Advanced: Behaviour of direct labour costs and CVP analysis An electrical goods manufacturing company made a 10% profit on sales of £1 million in its last trading year. The composition of its costs was direct labour 25%, direct materials 60% and fixed overhead 15%.

The general manager has drawn your attention to the fact that, although the sales were just below forecast, the profit was very much lower than he had expected.

Your initial investigation shows that the significant difference appears to be caused by the direct labour costs. The company uses the marginal cost accounting principle to price its products. In all price quotations the direct labour was treated as a variable cost directly related to volume of output. However, the review indicates that the direct labour cost showed little change when output decreased for any reason.

You are required to:

(a) state whether you agree that direct labour costs should be treated as wholly variable with output; (8 marks)

(b) calculate, using the last year's results, the sales value at break-even point and the margin of safety when the direct labour costs are treated as:

(i) wholly variable

(ii) fixed; (6 marks)

(c) comment on the results obtained in part

(b) above