Measurement and Decision Making/Cost behaviours and cost classifications
Task 1: Cost behaviours and cost classifications
Jason Day, financial controller for Nilstrom Industries, was reviewing production cost reports for the year. One type of costs in these reports continued to bother him?fixed manufacturing overhead such as rental cost of the companies? factories, and some of the electricity and other utility costs. This total fixed manufacturing overhead cost had grown sharply in recent years and is now approaching 30% of total manufacturing cost.
There had been much internal debate as how to report this overhead cost, both internally and externally. The Vice President of Operations, Maria Crane, argued that the current approach to these costs of reporting them as a cost of production, just like direct materials and direct labour should continue. She therefore recommended that this cost be identified as manufacturing overhead and reported as part of inventory costs until sold ? saying ?I?m not a qualified accountant but from my MBA I remember that all manufacturing costs must go to inventory and be expensed only when sold. To be consistent, this approach also needs to be followed for internal reporting.?
Day, however, was unsure and thought that perhaps this cost should be reported as an expense of the current period ? and that perhaps Maria Crane had a vested interest in not wishing to do so. He was also unsure why Maria had insisted on increasing production recently even though sales demand had fallen. Others argued that fixed manufacturing overhead be reported differently internally than externally. The president finally had to decide the issue and asked each executive to submit a formal opinion on the matter.
Jason Day approaches you as a trusted advisor to draft some advice for him evaluating the arguments as to how the cost should be accounted for both externally in the financial statements and internally for performance evaluation purposes. He is also keen to understand if there could be any reason why Maria Crane chose to build up inventories. Discuss all relevant points of view, but come to a conclusion as to the most appropriate way to account for fixed manufacturing overhead costs.
Task 2: Understanding Overheads
Cinto Ltd, a distributor of special pharmaceutical products, operates at capacity and has three main market segments:
a) General supermarket chains
b) Pharmacy chains
c) Pharmacist-owned single-store pharmacies.
John Best, the new management accountant of Cinto, reported the following data for 2014:
Cinto Ltd, 2014 General Pharmacist-
Supermarket Pharmacy owned
Chains Chains Single stores Cinto Ltd
Revenues $3 708 000 $3 150 000 $1 980 000 $8 838 000
Cost of goods sold 3 600 000 3 000 000 1 800 000 8 400 000
Gross Margin $108 000 $150 000 $180 000 438 000
Other operating costs 301 080
Operating profit $136 920
For many years, Cinto has used gross margin percentage ((Revenue ? Cost of goods sold) ? Revenue) to evaluate the relative profitability of its market segments. But John recently attended a seminar on activity-based costing and is considering using it at Cinto to analyse and allocate ?other operating costs?. He meets with all the key managers and several of his operations and sales staff and they agree that there are five key activities that drive other operating costs at Cinto:
Activity Area Cost Driver
Order processing Number of customer purchase orders
Line-item processing Number of line items ordered by customers
Delivering to stores Number of store deliveries
Cartons shipped to store Number of cartons shipped
Stocking of customer store shelves Hours of shelf-stocking
Each customer order consists of one or more line items. A line item represents a single product (e.g. Nurofen Plus tablets). Each product line item is delivered in one or more separate cartons. Each store delivery entails the delivery of one or more cartons of products to a customer. Cinto?s staff stacks cartons directly onto display shelves in customers? stores. Currently, there is no additional charge to the customer for shelf-stocking, and not all customers use Cinto for this activity. The level of each activity in the three market segments and the total cost incurred for each activity in 2014 is shown below:
Activity- based cost data Activity level
Cinto 2014 General Pharmacist- Totoal cost
Supermarket Pharmacy Owned Of activity
Activity Chains Chains Single stores In 2014
( Number) 140 360 1 500 $80 000
Line-items ordered(number) 1 960 4 320 15 000 63 840`
Store deliveries made
( number) 120 360 1 000 71 000
Cartons shipped to stores (number) 36 000 24 000 16 000 76 000
Shelf-stocking(hours) 360 180 100 10 240
a) Calculate the 2014 gross-margin percentage for each of Cinto?s three market segments.
b) Calculate the cost driver rates for each of the five activity areas.
c) Use the activity-based costing information to allocate the $301 080 of ?other operating costs? to each of the market segments. Calculate the operating profit for each market segment as a dollar number and a percentage of revenues.
d) Comment on the results. What new insights are available with the activity-based costing information?
Task 3: Human aspects of budgeting
Jack Milatic owns three upscale hair salons: Hair Suite I, II and III. Each salon has a manager and 10 stylists who rent space in the salons as independent contractors and who pay a fee of 10% of each week?s revenue to the salon as rent. In exchange, they get to use the facility and utilities but must bring their own equipment.
The manager of each salon schedules (budgets) each customer appointment to last an hour, and then allows the stylist 10 minutes between appointments to clean up, rest and prepare for the next appointment. The salons are open from 10 am to 6 pm, so each stylist can serve seven customers per day. Stylists each work five days a week on a staggered schedule, so the salon is open seven days a week. Everyone works on Saturdays, but some stylists have Sunday and Monday off, some have Tuesday and Wednesday off and some have Thursday and Friday off.
Jack Milatic knows that utility costs are rising. Jack wants to increase revenues to cover at least some part of rising utility costs, so he tells each of the managers to find a way to increase productivity in the salons so that the stylists will pay more to the salons. Jack does not want to increase the rental fee above 10% of revenue for fear the stylists will leave, and each salon has only 10 stations, so he feels each salon cannot hire more than 10 full-time stylists.
The manager of Hair Suite I attempts to address the problem by telling the stylists that customers will be scheduled (budgeted) for 40 minute appointments and breaks will be five minutes. This will allow each stylist to add one more customer per day.
The manager of Hair Suite II asks the stylists on a voluntary basis to work one extra hour per day, from 10 am to 7 pm, to add an additional customer per stylist per day.
The manager of Hair Suite III sits down with the stylists and discusses the issue. After considering shortening the appointment and breaks, or lengthening the hours of operation, one of the stylists says: ?I know we rent stations in your store, but I am willing to share mine. You could hire an eleventh stylist, who will work at whatever station is vacant during our days off. Since we use our own equipment, this will not be a problem for me as long as there is a secure place I can leave my equipment on my days off.? Most of the other stylists agree that this is a good solution.
a) Which manager?s style do you think is most effective? Why?
b) How do you think the stylists will react to the managers of salons I and II? If they are unhappy, what actions may they take?
c) In Hair Suite III, if the stylists did not want to share their stations with another party, how else could they find a way to increase revenues?
d) Refer again to the action that the manager of Hair Suite I has chosen. How does this relate to the concept of stretch targets?
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