7Ac002 Accounting And Finance: Claret Assessment Answers

Claret and Blue Ltd: Costing and Decision Making December 2017

Answer:

Introduction

The present report is based on analyzing the costing procedures of the company claret and Blue Ltd. The company is involved in production of machinery components to the customers as per this requirement. The company carries out its operations on the cost plus’ basis. In this context, the report has provided an analysis of the cost incurred on job number 339 and the methods of production overheads. It has also discussed the factors to be considered for investing and the benefits and limitations of purchasing or leasing anew warehouse for the company.

Part A:

Business Report for Claret and Blue Ltd in order to take the effective decision making on the total amount that has to be charged for JOB number 339

Detailed Calculations to support the decision making process

 Working Notes

 

 

 Report on decision making process

Cost managers have to make decisions in order to make sure that goals of the company are fulfilled. In this case there is requirement to make decisions regarding the manufacturing cost and selling value of Job number 339. Claret and Blue Limited manufactures machinery components as per the specifications of the customers. While deciding the selling value of the particular job they charge profits on the basis of the “Cost plus”. It means profit is calculated on the percentage of the total cost of the job.

As mention in the requirements that company uses three main direct materials for the job number 339, they form the part of total cost as direct material refers to the relevant cost while making the decisions. Net price is charged from the customers while calculating the cost of direct material as trade discount does not form part of selling value. Therefore, while estimating the cost of each direct material 15% trade discount has been removed from the total cost of each material. Please refer to the working note for detailed calculation of cost of direct material. It is important to note that cost of assorted components are taken as given cost is net of trade discount (Brealey, Myers and Marcus, 2007).

Detailed information has been provided for the direct labour cost and on the basis of such information total direct labour cost has been calculated. The detailed working of the direct labour cost has been shown in working note. The direct labour cost has been charged on the basis of each department and cost is provided for the actual time taken. As per the rules of decision making process labour should be charged for hours that are actually consumed not on the basis of available direct labour hours. Company also provides the bonus wages as the part of rewards system. As per this rewards system labors are paid for each hours saved from the time allocated to each work. For this purpose labors get half of the labour hour rate for each of bonus time allocated to each department. This rewards system helps in timely completion of the order; therefore, it becomes the relevant cost for this job work. The actual time taken in each department has been paid full on the basis of each labour rate and for bonus hours labors are paid half of the labour rate for each bonus hour. All the calculations are shown in working note in detail. Direct labour cost also includes the bonus labour cost, so both the cost forms the part of decision making process. As per the discussion it can be said that bonus labour cost refers to relevant cost for this decision making process (Bromwich and Bhimani, 2005).

Production overheads are charged on the basis of the direct labour cost and direct labour hours depending upon the departments. So for the decision making process production cost must be calculated on the basis of the each department and for this overhead allocation basis should be used for each department. Detail of overhead allocation basis is given below:

On the basis of above table overhead must be divided for each department so that relevant cost of job work can be computed properly. The calculation of the overhead allocation in each department is presented in the working note. Production overhead occurs when this job work is executed. So it can be said that production overhead is directly linked with the job work and it can be avoided if job work is not taken. Therefore, total production overhead is taken as relevant cost and it is included in value of total cost of the Job 339.

Administrative overhead costs are charged at the rate of 20% of the total production cost. So it can be said that administrative cost is indirect cost that not relevant for decision making process but it is vital for giving the estimation of total price for the Job work 339. When it comes to price negotiations cost manager can consider this cost to be irrelevant and accept any price excluding the administrative cost. Therefore, administrative cost is termed as the irrelevant cost for decision making process but it is important for calculating the total cost for job 339. Production cost includes direct material cost, direct labour cost and production overheads.

Profit margin refers to the amount charged above the cost of the goods and it is net income of the company. Company has the policy to charge profit on cost plus basis, which implies profit is charged as the percentage of total cost of goods sold. Here, 20 % is charged as the profit margin and it is calculated on the percentage of total cost of goods sold (Damodaran, 2011).

While making the decision for taking the job work 339 or not taking it, company must refers to all the relevant cost of cost of production and price offered by the customer. If customer is giving any price above the relevant cost of production, than such job work must be taken. It is important to consider any opportunity cost that occurs due to not taking the job work 339 and it must be added to the total relevant cost in order to calculate minimum cost to be charged from customer (Davies and Crawford, 2011).

Part B:

Absorption of Overheads and its Methods for Claret and Blue Ltd

The absorption of overheads can be stated as the process of allocating the overheads to individual department or cost centre in proportion to the units produced. The overheads are absorbed through the application of rates at which the overheads are absorbed in each of the cost centre. The overheads that are charged over different units of costs are again absorbed into the unit cost. The overheads absorbed in each cost centre can be calculated through dividing the total overhead cost for each department over the cost units produced by that cost centre. However, in the case when the department units manufacture different units the amount of production will be expressed in a common measurement such as direct wage hours. On the other hand, if cost unit is passed between different centers then the overhead costs are absorbed distinctly in each of the cost centre.

The Claret and Blue Ltd adopts the use of charging the production overheads to each cost centre based on each department activity. The direct labor cost of 150% is absorbed in the machinery and assembly departments. The finishing departments also absorb the overheads of direct labor cost at the rate of £12 per direct labour hour. The overheads rates are determined as per the actual labour costs that are charged to the customers. The different methods that can be used by the company for absorbing production overheads can be as follows:

Production unit method

The method involves absorbing the production overheads on the basis of the rate obtained through dividing the total budgeted overheads over the total number of units produced.  For example, if the overhead budget is of Rs. 3, 00,000 p.a. and the no of units produced are 60,000 units p.a., then the absorption rate can be calculated as: Actual Overhead/ No. Of units budgeted=Rs.3, 00,000/60,000 unit =Rs. 5 per unit

The method is suitable to be used by Claret and Blue Ltd as it manufactures only one product of machinery components and therefore can apply this method of absorbing the production overhead easily. Also, the company involves production of similar products and thus the method can be applied to compute the absorption rate of production overheads.

Percentage of Direct Labour Cost Method

The absorption rate is calculated in this method by dividing the overhead cost budgeted by the direct labor cost and expressing it in the percentage terms. For example, if the budgeted overhead is Rs. 2, 00,000 and the direct labor cost is Rs. 4, 00, 00 then the absorption rate can be expressed as:

Budgeted Overhead cost/ Actual direct labor cost*100

=Rs. 2, 00,000/Rs. 4, 00,000*100=50% of direct labor cost

The method can be applied to Claret and Blue Ltd as direct labor cost is an important component of overall unit cost of the company. Also, the method is very simple and easy to apply for calculating the absorption rate of production overheads. However, the method is also associated with the limitation of not taking account the time used for completing a specific job in the unit and also the o work carried out by the use of machinery equipments. Also, the method does not distinct between the time taken by a skilled and unskilled labor and therefore it can be unfair to allocated different amounts of overhead to them.

Direct Labor Hour Rate Method

The method calculates the overhead absorption rate through dividing the budgeted overhead with the direct labor hours. The method can be applied by the company as they attribute per direct labor cost to the finishing department. Therefore, labor is the limiting factor in the production overheads of the company and thus the absorption rate can be calculated easily by the application of this method. Also, the method takes into account the time spent by the labor in producing each unit where there is not similar units of production as in the case of Claret and blue Ltd. The company involved in the manufacturing of machinery components have labor intensive cost centre and thus the method of calculating the absorption rate by estimating the per hour labor rate is highly suitable. However, the method also suffers from the drawback of maintaining the proper labor records that is extremely difficult for the company that is labor intensive. Also, the absorption rate determines through the use of this method does not provide any distinction between the hours used in the production unit by skilled and unskilled labor.

Direct Material Cost Percentage Method

The method involves the absorption of overhead on the basis of expressing the overhead cost in percentage of the actual overheads to the direct material cost. The method of overhead absorption can be used by the company as direct material cost is an important part of the unit costs in the company. Also, the method is relatively simple to be implemented by the company for calculating the absorption rate.

Part C:

Factors that potential investor must consider while making investment

There are many factors that investors should consider while making the investment in company like Claret and Blue Limited. Some of the factors are provided below:

• Financial performance of the company: It is very important to review the financial performance of the company in order to compute the percentage of return that investor will earn on their investment. It is important to consider the trend in the profit earned by the company as decreasing trend in profit means company will make losses in future year.
• Investment type/amount: The type of company in question is small or medium size company and it is very important for the any investor to know the percentage of share in capital investor will be allocated on the basis of investment made.
• Market analysis/external analysis: It is critical to known whether market in which company operates has stable environment and has government stability (Peterson and Fabozzi, 2002)

Part D:

Benefits and Limitations of Sources of Funding Available to Claret and Blue Ltd for the new warehouse

The management of the company is considering the option of purchasing or leasing the new warehouse as such the benefits and limitation of various sources of funding to the company can be discussed as follows:

Benefits of Purchasing

• Fixed Cost: The main benefit of purchasing a new warehouse to the company it does not have to pay the rent and it can get a fixed rate of interest to be paid for the mortgage loan. Therefore, the option does not increase the monthly expenses of the company also the complete payment of mortgage loan will completely eliminate the monthly expenses on the property used.
• Deduction of Tax: The reduction in the mortgage interest payments can also significantly held in reducing the liability of the tax.
• More Control: The use of own property will provide the advantage to the company to utilize more space and also can carry out the business activities as per their own interest and convenience. There is also more control over improving the infrastructure of the building as per the business s needs in the option of purchasing the property. On the other hand, the use of rent building offers less space and thus restricts the carrying of business activities as per the desire. Also, the additional space in case of owned property can be used for leasing purpose to gain extra income.
• Capital Gain: The increase in the value of property over time can help the company to realize capital gain in the future period of time on its selling and thus gaining more income in comparison to the cost incurred in its purchasing (Bendrey, Hussey and West, 2003).

Benefits of Leasing

• No repayment of mortgage loan: The option of leasing a new property provides the benefit to the company of reduced cash outflows as mortgage loan repayment on monthly basis. Thus, this can help the company to use the cash inflows in the business activities.
• Removal of Cost incurred in maintenance: The use of leased property will also provide the benefit to the company of not incurring extra expenses on maintaining the property which can also save the time consumed in carrying out building maintenance.
• Easy to obtain: The leased property can be easily obtained by the company for starting a new business opportunity as it does not involve high investment.
• Less Time consumed: There is more availability of leased commercial sites and thus the company can quickly obtained a leased property and thus moving its business to the leased site rapidly (Weston and Brigham, 2015)

Limitations of Purchasing:

• High Initial investment: The option of purchasing a new property on the part of the company will require huge investment and generating a credit report to gain capital for funding the option. Thus, as such it can cause the reduction in the cash availability in the company required to carry out daily operational activities.
• Huge Responsibility: There is higher responsibility over the owner to maintain all aspects of the building such as infrastructure, lightening, water and other availability of resources. This can require consumption of large time on the part of the business manager and thus reduced focus on the business operations.
• Increase in the fixed Cost: The fixed monthly payment as mortgage loan can cause an increased cost burden over the company.
• Purchasing the right Building: The major challenge before the company is to finds an appropriate warehouse location that posses all the availability of resources to carry out the business operations efficiently. This also requires significant research and time on the part of the company resulting in delay to shift to the new business location (Bendrey, Hussey and West, 2003).

Limitations of Leasing

• Lease expenses: The option of leasing a warehouse is associated with the limitation of incurring a lease expense till the time of the use of property. Also, after the expiry of the lease tern the company has to incur extra cost for the renewal of the lease contract.
• Change of Business Location: The building owner can also decide of not renewing the leasing contact after its expiry for several reasons. This may cause the shift of the business activities to a new location which can prove to be both costly and time-consuming for the company.
• No Capital Gain:  The use of leased property will not provide any opportunity to the company to gain capital profits from the increase in the value of the building in future period of time
• No Control: The management of the company does not have any authority to modify the building infrastructure as per the business needs and have to rely on the owner to make such decisions

Therefore, after analyzing the benefits and limitation of the both sources of funding available for Claret and Blue Ltd, it is recommended that the company should align its resource availability with these benefits and limitations for taking appropriate decisions (Schmitt, 2014).

Conclusion

Thus, the overall report has provided an effective guidance to the Claret and Blue Ltd on costing and decision-making through detailing the amount to be charged for job number 39 and also stating the methods of production overhands absorption. In addition to this, the factors impacting the potential investment decision and the benefits and limitations of various source of funding are provided in the report.

References

Bendrey, M., Hussey, R. and West, C. 2003. Essentials of Management Accounting in Business. Cengage Learning EMEA.

Brealey, R., Myers, S.C. and Marcus, A.J., 2007. FundamentalsofCorporate Finance. Mc Graw Hill, New York.

Bromwich, M. and Bhimani, A., 2005. Management accounting: Pathways to progress. Cima publishing.

Collier, P. 2015. Accounting for Managers: Interpreting Accounting Information for Decision Making. John Wiley & Sons.

Damodaran, A, 2011. Applied corporate finance. John Wiley & sons.

Davies, T. and Crawford, I., 2011. Business accounting and finance. Pearson.

Drury, C. 2008. Management and Cost Accounting. Cengage Learning EMEA.

Kinney, M. and Raiborn, C. 2010. Cost Accounting: Foundations and Evolutions. Cengage Learning.

Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.

Schmitt, D. 2014. Advances in Accounting Behavioral Research. Emerald Group Publishing.

Weston, J.F. and Brigham, E.F., 2015. Managerial finance. Hinsdale, IL: Dryden Press.