A1. Costing Method Recommendation
This report has been prepared to analyze the current costing method at Competition Bikes, Inc. (CBI) and provide a recommendation for improvement. To support this analysis, the differences between traditional based costing and activity based costing will be examined, along with the benefits and drawbacks for each method. A cost-volume-profit evaluation with break-even analysis for both sales units and sales dollars for the CarbonLite and Titanium bike lines will also be provided. The main differences between activity-based costing and the traditional costing: Traditional costing includes both direct and indirect components.
Indirect costs (overhead) are grouped together. There’s only one cost driver (such as direct labor hours) used to calculate costs regardless of what they are. Activity-based costing breaks down the overhead costs into activity cost pools. All overhead costs are then allocated into these activity cost pools. This method of costing does require more time to compute the cost to the activity yet it earns that money back plus dividends by having a more accurate forecast of the true costs that are associated with each activity.
In addition to a better understanding of costs, implementation of activity-based costing can drive improved financial results in the long run.
By looking at each product and what drives its specific costs, management can have a much more detailed sense of the true costs involved in producing each product. They can then compare the activity-based costs with the costing system they have been using to discover what products they may be overpricing, or underpricing for sale in the market.
They can also spot potential money wasting activities in their manufacturing process, and work to make those activities more efficient. If management has a better understanding of costs, they can present a stronger business case to get future capital projects funded. The downside to activity-based costing is that it requires a substantial commitment of personnel and financial resources up front. Management must be willing to examine their operations rigorously and the data that is gathered may be difficult to accept, particularly by those who are believe the current costing system is just fine and are resistant to change.
Traditional costing, on the other hand, is much easier to calculate than activity-based costing, and this makes manager’s jobs easier. However, traditional costing is so generally calculated that it may be hiding inefficiencies in the supply chain. Products may be overpriced or underpriced, and this can negatively impact the company’s bottom line in the long run.
By moving to the activity-based cost system, CBI could pinpoint if they have been overpricing items, losing market share to competitors. On the flip side, if they underprice an item, they are likely losing money as the price may be lower than what it costs to produce the bike. They would lose potential revenue to further fund research and development to improve the product for the future. If prices are significantly lower than those of the competition, customers may even hesitate to purchase the product, as they could wonder why the bike is priced so much lower than all the others in the market and have a perception that sub-par materials or manufacturing processes have been used. Since these bikes are a specialty product built to order, customers are generally not as price sensitive as shoppers looking for ready-made bikes.
By switching to the activity based costing (ABC) method, CBI is also taking advantage of the in-depth knowledge of costs that will result in savings for the company. In the overhead analysis, six manufacturing overhead items and their cost drivers are identified, with a comparison provided between ABC costing, and Traditional costing assuming 900 units produced for the Titanium line, and 500 units produced for the Carbonlite line. The cost driver for manufacturing overhead using the traditional method is not identified, but the totals are given in the Competition Bikes spreadsheet and are reflected below. Traditional costing method
-Titanium line manufacturing overhead cost: $239,020
-Carbonlite line manufacturing overhead cost: $232,380
Total traditional manufacturing overhead cost: $471,400
ABC costing method
-Titanium line manufacturing overhead cost: $188,415
-Carbonlite line manufacturing overhead cost: $282,985
Total traditional manufacturing overhead cost: $471,400
It’s important to note that the manufacturing overhead totals are identical when calculated using both traditional and ABC methods. This is because it’s not a difference in overhead, but instead a change in where the overhead is allocated. In the case of CBI, the allocation is quite different between methods.
For the Titanium line, the total manufacturing overhead cost with ABC costing is $50,605 lower than with traditional costing – a difference of 21%. In other words, CBI has overestimated manufacturing overhead for the Titanium line by 21% using traditional costing. Looking at unit costs, the traditional method per unit cost is $713, while the ABC unit cost is $656. The higher unit cost in the traditional costing method makes sense given that the allocation for manufacturing overhead was higher. CBI may be overpricing this bike, which could result in a negative effect on sales. If they could lower the price to a number closer to the true unit cost, they will likely see sales rise.
For the Carbonlite line, the total manufacturing overhead cost with ABC costing is $50,605 higher than with traditional costing. CBI had underestimated manufacturing overhead for the Carbonlite line by 18% using traditional costing. Looking at unit costs, the traditional method per unit cost is $1,359, while the ABC unit cost is $1,460. The unit cost calculated using ABC costing was higher than CBI had realized; they are likely underpricing this bike, losing out on potential revenues. A review of competitors’ prices may be in order, to evaluate what the market will bear, as well as an analysis of the impact of raising prices and how that affects sales. Once they have this data, CBI management can make an informed decision whether or not to adjust the Carbonlite sales price, and by how much.
A2a. Cost-volume-profit and break-even point evaluation: Current scenario CVP
Cost-volume-profit (CVP) analysis is a tool that managers and businesses often use to estimate future levels of operational activity needed to avoid financial losses, to break even, and to generate a profit. This analysis also helps to target future revenues. CVP analysis can also be used to estimate production levels needed to generate revenues sufficient to recoup capital expenditures such as operational expansion. CVP analysis examines changes in profits in response to changes in sales volumes, costs and prices. The basic CVP equation is sales minus variable costs = contribution margin. Sales revenues per unit for the Titanium product are set at $900. The variable cost per unit (costs that vary directly with volume) for the Titanium product is $679. Based on these numbers, the resulting contribution margin (sales revenue minus variable cost) per unit is $900 – $679 = $221. Contribution margin is the amount of profit left after variable costs are subtracted; therefore they can be considered the ‘contribution’ to profit for each unit sold.
For the Carbonlite product, the sales revenue per unit is higher at $1,495 due to the specialized materials and increased amount of labor required to manufacture the product. Variable cost is $1,384. The resulting contribution margin per unit is $1,495 – $1,384 = $111. It’s worth noting that the contribution margin for this product is much smaller than that for the Titanium line. A smaller contribution margin generally means the product is not as profitable. When multiple product lines are included in the analysis, to calculate total break-even sales units, a weighted average contribution margin (WACM) must be calculated. This is important because various products in the sales mix contribute different amounts of profit. The WACM is calculated by multiplying the unit contribution margin by the percentage of the total sales mix for each product. Expressed as a formula: WACM = Product one unit contribution margin (product one sales mix percentage) + product two unit contribution margin (unit two contribution margin percentage)
Incorporating the CBI data, with the sales mix proportion of 9 units of Titanium for every 5 units produced of Carbonlite, the WACM is calculated as 221 (.643) + 111 (.357) = $181.71. This number is what the average unit contributes to CBI’s profit on a per unit basis.
When the WACM is known, the Total Contribution Margin Dollars can be calculated. This is the amount of money that the company has to pay fixed costs. Any money left over after fixed costs are paid is profit. If total contribution margin dollars equal fixed costs, the company is at break-even. If total contribution margin dollars are less than fixed costs, that represents a loss for the company. The equation for this figure is: Total Contribution Margin Dollars: Units sold multiplied by the WACM
Break-even sales units can be calculated if the WACM and Total Contribution Margin Dollars needed to break-even are known, as follows: Total Contribution Margin Dollars/WACM. To calculate sales units and sales dollars required for break-even, a few steps are required. The first step is to calculate the break-even point in units of sales mix. Break-even point in units of sales mix = Total fixed cost/WACM per unit For CBI, break-even point in units of sales mix is $400,000/$181.71 = 2201 The next step is to calculate the number of units of Titanium and Carbonlite units at the break-even point. The equation is as follows: Number of units at break-even point = Sales mix ratio (total break even units) Break-even point in units for Titanium: 0.643 (2201) = 1415
Break-even point in units for Carbonlite: 0.357 (2201) = 786 The last step is to calculate the break-even point in dollars. The equation is as follows: Break-even point in dollars = Product units at break-even point (sales price per unit) Break-even point in dollars for Titanium: 1415 (900) = $1,273,500 Break-even point in dollars for Carbonlite: 786 (1495) = $1,175,070 Total sales needed to break-even: $1,273,500 + $1,175,070 = $2,448,570.
To summarize, CBI would need to sell 1415 units of Titanium and 786 units of Carbonlite, generating sales revenues of $2,448,570 to break-even (revenues and costs are equal). A2b. Cost-volume-profit and break-even point evaluation: Variable and fixed cost increase scenarios Suppose management needed to increase the cost of direct materials by 10% as well as add $50,000 in fixed costs to the production facility. What effect would this have on the break-even point?
Because the equations are based on the contribution margin as well as the WACM, an increase in the cost of direct materials (variable costs) by 10% will have a significant impact. Let’s first examine how cost-volume-profit and break-even point would be impacted if management needed to increase direct materials cost by 10%. I will analyze the $50,000 fixed cost increase separately.
Variable cost increase (10% direct materials increase) scenario
Contribution Margin per unit for Titanium: $900 – $709 = $191 Contribution Margin per unit for CarbonLite: $1495 – $1451 = $44
The contribution margins for both product lines decreased. Titanium decreased by 13%, and of particular note is the whopping 60% reduction in contribution margin for Carbonlite. This makes sense given that Carbonline has a higher variable cost and lower volume, so a percentage increase in variable cost has a greater impact. This product is even more expensive to produce in this scenario, and generating very low profits for the company at this point.
With the sales mix proportion of 9 units of Titanium for every 5 units produced of Carbonlite, the WACM per unit is calculated as 191 (.643) + 44 (.357) = $138.50. CVP Summary: the 10% increase in direct materials resulted in a 24% decrease in WACM per unit. The bikes are contributing 24% less profit towards profits.
Break-even point in units of sales mix is $400,000/$138.50 = 2888 Break-even point in units for Titanium: 0.643 (2888) = 1857
Break-even point in units for Carbonlite: 0.357 (2888) = 1031 Break-even point in dollars for Titanium: 1857 (900) = $1,671,300 Break-even point in dollars for Carbonlite: 1031 (1495) = $1,541,345 Total sales needed to break-even: $1,671,300 + $1,541,345 = $3,212,645
Break-even summary: the 10% increase in direct materials cost resulted in a reduced contribution margin per unit for both products. Given that fixed costs in this example were unchanged at $400,000, it makes sense that an increase in variable costs would require an increase in the break-even point to cover the additional expense. In this scenario, the break-even point in units and total sales need to break-even increased by 24% from the current scenario. It’s clear that an increase in variable costs can have a disproportionate impact on profits and the break-even point.
Fixed cost increase ($50,000) scenario
For this scenario, I assumed that variable costs remained unchanged from the current scenario (no 10% increase in variable costs) and that fixed cost for the production facility increased from $400,000 to $450,000.
Contribution margin per unit for Titanium: $900 – $679 = $221 Contribution margin for per unit for Carbonlite: $1,495 – $1,384 = $111
With the sales mix proportion of 9 units of Titanium for every 5 units produced of Carbonlite, the WACM per unit is calculated as 221 (.643) + 111 (.357) = $181.71. CVS Summary: Since variable costs did not change in this scenario, the contribution margin per unit and weighted average contribution margin/unit are at the same level as the original example.
Break-even point in units of sales mix is $450,000/$181.71 = 2476 Break-even point in units for Titanium: 0.643 (2476) = 1592
Break-even point in units for Carbonlite: 0.357 (2476) = 884 Break-even point in dollars for Titanium: 1592 (900) = $1,432,800 Break-even point in dollars for Carbonlite: 884 (1495) = $1,321,580 Total sales needed to break-even: $1,432,800 + $1,321,580 = $2,754,380
Break-even summary: Compared to the current scenario, the $50,000 increase in fixed costs (11% over the $400,000 example in the current scenario) had an impact of increasing the break-even point in units of sales mix by 275 units, or 11%. Since the contribution margin was unchanged in this example, the increase is less than in the scenario with 10% increase in direct materials. The break-even point in dollars also increased by 11%. The fact that the increase in the break-even point exactly matches the increase in fixed costs illustrates that as fixed costs rise, the break-even point will rise in proportion assuming the sales mix remains unchanged.
Comparing all three scenarios, the CVP and break-even analysis provides insight on how increases in variable and fixed costs affect contribution margins and break-even numbers. Variable cost increases have a disproportionate impact on increasing margins and break-even numbers, while the fixed cost increases result in a proportionate impact on increasing these measures. CBI’s management should consider these impacts when considering cost increases for their product lines.