheque:
$0.50;
$0.02;
$1.00;
$0.02;
$0.04;
$1.00;
$5.00 per month;
$1.00 per month;
$50 each.
$20 per month;
$2 each.
The following data refers to three typical customers:
# cheques:
# automated teller payments
# teller payments:
# direct deposits:
# automated teller deposits:
A
2
6
0
1
3
B
5
9
2
5
5
C
10
2
5
1
0
# teller deposits:
monthly statement:
passbook
manager interview:
low balance:
# overdrawn cheques:
0
yes
no
no
yes
0
0
yes
no
yes
no
2
2
no
yes
twice
no
0
Required:
a) calculate the cost of servicing each customer;
A
B
# cheques @ $0.50
1.00
2.50
# automated teller payments @ $.02
.12
.18
# teller payments @ $1
nil
2.00
# direct deposits @ $.02
.02
.10
# automated teller deposits @ $.04
.12
.20
# teller deposits @ $1
nil
nil
monthly statement @ $5
5.00
5.00
passbook
nil
nil
manager interview:
nil
50.00
low balance:
20.00
nil
# overdrawn cheques:
nil
4.00
Total:
$26.26
$63.98
C
5.00
.04
5.00
.02
nil
2.00
nil
1.00
100.00
nil
nil
$113.06
b) which is the best customer for the bank?
Can’t say: clearly C is the most costly, but to know the best customer
we would also have to understand the revenue each customer
generates.
7.10
Customer profitability analysis using activity based costing has revealed that
Serious Supermarkets has a higher cost, and a lower return on sales that any of
the other customers of Provincial Foods.
Monthly cost:
Sales personnel visits:
Ordering:
Deliveries:
Expedited deliveries:
Sales allowances:
Serious Supermarkets
$500
50
800
200
250
Average customers
$400
45
675
50
200
Required:
as Sales Manager for Provincial Foods, what steps could you take to turn
Serious Supermarkets into a more profitable customer?
The additional costs may be justified by a high level of sales.
To reduce the cost of this customer it will be necessary to reduce the
activities that drive sales costs:
Fewer sales personnel visits, fewer orders, fewer deliveries, fewer
expedited deliveries and fewer sales allowances.
This can be done by negotiation with the customer.
If this cannot be achieved the costs would have to be compared with the
contribution margin to assess whether or not the customer is worthwhile
retaining.