Chapter 8, Problem 1PSB

Tohono Company’s 2015 master budget included the following fixed budget report. It is based on an expected production and sales volume of 20,000 units.

Required

1. Classify all items listed in the fixed budget as variable or fixed. Also determine their amounts per unit or their amounts for the year, as appropriate.

2. Prepare flexible budgets (see Exhibit 8.3) for the company at sales volumes of 18,000 and 24,000 units.

3. The company’s business conditions are improving. One possible result is a sales volume of 28,000 units. The company president is confident that this volume is within the relevant range of existing capacity. How much would operating income increase over the 2015 budgeted amount of $125,000 if this level is reached without increasing capacity?

4. An unfavorable change in business is remotely possible; in this case, production and sales volume for

2015 could fall to 14,000 units. How much income (or loss) from operations would occur if sales volume falls to this level?

To determine

Concept introduction:

Fixed Budget:

A fixed budget, also known as static budget does not adjust throughout the budget period and is prepared on the assumption that specific amount of goods would be sold in the concerned period.

Requirement 1:

Classification of items of fixed budget as fixed or variable and their amounts per unit or their amounts for the year.

Answer to Problem 1PSB

Classification of fixed budget items as fixed or variable (Amount in $):

Particulars	Total amount	Amount per unit
Variable costs:
Direct materials	12, 00, 000	60
Direct labor	2, 60, 000	13
Machinery repairs	57, 000	2.85
Utilities	50, 000	2.5
Packaging	80, 000	4
Shipping	1, 16, 000	5.8
Total variable costs		88.15
Fixed costs:
Depreciation- machinery	2, 50, 000
Utilities	1, 50, 000
Plant manager salaries	1, 40, 000
Sales salaries	1, 60, 000
Advertising	81, 000
Salaries	2, 41, 000
Entertainment expense	90, 000
Total fixed costs	11, 12, 000

Explanation of Solution

The items laid in fixed budget of the company in the given problem can be classified into variable or fixed based on their nature i.e. on the basis of their behavior and traceability as explained below:

Variable costs vary directly with the production level i.e. company’s variable cost increases as the production increases and vice-a-versa. Therefore, following costs would be classified as Variable:

• Direct materials: The direct materials would be relate to the amount paid for procurement of materials which would vary
• Direct labor: The payment made to direct labor would vary depending upon the production
• Machinery repairs: The repairs done on machinery would be varied depending upon the usage of machinery for production of output
• Utilities: Utilities would be acquired depending on their requirement which would vary
• Packaging: The amount spent on packaging would be in relation to products produced which would vary
• Shipping: Expenses incurred on shipping would be incurred based on the number of products produced

Fixed costs do not vary with the level of production. They do not change with the amount of goods or services a company produces. Therefore, those costs which are fixed in nature would be covered under fixed costs as given below:

• Depreciation- Machinery: The depreciation charged on machinery is straight- line and would remain fixed
• Utilities: Utilities other than variable in nature would be covered under fixed cost
• Plant manager salaries: The salaries paid for managing would be fixed in nature
• Sales salaries: Salaries paid to sales staff would remain fixed in nature
• Advertising: The expenses on advertising would be covered under fixed cost
• Salaries: Salaries paid to staff would remain fixed in nature and would not change with the level of production
• Entertainment expense: Expenses on entertainment are fixed irrespective of the level of production

Further, it is given in the problem that sales volume is 20, 000 units and Sales are $3, 000, 0000. Therefore, calculation of Variable cost per unit has been calculated using the following formula:

$Variablecostperunit=Variablecost/Numberofunitssold$

Following would be the per unit amounts:

$Directmaterials=\$12,00,000/20,000units=\$60$

$Directlabor=\$2,60,000/20,000units=\$13$

$Machineryrepairs=\$57,000/20,000units=\$2.85$

$Utilities=\left(\$2,00,000*25\%\right)/20,000units=\$2.5$

$Packaging=\$80,000/20,000units=\$4$

$Shipping=\$1,16,000/20,000units=\$5.8$

Thus, the total variable costs would be the following:

$Totalvariablecosts=DirectMaterials+Directlabor+Machineryrepairs+Utilities+Packaging+Shipping$

$Totalvariablecost=\$60+\$13+\$2.85+\$2.5+\$4+\$5.8=\$88.15$

Also, fixed costs would include the following;

$Fixedcosts=\$3,00,000+\$1,50,000+\$2,00,000+\$2,50,000+\$1,25,000+\$2,41,000+\$90,000=\$13,56,000$

$Fixedcosts=\$2,50,000+\left(\$2,00,000-\$50,000\right)+\$1,40,000+\$1,60,000+\$81,000+\$2,41,000+\$90,000=\$11,12,000$

Therefore, classification of fixed budget items as asked in the given problem is shown below in the tabular manner:

Classification of fixed budget items as fixed or variable (Amount in $):

Particulars	Total amount	Amount per unit
Variable costs:
Direct materials	12, 00, 000	60
Direct labor	2, 60, 000	13
Machinery repairs	57, 000	2.85
Utilities	50, 000	2.5
Packaging	80, 000	4
Shipping	1, 16, 000	5.8
Total variable costs		88.15
Fixed costs:
Depreciation- machinery	2, 50, 000
Utilities	1, 50, 000
Plant manager salaries	1, 40, 000
Sales salaries	1, 60, 000
Advertising	81, 000
Salaries	2, 41, 000
Entertainment expense	90, 000
Total fixed costs	11, 12, 000

To determine

Concept introduction:

Flexible Budget:

A flexible budget, also known as variation budget adjusts to changes in volume or activity. Flexible budgets are prepared for comparing actual to budgeted performances at many levels of activity during the previous year. In order to accurately predict the changes in costs, management identifies them into fixed or variable costs.

Fixed cost:

These costs do not vary with the level of production. They do not change with the amount of goods or services a company produces. They remain same even if the company does not produce any product or provide any service during an accounting period.

Variable cost:

These costs vary with the level of production. They are usually shown in the budget as either a percentage of total revenue or at a constant rate per unit produced.

Requirement 2:

Flexible budget for the company at sales volume of 18, 000 units and 24, 000 units.

Answer to Problem 1PSB

Flexible budget for the company for the year ended December 31, 2015 (Amount in $):

Company
Flexible budget
For year ended December 31, 2015
Particulars	Flexible budget		Flexible budget for 18, 000 units sold	Flexible budget for 24, 000 units sold
	Variable amount per unit	Total fixed cost
Sales	150		27, 00, 000	36, 00, 000
Variable costs:
Direct materials	60		10, 80, 000	14, 40, 000
Direct labor	13		2, 34, 000	3, 12, 000
Machinery repairs	2.85		51, 300	68, 400
Utilities	2.5		45, 000	60, 000
Packaging	4		72, 000	96, 000
Shipping	5.8		1, 04, 400	1, 39, 200
Total variable costs	88.15		15, 86, 700	21, 15, 600
Contribution margin	61.85		11, 13, 300	14, 84, 400
Fixed costs:
Depreciation- machinery		2, 50, 000	2, 50, 000	2, 50, 000
Utilities		1, 50, 000	1, 50, 000	1, 50, 000
Plant manager salaries		1, 40, 000	1, 40, 000	1, 40, 000
Sales salary		1, 60, 000	1, 60, 000	1, 60, 000
Advertising		81, 000	81, 000	81, 000
Salaries		2, 41, 000	2, 41, 000	2, 41, 000
Entertainment expense		90, 000	90, 000	90, 000
Total fixed costs		11, 12, 000	11, 12, 000	11, 12, 000
Income from operations			1, 300	3, 72, 400

Explanation of Solution

For preparation of flexible budget of the company, following formulas would be used:

$Sellingpriceperunit=Sales/Numberofunitssold$

$Variablecost=Variablecostperunit*Numberofunitssold$

In the given problem, it is given that sales are $30, 00, 000 and sales volume is 20, 000 units.

$Thus,Sellingpriceperunit=\$30,00,000/20,000unitssold=\$150$

Flexible budget has to be prepared at sales volume of 14, 000 and 16, 000 units. We have already calculated variable cost per unit of all the items. Now, calculations for variable cost have been made in the following manner:

Particulars	Variable amount per unit (Amount in $)	For 18, 000 units sold	For 24, 000 units sold
Sales	150	$150*18, 000 = 27, 00, 000	$150*24, 000 = 36, 00, 000
Variable costs:
Direct materials	60	$60*18, 000 = 10, 80, 000	$60*24, 000 = 14, 40, 000
Direct labor	13	$13*18, 000 = 2, 34, 000	$13*24, 000 = 3, 12, 000
Machinery repairs	2.85	$2.85*18, 000 = 51, 300	$2.85*24, 000 = 68, 400
Utilities	2.5	$2.5*18, 000 = 45, 000	$2.5*24, 000 = 60, 000
Packaging	4	$4*18, 000 = 72, 000	$4*24, 000 = 96, 000
Shipping	5.8	$5.8*18, 000 = 1, 04, 400	$5.8*24, 000 = 1, 39, 200
Total variable costs	61.85	11, 13, 300	14, 84, 400

Further, contribution margin can be calculated using the below- mentioned formulas:

$Contributionmarginperunit=Sellingpriceperunit-Totalvariablecostsperunit$

$Contributionmargin=Sales-Totalvariablecosts$

Thus, contribution margin would be:

$Contributionmarginperunit=\$150-\$61.85=\$88.15$

$Contributionmarginat18,000units=\$27,00,000-\$15,86,700=\$11,13,300$

$Contributionmarginat24,000units=\$36,00,000-\$21,15,600=\$14,84,400$

Fixed costs would remain same irrespective of the changes in sales volume. Also, Income from operations can be computed using the following formula:

$Incomefromoperations=Contributionmargin-Fixedcosts$

$Incomefromoperationsat18,000units=\$11,13,300-\$11,12,000=\$1,300$

$Incomefromoperationsat24,000units=\$14,84,400-\$11,12,000=\$3,72,400$

Therefore, flexible budget asked in the given problem at 18, 000 and 24, 000 units is given below:

Flexible budget for the company for the year ended December 31, 2015 (Amount in $):

Company
Flexible budget
For year ended December 31, 2015
Particulars	Flexible budget		Flexible budget for 18, 000 units sold	Flexible budget for 24, 000 units sold
	Variable amount per unit	Total fixed cost
Sales	150		27, 00, 000	36, 00, 000
Variable costs:
Direct materials	60		10, 80, 000	14, 40, 000
Direct labor	13		2, 34, 000	3, 12, 000
Machinery repairs	2.85		51, 300	68, 400
Utilities	2.5		45, 000	60, 000
Packaging	4		72, 000	96, 000
Shipping	5.8		1, 04, 400	1, 39, 200
Total variable costs	88.15		15, 86, 700	21, 15, 600
Contribution margin	61.85		11, 13, 300	14, 84, 400
Fixed costs:
Depreciation- machinery		2, 50, 000	2, 50, 000	2, 50, 000
Utilities		1, 50, 000	1, 50, 000	1, 50, 000
Plant manager salaries		1, 40, 000	1, 40, 000	1, 40, 000
Sales salary		1, 60, 000	1, 60, 000	1, 60, 000
Advertising		81, 000	81, 000	81, 000
Salaries		2, 41, 000	2, 41, 000	2, 41, 000
Entertainment expense		90, 000	90, 000	90, 000
Total fixed costs		11, 12, 000	11, 12, 000	11, 12, 000
Income from operations			1, 300	3, 72, 400

Thus, the income from operations of company at sales volume of 18, 000 and 24, 000 units are $1, 300 and $3, 72, 400 respectively.

To determine

Concept introduction:

Fixed cost:

These costs do not vary with the level of production. They do not change with the amount of goods or services a company produces. They remain same even if the company does not produce any product or provide any service during an accounting period.

Variable cost:

These costs vary with the level of production. They are usually shown in the budget as either a percentage of total revenue or at a constant rate per unit produced.

Requirement 3:

Increase in operating income at 28, 000 units without increasing capacity.

Answer to Problem 1PSB

Increase in operating income at 28, 000 units without increasing capacity = $4, 94, 800

Explanation of Solution

Sales volume has been increased to 28, 000 units from 20, 000 units, thereby increasing 8, 000 units sold (28, 000 units- 20, 000 units). For calculating increase in operating income with existing capacity and fixed costs, firstly total contribution margin would be calculated using the following formula:

$Totalcontributionmargin=Contributionmarginperunit*Salesvolume$

Contribution margin per unit has already been calculated as $61.85 per unit. Thus,

$Totalcontributionmargin=\$61.85*28,000units=\$17,31,800$

Total fixed costs are calculated as $11, 12, 000. Therefore, all the calculations have been shown in the table below:

Particulars	Amount
Total contribution margin	$61.85* 28, 000 units = $17, 31, 800
Less: Fixed costs	($11, 12, 000)
Potential operating loss	$6, 19, 800
Budgeted income of 2015	($1, 25, 000)
Increase in operational income	$4, 94, 800

Therefore, Increase in operating income at 28, 000 units without increasing capacity is coming out to be $4, 94, 800.

To determine

Concept introduction:

Fixed cost:

These costs do not vary with the level of production. They do not change with the amount of goods or services a company produces. They remain same even if the company does not produce any product or provide any service during an accounting period.

Variable cost:

These costs vary with the level of production. They are usually shown in the budget as either a percentage of total revenue or at a constant rate per unit produced.

Requirement 4:

Income (or loss) from operations if sales volume fall to 14, 000 units.

Answer to Problem 1PSB

Potential operating loss at sales volume of 14, 000 units = $2, 46, 100

Explanation of Solution

Sales volume has fallen to 14, 000 units from 20, 000 units, thereby decreasing 6, 000 units sold (20, 000 units- 14, 000 units). For calculating income (or loss) from operations, firstly total contribution margin would be calculated using the following formula:

$Totalcontributionmargin=Contributionmarginperunit*Salesvolume$

Contribution margin per unit has already been calculated as $61.85 per unit. Thus,

$Totalcontributionmargin=\$61.85*14,000units=\$8,65,900$

Total fixed costs are calculated as $11, 12, 000. Therefore, all the calculations have been shown in the table below:

Particulars	Amount
Total contribution margin	$61.85* 14, 000 units = $8, 65, 900
Less: Fixed costs	($11, 12, 000)
Potential operating loss	$2, 46, 100

Therefore, the potential operating loss at 14, 000 units is coming out to be $2, 46, 100.