Sparklin Automotive Company - Case Study Example

?Sparklin Automotive Co. A Managerial Accounting Case Study I.Overview Sparklin Automotive Company had its 2006 journal entries available for the useof management in analyzing profitability and forecasting under high and low performance scenarios. However, cost and expense accounts have yet to be classified under Fixed Cost, Variable Cost, or Mixed Cost. The possible results of operations can then be simulated under possible scenarios involving a decrease in sales volume and an increase in sales volume. This exercise of distinguishing classifications of costs will allow the management to compute and have an awareness of the impact on profitability as well as the different costs. The primary objective of this case study is (a) to define fixed, variable, and mixed costs; (b) to determine cost behaviour patterns, and (c) to explain how these different patterns affect operating and pricing decisions. II.Cost Analysis a. Definition of Variable Costs + Example All expenses incurred that increase as the Production Output and Sales increases and decreases whenever the Production Output and Sales decreases should be considered as variable costs. Albrecht, Steve W., et.al.(2010, p.1062) defined variable costs in a more general way by saying that they are the costs that change in total in direct proportion to changes in activity level.. In the SAC operations, an example of the variable cost would be Raw Materials. The higher the demand for the product which would be evident in the increase in Sales volume, the higher the required Production Output, and a corresponding set of Raw Materials will be needed to produce the desired order quantity. b. Definition of Fixed Costs + Example All expenses that are incurred whether or not operations are at high or low level should be called Fixed Costs. Rich, J.S., et. al. (2009, p.757) defined fixed cost as constant costs “within the relevant range as the level of of output increases or decreases.” At SAC, an example of that fixed cost is Depreciation Expense – Factory. Each month, whether or not the factory produces for high demand or for low demand, the value of depreciation expense will not change. c. Definition of Mixed Costs + Example Some costs known as mixed costs are made up of a combination of fixed cost and variable cost. Weygandt, J.J. et.al. (2009, p.209) teaches the need to separate these two in order to properly perform a cost-volume-profit analysis. Kinney, M.R. and Raiborn, C.A. (2012, p.70) also refers to the “high-low method” of determinine variable costs per unit and then separating it from fixed costs. That is, the formula to determine the portion that is variable in a mixed costshould be as follows: Cost at High Level of Operations less Cost at Low Level Operations divided by High Activity Level expressed in volume of production or sales less Low Activity Level also expressed in volume of production or sales. The result will be the variable cost per unit within that mixed cost. Variable Costs may then be computed for its total and then separated from the total mixed cost in order to arrive at the fixed cost total within the mixed cost. In the case of SAC, there are data from two years, 2005 and 2006. Cost of Goods sold in 2005 was 50.81% whereas in 2006, the percentage increased to 59.30%. This means Cost of Goods Sold (CGS) may not be considered as 100% variable costs. A closer look at the details of CGS in the 2006 journal entries shows the following accounts: Cost of Goods Sold Raw Materials Labor Overhead Classification: Fixed, Variable, Mixed Supplies-Factory 3,500 MC Insurance-Factory 800 FC Indirect Labor 16,000 MC Factory Salaries 12,500 FC Factory Property Tax 7,500 FC Maintenance Expense- Factory 8,700 FC Depreciation Expense-Factory 1,600 FC Utilities- Factory 3,650 MC Raw Materials RM, beg.=19,360 Purchases=33,710 RM, end= 10,000 RM, used 43,070 WIP, beg.= 1,800 RM processed = 41,270 WIP,end= 7,000 FG added=34,270 FG,beg.= 25,360 FG,total= 59,630 FG,end= 36,360 FG,sold= 23,270 VC Direct Labor 8,500 VC Selling Expenses 1,560 MC Admin. Expenses 3,000 FC Bad Debt 120 VC Interest Expense 19,146 FC “Some overhead (indirect costs) such as indirect labor, supplies, and some utilities are also variable.” according to Myers, G.M. (2005). But it can be argued in the absence of statistical information that these are mixed costs, because a part of each of these cost items can be proven to be fixed while another part can be variable. For example, the salaries of laborers in just cleaning up the factory each day will be fixed indirect labor. But when production increases, and more dirt have to be clean, additional people will necessarily be hired or contracted to clean a bigger mess. For purposes of conservatism principle of accounting, these items will be treated as mixed costs to account for more fixed costs. Heisinger, K. (2009, p.203) mentions “the two most common variable costs are direct materials and direct labor. Other examples include indirect materials and energy costs.” In the automotive industry wherein SAC belongs, selling expenses consist of salaries of sales personnel plus commissions based on units sold or sales value. Their salaries are generally fixed. But their commissions will depend on their sales. Another part of selling expenses would be advertising which can increase the sales. Normally, the higher the cost of advertising, the higher the sales should be. Thus Selling Expenses are mixed costs. III.How Costs Will Be Affected By Sales Adjustments a.Effects on Unit Fixed Cost due to Increase / Decrease in Sales Volume Based on the classifications of all costs and expenses, there can be two methods of analyzing effects on the unit FC as a result of increases / decreases in sales volume. The first is by classifying all the mixed costs as variable costs. But the second which is more conservative would be by segregating the fixed costs from the variable costs from the mixed costs, and then computing the more accurate Total FC and Total VC. To apply the 2nd method, SAC should consider the high-low method of apportioning the FC from the VC of the MC. Applying the 1st Method for Simplification Fixed Costs = 800 + 12,500 + 7,500 + 8,700 + 1,600 + 3,000 + 19,146 = 53,246 Variable Costs* = 3,500 + 16,000 + 3,650 + 23,270 + 8,500 + 1,560 + 120 = 56,600 Note that *Variable Cost in the 1st method assumes all Mixed Costs are VC. This is why it is a simplified method. There is no need to determine how much FC there might be in the total MC. Unit fixed cost will be smaller as the sales volume increases. And that is because Total Fixed Cost (numerator) will remain the same while Total Sales value (denominator) will increase. For SAC, based on the actual sales records in 2005 and 2006, the effect will be as follows: 2005 --- ( 53,246 / 155,000) x 100% = 34.35 % of sales = UFC % to Sales 2006 - ( 53,246 / 168,000 ) x 100% = 31,69% of sales = UFC % to Sales To convert these into units, the average price can be utilized to divide both the results of computation in 2005 and 2006. The higher unit sales will definitely distribute the FC per unite or unit FC to more units so that the average unit FC will be smaller in the year where sales was higher, assuming no change in price from 2005 to 2006. Whenever the Unit Sales goes down, the Unit Fixed Cost or FC/unit becomes bigger. If the Mixed Costs will be divided into FC and VC, the Total Fixed Costs will be higher and the Unit Fixed Costs for both 2005 and 2006 will be also higher. Nonetheless, 2006 performance would still have the lower Unit Fixed Cost compared to 2005. The case of SAC does not show the breakdown of Cost of Goods Sold in 2005. Thus, the Mixed Costs between 2006 and 2005 cannot be compared. Only the Sales data for both years are comparable. Although the preferred way is conservatism by breaking apart Mixed Costs, in the absence of Cost of Goods breakdown in 2005, a high-low computation to determine FC and VC out of MC is not yet possible. Therefore, SAC may only use the simplified way by considering MC as VC until such time that additional data for 2005 can become comparable with those of 2006. b.Effects on Unit Variable Cost due to Increase / Decrease in Sales Volume Using 2006 as basis for determining the Total Variable Cost, computation will show that the percentage of VC / Sales will be (56,600 / 168,000) x 100% = 33.69%. The effect on Unit VC in the event of an increase or decrease in Sales will then be a directly proportional 33.69% increase or decrease. c.Effects on Total Fixed Costs (TFC) due to Increase / Decrease in Sales Volume Up to a certain extent, TFC will remain the same in the event of a decrease of increase in Sales Volume. Demand can however change that figure. If there is a trend showing very low demand, the management should decide to reduce its level of operations by likewise cutting off a part of the Fixed Cost that may be expendable. For example, Administrative Fixed Salaries may be reduced by retrenching if there is less need for staff and management functions due to low demand while maintaining a smaller workforce will be good enough. Shutting down one of the production sites while maximizing productivity in the other production site will reduce the Fixed Costs of electricity It will cut down Fixed Cost of compulsory repairs and maintenance of an unnecessary production site, and Production Staff and Management salaries. Total Fixed Costs should then be reduced as a result. But it is also possible for the company to reach a maximum production capacity as a result of rising demand. In such a fortunate case, management may decide to expand operations by adding more equipment and manpower in order to meet demand. This will result in having to increase the depreciation cost fixed value each month plus the total fixed salaries per month. And if the company decides to avail of loans, the fixed interest rates can likewise add to the Total Fixed Cost. d.Effects on Total Variable Costs Due to Increase / Decrease in Sales Volume. Assuming no price increases in the cost factors that are variable, e.g. raw materials and direct labor, Total Variable Costs will remain at 33.69% of the Total Sales. The effect of price increases will oblige the management to consider a proportionate increase in the automotive products for sale in order to maintain the profitability of the business. Of course, price competition must be considered as well. If increasing the price will lower the demand as a result of a shift in demand in favor of the competitors with lower prices or no price increase, the management must weigh consequences and benefits of price increase. IV. Conclusion SAC management can improve the accuracy of planning for contingencies and maximization of profits through cost control by striving to identify the mixed costs in 2005 to compare them with the mixed costs of 2006. Thereafter, a better analysis can be derived out of first establishing a more accurate set of figures for the Total Fixed Costs and Total Variable Costs. More accurate profitability computations can be achieved following a sensitivity analysis based on historical trend of the actual total fixed costs and actual total variable costs. With such an accuracy, the management will be able to retain earnings for the forecasted increases in TFC and become more prepared for economic crisis that can last several years. The reason is plain and simple. Investors look at the profitability of a business and its liquidity, speciality in times of crisis. Going below the fixed costs utilizing conservative means of computations (e.g. using Mixed Costs breakdown) will certainly scare the potential investors away. In contrast, controlling costs to a level far above the fixed costs even under the conservative method of computation (by breaking down Mixed Costs into VC and FC) will speak of a profitable business in spite of an economic crisis. Thus SAC can be more hopeful of maintaining or increasing investors whenever needed. Long-term stability aside from year-to-year profitability can be assured with such a management accounting strategy that is concerned with accuracy and conservatism in the computation of Fixed Costs, Variable Costs, and Mixed Costs. References Albrecht, Steve W.; Stice, Earl K.; Stice, James D.; Swain, Monte R. PhD..Accounting: Concepts and Applications, 11th Edition. USA: Cengage Learning, February 26,2010. Heisinger, Kurt. Essentials of Managerial Accounting. USA: Cengage Learning, 2009. Kinney, Michael R. and Raiborn, Cecily A. Cost Accounting: Foundations and Evolutions. USA & Canada: Cengage Learning, May 30, 2012 Myers, Gerald M. Management Accounting Web: Cost Behavior. 2005. Viewed January 19, 2013 @ http://www.plu.edu/~mgtacctg/cost_behavior.htm Rich, Jay S.; Jones, Jefferson P.; Heitger, Dan; Mowen, Maryanne M.; Hansen, Don R.. Cornerstones of Financial & Managerial Accounting: Current Trends Update. USA:Cengage Learning, June 12, 2009. Weygandt, Jerry J.; Kimmel, Paul D.; and Kieso, Donald. Managerial Accounting: Tools for Business Decision Making, 5th Edition. USA: John Wiley & Sons, October 19, 2009. Read More