550 9-2 Final Project- Quantitative Analysis and Memo to Management

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Jan 9, 2024

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Cost-Volume-Profit Analysis Cost-Volume-Profit (CVP) analysis is a valuable tool that allows companies to assess the impact of various factors on their profitability. By examining the relationships between sales volume, variable and fixed costs, managers can gain insights into the behavior of their business as these factors fluctuate. This analysis is particularly useful in understanding the breakeven point and the required sales volume to achieve profit targets. CVP analysis aids managers in evaluating the feasibility of entering into contracts that involve selling units at different prices. For instance, Hampshire Company can utilize CVP analysis to determine whether selling 5000 umbrellas to the Specialty Company at a reduced price of $11.00 per unit would yield a loss, breakeven, or increase their profit. By separating costs into fixed and variable components, CVP analysis provides a clear understanding of product profitability and enables companies to strategize ways to achieve their financial goals. In the provided spreadsheet, The Company can employ CVP analysis to forecast the number of umbrellas that need to be sold in order to generate an additional $120,000 in income before taxes. According to the analysis, The Company would have to sell an additional 18,462 umbrellas at a price of $12.50 per unit to achieve this financial target. CVP analysis allows companies to assess their margin of safety, which measures the extent to which actual revenues can drop below budgeted levels before reaching the breakeven point. By understanding this margin, companies can evaluate the risks associated with revenue fluctuations. CVP analysis helps companies determine their degree of operating leverage, which expresses the impact of fixed costs on changes in operating income arising from variations in sales volume and 1

contribution margin. This understanding allows businesses to make informed decisions regarding their cost structure and revenue generation. It is important to note that while CVP analysis is a valuable tool for short-term decision-making, it may not be as reliable for long-term decisions. This is because it relies on certain assumptions, such as the assumption that all units produced will be sold and that fixed costs remain constant within a specified production level and period. Nevertheless, CVP analysis can provide valuable insights into the profitability of investments, such as the potential purchase of new technology for enhanced production speed. Considerations can be made regarding the impact on fixed and variable costs if sales volumes remain steady. By utilizing CVP analysis, the company can swiftly determine the financial feasibility of the purchase in the short-term. It also assists in deciding whether the company should engage in contracts to produce units at a price lower than their usual selling price. The attached spreadsheet employs CVP analysis to assess whether selling the 5000 umbrellas at $11.00, instead of $12.50, is a wise choice and what impact it would have on profitability. Furthermore, it helps to determine if the company reaches the breakeven point. What are the implications of CVP analysis on planning? Yes, The Hampshire Company manages to reach its breakeven point at 14,535 units or $568,313 in sales. Consequently, in 2014, the company achieved sales that exceeded the breakeven point by $181,687, indicating a margin of safety of 24%. Moreover, the company has an Operating Leverage point of 4.1281, This signifies that with the current sales of 60,00 units, any 1% variation in sales will lead to an approximate 4.13% alteration in operating income. This suggests that The Company's operating income is susceptible to significant fluctuations depending on sales. Consequently, The Company faces a higher possibility of losing a larger portion of its operating income when encountering a minor 2

decline in sales. In order to plan for the future, The Company should adopt measures to decrease both fixed and variable costs while simultaneously enhancing the contribution margin. By doing so, the degree of operating leverage will be diminished, subsequently reducing risk too. Based on the comprehensive CVP analysis conducted, it can be deduced that The Hampshire Company will continue to achieve breakeven in the future. The Company has evaluated various scenarios using CVP analysis, and all of them indicate profitability for The Company. Inventory Management Inventory management allows management of a company to minimize the cost to maintain inventory and maximize returns. The attached excel spreadsheet provides an analysis to determine the optimal inventory management system for Hampshire Company (the Company). There are two primary methods to choose from, the variable costing method and the absorption method. These two utilize the same data but have different effects on the income statement. Relevant Costs Based on the current data available, the optimal cost allocation method for the Company to utilize would be the absorption method. As you can see from the attached excel spreadsheet, the operating income for the variable costing method would only be $94,475, whereas the absorption method would result in an operating income of $148,475. This data is based on a selling price of $12.50 per umbrella, direct materials of $3.00, direct labor at $1.50, variable manufacturing overhead of $.40, variable selling expenses of $1.10. Fixed manufacturing expenses for the period were $216,000 and fixed administrative costs for the period were $79,525. There was a zero-beginning inventory, a production of 80,000 umbrellas and sales of 60,000 umbrellas. This gives an ending inventory of 20,000 umbrellas. Absorption Method 3

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Absorption costing is a comprehensive approach that encompasses both fixed and variable manufacturing expenses associated with a business's production activities. As the name suggests, it absorbs all the relevant costs incurred in the manufacturing process. In comparison to other methods, the absorption cost method excels at precisely monitoring profit throughout a specific accounting period. Absorption costing is not only GAAP permissible but is s the required inventory costing method for external financial reporting in most countries. (Datar & Rajan, 2021) This approach enables managers to effectively demonstrate the financial performance of a specific timeframe, particularly when the company enhances production in anticipation of a seasonal surge in sales. For instance, the company may ramp up production during winter in order to adequately stock up for the demand during the rainy seasons in spring. Recommended Method Among the two costing methods evaluated here, namely variable costing and absorption costing, the method I propose The Company use would be the absorption method. When it comes to providing reports, the absorption method proves to be more advantageous as it aligns with the preferences of external reporting authorities. Additionally, this method yields a greater Operating Income for the Company. Just-in-Time (JIT) Inventory System The JIT inventory system is procurement and delivery method that ensures inventory is ordered and delivered exactly when needed for production. This approach effectively eliminates unnecessary surplus inventory. Like any other system, the JIT inventory system has advantages and disadvantages. One of the key benefits is that it minimizes waste by maintaining the bare minimum level of inventory required. With the JIT system, goods are produced only as and when 4

they are needed, preventing any excess production and reducing warehouse charges. When excess inventory is produced, additional storage facilities are required, resulting in increased storage costs. However, by implementing the JIT method, the need for these extra storage costs due to surplus inventory is completely eliminated. The JIT system has drawbacks related to the provision of goods and raw materials. The issue with supply goods occurs when a company receives a substantial order but cannot meet the customer's requirements due to inadequate or absent finished goods in inventory. On the other hand, the problem with supply raw materials arises when there is a potential delay in providing the necessary materials to the business, leading to immediate repercussions in the production process and subsequent delays in delivering goods. Given that the company manufactures seasonal items, the advantages of the JIT method are outweighed by the disadvantages. The JIT system fails to account for the fluctuating demands and variations in the product's needs throughout the different seasons. Moreover, if unexpected adverse weather conditions occur, the JIT method may not enable the company to promptly respond to the increased demands. Benchmarking The effectiveness of a performance measure is contingent upon its application. In order for performance measures to hold significance and offer valuable insights, it becomes essential to conduct comparisons, and this is where benchmarking assumes pivotal importance. These comparisons can evaluate the advancement towards predetermined objectives or targets, assess the patterns in performance over a period of time, or juxtapose the performance of one entity with another. Benchmarking is the continuous process of comparing one company’s performance levels against the best levels of performance in competing companies or in companies having 5

similar processes. When benchmarks are used as standards, managers and management accountants know that the company will be competitive in the marketplace if it can meet or beat those standards. (Datar & Rajan, 2021) Benchmarking, a widely adopted practice, can be approached in two main ways: competitive benchmarking and functional benchmarking. Competitive benchmarking entails evaluating a company's performance in relation to its competitors. This method helps determine if a company should consider restructuring its business strategies to mirror those of more successful counterparts. On the other hand, functional benchmarking involves comparing similar or identical processes among companies operating in the same industry. Through functional benchmarking, companies can gain insights into superior production processes within the industry. Recommended Method My recommendation is for the Company to implement the competitive benchmarking approach. This approach will enable the Company to assess its performance in relation to industry competitors. By comparing profitability with competitors, the Company can identify areas for improvement and potentially develop new strategies to not only match but also surpass competitors' profitability. Additionally, adopting this strategy would enable the Company to establish production goals aligned with its competitors. Activity-Based Costing When Hampshire Co. exclusively produces stick umbrellas; it is advisable to employ a conventional costing approach. This method involves allocating the manufacturing overhead costs to the manufactured products. In the case of Hampshire Co., the traditional approach assigns the factory's indirect costs to the items manufactured based on their volume and direct 6

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labor hours. By utilizing direct labor hours as the basis for allocating the manufacturing overhead, it indicates that these hours are the primary factor contributing to the factory overhead. When Hampshire Co decides to produce a Collapsible Umbrella or any other additional product, I suggest implementing the Activity-Based Costing system (ABC). ABC offers a more precise estimation of product costs. Unlike traditional costing, ABC utilizes different allocation bases. This approach identifies all activities involved in manufacturing an item and assigns costs to each activity. Subsequently, the costs associated with the activities are allocated to the products that necessitate them during production. When the Hampshire Co. begins manufacturing multiple types of umbrellas, it is recommended to implement the ABC system. Firstly, by structuring activity cost pools more accurately and using cost drivers for each pool as the cost-allocation base, managers can achieve more precise cost estimation for activities. This ensures that the costs are allocated appropriately. Secondly, by assigning these costs to products based on the utilization of different activities by each product, the Hampshire Co. can calculate more accurate product costs. Furthermore, the implementation of the ABC system will result in the company gaining the following benefits: 1. Improves Business Processes - In an ABC system, indirect costs are assigned to products based on their respective cost drivers, which are the factors responsible for incurring those costs. By allocating costs on a per-product basis, this system provides insights into the performance of different business processes. It helps identify areas of improvement as well as non-value added activities. Moreover, ABC facilitates the optimal allocation of resources to enhance efficiency and profitability. Additionally, the implementation of ABC contributes to the ongoing enhancement of business processes, thereby creating value. 7

2. Identifies Wasteful Products- By implementing the ABC approach, Hampshire Co. can minimize the consumption of time, money, and effort on unsuitable products. This method also provides a means to evaluate costs in a manner similar to the workflow of production activities. Consequently, Hampshire Co. gains a deeper insight into the allocation of overhead costs. Through the analysis of the obtained data, the identification of wasteful products and avoidable expenses becomes possible, facilitating the productive utilization of resources. 3. In addition, this approach aids in rectifying the prices of products or services that are unreasonably high or inaccurate. Furthermore, the overall quality of products and services can be enhanced as the data provided by ABC highlights crucial production and cost concerns that require resolution. The Collapsible Umbrella Evauation Upon initial examination using the conventional costing method, the collapsible umbrella appears to possess a superior profit margin (20%) compared to the stick umbrella (13%) and generates more net income per unit ($2.88) than the stick umbrella ($1.58) does. However, when applying the ABC method of costing, the figures undergo a significant transformation. Surprisingly, the collapsible umbrella only yields $0.14 per unit, while the stick umbrella generates $1.71 per unit. In order to make the collapsible umbrella a more lucrative product, management must either raise the sales price or implement measures to lower the cost. The most notable disparity lies in the production cost, which constitutes 28% of the total cost for the collapsible umbrella, compared to just 13.5% for the stick umbrella. This discrepancy arises because, on average, each production run of collapsible umbrellas consists of only 500 units, 8

whereas the average production run for stick umbrellas is 1,333 units. Management may consider doubling the number of units produced per production run for the collapsible umbrella. Memorandum to Management Introduction In response to your request, our team has conducted a comprehensive analysis with the goal of identifying strategies to enhance business performance. Our investigation encompassed several crucial areas including cost-volume-profit analysis, variable and absorption costing, inventory management, benchmarking, and costing methods. CVP Analysis Cost-volume-profit analysis, a valuable analytical tool, allows us to examine the impact of cost and volume variations on profit. Through our analysis of the Hampshire Company, we have examined various factors such as contribution margin, breakeven point, and margin of safety. The contribution margin is an important metric that demonstrates how the number of units sold affects income. Our findings reveal that for the Hampshire Company, each package contributes $6.50 towards income. This indicates that this specific sum can be attributed to income from every package sold. The breakeven point is the threshold at which operational costs are exactly covered by the units sold. Based on our examination, our organization's breakeven point is 45,465 umbrellas, or $568,317 in sales. The margin of safety represents the difference between current unit sales and the breakeven point. In our analysis, we determined the margin of safety for the Hampshire Company to be 14,535 units. The positive result signifies that profit has been achieved, indicating that our organization's sales currently exceed the breakeven point. 9

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Variable and Absorption Costing Variable costing and absorption costing are two approaches utilized by manufacturing companies to calculate the cost of inventory. Variable costing separates the variable and fixed manufacturing costs, whereas the absorption method includes all manufacturing costs in the inventory. Both methods allocate variable manufacturing costs to inventory, while nonmanufacturing costs are recognized as expenses in the period they occur. A recent evaluation of associated expenses concluded that the absorption cost allocation method is the most favorable option for Hampsire Company. Inventory Management After careful evaluation, it is not advisable for Hampshire Company to adopt the Just-In-Time (JIT) inventory system. Although the JIT method offers potential cost savings and reduces the amount of inventory held, as materials are procured only when needed, it fails to fully address the unique challenges faced by a company that produces seasonal items. While implementing JIT would result in lower carrying costs and a notable reduction in overall operating expenses, its drawbacks outweigh the benefits in this case. The JIT system does not adequately consider the fluctuating demands of consumers during different seasons. Additionally, unforeseen adverse weather conditions can further hinder the company's ability to effectively respond to increased customer demands if they rely solely on the JIT approach. Benchmarking Benchmarking is a valuable tool that organizations can utilize to gauge their competitiveness in the marketplace and identify areas for enhancement. Performance benchmarking involves analyzing quantitative data to identify performance gaps, while practice benchmarking relies on qualitative data. In my opinion, it is recommended for Hampshire Company to adopt the 10

competitive benchmarking method. This methodology will allow Hampshire Company to evaluate its performance in comparison to industry rivals. By comparing profitability with competitors, we can pinpoint areas for improvement and potentially develop innovative strategies to not only meet but also surpass the profitability of competitors. Furthermore, implementing this strategy will enable us to establish production goals that align with those of our competitors. Costing Method While Hampshire Co. exclusively produces stick umbrellas; it is advisable to employ a conventional costing approach. This method involves allocating the manufacturing overhead costs to the manufactured products. In the case of Hampshire Co., the traditional approach assigns the factory's indirect costs to the items manufactured based on their volume and direct labor hours. By utilizing direct labor hours as the basis for allocating the manufacturing overhead, it indicates that these hours are the primary factor contributing to the factory overhead. If and when Hampshire Co decides to produce a Collapsible Umbrella or any other additional product, I suggest implementing the Activity-Based Costing system (ABC). Based on our findings, we can advise:  Assuming there is no sudden increase in demand, the absorption cost allocation method would be the optimal choice for our organization when costing inventory.  Transitioning to the Just-In-Time inventory system would not be a good choice given the seasonality of our products.  Competitive benchmarking would enable us to assess our performance in relation to industry competitors.  Should we expand our product line a transition to ABC Costing would be worth the 11

initial investment needed. 12

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