Finical Analysis Task 4 A. 1. To: Vice President This report has been prepared to argue the case that the company’s current costing method should be changed to the activity based costing method. This report will review; the difference between traditional based costing and activity based costing; traditional split and allocations with activity based costing; and discusses the breakeven point for Competition bikes Inc. with regards to sales units and sales dollars for both CarbonLite and Titanium bikes.
The first item at hand is what kind of detail does activity based costing provide that is different than traditional costing? The main difference between activity based costing and the traditional system is that activity based costing requires four steps to build its cost point.
Traditional costing uses one rate where first, activity based costing must identify each activity and estimate its total and indirect cost. Second for activity based costing is that the cost driver for each activity must be estimated along with the total quantity of each driver’s allocation base.
Third the cost allocation for each activity must be computed.
Fourth costs to cost object are allocated. Activity-based costing focuses on activities. The costs of those activities become the building blocks for measuring (allocating) the costs of products and services. (Horngren, Harrison, Jr & Oliver, 2008) This method of costing does require more time to compute the cost to the activity yet it earns that money back plus dividends by having a more accurate forecast of the true costs that are associated with each activity. The second item is understanding how to define the difference between the traditional split and the allocations with activity cost pools.
In traditional costing there was a wide acceptance that the much of the overhead cost had come from direct labor costs. This assumption was satisfactory when direct labor when direct labor was a major portion of the total manufacturing costs. With activity based costing the activity cost pools are assigned to product or services via means of cost drivers. So any factor that would have a cause-effect relationship with the resources being consumed would be calculated and grouped based on the event or action that incurs cost when producing a product or providing a service (Hilton, R. W. , 2009).
In traditional costing the assumption is made that the volume metric is the underlying driver of manufacturing overhead cost. This fails to account for nonmanufacturing costs that also are associated with the production of an item such as administrative costs. Third and last the question to answer is; with all this detail on specific cost will that actually lead to improved results? Simply the answer is, yes! By looking at each activity and what drives its specific costs the true cost of the item can thus be realized thus having a better idea what the price should be to consumers and wholesalers alike.
By moving to the activity based cost system Competition Bikes could realize that the company has been overpricing items thus losing market share or under pricing an item, thus loosing precious revenue to further fund research and development to improve the product for the future. One major example is that of airlines that began to look at the cost to carry luggage, and then passed that cost onto the customers. Airlines realized that all the tagging, bagging, moving, loading, unloading was extremely labor intensive and costing them lots of money.
Many passengers now opt to pack more simply and only bring a bag that passengers carry onto the plane. This is exactly what the airline is hoping for as that extra room in the plane can be used to carry cargo. Airlines can charge a premium for cargo as same day cargo delivery demands a premium price. This was only figured out once airlines analyzed the costs of luggage using the activity based costing method. By switching to the activity based costing (ABC) method, Competition Bikes is also taking advantage of the cost savings and important in depth knowledge that could will bring to the company.
From the overhead analysis completed, it analysis six overhead items with associated costs. This analysis also compares numbers from traditional based costing vs activity based costing. With traditional based costing the analysis shows a total product cost number of 641,320 for Titanium bikes, where as ABC method shows a total product cost as 590,715. There is a difference for Carbon bikes as well. The traditional method shows a 679,380 where the ABC method shows a total product cost of 729,985. These numbers show that Competition Bikes could be overpricing the titanium bikes nd could afford to lower the cost in order to be more competitive in the marketplace and maybe even bring in more revenue than previous years. As for the Carbon bikes the analysis states that using the traditional method that total product cost was at 679,380. Once the same analysis for total product cost using ABC method for Carbon bikes shows that number to be 729,985. This knowledge gained from getting a better understanding of each bikes specific costs can really help price the product better so that Competition Bikes remains more competitive in the industry. . 1. a. Analyze the breakeven point for Competition Bikes Inc. with regard to sales units and sales dollars for both CarbonLite and Titanium bikes. The cost volume profit (CVP) analysis is a tool that managers and business often use to estimate future levels of operational activity needed to avoid taking losses. This analysis also helps to target future revenues. Another item it is used for is when the company is planning to expand operations, the CVP analysis can help estimate what production will be needed to cover those expansion costs.
CVP analysis examines changes in profits in response to changes in sales volumes, costs and prices. Accountants often perform CVP analysis to plan future levels of operating activity along with the volume of sales needed to achieve a targeted level of profit. (Hilton, R. W. , 2009). The basic cost volume profit equation starts with a basic profit equation: Profit = Total revenue – Total costs. By separating costs into variable and fixed categories, the expression of profit is now: Profit = Total revenue – Total Variable costs – Total fixed costs. Once that is understood the contribution margin can be found.
The contribution margin equation is the total revenue – total variable costs. It is also important to note that if the company is offering different products for sale, each product/unit will need to be figured for the contribution margin per unit. The equation for contribution margin per unit is: Selling price per unit – variable costs per unit. Titanium: 900-679=221 CarbonLite: 1495-1384=111 Thus the profit equation is now rewritten in terms of the contribution margin per unit assuming that the selling price and variable costs per unit are constants is: Profit = Selling price per unit x Quantity of product sold –
Variable costs per unit x Quantity of product sold – Total fixed costs = (Contribution margin per unit) x Quantity of product sold – Total fixed costs. For Competition Bikes based on the sales mix that would be: Total revenue: Titanium 900 x 450 + CarbonLite 250 x 1495 = 778,750 Total variable cost: Titanium 679 x 450 + CarbonLite 1384 x 250 = 651,550 Total Contribution Margin: 778,750 – 651,550 = 127,200 (Titanium: 99,450 CarbonLite: 27,750) Contribution margin ratio: 127,200 / 778,750 = 0. 163
The contribution margin ratio is the percent by which the selling price/revenue per unit exceeds the variable cost per unit or simply stated as the contribution margin as a percent of revenue. Now that the CVP equations are understood, most companies like to simply know what the numbers are for units as well as for revenue that are needed in order for the company to break even. The breakeven point is the level of operating activity at which revenues cover all fixed and variable costs, resulting in a zero profit. Horngren, C. T. , Harrison, W. T. , Jr, W. T. , & Oliver, M. S, 2008) Thus using the CVP formulas the breakeven point for both units and for sales/revenue can be found. Companies such as Competition Bikes that produce and sell a number of different products, a weighted average contribution margin (WACM) ratio is used to determine the breakeven point. The ‘weighted average’ is simply using the sales mix numbers to represent a proportion that then can be used to get the appropriate units to calculate the breakeven point.
The WACM ratio is found by taking the combined contribution margin (127,200) divided by the total number of unites expected to be sold (700) = 181. 71. Now that we have these numbers we use the given equations to find the break even points for both the sales units and sales dollars for Competition Bikes. Sales units x WACM = Total contribution margin dollars Total contribution margin dollars – fixed costs = 0 at breakeven So total contribution margin = fixed cost at breakeven Thus Sales Units x WACM = Fixed costs
Therefore Fixed costs/WACM = Sales units at breakeven point For Competition Bikes: 400,000/181. 71= 2201 Then we need to break that total units for each product. For Titanium: 450/700 x 2201 = 1415 Sales units at the breakeven point For CarbonLite: 250/700 x 2201 = 786 Sales units at the breakeven point Now to calculate the sales dollars at the breakeven point is to simply multiply the breakeven sales units by the sales price per unit. For Titanium: 1415 x 900 = 1,273,500 For CarbonLite: 786 x 1495 = 1,175,070 Total: 2,448,570 . Prepare a summary report that describes the impacts to the breakeven point if company management needed to increase the cost of direct materials by 10% cost increase and needed to add $50,000 in fixed costs to the production facility. Because the equations are based on the contribution margin as well as the WACM, an increase in the cost of direct materials (variable costs) by 10% will have a significant impact. First a look at if management needed to increase materials by 10% how that would affect the cost margin and WACM.
Revenue Per Unit: Titanium 900 CarbonLite 1495 Total – 778,750 Variable cost per Unit: Titanium 709 CarbonLite 1451 Total – 681800 Contribution Margin Per Unit: Titanium 191 CarbonLite 44 Total – 96,950 Total Contribution Margin: Titanium 85,950 (wrong on excel sheet) CarbonLite 11,000 This is broken down by unit just so that the 44 as the contribution margin for CarbonLite really stands out. This went from 111 (before the increase) to 44 per unit. That is a 60% decrease per unit from a simple 10% increase in direct materials cost.
That is a significant and impactful change made to the contribution margin. The WACM (96,950/700) is now 138. 5 (wrong on excel sheet) also a significant drop from the 181. 71 it was before the 10% increase. Because of the multiplication of each unit the 10% has a much larger impact. That is why so many companies spend so much time and effort to find ways to lower variable cost per unit. Now for the breakeven we see that lower WACM compounded again Fixed costs/WACM= Sales units at breakeven point 450,000/138. = 3249 For Titanium: 450/700 x 3249 = 2089 Sales units at the breakeven point For CarbonLite: 250/700 x 3249= 1160 Sales units at the breakeven point Now Competition Bikes will have to produce 1048 more bikes than before the increase in the 10% direct and 50,000 increase in fixed costs to simply break even. For sales dollars- Titanium: 2089 x 900 = 1,880,100 CarbonLite: 1160 x 1495 = 1,734,200 Total: 3,614,300 From a previous total dollar figure of 2,448,570 this is 1,165,730 difference just to break even.
This again drives the point at what a significant difference these costs are making to the break even figures. Increases to variable costs can have a more of a significant impact than an increase in a fixed cost. For Competition Bikes to as can clearly be seen from the CarbonLite sales price at 1495 and the variable cost per unit at 1451, there is very little margin for profit. This slim contribution margin barely gives from for revenue, let alone enough revenue to cover any overhead (fixed costs).
Combining that with having to overcome another 50,000 in fixed costs, the numbers speak for themselves on what a tremendous impact such increases in costs have to overall profitability of a company. Seeing these numbers is exactly what a cost volume profit analysis is supposed to show a company. Based on estimated figures Competition Bikes will either need to find ways to increase sales in order to produce a larger amount of bikes to break even or simply find ways to reduce direct costs for each unit, especially.
References Hilton, R. W. (2009). Managerial Accounting: Creating Value in a Dynamic Business Environment. Retrieved January 1, 2013, from http://online. vitialsource. com/#/books/0077771540/pages/53094067. Horngren, C. T. , Harrison, W. T. , Jr, W. T. , & Oliver, M. S. (2008). Accounting 8th edition. Prentice Hall. Retrieved from http://wpscms. pearsoncmg. com/wps/media/objects/6716/6877765/hha08_flash_main.
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