Management accounting

Topic: Relevant costing

Question 4 Background Gaslight Ltd produces gas boilers. Each gas boiler requires a circuit board. The contribution earned from each gas boiler, before deducting the cost of the circuit board, is 300. The company's volume of business is steadily expanding. 60,000 boilers were sold in the year ended 31 August 2011 and sales demand for the next three years is projected to be as follows: Year ending 31 August 2012 62,000 Year ending 31 August 2013 65,000 Year ending 31 August 2014 68,000 Capacity Constraint - Circuit Boards Circuit boards are currently manufactured in-house by Gaslight Ltd. Unfortunately, the company only has the capacity to produce 60,000 circuit boards per annum during normal working hours. If overtime hours are worked the annual production capacity for circuit boards can be increased to 65,000 units per annum, thus allowing production of gas boilers also to increase to 65,000 units. However, the variable cost per unit of each circuit board produced during overtime hours would be 20 higher than the variable cost per unit of a circuit board produced during normal working hours. Costs Incurred in Producing Circuit Boards No price changes are expected to occur until 2015. The costs of producing a circuit board in- house during normal working hours may be summarised as follows: Direct materials 22 Direct labour 30 Variable overheads 15 (based on 50% of labour cost) Fixed overheads 18(based on absorption rate of 60% of labour cost for output of 60,000 units) 85 The fixed overheads absorbed by each circuit board include an allocation of centrally incurred costs, as well as overheads incurred specifically in respect of the production of circuit boards. If production of circuit boards was discontinued 380,000 in fixed overheads directly attributable to circuit boards would be avoided. Fixed overheads directly attributable to the production of circuit boards would increase to 490,000 if the volume of circuit boards produced exceeds 62,000 units. Offer from External Party to Supply Circuit Boards to Gaslight Ltd The capacity constraints affecting the production of circuit boards have prompted management to explore the possibility of sourcing the circuit boards from an external supplier. A reliable company, with a reputation for high quality products, has offered to supply circuit boards to Gaslight Ltd at a price of 110 per unit, once Gaslight Ltd agrees to purchase at least 55,000 units per annum from them. Financial Consequences of Sourcing Circuit Boards Externally The company only purchases the direct materials for circuit boards as required, and therefore there would not be a stock of raw materials to dispose of if production of circuit boards was discontinued. 40 employees, whose annual salaries average 45,000, are employed in the production of circuit boards. If circuit boards are purchased, these employees will be made redundant ,each receiving a once-off redundancy payment of 6,000 A member of warehouse staff, who earns a salary of 50,000 per annum currently spends 40% of her time processing orders and requisitions in relation to circuit boards. If production of circuit boards ceases, this member of staff will be re-allocated to spend the time freed on other tasks. However, if production of circuit boards continues, the company will have to recruit a new employee to perform these other tasks at a cost of 28,000 per annum. If circuit boards are purchased from an external supplier, an employee will have to be recruited to liaise with the supplier and monitor the quality and supply of the products. It is expected that such an employee will be paid a salary of 46,000 per annum. The manufacturing of circuit boards occupies an area of 28,000 square metres. If circuit boards were sourced externally, this space would become free and could be rented out for 80 per square metre per annum. Alternatively, this space could be used for gas boiler production and would enable the company to increase their production capacity for gas boilers up to 77,000 units per annum. At present the company only has enough space in the factory to produce 65,500 gas boilers. If the company becomes reliant on an external supplier, management believe it would be necessary to carry a higher volume of finished circuit boards in stock than currently is the case. This would lead to an increase in stock-holding costs of 9,000 per annum. Requirement (a) Advise which of the following is best from a financial perspective of performance over the entire three year period ending 31 August 2014 is considered (You may ignore the time value of money in your calculations): (i) continue to manufacture circuit boards internally; (ii) purchase circuit boards from an external supplier and rent out freed factory space; (iii) purchase circuit boards from an external supplier and use freed factory space to increase gas boiler production capacity 17 marks (b) Suggest strategic and other non-financial issues which should be considered when deciding whether to make or purchase the circuit boards. 6 marks (c) Comment on each of the following statements: (i) Fixed costs are always irrelevant; (ii) Direct costs are always relevant. 7 marks Total: 30 marks