Question solutions. Learning Unit 4. Costing and pricing. Question 4.1

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1 Financial Management 1 A Degree Question solutions Learning Unit 4 Costing and pricing Question 4.1 Banks often make use of cost analysis in determining the cost of offering services like cheque accounts, personal loans and credit cards. Take for example, First National Bank that introduced a service product called the Million-a-Month Account during Clients that opened such an account forfeited some or all of their interest that they could have earned to go into a monthly draw during which the forfeited interest was pooled together, and where one lucky winner would walk away with R 1 million. Of course, launching such a product could only have been done after careful consideration and costing had been done. Quite often such service products are only launched after modelling the risks and potential rewards for the bank on a custom-made actuarial model. Probably the most prolific users of costing in business today are the insurance companies. The price one pays for life insurance depends largely on a series of risk factors, which include, but is not limited to: The expected mortality of an average potential client. What is interesting to note is that females in South Africa, on average, outlive their male counterparts by 3-4 years. If all other factors are ignored, a female will therefore pay slightly less for her life cover than a male, since the average female in the pool of premium-paying clients will be paying her premiums for a longer term (compared with their male counterparts) before she would pass away and the insurance company had to make a payment to her beneficiaries. The age of the client. The older a client, the bigger the chance of dying soon. Older clients will pay more for life cover than younger clients. EDGE Learning Media CC 1

2 The occupation of the client. The riskier the working environments of a client the higher the premium for life cover. A mine worker will pay much more for life cover (all other variables being constant, of course) than a secretary because the chance of being killed in his/her working environment is much higher than that of the office worker. The health of the client. Most insurance companies will send a prospective client wishing to take out life cover for a blood test. A standard blood test for life insurance will test the HIV status of the client, whether the client has high cholesterol, sugar or cotinine levels (a test for smoking), and whether their liver function is normal. If the blood tests reveal dangerously high levels on any of the above, premium loadings may be imposed. Etc. EDGE Learning Media CC 2

3 Question 4.2 Marketing, distribution or selling cost Period costs (R) Administrative cost Direct materials Polyethylene purchased per week, R Wages of the machine operators: R per operator per week. There are 30 machine operators on duty in the factory at any point in time. Monthly salary of the factory supervisor, R Depreciation on plastic extruding machines, R per machine per annum. Depreciation on office equipment, R per annum Depreciation on delivery vehicle, R per annum CEO s travelling costs, R per month Rates and taxes amount to R per month, and must be apportioned in relation to floor space (the factory takes up 75 % of the total floor space of the entire premises) Advertising and distribution costs, R per week Indirect materials used in production, R 23 per ton of RX 007 manufactured. Product costs (R) Direct labour Manufacturing overhead Wages of the factory cleaning staff, R per week Fees paid to security company for the security guard positioned at the front entrance to the factory, R 800 p.m. Fees paid to the security company for the security guard positioned at the main entrance to the administrative building, R 800. Monthly insurance premium, R (R of which relates to the factory). Import tariffs and customs duties paid on polyethylene imported from abroad, R per 100 tons imported. Telephone, stationery and general office expenses, R p.m. Railage and carriage on sales, R per consignment of 400 tons sold TOTALS: Note: Total cost = R EDGE Learning Media CC 3

4 Question 4.3 Semi-variable costs These are cost items which are partly fixed and partly variable. In managerial accounting the costs are usually dealt with by dividing them into their fixed and variable components. A good example of such a cost is a telephone account. The line rental is the fixed component and it must be paid, even if no calls are made. The moment any calls are made, the variable component comes into play. The more calls you make, the more the variable cost will be and this cost rises in direct relationship to the usage (the number of calls x the cost per call). The total cost of using a telephone will be the sum of the fixed cost and the variable cost. It is important to note that the total cost can never be below the fixed cost. Semi-fixed costs These are costs which will stay fixed for a given level of production, but will increase in increments once production has passed the maximum level applicable to the cost. An example of this type of cost is a transport contractor who has one truck for which he pays R per month according to a lease agreement. This truck can carry a maximum load of 10 tons. If the contractor should sign a contract for the transportation of 5 tons, the cost of leasing the truck will be R If he should sign an additional agreement for a further 4 tons, his lease cost will still be R 5 000, because he has not reached the maximum carrying capacity of the truck yet. Should he be offered a third contract to transport a further 2 tons, he will have to consider the situation closely. Transporting of the first 10 tons will mean a leasing cost of R Should he accept the third contract, he will have to transport 11 tons and he will have to lease a second truck. This means that his total cost will be R Leasing the second truck will enable him to transport loads of up to 20 tons. If he would sign more contracts and he exceeds 20 tons (but not 30 tons) he will have to lease a third truck and his cost will increase to R Loads of 0 to 10 tons total cost of leasing = R Loads up to 20 tons total cost of leasing = R Loads up to 30 tons total cost of leasing = R Loads up to 40 tons total cost of leasing = R EDGE Learning Media CC 4

5 (i) Question 4.4 Fixed costs per month (R) Variable costs per month (R) Polyethylene purchased per week, R Wages of the machine operators: R per operator per week. There are 30 machine operators on duty in the factory at any point in time. Monthly salary of the factory supervisor, R Depreciation on plastic extruding machines, R per machine per annum Depreciation on office equipment, R per annum Depreciation on delivery vehicle, R per annum CEO s travelling costs, R per month Rates and taxes amount to R per month, and must be apportioned in relation to floor space (the factory takes up 75+% of the total floor space of the entire premises) Advertising and distribution costs, R per week Indirect materials used in production, R 23 per ton of RX 007 manufactured Wages of the factory cleaning staff, R per week Fees paid to security company for the security guard positioned at the front entrance to the factory, R 800 p.m. Fees paid to the security company for the security guard positioned at the main entrance to the administrative building, R 800. Monthly insurance premium, R (R of which relates to the factory) Import tariffs and customs duties paid on polyethylene imported from abroad, R per 100 tons imported. Telephone, stationery and general office expenses, R p.m Railage and carriage on sales, R per consignment of 400 tons sold TOTALS: Note: Total cost = R (ii) (iii) Variable cost: R / (4 x 320) = R per ton Selling price per ton: R % = R per ton (iv) Marginal income ratio: ( ) / x 100 = 60 % Or: 150 / 250 x 100 = 60 % (v) Breakeven point in units: Fixed costs / marginal income per unit: R / (R R ) = tons, rounded to 416 tons EDGE Learning Media CC 5

6 (vi) Breakeven point in rand value: Fixed costs / marginal income ratio: R / 0.6 = R (vii) Units to be sold to achieve a net profit of R per annum: Fixed costs per annum + profit target per annum / marginal income per unit (R ) / R = tons, rounded up to tons. (viii) The direct material, called polyethylene, is the main ingredient in the businesses production costs. Renegade Dealers should constantly benchmark the prices charged by their preferred supplier(s) against alternative suppliers. Suppliers often attract customers with very low prices, only to increase these prices considerably in due course to such an extent that an alternative suppler might have been a better bet in the long run. Wages is a very contentious issue. The wages paid should always be relative to the output provided. If the labourers produce twice as much as the competitors of a certain product in a week, but the wage rate offered is 50 % higher than that of the competitors, then the real wage is actually quite low. Adding 50 % to cost, but 100 % to productivity is a winning recipe. Ways in which this can be done is to introduce incentive schemes as part of every employee s pay package. Carriage on sales is a difficult cost item. It is not only price that is important, but also the timeliness of deliveries, the safeguarding of the cargo and the roadworthiness of the vehicles used. When volumes produced become enormous, companies often negotiate substantial rebates with cartage contractors. Due to the high maintenance on these vehicles, most companies prefer to outsource the function, so that they can concentrate on what they do best: production! Question 4.5 (i) When costing the operations of a business, the cost per hour to deliver the product or service should be averaged. To explain this concept, let s focus on the operations of a vehicle maintenance workshop. Sometimes workers will be very efficient in their jobs, i.e. when there are no power outages, everyone is motivated, and equipment and operations are streamlined to perfection. At other times, outputs will be less than favourable, i.e. downtime is rife; systems, staff and processes are slow. Let s say the business pays a motor mechanic R 100 per hour, and the average car service takes two hours to complete. If the business wants to earn double the income than the cost it has incurred, it will quote the client two hours on the job-card for a R 200 p/h = R 400 for the labour to complete a standard service. This does not mean that it will necessarily take two hours to complete the service. It might take one hour, or it might take three hours, but the business needs to create a benchmark on which it can base its costings, and charge rates and hours that are fair to customers and to staff. Let s say a mechanic dropped a washer in the carburettor of a car he/she was servicing. This could mean that the time spent on completing that service could end up being five or six hours long. It would be unfair to charge the EDGE Learning Media CC 6

7 client for six hours of work, though, since the reason for the extended number of hours spent was due to an error on the part of the supplier. If the service took one hour to complete, because there was a second mechanic available to help with the service, the business would still charge the two hours, essentially partially recouping the loss they incurred on the previous client (this loss is called an opportunity cost, i.e. the income forfeited due to the man hours lost in searching for the washer in the carburettor). (ii) Gross means before deductions. When we speak of gross profit, we refer to the profit before the deduction of overheads/operating expenses. Net profit refers to the bottom line or the profit after the deduction of overheads/operating expenses. Gross profit is the difference between the sales revenue and the cost of sales (also called the cost of goods manufactured). From a costing perspective, the cost of sales equals the direct materials + direct labour + manufacturing overheads. It is easy to explain a mark-up percentage. The term explains itself. A manufacturer produces a product for R 100 and marks it up by 50 %, thus adding 50 % of R 100 to the R 100 to arrive at R 150. When explaining a mark-up percentage, use the following equation: Cost price + Gross Profit = Selling price R R 50 = R 150 The mark-up percentage can be calculated as follows: X 100 = 50 % The gross margin is a bit harder to explain. In board meetings, directors often speak of gross margins. This is easier to use in strategic decision-making than mark-up percentages. A gross margin of 25 % basically means that 25 cents of each R 1 in sales revenue becomes available to cover overheads with. The reason why directors and managers use this ratio is that it now becomes relatively easy to calculate breakeven points. One could divide fixed costs by the gross profit per unit to obtain a breakeven point. In the costing sphere, this could be misleading, though, since the cost of sales could include manufacturing overheads that are fixed, not variable in nature. Therefore, in costing circles, one would rather speak of a contribution margin, and a marginal income ratio. Such a figure will exclude all forms of fixed costs, and will only focus on the marginal cost or marginal profit of every additional unit produced and sold. EDGE Learning Media CC 7

8 When explaining a gross margin, use the following equation: Cost price + Gross Profit = Selling price R R 50 = R 150 The gross margin can be calculated as follows: X 100 = 33 1 / 3 % When products are marked up on cost, the particular cost could either be the cost of sales or the total variable cost. Per definition, cost of sales is the total cost incurred to get a product onto the shelf; ready for sale (this cost could include fixed and variable components). The total variable cost includes only the variable cost components of production. Most accountants will use the cost of sales as the basis for mark-ups and margins, not the variable cost. The advantages of using a mark-up instead of a gross margin as a basis for costing, is that the denominator in all interpretations of results will be the cost, not the revenue. This makes it easier to think like a cost accountant, not like a strategic manager. The disadvantage of this method is that many executives in a board meeting on business strategy will misconstrue the mark-up percentage as a gross margin. Strategic planners speak of gross margins, since they relate all decisions to revenue and revenue-generating activities. The advantages and disadvantages of using a gross margin instead of a mark-up on cost are converse to the above. EDGE Learning Media CC 8

9 Question 4.6 (i) Cost item Variable cost Fixed cost Manufacturing overhead Administrative overhead Direct materials Indirect materials Direct labour Factory supervisor s salary X X X Executive training programme X X Lubricants for machines X X X Top management salaries X X Product advertising X X Assembly-line workers wages X X Headquarters secretarial salaries Rent on factory building X X Salesmen s commissions X X Raw materials X X X X Indirect labour (ii) Cost item Cost behaviour In relation to units of production Variable Fixed Direct Indirect Paper used in producing a text book X X Lubricants for machines X X Glue used in producing a text book X X Depreciation of equipment in the staff room X Cloth used in producing women s clothing X X A supervisor s salary X X Screws used in manufacturing furniture X X Wood used in producing skateboards X X Rent on a factory building X X Clay used in manufacturing bricks X X Salaries of the cleaning staff in the factory X X Wages of the workers that assemble the product X X EDGE Learning Media CC 9

10 Question 4.7 Workings: To calculate the breakeven point for each investment opportunity, the following analysis of cost, distinguishing between fixed and variable cost is required Type of cost Variable cost per unit Opportunity 1 Opportunity 2 Total variable cost Fixed cost Variable cost per unit Total variable cost Fixed cost Direct manufacturing cost R 128 R R R 4 R R Indirect manufacturing cost Selling and administrative costs R 208 R R R 12 R R (i) The breakeven point in units can be calculated as follows: Opportunity 1 Fixed cost / Marginal income per unit / ( ) = units Opportunity 2 Fixed cost / Marginal income per unit / (40 12) = units (Note: breakeven amounts must be rounded upwards, as rounding downwards will not ensure complete recovery of fixed cost). (ii) The breakeven point in sales revenue can be calculated as follows: Opportunity 1 Fixed cost / Marginal income ratio / [( ) / 400] = R OR: x R 400 = R Opportunity 2 Fixed cost / Marginal income per unit / [(40 12) / 40] = R OR: x R 40 = R (iii) CVP graphs See the following pages: EDGE Learning Media CC 10

11 Opportunity 1 EDGE Learning Media CC 11

12 Opportunity 2 EDGE Learning Media CC 12

Answer to PTP_Intermediate_Syllabus 2008_Jun2015_Set 1

Answer to PTP_Intermediate_Syllabus 2008_Jun2015_Set 1 Paper 8: Cost & Management Accounting Time Allowed: 3 Hours Full Marks: 100 Question No 1 is Compulsory. Answers any five Questions from the rest. Working Notes should form part of the answer. Question.1