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Foster Corporation produces a molded plastic casing for its video game consoles. Summary data from its 2016 income statement are as follows:

Revenues

$4,000,000

Variable costs

2,400,000

Fixed costs

1,728,000

Operating income

$ (128,000)

The President, Wanda Wilson is very concerned about the company's poor profitability. She asked the production manager and controller to see if there are ways to reduce costs. The production manager suggests that variable costs can be reduced to 52% of revenues by reducing the cost the company currently incurs for safe disposal of wasted plastic. The controller is concerned that this would expose the company to potential environmental liabilities and tells the production manager that they would need to estimate some of these potential environmental costs and include them in the analysis. The production manager feels like they are not violating any laws and that while there may be some possibility that they would incur environmental costs in the future, if they bring it up now the proposal would not go through because their senior management always assumes the costs to be larger than they turn out to be. The market is very tough and we are in danger of shutting down the company and costing them all their jobs. He feels the only reason their competitors are making money is that they are doing exactly what he proposes doing.

Calculate the current break-even revenues. (Show all calculations)

Calculate the break-even revenues if variable costs are 52% of revenues. (Show all calculations)

Calculate what the operating income would be with the proposed change. (Show all calculations)

What advice would you give to Wanda? Take into consideration both quantitative and quantitative factors.

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Bunny Greenfelder
Bunny GreenfelderLv2
28 Sep 2019

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Camelback Communications, Inc. (CCI), located near Phoenix,Arizona, manufactured radio and television antennas. The firm hadfour distinct product lines, each serving a different aspect of theantenna market.

The first product line consisted of simple "rabbit ear"antennas. There were several models in the line ranging from thesimplest FM and TV antennas to more complicated designs that couldimprove reception by rejecting multipath signals.

The second product line contained dipole antennas for FM and TVreception. These were more sophisticated antennas than the "rabbitear" line and were the type typically seen attached tochimneys.

The third product line was rotators for the dipole line.Rotators consisted of an electric motor that rotated the dipole anda controller that resided by the receiving unit (FM radio or TV).There was little variation in the motors, but the controllersvaried considerably from simple controllers that were operated byturning a knob on the controller base to more sophisticatedversions that had present antenna positions keyed to the channelbeing received.

The final product line consisted of two electronic antennas, onefor FM and the other for TV. These were used in weak receptionareas and, in addition to acting as antennas, amplified the signalso that it was strong enough for the receiver to be able toreproduce it properly.

In the last five years, CCI had doubled the number of productsoffered, expanded the production facility twice, and just recentlyintroduced the electronic antenna line. While CCI was veryprofitable, company president Lincoln McDowell was concerned aboutits ability to cost products accurately. In particular, someproduct seemed exceptionally profitable, while other potentialproducts which the firm should have been able to make, appearedimpossible to manufacture at a profit. The production manager wasconvinced that his production processes were as good as any in theindustry, and he was unable to explain the apparent high cost ofproducing these potential products.

McDowell agreed with his production manager and was convincedthat the cost accounting system was at fault. He had just recentlyhired Glenn Peterzon, a management consultant, to analyze thefirm's cost system and to prepare a presentation to the seniormanagement team. Specifically, McDowell had asked Peterzon toprepare a simple example that demonstrated how the cost systemdistorted the firm's knowledge of its product costs.

Peterzon had begun his study by documenting the existing costsystem. It was a very simple system that used a single burden ratefor all overhead costs. The burden rate for the year was determinedby adding together the budgeted variable and fixed overhead costsand dividing this sum by the number of budgeted direct labor hours.The standard cost of a product was then found by multiplying thenumber of direct labor hours required to manufacture that productby the burden rate and adding this quantity to the direct labor andmaterial cost.

Peterzon became convinced that the cost system was partially toblame for some of the problems the firm was experiencing. However,with over a hundred products, it was difficult to understand howthe cost system was distorting product costs.

To help illustrate the source of these distortions to seniormanagement, Peterzon decided to develop a simple four-productmodel. He decided it would be helpful if the actual productioncosts of the four products were known a priori (see Table A).

A B C D
Material cost 15 5 10 5
Direct labor 30 5 15 10
Variableoverhead 15 7.5 5 7.5
Variable Cost 60 17.5 30 22.5
Fixed Cost 10 10 12,500 12,500

Product lines A and B used identical equipment that could eachproduce 1,000 units of A
or B. Product lines C and D used identical equipment that couldeach produce 1,000 units of C or D.


He then calculated the direct labor allocation rate that theexisting single burden rate cost system would generate assumingthat each product sold a thousand units, the maximum that could beproduced, and that each direct labor hour cost $5. Under thisscenario, the costs incurred would be:

Variable Product Overhead Labor Hours PerUnit VariableOverhead/unit No. Units Total LaborHours Total
A 6 15 1 6 15
B 1 7.5 1 1 7.5
C 3 5 1 3 5
D 2 7.5 1 2 7.5
Total 4 12 35

and the new allocation rate:

Variable overhead 35,000
FixedOverhead 45,000
Total Cost to beAllocated 80,000
Labor Hours($60,000/5) 12,000
Allocationrate/hour $6.67


Using this allocation rate per hour, Peterzon calculated thestandard cost of the four products.

Product A B C D
Material 15 5 10 5
Labor 30 5 15 10
AllocatedCost 40 6.67 20 13.33
Standard Cost $85 16.67 45 28.34

If the firm set out to make a 40% mark-on,b then it would wantto charge the following prices for the four products:

Product A B C D
Standard Cost 85 16.67 45 28.34
40% Mark-on 34 6.67 18 11.34
Selling Price $119 23.34 63 39.68

Mark-on % = profit/cost

If industry selling prices were established using actualproduction costs and a 40% mark-on, they would be:

Product A B C D
Standard Cost 70 27.5 42.5 35
40% Mark-on 28 11 17 14
Selling Price $98 38.5 59.5 49


By comparing the "industry" prices to the firm's costs and assumingthat the firm had to match industry prices, Peterzon coulddetermine which products would appear profitable.

Selling Price 98 38.5 59.5 49
Standard Cost 85 16.67 45 28.34
Profit 13 21.83 14.5 20.66
Markup 15% 131% 32% 73%

CCI had recently adopted a policy of discontinuing all productswhose mark-ons were under 25%. Under this policy, product A wouldbe dropped and additional product B manufactured. Assuming the firmcould sell all of product B that it could manufacture, then thesales would be

Budgeted A B C D
CurrentVolume 1,000 1,000 1,000 1,000
Actual Volume 0 2,000 1,000 1,000

aThe unused production capacity was used to produce anadditional 1,000 units of B.

The resulting product mix was so different from the starting mixthat Peterzon decided to recalculate the allocation rate per hourto determine if it had been affected:

Costs Incurred ($ thousand)

Variable Product Overhead LaborHours/Unit Variable Overhead/Unit No. Units Total LaborHours Total
B 1 7.5 2,000 2,000 15,000
C 3 5 1,000 3,000 5,000
D 2 7.5 1,000 2,000 7,500
Total 4,000 7,000 27,500

and the new allocation rate:

Variable Overhead : 27,500

Fixed Overhead: 45,000

72,500

Labor Hours ( 35,000/5) : 7,000

Allocation rate/hour: $10.36

Questions:

4. What would happen if the firm kept its existingcost system but differentiated between variable and fixed cost anddecided to maximize contribution?
5. What would happen if the firm modified its costsystem so that all variable costs were traced to the productaccurately but fixed costs were allocated using the existingsystem?
6. What would happen if the firm modified its costsystem so that it contained two cost pools, one containing theoverhead costs associated with Products A and B and the other theoverhead costs associated with Products C and D, and then allocatedthese overhead pools on the basis of direct labor hours?

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