BSB005 Management Accounting

Tutorial - Weeks 3/4

Problem 2-12 from Seal, Rohde, Garrison and Noreen (2019)

Tracy Beckham began dabbling in pottery several years ago as a hobby. Her work is
quite creative, and it has been so popular with friends and others that she has decided to
quit her job with an aerospace firm and manufacture pottery full time. The salary from
Tracy’s aerospace job is £2,500 per month.

Tracy will rent a small building near her home to use as a place for manufacturing the
pottery. The rent will be £500 per month. She estimates that the cost of clay and glaze
will be £2 for each finished piece of pottery. She will hire workers to produce the pottery
at a labour rate of £8 per pot. To sell her pots, Tracy feels that she must advertise
heavily in the local area. An advertising agency states that it will handle all advertising
for a fee of £600 per month. Tracy’s brother will sell the pots; he will be paid a
commission of £4 for each pot sold. Equipment needed to manufacture the pots will be
rented at a cost of £300 per month.

Tracy has already paid some start-up fees associated with her business. These fees
amounted to £500. A small room has been located in a tourist area that Tracy will use as
a sales office. The rent will be £250 per month. A phone installed in the room for taking
orders will cost £40 per month. In addition, a recording device will be attached to the
phone for taking after-hours messages.

Tracy has some money in savings that is earning interest of £1,200 per year. These
savings will be withdrawn and used to get the business going. For the time being, Tracy
does not intend to draw any salary from the new company.

Required

1. Prepare an answer sheet with the following headings:

Name Variable Fixed Product cost Period Opportunit Sunk

of cost cost cost y cost cost
cost Direct Direct Manufacturin
material labour g overhead
s

List the different costs associated with the new company down the extreme left column
(under Name of cost). Then place an X under each heading that helps to describe the
type of cost involved. There may be Xs under several column headings for a single cost.
(That is, a cost may be a fixed cost, a period cost, and a sunk cost; you would place an X
under each of these column headings opposite the cost.)

Under the Variable cost column, list only those costs that would be variable with respect
to the number of units of pottery that are produced and sold.

2. All the costs you have listed above, except one, would be differential costs between
the alternatives of Tracy producing pottery or staying with the aerospace firm. Which
cost is not differential? Explain.

1
Question 2

A service company, Plumbco Ltd., employs 20 plumbers. The estimated costs for the
next year are as follows:

£ per year
Wages for each plumber 30,000
Operating cost per van (each plumber has one to use) 6,000
Premises – rent, rates and heating 120,000
Materials 10,000
Average miles travelled per plumber 12,000 miles

Each plumber works 40 hours per week for 50 weeks of each year.

The prices quoted to customers contain the following:

i) 10% is added to the cost of materials to cover handling and wastage, plus
ii) Direct travel costs, plus
iii) A further 30% is added to the total cost of each job to provide for profit.

The following information relates to Job 246: Fitting a bath for Mrs A Spence

Mileage 2 trips of 35 miles per trip

Bath, taps, pipe and miscellaneous materials £316
Plumber’s time 12 hours

Required

(a) Calculate the price to be quoted to Mrs Spence for job 246.

(b) Discuss the advantages and disadvantages of using a pre-determined overhead rate
to absorb overheads.

(c) Assume that in the forthcoming year actual activity turns out to be 41,000 hours
worked. Overheads incurred were as estimated and the extra hours represent
increased activity not inefficiency.

Calculate what adjustment is required for overheads under- or over- absorbed and
explain how this figure would be treated in the management accounts.

2
THOUGHT STIMULATION CASE: Evaluation of assertions made in a
dialogue.
The following discussion was printed in the Lybrand Journal in 1960, as well as in
numerous other sources. The original source is unknown.

In discussing the cost associated with various types of operations, the following
analogy was drawn: A restaurant adds a rack of peanuts to the counter, hoping
to pick up a little additional profit in the usual course of business. Consider the
actual problem faced by the restauranteur (Joe) as revealed by his
accountant/efficiency expert (Eff Exp).

Please read the case.

Eff Exp: Joe, you said you put in these peanuts because some people ask for
them, but do you realise what this rack of peanuts is costing you?

Joe: It ain’t gonna cost. It’s gonna be a profit. Sure, I had to pay $25 for
a fancy rack to hold bags, but the peanuts cost 6 cents a bag, and I
sell ‘em for 10 cents. ‘Figger I sell 50 bags to start. It’ll take 12 ½
weeks to cover the cost of the rack. After that I gotta clear profit of
4 cents a bag. The more I sell the more I make.

Eff Exp: This is an antiquated and completely unrealistic approach, Joe.

Fortunately, modern accounting procedures permit a more accurate
picture that reveals the complexities involved.

Joe: Huh?

Eff Exp: To be precise, those peanuts must be integrated into your entire
operation and be allocated their appropriate share of business
overhead. They must share a proportionate part of your
expenditures for rent, heat, light, equipment depreciation,
decoration, salaries for your waitress, cook,…

Joe: The cook? What’s he gotta do with peanuts? He don’t even know I
got ‘em!

Eff Exp: Look, Joe, the cook is in the kitchen. The kitchen prepares the
food.The food is what brings people in here, and the people ask to
buy peanuts. That’s why you must charge a portion of the cook’s
wages, as well as a part of your own salary, to peanut sales. This
carefully calculated cost analysis sheet indicates the peanut
operation should pay exactly $1,278 per year toward these general
overhead costs.

Joe: The peanuts? $1,278 a year for overhead? The nuts?

Eff Exp: It’s really a little more than that. You also spend money each week
to have the windows washed and to have the place swept out in the

3
 morning, keep soap in the washroom, and provide free cokes to the
police. That raises the total to $1,313 per year.

Joe: (thoughtfully) But the peanut salesman said I’d make money. Put
‘em on the end of the counter, he said, and get 4 cents a bag profit.

Eff Exp: (with a sniff) He’s not an accountant. Do you actually know what
the portion of the counter occupied by the peanut rack is worth to
you?

Joe: Ain’t worth nothing. No stool there, just a dead spot at the end.

Eff Exp: The modern cost picture permits no dead spots. Your counter
contains 60 square feet and the counter grosses $15,000/year, so
the square foot of space occupied by the peanut rack is worth $250
per year. Since you have taken that area away from the general
counter use, you must charge the value of the space to the
occupant.

Joe: You mean I gotta charge $250 a year or more to the peanuts?

Eff Exp: Right. That raises their share of the general operation costs to a
grand total of $1,563 per year. Now then, if you sell 50 bags of
peanuts per week, these allocated costs will amount to 60 cents per
bag.

Joe: What?

Eff Exp: Obviously, to that must be added your purchase price of 6 cents per
bag, which brings the total to 66 cents. So you see, by selling
peanuts at 10 cents per bag you are losing 56 cents on every sale.

Joe: Somethin’s crazy?

Eff Exp: Not at all! Here are the figures. They prove your peanut operation
cannot stand on its own feet.

Joe: (brightening) Suppose I sell lotsa peanuts, thousand bags a week

‘stead of fifty?

Eff Exp: (tolerantly) Joe, you don’t understand the problem. If the volume of
peanut sales increases, your operating costs will go up. You’ll have
to handle more bags, with more time, more depreciation, more
everything. The basic principle of accounting is firm on that
subject: the bigger the operation, the more general overhead costs
that must be allocated. No, increasing the volume of sales won’t
help.

Joe: Okay. You’re so smart. You tell me what I gotta do.

4
Eff Exp: (condescendingly) Well, you could first reduce operating expenses.

Joe: How?

Eff Exp: Move to a building with cheaper rent. Cut salaries. Wash the
windows biweekly. Have the floor swept only on Thursday. Remove
the soap from the washrooms. Decrease the square-foot value of
your counter. For example, if you can cut your expenses 50%, you
will reduce the amount allocated to peanuts from $1,563 down to
$781.50, reducing the cost to 36 cents per bag.

Joe: (slowly) That’s better?

Eff Exp: Much, much better. However, even then you would lose 26 cents
per bag if you charge only 10 cents. Therefore, you must also raise
your selling price. If you want a net profit of 4 cents per bag, you
would have to charge 40 cents.

Joe: (flabbergasted) You mean after I cut operating costs 50% I still
gotta charge 40 cents for a 10 cent bag of peanuts? Nobody’s that
nuts about nuts! Who’s gonna buy ‘em?

Eff Exp: That’s a secondary consideration. The point is at 40 cents you’d be

selling at a price upon a true and proper evaluation of your then-
reduced costs.

Joe: (eagerly) Look! I gotta a better idea. Why don’t I just throw the
nuts out. Put ‘em in a trash can?

Eff Exp: Can you afford it?

Joe: Sure. All I got is about 50 bags of peanuts. They cost about three
bucks, and I lost $25 on the rack. But I’m out of this nutsy business
and no more grief.

Eff Exp: (shaking head) Joe, it isn’t quite as simple. You are in the peanuts
business! The minute you throw those peanuts out, you are adding
$1,563 of annual overhead to the rest of your operations. Joe, be
realistic. Can you afford to do that?

Joe: (completely crushed) It’s unbelievable! Last week I made money.

Now I’m in trouble, just because peanuts on a counter is gonna
bring me some extra profit, just because I believe 50 bags of
peanuts a week is easy.

Eff Exp: (with raised eyebrow) That is the object of modern cost studies, Joe,
to dispel those false illusions.

Required

5
(a) Has the efficiency expert identified some relevant issues in his
discussion with Joe? Explain.
(b) Note down, referring to the case, the various functions of the
Managerial Accountant in a commercial organisation.