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Transcript of Meeting with Anna, Omar, and Ted, and Peter Graff and Student on September 29, 2020 Anna: I feel so bad that we did not live up to our Dad's expectations and the company is now losing money. I stopped my PhD and moved back to Surrey to oversee marketing and sales. I started by giving all our clients a 10% discount. I thought we were doing a very good job, so I requested that production be increased. Omar: I closed my successful dentistry practice to manage the company. I prepared the income statement myself as I have done in my dentistry practice for the past 10 years. Ted: I was extra motivated this year because of the sudden death of our Dad. I never saw production going as smoothly as it did this year. Omar: Peter, please we need your advice here. Obviously, our Dad left us big shoes to fill. He was so smart, and he managed everything by himself. He did the accounting and the marketing. Maybe it is time for us to sell the business? Anna: How could we sell the business if it is losing money? Ted: We should never think about selling! There must be something wrong. I do not know accounting, but I have been working long enough at PML to know we should have made a profit and not a loss this year. Peter: Do not worry guys your late Dad was a good friend of mine. I knew him since we did our undergrad together at SFU and he always made things look easy. Omar: Thank you Peter, my dad always spoke highly of you. As I mentioned, I prepared the Income Statement as I have done for many years for my dentistry practice using a modified cash basis accounting. I used accruals for long-term balance sheet elements such as equipment and the cash basis for short-term ones such as raw materials. I feel that this method gives us a more accurate picture of our cash position. Peter: While it does better reflect your cash inflows and outflows, if your inventory is increasing it results in a net income that understates where you truly are. As you have a line of credit, I am sure that the bank would like to see your financial statements and if you give them this, they are likely to cancel your line of credit. Omar: You are correct, we have a line of credit up to 3 million dollars at a very competitive interest rate of 4.5% and I agree with you, I don't want to lose it especially during these difficult times. Now, I am afraid that our net income might be even lower, and we will lose our line of credit. Ted: I don't recall that we ever had to use our line of credit as extensively as we did last year. This included paying someone's house rent!! Anna: Dad always helped me financially. Paying my rent for my house in Surrey is the least you could do for me. I am working very hard to increase our sales. Peter: Don't worry guys! You are all hard-working honest people. We need to review the paperwork and see what is wrong here and how could we fix it? It might take some time to analyze your situation and come up with clear answers for you. That is why I have brought with me extra help, a bright Student from VIU. Peter: The first thing that student must do is to restate the results of last year. Omar, while the format you have used works well for a service industry like yours, a manufacturing operation reflects its results differently. Student, could you please take the information provided and restate the results using a Schedule of Cost of Goods Manufactured and a separate Income Statement? Student: I can do that. Ted: I have never seen our warehouse packed with so many unsold machines. There is no more room in the warehouse or even in the storage room for anything. Anna: Those discounts encourage people to buy our products. In addition, I think we should consider doing customer orders. Currently our production process is fairly labour intensive so I think it would be easy to reallocate our workers to work on customer jobs. Peter: Anna, have you done any calculations to see how much you would have to charge for customer orders? Anna: No, I have not. I have some figures that I can give you based on a food industry customer who called me last week. Peter: Great! In addition to illustrating how to cost out this customer job, we can also provide you with a memo which describes the different characteristics of customer jobs compared to your regular manufacturing process for your standard machines. That will allow you to understand in the future which machines or processes should be considered under Job Costing and which ones should be considered under Process Costing. Student, if you could do this and please illustrate 2 different scenarios. As we are not yet sure what the best choice will be for the allocation base of manufacturing overhead do one example using direct labour dollars as the cost driver and a second example using machine hours as the cost driver. Please use the figures from the 2020 year as the predetermined amounts. Student: I can do with the information that I have been given already. Omar: I think one of our problems is that we are stretching our resources between two packaging machine product lines: Cosmetics and Food. I wish I knew which product line more profitable, then I could discontinue the other line. Peter: Do these types of machines use different amounts of resources in their manufacture (e.g., labour, machinery, materials... etc.)? Omar: Yes, they do. As the food machines are going to be used in an environment that cannot be contaminated in any way, we are required to take greater care in their manufacture. Therefore, we need more supervisors on staff, there is greater inspection time, the factory insurance and the factory building is more related to the production of the Food machines than the Cosmetic machines. Peter: If we can get a bit more information on the supervisory, inspection, insurance and space utilization differences for the product lines we can do some Activity Based Costing that should give us an indication of how profitable each type of machine is. Student, the actual results for 2020 information page that Omar has provided us has a variety of information on it. I would like you to do a brief memo (1 page) identifying what measure is the best choice as a cost driver for supervisory cost, inspection cost, factory insurance and factory building amortization. All other costs should use machine hours as the cost driver. Student, when do you think you can have this information ready? Student: I'll be glad to review the paperwork and give you my answers within five weeks, let us say no later than Friday, November 6h. 1) Using the information provided restate the results by preparing (in good form) a Schedule of Cost of Goods Manufactured and a separate Income Statement. (20 Marks) {No page limit) 2) Customer Jobs a. Prepare a memo detailing out the similarities and differences between process costing and job order costing. (8 Marks) {1-page limit; b. Calculate the predicted total cost and proposed selling price for the customer order using the following separate assumptions: (10 Marks) {No page limit; i. Direct Labour Dollars is the cost driver. ii. Machine hours is the cost driver Note: Assume a Gross Margin of 15% in order to determine the proposed selling price. 3) Activity Based Costing a. Prepare a memo identifying and explaining your choices of cost drivers for the following expenses: (6 Marks) {1-page limit) i. Supervisory costs ii. Inspection costs iii. Factory insurance iv. Factory building amortization b. Using the concepts of ABC costing, calculate the resulting total cost and gross margins for both the Cosmetic and Food lines. (35 Marks) {No page limit) c. Discuss two advantageous and two disadvantages of implementing ABC costing by PML. (6 Marks) {1-page limit; PML Packaging Machinery Ltd. You Make It, We Pack It! Exhibit 1 Results for the year ended August 31, 2020 Cosmetic Food Total Revenue $12,000,000 $22,000,000 34,000,000 Discount (1,200,000) (2,200,000) (3,400,000) Net Revenue $10,800,000 $19,800,000 $30,600,000 Materials purchased 7,899,802 15,377,198 23,277,000 Accounting and legal 5,000 Utility Costs- Head Office 30,000 Utility Costs- Production 240,000 Administrative salaries 76,000 Inspection Costs 760,000 Factory Insurance 80,000 Sales commissions 340,000 Interest on business credit line 100,000 Management salaries (Omar, Anna, Ted $120,000 each) 360,000 Property Taxes. Head Office 6,500 Factory Building Amortization 412,000 Office supplies, Courier and Postage 7,760 Annual Business Licenses and Fees 2,500 Warranty Program Costs 500,000 Amortization Expense- Fabrication Equipment 650,000 Amortization Expense-Office Equipment 12,000 Business Liability Insurance 10,000 Telephone Costs. Factory 3,000 Telephone Costs. Head Office 6,000 Anna's House Rent $15,000 Labour-Assembly workers 2,000,000 3,500,000 5,500,000 Labour- Production supervisors 600,000 Total Expenses 32,992,760 Net Income (Loss) ($2,392,760) Current Year End Balances Cosmetic Food Total Raw Materials $1,500,000 $3,000,000 $4,500,000 Costs-Machines unfinished at year end 1,000,000 3,000,000 4,000,000 Costs- Machines complete but not sold 3,000,000 6,000,000 9,000,000 Last Year End Balances Raw Materials 1,000,000 2,000,000 3,000,000 Costs - Machines unfinished at year end 2,500,000 5,000,000 7,500,000 Costs- Machines complete but not sold $500,000 $1,500,000 $2,000,000 PML Packaging Machinery Ltd. Exhibit 2 Actual Results for Fiscal 2020 Cosmetic Food Total Net Revenue in $ $10,800,000 $19,800,000 $30,600,000 Direct Labour Cost in $ $2,000,000 $3,500,000 $5,500,000 # of Assembly Labour Hours 75,000 175,000 250,000 # of Fabrication Machine Hours 200,000 375,000 575,000 # of Machines sold 40 100 140 # of Machines Produced 70 120 190 Inspection Hours 420 2,160 2,580 Factory Area used (sq metres) 11,250 22,800 34,050 PML Packaging Machinery Ltd. Exhibit 3 Details of Proposed Customer Order Direct Materials $226,000 $57,000 Direct Labour Expected #of Fabrication Machine Hours 5,642 Transcript of Meeting with Anna, Omar, and Ted, and Peter Graff and Student on September 29, 2020 Anna: I feel so bad that we did not live up to our Dad's expectations and the company is now losing money. I stopped my PhD and moved back to Surrey to oversee marketing and sales. I started by giving all our clients a 10% discount. I thought we were doing a very good job, so I requested that production be increased. Omar: I closed my successful dentistry practice to manage the company. I prepared the income statement myself as I have done in my dentistry practice for the past 10 years. Ted: I was extra motivated this year because of the sudden death of our Dad. I never saw production going as smoothly as it did this year. Omar: Peter, please we need your advice here. Obviously, our Dad left us big shoes to fill. He was so smart, and he managed everything by himself. He did the accounting and the marketing. Maybe it is time for us to sell the business? Anna: How could we sell the business if it is losing money? Ted: We should never think about selling! There must be something wrong. I do not know accounting, but I have been working long enough at PML to know we should have made a profit and not a loss this year. Peter: Do not worry guys your late Dad was a good friend of mine. I knew him since we did our undergrad together at SFU and he always made things look easy. Omar: Thank you Peter, my dad always spoke highly of you. As I mentioned, I prepared the Income Statement as I have done for many years for my dentistry practice using a modified cash basis accounting. I used accruals for long-term balance sheet elements such as equipment and the cash basis for short-term ones such as raw materials. I feel that this method gives us a more accurate picture of our cash position. Peter: While it does better reflect your cash inflows and outflows, if your inventory is increasing it results in a net income that understates where you truly are. As you have a line of credit, I am sure that the bank would like to see your financial statements and if you give them this, they are likely to cancel your line of credit. Omar: You are correct, we have a line of credit up to 3 million dollars at a very competitive interest rate of 4.5% and I agree with you, I don't want to lose it especially during these difficult times. Now, I am afraid that our net income might be even lower, and we will lose our line of credit. Ted: I don't recall that we ever had to use our line of credit as extensively as we did last year. This included paying someone's house rent!! Anna: Dad always helped me financially. Paying my rent for my house in Surrey is the least you could do for me. I am working very hard to increase our sales. Peter: Don't worry guys! You are all hard-working honest people. We need to review the paperwork and see what is wrong here and how could we fix it? It might take some time to analyze your situation and come up with clear answers for you. That is why I have brought with me extra help, a bright Student from VIU. Peter: The first thing that student must do is to restate the results of last year. Omar, while the format you have used works well for a service industry like yours, a manufacturing operation reflects its results differently. Student, could you please take the information provided and restate the results using a Schedule of Cost of Goods Manufactured and a separate Income Statement? Student: I can do that. Ted: I have never seen our warehouse packed with so many unsold machines. There is no more room in the warehouse or even in the storage room for anything. Anna: Those discounts encourage people to buy our products. In addition, I think we should consider doing customer orders. Currently our production process is fairly labour intensive so I think it would be easy to reallocate our workers to work on customer jobs. Peter: Anna, have you done any calculations to see how much you would have to charge for customer orders? Anna: No, I have not. I have some figures that I can give you based on a food industry customer who called me last week. Peter: Great! In addition to illustrating how to cost out this customer job, we can also provide you with a memo which describes the different characteristics of customer jobs compared to your regular manufacturing process for your standard machines. That will allow you to understand in the future which machines or processes should be considered under Job Costing and which ones should be considered under Process Costing. Student, if you could do this and please illustrate 2 different scenarios. As we are not yet sure what the best choice will be for the allocation base of manufacturing overhead do one example using direct labour dollars as the cost driver and a second example using machine hours as the cost driver. Please use the figures from the 2020 year as the predetermined amounts. Student: I can do with the information that I have been given already. Omar: I think one of our problems is that we are stretching our resources between two packaging machine product lines: Cosmetics and Food. I wish I knew which product line more profitable, then I could discontinue the other line. Peter: Do these types of machines use different amounts of resources in their manufacture (e.g., labour, machinery, materials... etc.)? Omar: Yes, they do. As the food machines are going to be used in an environment that cannot be contaminated in any way, we are required to take greater care in their manufacture. Therefore, we need more supervisors on staff, there is greater inspection time, the factory insurance and the factory building is more related to the production of the Food machines than the Cosmetic machines. Peter: If we can get a bit more information on the supervisory, inspection, insurance and space utilization differences for the product lines we can do some Activity Based Costing that should give us an indication of how profitable each type of machine is. Student, the actual results for 2020 information page that Omar has provided us has a variety of information on it. I would like you to do a brief memo (1 page) identifying what measure is the best choice as a cost driver for supervisory cost, inspection cost, factory insurance and factory building amortization. All other costs should use machine hours as the cost driver. Student, when do you think you can have this information ready? Student: I'll be glad to review the paperwork and give you my answers within five weeks, let us say no later than Friday, November 6h. 1) Using the information provided restate the results by preparing (in good form) a Schedule of Cost of Goods Manufactured and a separate Income Statement. (20 Marks) {No page limit) 2) Customer Jobs a. Prepare a memo detailing out the similarities and differences between process costing and job order costing. (8 Marks) {1-page limit; b. Calculate the predicted total cost and proposed selling price for the customer order using the following separate assumptions: (10 Marks) {No page limit; i. Direct Labour Dollars is the cost driver. ii. Machine hours is the cost driver Note: Assume a Gross Margin of 15% in order to determine the proposed selling price. 3) Activity Based Costing a. Prepare a memo identifying and explaining your choices of cost drivers for the following expenses: (6 Marks) {1-page limit) i. Supervisory costs ii. Inspection costs iii. Factory insurance iv. Factory building amortization b. Using the concepts of ABC costing, calculate the resulting total cost and gross margins for both the Cosmetic and Food lines. (35 Marks) {No page limit) c. Discuss two advantageous and two disadvantages of implementing ABC costing by PML. (6 Marks) {1-page limit; PML Packaging Machinery Ltd. You Make It, We Pack It! Exhibit 1 Results for the year ended August 31, 2020 Cosmetic Food Total Revenue $12,000,000 $22,000,000 34,000,000 Discount (1,200,000) (2,200,000) (3,400,000) Net Revenue $10,800,000 $19,800,000 $30,600,000 Materials purchased 7,899,802 15,377,198 23,277,000 Accounting and legal 5,000 Utility Costs- Head Office 30,000 Utility Costs- Production 240,000 Administrative salaries 76,000 Inspection Costs 760,000 Factory Insurance 80,000 Sales commissions 340,000 Interest on business credit line 100,000 Management salaries (Omar, Anna, Ted $120,000 each) 360,000 Property Taxes. Head Office 6,500 Factory Building Amortization 412,000 Office supplies, Courier and Postage 7,760 Annual Business Licenses and Fees 2,500 Warranty Program Costs 500,000 Amortization Expense- Fabrication Equipment 650,000 Amortization Expense-Office Equipment 12,000 Business Liability Insurance 10,000 Telephone Costs. Factory 3,000 Telephone Costs. Head Office 6,000 Anna's House Rent $15,000 Labour-Assembly workers 2,000,000 3,500,000 5,500,000 Labour- Production supervisors 600,000 Total Expenses 32,992,760 Net Income (Loss) ($2,392,760) Current Year End Balances Cosmetic Food Total Raw Materials $1,500,000 $3,000,000 $4,500,000 Costs-Machines unfinished at year end 1,000,000 3,000,000 4,000,000 Costs- Machines complete but not sold 3,000,000 6,000,000 9,000,000 Last Year End Balances Raw Materials 1,000,000 2,000,000 3,000,000 Costs - Machines unfinished at year end 2,500,000 5,000,000 7,500,000 Costs- Machines complete but not sold $500,000 $1,500,000 $2,000,000 PML Packaging Machinery Ltd. Exhibit 2 Actual Results for Fiscal 2020 Cosmetic Food Total Net Revenue in $ $10,800,000 $19,800,000 $30,600,000 Direct Labour Cost in $ $2,000,000 $3,500,000 $5,500,000 # of Assembly Labour Hours 75,000 175,000 250,000 # of Fabrication Machine Hours 200,000 375,000 575,000 # of Machines sold 40 100 140 # of Machines Produced 70 120 190 Inspection Hours 420 2,160 2,580 Factory Area used (sq metres) 11,250 22,800 34,050 PML Packaging Machinery Ltd. Exhibit 3 Details of Proposed Customer Order Direct Materials $226,000 $57,000 Direct Labour Expected #of Fabrication Machine Hours 5,642