Strategies For Improving Profitability And Budgeting Techniques

Analysis of Financial and Other Data for a Power Drill Company

1. Bonza Handtools Ltd. manufactures a popular power drill suitable for the home renovator. Financial and other data for this product for the last twelve months are as follows :

Sales	20000 units
Selling price	$130 per unit Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
Variable manufacturing cost	$50 per unit
Fixed manufacturing costs	$400000
Variable selling and administrative costs	$30 per unit
Fixed selling and administrative costs	$300000.

The directors of Bonza Ltd. want to try to increase the profitability of this product and invited senior staff to suggest how this might be done. Three suggestions have been received.

• The accountant, Jan Rossi, believes that a price increase of $10 per unit is the best way to boost profits. She would spend an additional $125000 on national advertising and contends, that if this is done, sales volume would not drop appreciably from last year.

• The production manager, Tom Tune, thinks that an improved quality product could increase sales volume by 25% if accompanied by an advertising campaign costing $50000 aimed at tradespeople as well as home renovators. The improved quality would add $5 per unit to the variable cost. Mr Tune believes that the price should not be increased.

• The sales manager, Mary Watson, wants to undertake a promotion campaign where a $10 rebate is offered on all drills sold during the three months beginning 1 April. Normally 6000 units are sold during that period and Ms Watson believes that this could be boosted to 10000 units if an advertising campaign costing $40000 were launched late in March.

The Tassie Company estimates that next year it will manufacture and sell 150000 units of its product. On the basis of that level of activity, it has budgeted for the following costs and prices per unit:

Direct Material Cost	$2.50
Direct Labour Cost	3.00
Variable Factory Overhead	1.50
Fixed Factory Overhead	2.00
Manufacturing Cost	9.00
Variable Selling and Administrative Cost	2.00
Fixed Selling and Administrative Cost	1.50
Total Cost	12.50
20% Mark-up	2.50
Selling Price	$15.00

The Company has an opportunity to bid for the supply of an additional 40000 units of its product to a government department. No sales commission (variable selling and admin. cost) is involved and no additional fixed costs will be incurred.

Give a reasoned opinion on the level of the bid that should be made in each of the following two circumstances:

(i)         The capacity of the Tassie Company’s factory is 200000 units per    year.

(ii)        The capacity of the factory is only 180000 units per year.

3. Critically discuss the following statements:

• ‘a budget is a forecast of what is expected to happen in a business during the next year’
• ‘budgets are okay but they stifle all initiative. No manager would work for a business that applies control through budgets.’
• ‘any sensible person would start with the sales budget and build up the other budgets from there.’
• ‘a budget trying to be realistic will not motivate best performance.’
• ‘only adverse variances are worth investigating, because favourable variances, by definition, must be good.’

4. ABC Ltd makes trailers. It receives a special order to produce 350 trailers for a local retail outlet. The order will take 2,100 kg of material that costs $16.10 per kg and will require 1,400 direct labour hours and 525 machine hours. The following are the expected/budgeted annual costs for ABC Ltd:

Direct labour	$327,600
Direct labour hours	25,795
Direct materials	$193,200
Indirect costs	$98,400
Machine hours	9,840

 
Required:

1. Calculate the overhead allocation rate: note that the process is labour-intensive
2. Calculate the total costs of the special order
3. Calculate the cost of the special order if ABC Ltd uses machine time as the basis for allocating overheads
4. Calculate the minimum price per trailer that ABC Ltd could accept.
5. Explain how segmented overhead cost pools and activity based costing can assist accurate costing for pricing purpose

Explaining how segmenting the overheads can help in allocating overhead costs to individual jobs or services. You must support your discussion by real world examples and acknowledge the source of your information (referencing).

Costing and Budgeting Techniques

1.

Bonza Handtools Ltd
Statement Showing Profitability under various proposals
Sl. No	Particulars	Note	Details	Current	Proposal 1	Proposal 2	Proposal 3
a	Sales	units	First 3 Months	6000	6000	6000	10000
b	Sales	units	Balance Period	14000	14000	19000	14000
c	Total Sales	units	annual	20000	20000	25000	24000
d	Selling Price	$ pu	First 3 Months	130	140	130	120
e	Selling Price	$ pu	Balance Period	130	140	130	130
f	Variable Manufacturing Cost	$ pu	given	50	50	55	50
g	Variable Selling and Administrative Cost	$ pu	given	30	30	30	30
				$
h	Total Sales		a*d+b*e	2600000	2800000	3250000	3020000
i	Total Variable Manufacturing Cost		c*f	1000000	1000000	1375000	1200000
j	Total Variable Selling and Administrative Cost		c*g	600000	600000	750000	720000
k	Fixed Manufacturing Cost		Given	400000	400000	400000	400000
l	Fixed Selling and Administrative Cost		Given	300000	300000	300000	300000
m	Additional Advertising Campaign Cost		Given	0	125000	50000	40000
n	Profit during the year		h-i-j-k-l-m	300000	375000	375000	360000

Proposal 1 (Jan Rossi)

If Proposal of Jan Rossi to increase the price of $10 has been accepted then, the profit has been increased by 75,000 from the current profit. The only risk associated is that if the advertisement campaign falls, then there might be huge fall in the profit along with the additional cost burden of advertisement cost. Further, it will create burden on the middle man consumer and the company may lose loyalty of the said group.

Proposal 2 (Tom Tune)

If proposal of Mr. Tom Tune to improve the quality along with advertisement campaign has been accepted then following scene may create

• Increase in quality will additionally cost $5 per unit, which will lower the contribution p.u.
• Additional advertisement cost of 50,000 is to be incurred, to increase the sale by 25%.
• This lead to increase in Profit by 75,000. Existing Consumer will more satisfied as they get the advanced product at the same price plus new consumer will also join.

Proposal 3 (Mary Watson)

With the proposal of Mr. Watson to reduce the sale price by $10 for first 3 month will increase the company profit by 60,000 after considering the additional advertisement expenditure of $40,000. There might be risk of reducing the consumer as the consumer may think that the fall in price may also led to fall in quality.

2. Case a) Capacity 200000 Units

Sl No	Particulars	Details	$ per unit
1	Direct Material Cost	Given	2.50
2	Direct Labour Cost	Given	3.00
3	Variable Factory Overhead	Given	1.50
4	Total variable Cost	1+2+3	7.00
5	Mark up	20% of 4	1.40
6	Minimum Price Charged	4+5	8.40

Since the Annual Capacity of Tassie Company is 200000 unit and currently the company is producing 150,000 unit. This means that the company has an additional capacity of 50,000 order.  So, the company can sell the product at Variable cost plus mark up which comes to $8.4. No need to Consider Fixed cost as it is irrelevant.

Case b) Capacity 180000 Unit

The Annual capacity is 180000 units and the current sale is 150000 unit. Now, if the company wants to full fill the government order then he has to scarify the current sale of 10,000. This mean the company has to scarify the profit on current sale which comes to $2.5 for 10,000 unit. So Average price should be for first 30,000 $8.4 units and for 10,000 unit (8.4+2.5) which comes to 10.9.

Now Average = (30000*8.4 + 10000*10.9) / (30000+10000)

                        = $9.025

3. ‘A budget is a forecast of what is expected to happen in a business during the next year’

Budget is just planning for the next year. Budget is just like a statement which consists of the target production to be achieved within the budgeted cost. It is a statement which consists of various head of expenditure along with the budgeted amount to be spent on each head. Budget is handy in controlling the expenditure of the organization. Budget basically focus on quantitative factor just like to reduce the cost or increase the profit of an organization, it does not consider the qualitative factor  which may occurs due to increase in cost. In most of the organization the performance and bonus of the manager will depend upon the budgeted expenditure that manager has achieved. Through Budget one can forecast it future along with the growth of its organization. Budget can also be revised as per change in scenario.

‘Budgets are okay but they stifle all initiative. No manager would work for a business that applies control through budgets.’

Job Costing Techniques

One cannot ignore the fact that Budget brings Control at any level. Many Managers would not like to work for a business which applies control through budget because budget brings control and they are not free to spend money as per will. They will not try the new innovation as they have the budgeted money to spend. The Budget is prepared mainly on traditional system which is depends upon the last year actual rate. But most of the time it has been noticed that the price of the material will increase from the last year and the expenditure will increase and cross the budgeted expenditure. This increase in expenditure will create problem for the Manager as now they have to justify their senior or the Top Management regarding the reason for increase in expenditure which is a big trouble for them.

Further, the performance of the Manager is also appreciated with the amount of saving that he can made in the budget and there bonus is also depend on the same. So, in order to earn bonus they sometime cut short the expenditure which may lead to quality reduction of the product.

“Any sensible person would start with the sales budget and build up the other budgets from there.’ 

Budget can be classified into many groups such as production budget, sale budget, expenditure budget, income budget. But a sensible person starts with the sale budget because every budget is linked with each other. From Sale budget we get can idea about the expected sale that the company can made within the given period of time. Depending upon the sale the production budgeted will be prepared after taking n account the opening inventory and the desires closing inventory that the company want to maintain. With Production budget we will get the amount of expenditure that the company wants to incur in producing the amount of unit that we get in the production budget. So, a sensible person first make the sale budget and all the other budget figure he will get from the said figure. Sale figure is the base and the rest we will find as per the follow disused above.

“A budget trying to be realistic will not motivate best performance.’

As already discussed earlier budget brings control. The Budget should be such that it brings the maximum utilization of the current resources so as to optimum increase in the profit of the company. The main motive of the budget is cost control or cost reduction. The production manager is always at the pressure to reduce the production cost to increase its bonus and also for performance appraisal. The another problem of the budget is that it consider only quantitative factor and not the qualitative factor. So, the production manager has to adhere with the amount of expenditure as fixed in the budget. They are not free to take risk and use new process or increase additional expenditure to improve the quality of the product.

“only adverse variances are worth investigating, because favourable variances, by definition, must be good.’

Once the budget has been prepared and the production has been started we must compare the budget with the actual expenditure in order to know the performance of the manager. We can do the variance analysis to know the activity/ expenditure head wise performance of the Manager. One of the most important feature of the budget is that we have to focus only on the adverse variance as the favorable is by definition is good. In Favorable variance the Manager has already made the saving. Now we have to concern on the adverse variance. i.e. how the same to be made favorable. The Management has to find the technique to decrease the expenditure and if the increase in expenditure is of permanent nature and is driven due to non wastage of the manager then the budget should be revised to give effect of such increase as the increase in expenditure is market driven and is justified.

5.

1. Overdraft Allocation Rate

Overhead Cost = 98,400

Direct Labour Hours = 25,795

Overhead allocation Rate = 98400 / 25795

                                          =3.81

1. Cost of Special Order

Statement of Total Cost
Particulars		Amount ($)
Direct Material Cost	(16.1X2100)	33,810.00
Direct Labour Cost	(327600/25795)X1400	17,780.20
Indirect Cost	(1400X3.81)	5,334.00
Total Cost	56,924.20

3. Cost of order if machine time used

Overhead Allocation rate              =  98,400/9840

                                                      =10

Statement of Total Cost
Particulars		Amount ($)
Direct Material Cost	(16.1X2100)	33,810.00
Direct Labour Cost	(327600/25795)X1400	17,780.20
Indirect Cost	(525X10)	5,250.00
Total Cost	56,840.20

4. Minimum Price of Trailer

	When Machine Hr Rate is considered	When Labour Hr Rate is considered
Price per Trailer	162.40	162.64
	(56840.2/350)	(56924.2/350)

5. Segment Cost Pool

The main Purpose of Segment Cost pools and Activity is to allocate the total cost incurred for an activity in particular head wise department. In activity based costing, cost is being allocated for the job based upon the time spent by the particular department in manufacturing such goods. The Activity based costing helps in better costing of the project and also assists the manager in efficient decision making regarding the pricing of the product to maximize the profit. The Production Manager is in better position in negotiating the price of the product with the buyer of the product. In Activity based costing first of all total direct cost in an particular department has been identified , then the estimated hours is being calculated for the department for which each department shall works, then we will divide the total cost with the estimated hours to identify the rate per unit. The total cost is said to be cost pools and the estimated hours is known as cost driver, then rate per unit is calculated. It leads to cost reduction, better pricing and increase in profit of the company.

5. Overhead is a portion of the cost or an cost element which is also equally relevant as direct material cost and direct labour cost are important. Some of the examples of overhead costs incurred in an industry are electricity Expenses, rent expenses and repairs expenses of manufacturing parts, wages paid to work force for other than manufacturing activities. Overhead costs can be of both type i.e. the cost may be of fixed (which means it remains same and may does depend upon the level of production activity), variable cost (which depends on the total level of production activity), or semi variable cost. The Overhead costs incurred are to be apportioned among the various departments, as per their expenses incurred by the said department. The Overheads  cost are mainly apportioned in manufacturing department of the factory, administrative and office department at head office, selling expenses incurred by the selling & distribution department; all the said  costs are to be apportioned on the basis of certain basis of ratio. (Henry F. Garcia, 1995). There are many items which fall under the said departments of overhead.

Certain of examples to show how costs are apportioned on the basis of certain ratios is shown below.

1. Supervision charges would be apportioned on the base of total employees working in the departments.
2. Depreciation is to be apportioned on the basis of the machinery installed in the factory or HO.
3. Expenses regarding electricity and  machinery power shall be apportioned on the basis of unit power of the equipment.

There are various method of apportionment of cost in service sector. Some of the method are Step down Method, Direct Method, Repeated Distribution Approach, Reciprocal Method, and Algebraic Approach. When cost has been allocated to individual job sand  services it is easier to identify which the correct amount of cost that need to be incurred, and clear picture which helps in decision making and pricing policy as well. When overheads cost is allocated to different jobs and services the total cost of each department is identified along with the benefit derived from each department. Further, If the company wants to reallocate the costs of the departments whether service or manufacturing, to other departments then  percentage basis of allocation will be required. (Natalie Grace)

A real life example of how overhead allocation is done is mentioned hereby-

Suppose, there are two production department A & B of AB Ltd and two service departments.

Production Departments:

A	$30000
B	$26000	$56000

Service Departments:

Stores	$ 4000
Power	$3000	$7000

Information relating to production departments are:

	Dept.A	Dept.B
Horse power of machine	300	200
Value of Stores requisition	2500	1500

Apportionment of Cost of Service Departments over Production Departments

Items of Cost	Basis of Apportionment	Total	Dept A	Dept B
Cost as per		56,000	30,000	26,000
Stores	Value of Stores requisition	4000	2500	1500
	(2500:1500)
Power	Horse Power of Machine	3000	1800	1200
	(300:200)
Total		63000	34300	28700

If we have been provided with the apportionment percentage and cost of allocation to each department is provided, then we can further allocate the cost of service department to the production department. From the above example, it has been clearly seen that  the segmenting of the overhead cost to each jobs, services, or department is made and it can be easily allocated to such department.. (Studies 2009)

Henry F. Garcia, C.P.M. “Assignment of Overhead Costs In a Service Organization Using Activity-Based.” Assignment of Overhead Costs In a Service Organization Using Activity-Based, 1995: 1-3.

Natalie Grace. “Reasons to Allocate Costs.” Reasons to Allocate Costs 1.

Studies, Board of. Cost Accounting and Financial Management. New Delhi: The Publication Department on behalf of The Institute of Chartered Accountants of India, 2009.