Part A: Absorption and Marginal Costing
Golden Star Company manufactures and sells a unique product that has been quickly accepted by the consumers. The results of last month’s operations are shown below (absorption costing basis):
|
Sales (10,000 units @ $20) |
$200,000 |
|
Less: cost of goods sold (10,000 units @ $14) |
140,000 |
|
Gross margin |
60,000 |
|
Less: selling and administrative expenses |
45,000 |
|
Net income |
$ 15,000 |
Variable selling and administrative expenses are $2 per unit. Variable manufacturing costs total $10 per unit, and fixed manufacturing overhead costs total $48,000 per month. There was no beginning inventory. The company produced 12,000 units during the month.
Required:
1- Restate Golden Star’s income statement in contribution margin format, using variable costing.
2- Reconcile the variable costing and absorption costing net income figures.
3- State which costing approach is used in published financial statements, and briefly explain the usefulness of the other approach.
4- The easiest way to distinguish between relevant and irrelevant costs is by cost behavior; variable costs are relevant costs and fixed costs are irrelevant costs. Explain why you do or do not agree with this statement and support your answer with suitable example(s).
[Marks (Words): 15(150) + 10(150) + 10(200) + 10(200) = 45(700)]
Part B: Capital Investment Decisions
The management of a New Hotel Group is deciding whether to scrap an old but still serviceable machine bought five years ago to produce fruit pies, and replace it with a newer type of machine. It is expected that the demand for the fruit pies will last for further five years only and will be as follows:
|
Year |
Number of pies produced and sold |
|
1 |
70,000 |
|
2 |
50,000 |
|
3 |
40,000 |
|
4 |
30,000 |
|
5 |
25,000 |
Each machine is capable of meeting these requirements. Data for two machines are as follows:
|
|
Existing Machine ($) |
New Machine ($) |
|
Capital cost |
400,000 |
180,000 |
|
Operating cost per unit: |
|
|
|
Direct labor |
0.70 |
0.50 |
|
Materials |
0.70 |
0.70 |
|
Variable overheads |
0.40 |
0.30 |
|
Fixed overheads per unit: |
|
|
|
Depreciation |
0.90 |
1.10 |
|
Allocated costs (75% direct labor) |
0.525 |
0.375 |
|
|
3.225 |
2.975 |
The fruit pies are currently sold for $4 per pie. Unit operating costs, fixed overhead costs and selling price are expected to remain constant throughout the five year period.
Required:
a- Using data relating only to the new machine:
1- Calculate the net present value of the new machine. The New Hotel Group expects that its cost of capital will be 8% throughout the period.
2- Calculate the payback period of the new machine.
b- Using present value calculations, determine whether the existing machine should bereplaced by the new machine. Assume that the existing machinery could be sold for$150,000 immediately, if it were replaced.
c- Discuss the nonfinancial factors would you recommend that Hotel Group executives take into consideration regarding this proposal.
d- If the Hotel Group’s management is uncertain about the accuracy of the cost savings that have been estimated for this proposal. Explain the actions that they can take to ensure that the estimates of: costs, revenues, and cash flows are not overly optimistic or pessimistic.
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