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Part A – Short-run decision making: Relevant costing

Question 1

Valdivia Company produces remote control helicopters. The company has done research to improve the OS1 model. Consequently, the OS2 model was developed. The general manager of Valdivia has to decide whether to release the OS2 model on 1 October 2018, in time for Christmas.

The major problem is that Valdivia Company has overstocked the OS1 model. The general manager knows that once the OS2 model is introduced, Valdivia Company will not be able to sell any OS1 model helicopters. The general manager is wondering if it might be better to continue to sell the OS1 model until the inventory is sold out, anticipated to be around 1 January 2019, and then to introduce the OS2 model.

The following information is available per unit:

 

OS1 model$

OS2 model $

Selling price

2 020

2 340

Direct materials costs

480

520

Direct labour costs

610

668

Variable overhead costs

245

282

Development cost

150

210

Marketing and administrative cost

85

92

Total cost per unit

1 570

1 772

Operating profit per unit

450

568

Development cost per unit for each product equals the total costs of developing the helicopters divided by the anticipated unit sales over the life of the product. Marketing and administrative costs are fixed costs in 2018, incurred to support all marketing and administrative activities of Valdivia Company. Marketing and administrative costs are allocated to products on the basis of the budgeted revenues of each product.

Required:

(a)  Based on a quantitative (numerical) analysis, clearly identify relevant revenues and costs and state whether Valdivia should introduce the OS2 model on 1 October 2018 or wait until 1 January 2019? Justify your answer. Show all calculations. Clearly state which costs are irrelevant and why they are irrelevant.

(b)  Discuss at least four (4) qualitative factors that the general manager has to consider in making a decision. You will receive 0.5 mark for mentioning a factor and 1 mark for discussing and elaborating on the factor. You will not receive any marks for discussing quantitative factors. Word limit: 300 words with a 10% margin.

Continued on next page question 2

Question 2

The Caleta Division of Puerto Ltd makes and sells tables and chairs. The following estimated revenue and cost information for the 2018 year for the division is available:

 

4 000 Tables

24 000 Chairs

Total

Revenues

$1 000 000

$2 000 000

$3 000 000

Variable direct materials and direct labour costs

600 000

1 050 000

1 650 000

Depreciation on equipment used exclusively by each product line

84 000

116 000

200 000

Marketing and distribution costs:

$80 000 (fixed) + ($750 x 80 shipments)

$202 500 (fixed) + ($750 x 90 shipments)

140 000

270 000

410 000

General administration costs of the division allocated to product lines on the basis of revenue

220 000

440 000

660 000

Corporate office costs allocated to product lines on the basis of revenues

100 000

200 000

300 000

Operating profit (loss)

$(144 000)

$(76 000)

$(220 000)

Additional information:

  1. On 1 January 2018 the equipment of Caleta Division had a carrying value of $200 000 and zero disposal value. Any equipment not used will remain idle.
  2. Fixed marketing and distribution costs of a product line can be avoided if the line is discontinued.
  3. General administration costs of the division and corporate office costs will not change if sales of individual product lines are increased or decreased or if product lines are added or dropped.
  4. Assume that to make and sell 4 000 more tables, Caleta Division would have to acquire additional equipment costing $95 000 with a one-year useful life and zero terminal disposal value.
  5. Assume that the fixed marketing and distribution costs would not change but that the number of shipments would double if 4 000 more tables are made and sold.

Required:

(a)   What would be the effect on Caleta Division’s operating profit if it were to sell 4 000 more tables? State if the Caleta Division should sell the additional 4 000 tables and why. Show all calculations and state which costs are irrelevant. Justify your answer.

(b)   Given that Caleta Division’s expected operating loss when selling 4 000 tables only is $220 000, should Puerto Ltd shut it down? Assume that shutting down the Caleta Division will have no effect on corporate office costs but will lead to savings of all general administration costs of the division. Show all calculations and justify your decision.

Question 3

Discuss the criteria of irrelevant costs.

Short-run Decision Making with Relevant Costing

Part a

Particulars

Amount

Operating Profit per unit from OS2

$568

Less: Development Cost

-$150

Less: Marketing & Administrative Cost

-$85

Net Operating Profit

$333

The relevant costs which are incurred by Valdivia Company for producing the OS1 model are the variable costs such as direct material costs, direct labour costs and overhead costs of the business. The main source of revenue for the business is the sale of the product 0S1.

As per the table which is shown above, the operating profit per unit from OS2 helicopters is shown to be $ 568. The development costs and market and administration costs of producing OS1 model is considered for computing the net operating profit of the business. The management must start the sales of OS2 model from 1 January 2019 as the stocks of OS1 stocks needs to be cleared as the management has overstocked the OS1 Helicopter models. If the management starts sales of OS2 model on 1st October 2018 then the management will have to incur significant amount of losses.

The costs which are irrelevant are marketing and administration costs which the management incurs on promotion of the helicopters which will also be done in case of OS2 model of Helicopters

Part b

 The qualitative characteristic which the general manager needs to consider while taking a decision are discussed below:

  • Budgeted Plan of the Management: The plan of the management can affect the decision-making process of the business. The plan of the management can be to implement the new product on October 2018 which will affect the decision-making process of the business (Hussey, Wertheimer & Mehrotra, 2013). The decision of the management will be affected and the management will have make a decision as to whether sell OS2 model as per plan or clear the stocks of the business.
  • Demand of the customers:The overall demand of the customers is also an important factor which affect the decision-making process of the management. If the demand for OS2 model is more in the market than the demand for OS1 model than the management must swap the decision (Christ & Burritt, 2015). The demand of the customers also plays a vital role in the decision regarding which model of helicopter is to be offered to the general public. The main purpose of the business is to satisfy the needs of the public and therefore it will definitely affect the decisions of the management.
  • Supply of raw material:The materials which are supplied by the business also affect the decision which the management needs to take regarding the products which are to be offered. If the materials are easily available for producing OS2 model of Helicopters than the management will be taking decision in favor of producing and selling more of OS2 model in the market. Therefore, supply of raw materials also plays a vital role in the decision-making process of the business.
  • Competition: The level of competition in the market also affect the decision of the management as if the competitors of the business produces more of update helicopters, the management will also have to supply OS2 model in the market to maintain the competition of the business. The management needs to consider the activities of the competitors for the purpose of taking important decisions of the business.
Part 1

Question a:

 

Tables

Chairs

 

Tables

Chairs

 

Particulars

4000

24000

TOTAL

8000

24000

TOTAL

Revenues

$1,000,000

$2,000,000

$3,000,000

$2,000,000

$2,000,000

$4,000,000

Variable Direct Material & Direct Labour Costs

-$600,000

-$1,050,000

-$1,650,000

-$1,200,000

-$1,050,000

-$2,250,000

Depreciation on Equipment Used

-$84,000

-$116,000

-$200,000

-$179,000

-$116,000

-$295,000

Fixed Marketing & Distribution Cost

-$80,000

-$202,500

-$282,500

-$80,000

-$202,500

-$282,500

Variable Marketing & Distribution Cost

-$60,000

-$67,500

-$127,500

-$120,000

-$67,500

-$187,500

General Administration Costs

-$220,000

-$440,000

-$660,000

-$330,000

-$330,000

-$660,000

Corporate Office Cost

-$100,000

-$200,000

-$300,000

-$150,000

-$150,000

-$300,000

Operating Profit

-$144,000

-$76,000

-$220,000

-$59,000

$84,000

$25,000

The above table shows that the management should sell extra 400 tables as the same results in operating profits which is shown in the combination of 8000 tables and 24000 chairs. The management should select this combination. The depreciation on equipment and fixed marketing and distribution costs of the business can be said to be irrelevant costs of the business as the same expenses will be incurred no matter if the management chooses to incur expenses.

Part b

Question b:

 

Tables

Chairs

 

Tables

Chairs

 

Particulars

4000

24000

TOTAL

0

24000

TOTAL

Revenues

$1,000,000

$2,000,000

$3,000,000

$0

$2,000,000

$2,000,000

Variable Direct Material & Direct Labour Costs

-$600,000

-$1,050,000

-$1,650,000

$0

-$1,050,000

-$1,050,000

Depreciation on Equipment Used

-$84,000

-$116,000

-$200,000

-$84,000

-$116,000

-$200,000

Fixed Marketing & Distribution Cost

-$80,000

-$202,500

-$282,500

$0

-$202,500

-$202,500

Variable Marketing & Distribution Cost

-$60,000

-$67,500

-$127,500

$0

-$67,500

-$67,500

General Administration Costs

-$220,000

-$440,000

-$660,000

$0

-$440,000

-$440,000

Corporate Office Cost

-$100,000

-$200,000

-$300,000

$0

-$300,000

-$300,000

Operating Profit

-$144,000

-$76,000

-$220,000

-$84,000

-$176,000

-$260,000

The management of Puerto Ltd should shut down the business as the management earning operating losses from the same. In this case the management should select 4000 tables and 24000 chairs option as the loss incurred in this option is lower than the second option.

The irrelevant costs of the business are costs which are incurred by the management even if any alternative decision or plans are followed (Noreen, Brewer & Garrison, 2014). As the costs of the business have to be incurred no matter what the situation is, such costs are considered to be irrelevant for decision making purpose and therefore are not considered at all for decision making process (Leeds, Leeds & Motomura, 2015). Non-cash items of a business such as depreciation and amortization are often considered to be irrelevant costs of the business.

Reference

Christ, K. L., & Burritt, R. L. (2015). Material flow cost accounting: a review and agenda for future research. Journal of Cleaner Production, 108, 1378-1389.

Hussey, P. S., Wertheimer, S., & Mehrotra, A. (2013). The association between health care quality and cost: a systematic review. Annals of internal medicine, 158(1), 27-34.

Leeds, D. M., Leeds, M. A., & Motomura, A. (2015). Are sunk costs irrelevant? Evidence from playing time in the National Basketball Association. Economic Inquiry, 53(2), 1305-1316.

Noreen, E. W., Brewer, P. C., & Garrison, R. H. (2014). Managerial accounting for managers. New York: McGraw-Hill/Irwin.

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