Question

CASE 7: RELEVANT COST ANALYSIS (CICA) Fence Company Ltd. (FC) was incorporated in March 20X4, and is equally owned by Robert and Morris Wood. The company constructs residential wood fences. FC's first year was a difficult one. It is now late March 20X5, and the Wood brothers are making plans to improve FC's performance. Having decided that they need outside advice, they asked you to meet with them. At the meeting, you asked the brothers to describe their operations and to highlight their major concerns. The following paragraphs are your notes from the meeting FC lost business last year because it could not meet its promised installation dates during the peak period. The owners consider, however, that their biggest problem last year was caused by the need to repair fences. They guarantee their work, and they had to go back and change broken boards and clean up work sites, which cost them money and did nothing for their reputation The owners project that FC will construct 50,000 lincar metres of fence this year. To achieve this target, they think that one work team will be needed dur. ing the 12 weeks of April, October, and November, and three teams during the 20 weeks from May through September. Their projection assumes an eight- hour day and a regular five-day week. Last year they found that a good work team consisting of three people could build a 100-linear-metre fence in an eight-hour day. The average labour cost including benefits last year was $5 per hour. Labour and material costs are expected to increase 10% in 20X5. Last year there was little control over the amount of wood used on projects; the owners want to change this situation. The brothers recognize that fence building is not a year-round activity and are willing to cover any cash deficiency as long as there are prospects of prof- itability, • The owners need to take out at least $15,000 each per year. In addition, they intend to hire a full-time receptionist to start on April 1 and to employ this person year-round. They expect that the salary will be about $12,000 a year but think that the cost will be worth it to ensure continuity and maintain the company's image. A truck will have to be rented for each work team, at S500 per month. Robert Wood thinks that they should keep two of the trucks from December to March for snow removal. He and Morris could do the work and lay off everyone ex- cept the receptionist FC will also need to rent a machine for $600 a month to dig holes. In addition, it will cost approximately $120 to move the machine from one work site to an other The company spent $8,000 on gas and maintenance and S1,200 on telephone last year. The owners expect to hold the line on these costs this year. Copyright 2010 Pearson Education Canada 1

Answer 1

REPORT TO WOODS BROTHERS

Feasibility of Operations

If Fence Company Ltd. is to succeed in business, then its fencing operations must be profitable. The snow removal activities are secondary, so I have not tried to quantify the revenue that may result from them. Instead, I have assumed that the revenue from snow removal will cover variable expenses only. Fixed costs, however, have been computed on the basis of a full year of expenses.

I have used contribution-margin analysis to calculate your break-even point and

have compared that to your capacity to see whether you currently have the resources you need to cover all of your costs.

The contribution approach separates costs into their fixed and variable components. Fixed costs are costs that do not change, regardless of how much business the company is doing. Variable costs, on the other hand, change in direct proportion to changes in levels of activity (how much business the company is doing). The difference between sales and variable costs is called the contribution margin. It is the amount available to recover fixed costs. Contribution margin is a useful tool for planning and tells you how income is affected when selling prices are changed, when different levels of output are produced, and when changes in costs are made. To use it, however, assumptions have to be made regarding different selling prices, levels of output, and so on.

Exhibit 1 shows my analysis of your contribution margin on the various orders you receive (i.e., one-house, two-house, and four-house orders). My assumptions are stated in the exhibit. As you can see, the biggest contribution, $1.66 per linear metre, is achieved on the two-house orders.

Exhibit 2 shows my calculation of your fixed costs. Please study my assumptions in this exhibit to ensure that you agree with them. Based on my assumptions, you have total fixed costs of approximately $100,000.

Using these figures, we can calculate your break-even point. Break-even is the point at which the company covers all its expenses, so there is neither profit nor loss. One problem in using break-even analysis is that an assumption has to be made about the sales mix among the different orders. I have assumed that the two-house order is most typical of your sales. As the two-house order contributes the biggest margin, the break-even in metres calculated below is the least you should sell to achieve a break-even position. If you want me to, I can re-calculate the break-even metres using different assumptions.

  $102,000 = 61,446 linear metres

$1.66

Based on my assumptions, the amount of fencing that must be installed to break even is 61,446 linear metres. This is more than your anticipated production of 50,000 linear metres.

Using the information you have given me, I have calculated the maximum number of metres that you can install. My assumptions, along with calculations, are shown in Exhibit 3. The maximum footage that can be installed in 2010 is 36,000 linear metres. This is less than your anticipated level of 50,000 linear metres. Incremental /fixed costs to increase capacity to 50,000 linear metres were estimated to be $19,500 (Exhibit 5). Assuming that all sales are two-house jobs (i.e., the maximum contribution), the contribution to fixed costs will be

50,000 x $1.66 = $83,000

This will result in a loss of

Contribution to fixed costs	$83,000
less fixed costs	102,000
Net loss	($19,000)

In conclusion, my analysis shows that Fence Company Ltd. will face a severe shortage of cash in the fall and may even face bankruptcy. Clearly, the operation is not feasible based upon the proposed pricing policy and the projected costs and level of output.

Ways to Improve Operations

Fence Company Ltd. can increase the contribution to fixed costs in several ways. It can increase prices, decrease its variable costs, decrease commissions and/or volume discounts, or increase its level of output. If fixed costs can be reduced, then the break-even point may also be reduced.

Increase prices

The contribution-margin analysis reveals that Fence Company Ltd. has a serious pricing problem. FC achieves its greatest contribution margin on sales of two-house installations. The savings from doing four-house instead of only one (economies of scale) do not appear to justify a volume discount or higher commissions. However, the cost figures do not accurately capture the economies of scale that may be present on volume orders, such as

• more efficient use of labour and less idle time
• less travel time and gas for transport of wood
• possible reduced wastage on volume orders

More accurate cost figures would be useful. We do not know how much of FC’s business will be single houses vs. bulk orders, and so forth. Therefore, the previous analysis (which uses the highest contribution margin of two-house fences) is suspect at best, unless the pricing and commission structure is altered to give a uniform contribution margin.

Exhibit 4 shows my analysis of the price increase that would be required to break even at 50,000 linear metres for each of the one-house, two-house, and four-house orders. For the two-house orders the price would have to be $12.38 per metre. This price is only slightly lower than the anticipated price of $13.00. Whether or not such a price can actually be charged will depend on the market conditions prevailing in 2010. Market prices would have to be analyzed to estimate the effect of a price increase on demand.

Decrease commission rate

An alternative to increasing the price is to decrease the commission. Assuming that one salesperson sells all of the budgeted output of 50,000 linear metres, then the salesperson will receive gross commission income of

50,000 x $12 x 0.06 = $36,000

This is a high level of remuneration, given that it represents about six months' work. The commission rate could be decreased to perhaps 3%, plus a small bonus based on performance.

The feasibility of decreasing the commission rate will depend upon negotiations with the salesperson and the arrangements made in the previous year. Possibly one of the Wood brothers could take on the job of selling, to save the entire commission.

The rates of commission should be linked to the contribution margins obtained on the sales. An increased commission on volume sales is unnecessary, since the salesperson will try to sell in bulk wherever possible anyway. The salesperson should not be allowed to give discounts if commission is based on gross revenue. (Salespeople will generally give discounts readily rather than lose sales.) The giving of the discount costs the salesperson only a small amount in remuneration because his or her commission is based on gross revenue, but it costs FC a great deal as a percentage of the contribution margin. By tying the salesperson's commission to the contribution margin, the problem of harmful discounting will disappear, while the salesperson will earn the same amount overall. In short, salespeople will become more aware of profitability.

Increase capacity

Assuming that the prices and commission remain the same as planned, the level of output can be increased. Exhibit 5 shows my analysis of the required level of output and the additional costs that will be incurred to achieve that output. The increased output will be achievable if

• sufficient sales can be made without reducing price
• work crews can be hired
• quality can be maintained without increased supervision
• FC has financial resources to cope with this higher volume of business
• warehouse capacity is sufficient

Feasibility of FC revised

Exhibit 6 provides my analysis of the overall impact of the changes suggested above. Assuming the selling price is increased to $13.00 per linear metre and output is projected to be 62,000 metres, FC will make a profit of

$63,880. The Wood brothers will be able to draw a salary of about $93,880, as $30,000 of remuneration is included in the fixed costs.

I cannot tell how likely it is that FC will be able to achieve an increased output at the assumed prices, as I have only a limited knowledge of the industry. However, FC's ability to produce at the increased level, charging a price that will not only produce a profit but will also be acceptable to customers, will determine the company's success. Thus the various options discussed above must be considered in light of the realities of FC's business world.

Inventory Control, Purchasing, Scheduling, and Costing

A systematic way of scheduling jobs must be devised. Customers should be given firm dates and, wherever possible, transportation of wood and machinery should be kept to a minimum. Installation of fences should be done on an area-by-area basis to reduce transportation costs and supervision. FC should purchase in bulk to take advantage of discounts. The company should also try to avoid having excess wood on hand due to costs of financing this inventory and storage problems. Trade-offs may have to be made when deciding on inventory levels, but they cannot be quantified without further information.

The wood allocated to each job should be accounted for by each team and given to them before the job starts. The team supervisor should complete a form showing the wood allocated; the wood remaining; the time spent on the job by employees; the amounts of supplies such as glue, stain used; and any tools broken. The teams should be controlled through site inspection and analysis of the costs.

Costs per metre for various jobs and teams should be reviewed and compared. Eventually, standard costs can be determined for each order on the basis of the above information. Once standard costs are known, it will be possible to use this information in planning future prices and levels of output.

The standards could serve as a benchmark: actual costs incurred on a job can be compared with the standards to identify any inefficiencies and ways of controlling them in the future. Standard costs will also be useful for financial reporting.

Exhibit 1 Contribution Margin Analysis Present Situation 1 House (100 metres) $1,200 2 Houses (200 metres) $2,400 4 Houses (400 metres) $4,800 480 384 60 144 Selling pricea less: volume discount sales commission Net revenue Cost of wood & incidentals Cost of labourd Transportation of machinery Total variable expenses Contribution margin Contribution margin per metre 1,140 770 132 2,256 1,540 264 120 1,924 3,936 3,080 528 120 120 1,022 3,728 $118 $332 $208 $1.18 $1.66 $0.52

It is assumed that two houses will require 200 metres of fencing and other supplies, but this will not be the case exactly, since they will usually have a common boundary. The total linear metres will depend upon the exact circumstances.

Assumptions in contribution-margin analysis

a It is assumed that the salesperson will generally discount to $12 per metre, since his or her commission is based on gross revenue, not on contribution margin.

b The sales commission has been based on the gross revenue before volume discount. The proposed commission scheme is unclear. Basing commission on gross revenue after volume discount would increase gross revenue and contribution margin by $38. The contribution margin per metre would be about $0.62.

c Costs of wood and incidentals have been adjusted for inflation by 10% to reflect assumed price increases.

d Cost of labour is computed as follows:

Three workers can build 100 metres per eight-hour day; therefore, time per 100 metres is 3 x 8 = 24 hours.

Average labour rate was $5 per hour last year; therefore, assume $5.50 per hour this year: ($5.00 + 10% increase)

24 hours x $5.50 = $132 per 100 metres

Exhibit 2 Fixed Costs for the Year April 1, 2010, to March 31, 2011 $30,000 30,000 3,0000 Salary to owners Warehouse lease Tools Truck rental April: May to September: October to November: December to March: Receptionist Machine Gas and maintenance Telephone Total fixed costs $ 500 7,500 1,000 4,000 13,000 12,000b 4,800 8,000 1.2008 $102.000

No provision has been made for insurance, office supplies, advertising, idle time, heat, light, power and property taxes at the warehouse, interest expense, and miscellaneous.

a Based on 2009 figures unadjusted.

b Approximate estimate only.

Fixed costs will probably exceed $102,000 due to inflation and items not included.

Exhibit 3 Capacity of Operations Months # of Teams Work Days Max. in metres April May-September October & November 1 3 20 100 2,000 30,000 4,000 1 40 36.000

Assumptions

• No provision for idle time or inclement weather; optimum projected crew efficiency is 100 metres per crew-day.
• Crews do not work overtime and work only a five-day week. If these assumptions are incorrect, the labour costs must be revised upwards.
• Same number of crews is assumed as last year; otherwise, the cost of gas and maintenance and of tools and truck rental must be increased. (These costs are not truly fixed costs.)

Exhibit 4 Increase Price Fixed costs Capacity Contribution per metre to break-even $102.000 50,000 metres $2.04 Price increase required $2.04 - 1.66 = Current price Selling price to break even $0.38 12.00 $12.38 Sensitivity analysis 1 house 4% discount $2.78 - 1.18 = 1.67 + 12.00 = $13.67 0.96 4 house: 8% discount $2.78 -0.52 = 2.76 + 12.00 = $14.76 0.82

61.446 metres Exhibit 5 Increase Capacity Break-even capacity fixed costs $102,000 C/M per metre $1.66 Additional fixed costs (to double capacity) truck Machine, May-September gas & maintenance tools $ 7,500 3,000 6,000 3,000 19,500 102,000 $121.500 Previous fixed costs Total fixed costs Adjusted break-even capacity on 2-house contracts fixed costs $121,500 C/M per metre $1.66 = 73.193 metres

This will be attainable with six crews during the period May–September and three crews in October and November. The fixed costs may vary slightly from those given above, since this is a circular calculation.

Exhibit 6 Feasability of FC–Revised Sales price is assumed to be $13 per linear metre. Output is projected to be 62,000 metres with six crews, as previously described. Sales Cost of wood & incidentals Cost of labour Cost of transportation of machinery (based on 200 metre jobs) $806,000 (477,400) (81,840) (37,200) Commission to salesperson (adjusted to 3%) Contribution to fixed costs Fixed costs Profit for the period before income taxes 209,560 24,180 185,380 (121,500) $63.880