Putting the People Component of the Business Entity

Question: Discuss about the Report for Putting the People Component of the Business Entity. Answer: 1. The income statement for Bonza Handtools Ltd. for the last twelve months is presented below: Particulars Amount in $ Sales 20000 units Selling price per unit 130 Revenue 26,00,000 Variable Manufacturing cost per unit 50 Variable Manufacturing cost 10,00,000 Fixed manufacturing costs 4,00,000 Variable selling administrative cost per unit 30 Variable selling administrative cost 6,00,000 Fixed selling administrative cost 3,00,000 Total operating cost 23,00,000 Operating income 3,00,000 Operating profit margin 11.5% The management wants to increase the profitability of the product, and for the purpose it is considering three alternatives to increase the profitability. The profitability of each of the alternative along with their analysis is presented below: Alternative 1 Increase selling price by $10 with an increased advertising expenditure of $125000 so that sales do not drop. Particulars Amount in $ Sales 20000 units Selling price per unit 140 Revenue 28,00,000 Variable Manufacturing cost per unit 50 Variable Manufacturing cost 10,00,000 Fixed manufacturing costs 4,00,000 Variable selling administrative cost per unit 30 Variable selling administrative cost 6,00,000 Fixed selling administrative cost 4,25,000 Total operating cost 2425,000 Operating income 3,75,000 Operating profit margin 13.4% The above increase in selling price has increased the operating profit margin by almost 2%. However, an increase in price of a product without any corresponding addition to the features or quality of the product may not work for the company, as the customer will not be willing to pay extra. Even though the company will increase its advertising expenditure which may attract some new customers but the existing sales is bound to come down with an increase in price. It is very difficult to garner new customers with an increased price because demand has the highest elasticity with price and with an increase in price; the demand is going to go down. Moreover, the advertising campaign is a national advertising and not directed towards the targeted audience, hence the results of the campaign might not be favourable. Alternative 2 Improving the quality of the product and additional advertising campaign expenses of $50000 to increase the volume of sales. An increase in variable cost by $5 per unit in order to improve sales. Particulars Amount in $ Sales 25000 units Selling price per unit 130 Revenue 32,50,000 Variable Manufacturing cost per unit 55 Variable Manufacturing cost 13,75,000 Fixed manufacturing costs 4,00,000 Variable selling administrative cost per unit 30 Variable selling administrative cost 7,50,000 Fixed selling administrative cost 3,50,000 Total operating cost 23,00,000 Operating income 3,75,000 Operating profit margin 11.5% The above proposal does not offer any increase in the profit margins. It is the same as last year. Even though the assumptions of this alternative are more realistic than the previous one, however this alternative offers no added advantage. An improvement in product quality without any corresponding increase in price is bound to increase the sales volume and an advertising campaign targeted at the home renovators and trade people will definitely lead to an increase in sales volume as they would be aware of the quality improvement and hence would demand more drills. The management expects the sales volume to increase by 25%, however if we consider a variation of 10% in the sales volume and expect the volume to increase by 27.5% instead of 25%, the expected operating margin would be 10.5%. Alternative 3 A rebate of $10 offered on drills sold for the first three months with an advertising cost of $40000. Particulars Amount in $ Sales 10000 units Selling price per unit 120 Revenue 12,00,000 Variable Manufacturing cost per unit 50 Variable Manufacturing cost 5,00,000 Variable selling administrative cost per unit 30 Variable selling administrative cost 3,00,000 Total variable cost 8,00,000 Particulars Amount in $ Sales 14000 units Selling price per unit 130 Revenue 18,20,000 Variable Manufacturing cost per unit 50 Variable Manufacturing cost 7,00,000 Variable selling administrative cost per unit 30 Variable selling administrative cost 4,20,000 Total variable cost 11,20,000 Particulars Amount in $ Total revenue 30,20,000 Total variable cost 19,20,000 Fixed manufacturing costs 4,00,000 Fixed selling administrative cost 3,40,000 Total operating cost 26,60,000 Operating income 3,60,000 Operating profit margin 11.92% From the above table, we see that the operating profit margin has increase by 0.4% to 11.92% in the last alternative. The assumptions of the suggestion are also realistic because it offers a discount of $10 to its customers along with an advertising campaign which is bound to increase the volume of sales because as mentioned earlier demand is the most elastic to price, hence a discount will lead to increase in sales. Moreover, the company offers rebate only for a limited period, and still it is able to increase its profits. Since volume increase is only an estimate, hence if we consider a variation of 10% in the increase in sales. Currently sales have increased by 4000 units in first three months, which is 66.7% increase from 6000. A variation of 10% would mean increase in sale by 60%. Hence new sale volume would be 9600 units instead of 10000 units. The resulting change would be operating profit margin of 11.57% which is still higher than the other proposals. Recommendation On the basis of the above analysis, it is recommended that the company should go ahead for the third alternative of giving a rebate of $10 in the first three months as it has the highest operating profit margin even after considering the variation of 10% in sales volume; it has the highest profit margin. 2. The budgeted income statement for Tassie Company is as follows: Particulars Per unit in $ Amount in $ Sales units 150000 Selling price 15 22,50,000 Direct Material 2.5 3,75,000 Direct Labour 3 4,50,000 Variable factory overhead 1.5 2,25,000 Fixed factory overhead 2 3,00,000 Variable selling and administrative cost 2 3,00,000 Fixed selling and administrative cost 1.5 2,25,000 Total cost 18,75,000 Operating income 3,75,000 Profit margin 16.67% a) Bid for supply of additional 40000 units to the government when the capacity is 200000 units per year The total production including the government supply will be 190000 units, so the factory can produce additional 40000 units. Variable costs additional 40000 units Particulars Per unit in $ Amount in $ Direct Material 2.5 1,00,000 Direct Labour 3 1,20,000 Variable factory overhead 1.5 60,000 The Income Statement for total 190000 units Particulars Per unit in $ Amount in $ Sales units 190000 Selling price 15 28,50,000 Direct Material 2.5 4,75,000 Direct Labour 3 5,70,000 Variable factory overhead 1.5 2,85,000 Fixed factory overhead 2 3,00,000 Variable selling and administrative cost 2 3,00,000 Fixed selling and administrative cost 1.5 2,25,000 Total cost 21,55,000 Operating income 6,95,000 Profit margin 24.4% The company will bid for 40000 units. b) When the production capacity is 180000 units per year. Even when the production capacity is 180000 units per year, the company will bid for additional 40000 units because the government bid is profitable in the sense that there is no variable selling and administrative costs and no additional fixed expenses are employed. Hence the total costs get reduced. Hence, the company will produce 180000 units but will supply 40000 units to the government and the remaining 140000 units will be sold in the market. The income statement for 180000 units sales is presented below: Particulars Per unit in $ 140000 units ($) 40000 units ($) Total in $ Revenue 15 21,00,000 6,00,000 27,00,000 Direct Material 2.5 3,50,000 1,00,000 4,50,000 Direct Labour 3 4,20,000 1,20,000 5,40,000 Variable factory overhead 1.5 2,10,000 60,000 2,70,000 Fixed factory overhead 2 3,00,000 3,00,000 Variable selling and administrative cost 2 2,80,000 0 2,80,000 Fixed selling and administrative cost 1.5 2,25,000 2,25,000 Total cost 17,85,000 2,80,000 20,65,000 Operating income 3,15,000 3,20,000 6,35,000 Profit margin 23.5% Here we see that even though the company is producing only 180000 units, however, it is making a profit margin of 23.5% as government supply with lower costs has helped in increasing the profit margin. Hence the bid would be for 40000 units. 3. An item is regarded as an asset it has been purchased by the company for a monetary value which can be measured and the asset provides economic benefits in the future. Salary cannot be regarded as an asset on the balance sheet because the employees are not owned by the company and they have not been purchased. (Otter, NA). Salary is the amount paid by the company to the employees for their services in the reporting period. An asset gives future benefits while a salary is recorded for the current services. Also purchase of an asset involves a transaction whereas no transaction is involved in hiring an employee. (Back, 2010) Depreciation is the decrease in value of an asset over the years. The total depreciation till date is called accumulated depreciation. Depreciation cannot be regarded as an asset because it is a contra asset that is reported in the balance sheet as a reduction from total assets. Since depreciation does not provide any economic benefits, it is not an asset. Also depreciation cannot be purchased or sold; rather the machine on which the depreciation is applied is purchased or sold. 4. Overhead allocation rate for the labour intensive process Allocation rate = total overheads / total budgeted labour hours = $98,400 / 25795 = $3.8 Total costs of special order of 350 trailers Amount in $ Direct material (2100kg@$16.1 per kg) 33810 Direct labour of 1400 hours @12.7 17780.2 Machine hours of 525 hours @12.7 6667.6 Indirect costs (3.8*350) 1335.1 Total cost 59592.9 Working notes Direct labour and machine hours cost has been calculated by the budgeted direct labour rate as the process is labour intensive which is $3,27,600 / 25,795 hours = $12.7 Overhead allocation rate on the basis of machine hours = 98400 / 9840 = $10 Total costs of special order of 350 trailers Amount in $ Direct material (2100kg@$16.1 per kg) 33810 Direct labour of 1400 hours @12.7 17780.2 Machine hours of 525 hours @12.7 6667.6 Indirect costs (10*350) 3500 Total cost 61757.8 Minimum price per trailer The minimum price per trailer would be the total cost per unit of the trailer. Since the overhead costs have been calculated using labour and machine hours as the allocation base, we see the total cost per unit by both methods: Labour hours allocation base minimum price = 59592.7 / 350 = $170.26 Machine hours allocation base minimum price = 61757.5 / 350 = $176.45 Segmented overhead cost pools are different cost pools created for various category of overheads and the cost is allocated to the products using a different overhead rate for each cost pool. An extension to above allocation is called activity based costing. ABC costing has two steps, first being identification of different cost drivers which have lead to the arising of the cost. Some of these activities include assembly, packaging, labelling, transport etc. once the cost drivers are identified, an overhead rate for each cost driver is determined using the total cost and usage of the activity. Now on the basis of the use of activity by each product, the overhead costs are assigned to the products. For example, a product uses 200 machine hours on assembly which has a overhead rate of $5 whereas it uses only 50 labour hours on packaging which has a overhead rate of $20, the product will have a total lower overhead costs as compared to a product which uses 50 machine hours on assembly an d 100 labour hours of packaging will have a higher overhead costs. Thus, ABC ensures overheads are allocated to the products on the basis of usage of the activity. (CIMA, 2008) References Otter, J. (NA), Putting the People Component of the Business Entity on the Balance Sheet, Department of Applied Accountancy, University of South Africa Back, L., (2010), The Most Important Assets are not on the Balance Sheet, accessed online on 13th September, 2016, available at https://www.triplepundit.com/2010/09/the-most-important-assets-are-not-on-the-balance-sheet/ CIMA, (2008), Activity Based Costing, Topic Gateway Series No. 1, accessed online on 13th September, 2016, available at, https://www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_activity_based_costing_nov08.pdf.pdf