QUESTION
You are the management accountant of a publishing and printing company, Cable Ltd, which has been asked to quote for the production of a brochure for a local charity. The work would be
carried out in addition to the normal work of the company. Because of existing commitments,
some weekend working would be required to complete the printing of the brochure. A
trainee accountant has produced the following cost estimate based upon the resources
required as specified by the production manager:
£
Direct materials − paper (book value) 10,000
− inks (purchase price) 4,000
Direct labour − skilled 250 hours @ £4.00 1,000
− unskilled 100 hours @ £3.50 350
Variable overhead 350 hours @ £4.00 1,400
Printing press depreciation 200 hours @ £2.50 500
Fixed production costs 350 hours @ £6.00 2,100
Estimating department costs 400
______
19,750
______
You are aware that considerable publicity could be obtained for Cable Ltd if you are able
to win this order, and the price quoted must be very competitive.
The following notes are relevant to the cost estimate above:
(1) The paper to be used is currently in stock at a value of £10,000. It is of an unusual
colour which has not been used for some time. The replacement price of the paper is
£12,000, whilst the scrap value of that in stock is £2,500. The production manager
does not foresee any alternative use for the paper if it is not used for the charity
brochures.
(2) The inks required are not held in stock. They would have to be purchased in bulk at a
cost of £5,000. 80% of the ink purchased would be used in printing the brochures.
No other use is foreseen for the remainder.
(3) Skilled direct labour is in short supply, and to accommodate the printing of the
brochures, 50% of the time required would be worked at weekends, for which a
premium of 25% above the normal hourly rate is paid. The normal hourly rate is £4.00
per hour.
(4) Unskilled labour is presently under-utilised, and at present 200 hours per week are
recorded as idle time. If the printing work is carried out at a weekend, 25 unskilled
hours would have to occur at this time, but the employees concerned would be given
two hours time off (for which they would be paid) in lieu of each hour worked.
(5) Variable overhead represents the cost of operating the printing press and binding
machines.
(6) When not being used by the company, the printing press is hired to outside
companies for £6.00 per hour. This earns a contribution of £3.00 per hour. There is
unlimited demand for this facility.
(7) Fixed production costs are those incurred by and absorbed into production, using an
hourly rate based on budgeted activity.
(8) The cost of the estimating department represents time spent in discussions with the
charity committee concerning the printing of its brochure.
Required:
(a) Prepare a revised cost estimate using the opportunity cost approach, showing clearly
the minimum price that the company should accept for the order. Give reasons for
each resource valuation in your cost estimate. Marks will be allocated to both the calculations and the reasoning given. 35%
(b) Explain the opportunity cost theory used in the calculation in part (a) 15%
(c) Explain the two types of pricing methods, full cost plus pricing and marginal cost plus pricing and the situations when each might be considered to be more appropriate 20%
(d) The managing director has recently read about Activity Based Costing (ABC) and wonders if it would be relevant to the company. Explain ABC to the Managing Director and how it differs from traditional absorption methods. Your explanation should also include why the selling price of the individual products may differ between the methods, how this may affect the profitability of the individual products and any implication for the product managers motivation and also how the company profit overall will be affected. 30%
SOLUTION
Solution:
£
Direct materials − paper (book value) 2,500 Note 1
− inks (purchase price) 5,000 Note 2
Direct labour − skilled 1,125 Note 3
− unskilled – Note 4
Variable overhead 2,450 Note 5
Printing press depreciation – Note 6
Fixed production costs – Note 7
Estimating department costs – Note 8
______
11,075
_______
Note 1: Since the Direct Material -Paper is already in stock of the company, with no alternate use; but to be discarded as scrap at £2,500; the relevant cost shall be taken as such scrap value in spite of the fact that the replacement cost of the same is £12,000.
Note 2: Further since the remainder 20% of Direct Material- Ink shall be of no further use to the company, the entire purchase cost of such material shall be taken for preparing the cost estimate.
Note 3: Direct Labor- Skilled are in short supply, to undertake the printing of the brochures, 50% of the time required would be worked at weekends at premium of 25% above the normal hourly rate i.e. at £4*125%=£5 per hour for 125 hrs; and at £4 for 125 hrs; aggregating to £1,125 for 250 hrs of Skilled Labour.
Note 4: Since the unskilled labour are underutilized, and have 200 hrs idle time i.e. time for which they are paid but no output is conceived thereon, the cost w.r.t such labourers shall be taken as nil; as because they shall have to be paid irrespective whether the project is accepted or declined.
Note 5: The variable cost of operating the printing press and binding machines is at £4 for 350 hrs, however if the press is outsourced in the market it would fetch contribution of £3 per hour to the company, this contribution of £1,050 shall be the opportunity cost of the project, over and above the normal cost of £1,400.
Note 6: Depreciation is not to be considered for costing purpose.
Note 7: Fixed Production Costs by their nature are fixed and shall be incurred irrespective of production, therefore not to be considered for costing purpose.
Note 8: Estimating Department Cost shall not be considered as it is sunk cost, it has been already incurred by the company, accepting or declining the project should have no impact on costs
Answer (b)
Opportunity cost is the cost of an activity which is determined in terms of the value of the next best alternative that is not chosen. In other words Opportunity cost is the sacrifice to the second best choice which is available among mutually exclusive choices.
In this case if the press is outsourced in the market it would fetch contribution of £3 per hour to the company, this contribution of £1,050 shall be the opportunity cost, as if the press was leased out in the market the company could earn contribution at rate of £3 per hour i.e. in 350 hours the company would have earned 350 x £3 = £1050 in order to undertake the project company has to incur a cost of £1400
Therefore the total variable cost in the case would be £1400 + £1050 = 2450, over and above the normal cost of £1,400
Answer (c)
Cost plus pricing
Full cost pricing is that pricing method where in the entire cost of the project that is to say the both fixed and variable cost are included in the cost estimate prepared. After estimating the cost margin is loaded to compute the price of the product or the project (i.e. costs are first estimated and then the profit margin is added to determine or set the marked up price.) (Wikipedia)
The full cost pricing method is easy, simpler and enables the manager of the company make to take prompt decisions about accepting or rejecting the project or assignment; it is appropriated where the projects are mutual exclusive i.e. independent project requires independent fixed cost and harmonization of common fixed cost is least. In other words the major cost to be incurred is fully variable in nature.
The major advantage of the method is that it gives the management flexibility in pricing the project or assignment or the product with the percentage profit as the profit % is not necessarily rigid or fixed.
The major drawback of the method is that it fails to determine the correct price of the product or assignment resulting loss of revenue to the organization. As price flexibility is low. So, the company losses many opportunities in this process. (RandikaLalith, 2010)
Marginal cost plus pricing
In this pricing method the additional cost to be incurred for the additional project proposed to be undertake by the firm is calculated i.e. to say while computing the total cost of the project or the product all variable costs and only those fixed cost specifically associated with such project or the product are determined and included in its cost. As common fixed cost shall have to be incurred irrespective of the fact that the additional project is accepted or not. Therefore while computing the cost of the project such common fixed cost should not be included as they are not incurred specifically to the project.(RandikaLalith, 2009)
After determination of such cost reasonable profit mark up is done to the cost of the project depending on the market forces
The advantages of a marginal cost plus pricing are as follows.
- Major advantage of this mechanizing is that the company is able to adopt the low cost strategy resulting in greater market share.
- It give company free way to adopt that price in which the company can easily penetrate in the new market
- It helps in determine the contribution and its effects of higher or lower sales volumes on the profit.
There are also some drawbacks to in this method:
- Often differentiating between common fixed costs and specific fixed cost is a difficult, and managers find it tedious to identify the same, which may result in determination of low price for the project, which eventually results in loss of revenue while implementing the project.
The situations when each might be considered to be more appropriate are
A full cost plus method of pricing draws its attention to net profit and net profit margin, where as a variable cost-plus method of pricing draws attention to gross profit and gross profit margin, or contribution.
Answer (d)
Overhead cost is allocated to different product on traditional basis like labour hour, machine hour; but there has been recent development in cost accounting to which overhead cost is allocated between different product on the vasis of different activity based costing. There may be four type of activites performed in the organization
Unit level activities
Batch level activities
Product level activities
Facility level activities
Under traditional absorption costing system,overhead cost of product is calculated as overhead recovery rate. Under ABC overhead cost of cost objects is calculated using appropriate resources consumed and the respective ABC recovery rate.
The major point of distinction between the traditional approach and the ABC system is that the in the former method overheads were absorbed under a rigid or fixed predetermined conditions such as floor area, electricity consumed, no of workers etc whereas in ABC System activities are classified into primary and secondary activities, and they are related using resource cost drivers, further apportionment of the costs of support activities is done on a more suitable basis.
The selling price of the individual products may differ between the methods because in absorption costing pricing is done on inventory basis. If the inventory is high, it will result in lower cost of production and vice versa; whereas in case of ABC price fixation in based after determination of cost drivers and allocations thereof based on the actual overheads incurred on a unit, and it does not vary with change in inventory levels.
Further ABC provides the more appropriate and correct cost of individual product unit, thereby helps to locate less profitable products which result in irradiation of resources of the organization.
Greater costing accuracy is the primary benefit of activity-based costing. Companies assign cost only to the products that require the activity for production. This method avoids allocating irrelevant costs to a product.ABC mechanism is costly and a time consuming process, therefore organizations which have a wider variety of products under its belt with a greater market share can opt for this mechanism. Smaller firms thus opt out from this system.( NNayab, Published: Sept 2010)
References:
1) http://www.brighthub.com/office/finance/articles/86649.aspx
2) http://ezinearticles.com/?Marginal-Cost-Plus-Pricing&id=2494533
3) http://en.wikipedia.org/wiki/Pricing_strategies#Cost-plus_pricing
4) http://ezinearticles.com/?Full-Cost-Plus-Pricing&id=2499889
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