# Contribution analysis and costing systems

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Module Code: C370

Assignment: TMA02

Word Count: 1,850

Question 3-72 (a)

Contribution Margin Income Statement

We need to first calculate the number of bottles of wine produces by A Votre Santé (AVS):

We first calculate the yield of the grapes (lbs):

 Chardonnay Grapes Generic Grapes Pounds Harvested 100,000 60,000 Loss in Processing 10% (10,000) 5% (3,000) Yield 90,000 57,000

Therefore from the yield, we can establish the number of bottles of wine produced:

 Chardonnay Estate Chardonnay Regular Blanc de Blanc Total Chardonnay Grapes 72,000 18,000 0 90,000 Generic Grapes 0 9,000 48,000 57,000 Total lbs of grapes 72,000 27,000 48,000 147,000 No. of bottles (lb/3) 24,000 9,000 16,000 49,000

We now move on to the contribution margin income statement which gives us the contribution margin and profit:

 Sales \$ \$ Chardonnay-Estate 528,000 Chardonnay-Regular 144,000 Blanc de Blanc 176,000 Total Revenue 848,000 Product/Variable Costs Grapes 124,000 Bottle, labels, corks 122,500 Harvest Labour 14,500 Crush Labour 2,400 Indirect Materials 6,329 Liquor taxes 147,000 Sales commissions 98,000 Barrels 4,725 Total Variable Costs 519,454 Contribution Margin 328,546 Fixed Costs Admin. rent & office 20,000 Depreciation 8,100 Lab expenses 8,000 Production office 12,000 Sales manager 30,000 Supervisor 55,000 Utilities 5,500 Waste treatment 2,000 Wine master 15,000 Administrative salary 75,000 Total Fixed Costs 230,600 Profit 97,946

(24,000 x 22)

(9,000 x 16)

(16,000 x 11)

(85,500 + 38,500)

(49,000 x 2.5)

(160,000/80 x 7.25)

(300 x 8)

(1.55/12 x 49,000)

(49,000 x 3)

(49,000 x 2)

(63 barrels[1] x 300/4)

Average revenue for one bottle of wine = \$848,000 / 49,000 = \$17.31 per bottle

Average net income for one bottle of wine = \$97,946 / 49,000 = \$2.00 per bottle

Question 3-72 (b)

This question requires us to calculate the no. of bottles of the additional chardonnay wine. This additional chardonnay wine will result in a reduction of the no. of bottles in the blanc de blanc wine. Therefore, we will need to calculate the total gain from selling the new chardonnay and subtract the loss resulted from not selling the blanc de blanc wine, which will give us the net gain from selling the additional chardonnay wine. To calculate the maximum price to pay per pound for the chardonnay grapes, we then calculate 15% of the return on sales for the additional chardonnay wine and subtract the net gain from this figure to get the additional gain AVS receives. We then divide this by the total available pounds of grapes (i.e. 20,000) to get the maximum price AVS would be able to pay per pound.

 New Chardonnay Chardonnay Grapes 18,000 Generic Grapes 9,000 Total lbs of grapes 27,000 No. of bottles (lb/3) 9,000
 Chardonnay Grapes Pounds Bought 20,000 Loss in Processing 10% (2,000) Yield 18,000
 Additional Gain from new Wine \$ \$ Sales 126,000 Costs Generic Grapes 6,079 Bottle, labels, corks 22,500 Indirect Materials 1,163 Liquor taxes 27,000 Sales commissions 18,000 Barrels 975 Wine master 5,000 Total Costs 80,717 Gain from new wine 45,283 Loss from Blanc de Blanc Sales 33,000 Costs Generic Grapes 6,079 Bottle, labels, corks 7,500 Indirect Materials 388 Liquor taxes 9,000 Sales commissions 6,000 Total Costs 28,967 Loss from wine 4,033 Net Gain 41,250 15% Return on sales 18,900 Additional Net Gain 22,350

(9,000 x 14)

(9,000 x 0.6754)

(9,000 x 2.5)

(1.55/12 x 9,000)

(9,000 x 3)

(9,000 x 2)

(13 barrels x 300/4)

(3,000 x 11)

(3,000 x 2.5)

(1.55/12 x 3,000)

(3,000 x 3)

(3,000 x 2)

(126,000 x 15%)

Therefore the maximum amount that AVS would pay for a pound of Chardonnay grapes = \$ 22,350 / 20,000 lb = \$1.1175 per pound

Question 3-72 (c)

Factors to consider supporting the purchase of the additional Chardonnay grapes include:

• The grapes are already crushed and harvested, therefore, AVS only has to buy the juice of the grapes. This saves time and money and enables AVS to spend more quality time on wine making rather than harvesting and crushing,
• If the quality of the grapes to be purchased is superior, it may give an added incentive to buy them.
• There is a potential to increase and diversify the number of suppliers. This diversifies the risk involved in the sense that if one supplier is unable to sell grapes for a given period, there are other suppliers that AVS can’t approach.
• Added production will help the fixed costs become more spread over a greater number of units of production, hence increasing profits.
• There is a potential to increase market share of AVS by supplying more bottles of wine to the market. This may create more relations with new buyers and expand AVS’ network of buyers.
• AVS may want to buy the grapes so that its competitor does not buy the grapes, therefore possibly reducing the competitors market share.

Factors to consider rejecting the purchase of the additional Chardonnay grapes include:

• There would be a lack of control over the harvesting and crushing process and may lead the juice of the grapes to not be of the standards accepted by AVS.
• If the quality of grapes is inferior, there may be no incentive to buy them.
• Additional sales forecasts maybe unpredictable and the additional wine produced may not sell and therefore may not materialise into profits.
• This may be a one-time new wine product and would be new to the market. Therefore, AVS may need to increase marketing costs to create awareness in the market. Moreover, it may cause confusion in the consumer market if buyers are not aware of the new product and therefore may not buy the product.
• AVS will not be aware of how reliable the supplier is and would be risking buying the grapes from him.
• There may not be enough capacity to handle the extra bottles of wine in the bottling and labelling department. Thus putting a strain on the resources of AVS.

Question (i)

According to Cooper (1987, 1989), there are eleven symptoms indicating potential problems of poorly designed or obsolete costing systems. These are:

1. Front line managers; such as production and marketing managers, want to drop seemingly profitable product or service lines.
2. Profit margins are hard to explain.
3. Hard-to-make products show big profits.
4. Departments have their own cost systems.
5. The accounting department spends a lot of time on special projects.
6. You have a high-margin niche all to yourself.
7. Competitors’ prices are unrealistically low.
8. Customers do not mind price increase.
9. The results of bids are hard to explain.
10. Vendor bids are lower than expected.
11. Reported costs change because of new financial accounting regulations.

In regards to AVS’s costing system, considering that the Chardonnay-Estate is the premium wine brand of AVS, and it produced in the largest quantity compared to its other products might indicate that AVS has a high-margin niche to itself. This could also mean that since it is a luxury product, customers may not mind price increases. Therefore, the Chardonnay-Estate could be said to be price inelastic in demand.

The fact that AVS is producing three different types of wines using different activities to produce each one might also be an indicator that their current costing system may have become obsolete. It might be better to shift to an activity-based costing system (ABC system). This might give AVS a better picture of the costs of its products.

The Chardonnay-Estate is also arguably the hardest product to make for AVS and it is also the most profitable product. Therefore it could be viewed as a symptom of an obsolete costing system since it may be under-cost using the current system.

Lastly, the profit margins for AVS may be hard to explain due to the three different products. It may become harder to identify the profit margins for each product.

Question (ii)

All these symptoms of the obsolete costing system of AVS may mean that the system needs to be redesigned and changed. This is because of the fact that AVS is producing three different types of wines using different activities to produce each one might also be an indicator that their current costing system may have become obsolete. It might be better to shift to an activity-based costing system (ABC system). This might give AVS a better picture of the costs of its products. Moreover, since there may be around four to five different symptoms of an obsolete costing system being used by AVS, and not just one, it may indicate that the costing system of AVS has become obsolete and needs to be abandoned.

However, the symptoms above may not indicate that AVS is in trouble regarding its costing system. The symptoms may be explained by the markets in which it does business in. For example, the fact that the Chardonnay-Estate that is produced by AVS, may be one-of-a-kind and the only one available in the market, this gives it a bit of a monopoly status and therefore justifies the high price and the fact that a price increase would not affect the consumers.

Therefore, in my opinion, the best way to decide whether to abandon a costing system or not to, is to run a pilot with a redesigned system and compare the results. If the results vary widely, then the old system has become obsolete and needs to be abandoned. If the results are similar, there might be nothing wrong with the old system.

Question (iii)

The cost information of AVS helps it in pricing of its products. It enables the management to be informed on how much the products cost to make and how much margin they should keep on cost. This pricing decision is critical for any management since it holds the key to the future of the company. Moreover, it also helps the management in knowing how efficiently they are running their business and what capacity the business is operating at. Costing information also helps managers keep a handle on the costs of the company and it encourages them to innovate and bring out ways in which to be more efficient and help cut costs and therefore improve the profitability of the company. Costing information also helps the company in determining what products are doing the best and what products should be dropped from the production line. It helps the company concentrate on the products it is best at.

References

Atkinson, A., Kaplan, R., Matsumara, E. & Young, S. (2012) Management Accounting, Sixth Edition, Harlow UK: Pearson Education.

Chan, S. and Lee, D. (2003) “An empirical investigation of symptoms of obsolete costing systems and overhead cost structure”,Managerial Auditing Journal, 2 (18), p.81–89.

Collier, P. (2012) Accounting For Managers: Interpreting Accounting Information for Decision-Making, Fourth Edition, Chichester UK: John Wiley & Sons Ltd.

Cooper, R. (1987) “Does you company need a new cost system?”, Journal of Cost Management, Spring, p.45-9.

Cooper, R. (1989) “You need a new cost system when…”, Harvard Business Review, January-February, p.77-82.

[1] (40x36)/0.9 = 1,600 lb of pre-fermenting grapes. Therefore, no. of barrels required = 100,000/1,600 = 62.5 = 63 barrels