Overview Open Book Publishers (Pty) Ltd ("OPB") was established a number of years ago with the main goal of "making reading more accessible for all. OPB's operations are based in Cape Town and the company focuses solely on the development and printing (commonly referred to as 'production') of two publications, an activity book and a magazine, which were developed by OPB and for which the company owns the copyright Activity book The activity book produced by OPB is a book used in Grade 0 teaching and is sold in large quantities to government schools at a price of R35.00 per book. The activity book was developed by OPB in 2014 and has not changed since it was originally developed. It is also not expected to change anytime soon. The paper used for the activity book is of an appropriate quality such that it cannot easily be damaged by young children and has only a few words but lots of pictures. This activity book is produced in four bulk production runs each year and goes through internal quality checks and external inspections required by government. OPB estimates that 1 000 000 activity books will be produced and sold in the company's financial year ending 28 February 2022 and that it will be subject 40 external inspections during the year, in addition to the standard internal quality assurance check performed on each production run. assurance to Magazine OPB's magazine is produced monthly and focuses on health issues. It has 12 production runs per year, each of which produces 10 000 magazines, i.e. there is 1 production run of 10 000 magazines every month. OPB expects to sell all magazines produced. The content for each monthly magazine comes from freelance journalists who are commissioned to submit articles and are paid per word written. Each monthly publication averages 14 articles, each of 750 words. Each month's magazine is compiled by two full time employees, being an editor and a graphic designer, using computer software. Following this the final copy is sent for printing. The paper used for the magazine is of average quality. A quality assurance check magazines produced is conducted with every production run. The magazine generates revenue on as adverts through magazine sales las well through that are placed in the magazine. The selling price of each magazine is R29.50. Management concerns Management concerns OPB's management, specifically the board of directors, have expressed concerns regarding the performance of the company and are debating whether one of the publications (the activity book or the magazine) should be discontinued. If one was discontinued, the company could then focus on its most profitable publication. Due to these concerns, market research study was recently commissioned by OPB's directors. The research indicated that the demand for the magazine would increase by 50% if there was a 10% reduction in its selling price. Cost information OPB currently uses an absorption costing system, allocating all fixed manufacturing overheads based on units of production, regardless of the type of publication produced and / or whether the costs are specific to the publication or not. The following budgeted information relating to the production and sales of the activity books and magazines has been prepared for the current financial year in order to aid in addressing management's concerns: 1. The paper used for an activity book is expected to cost R38.50 per kilogram (kg), while the magazine's paper costs R27.40 per kg. The activity book uses on average 400 grams (g) of paper for each book, on average 2 times as much weight in paper as each magazine. 2. Printing ink is estimated to cost R62.80 per litre (). The magazine uses 150 millilitres (ml) of printing ink per publication, while each activity book two thirds of the amount of printing ink used for each magazine. uses 3. It is estimated that freelance journalists will be paid at a rate of R3.50 per word. 4. The activity book requires 6 minutes of machine time to produce each book. The machines used to print the activity book owned by OPB and incur are associated operators' variable operating costs of R5.40 per hour. Fixed operating costs with the operation of these machines, which include machine salaries, are included in the fixed manufacturing overheads (referred to 6 below). in point are are 5. The magazine requires 10 minutes of machine time to produce each magazine. Specialised machines used to produce magazines which rented by OPB. The rental paid for the of the specialised machines include fixed monthly base rental and an additional amount that is related to the total hours that the use a are specialised machines used during the month. Rental rates are fixed in terms of the rental agreement and will not increase in the current year. Historic cost information related to the past six months is given below: Specialized machines used to produce magazines Month Hours used Total rental cos September 1 680 R142 324 October 1 700 R143 810 November 1 660 R142 838 December 1 670 R143 081 January 1 630 R142 109 February 1 660 R142 838 These specialised machines have an operating capacity of 2 000 hours per month, taking into account normal stoppages such as downtime for routine maintenance. costs 6. OPB's total fixed manufacturing overheads (excluding the machine rental in point 5 above) are expected to be R4 234 000 for the current year. overheads are made up as follows and relate to (next page): These Overheads Note R Property costs 6.1 598 000 Machine costs 6.2 1 882 000 Salary costs 6.3 898 000 Quality control costs 6.4 642 000 Production setup costs 6.5 214 000 4 234 000 6.1. Property costs relate to the rental paid for the production facilities (factory) as well as associated property maintenance and cleaning. The 40% of the production facility publication of the activity book occupies with the remainder utilised to produce magazines. 6.2. Refer to point 4 above. The salaries of machine operators producing activity books and magazines are included in this figure, which are R685 000 and R545 000 for the two publications respectively. 6.3. The salary costs relate to the salaries expected to be paid to the editor and graphic designer responsible for the magazine. 6.4. Quality control costs are made up of costs incurred by internal quality assurance checks, which account for 65% of these costs, and the costs incurred by external inspections, which account for the rest. Checks internal quality assurance are the same for activity performed for the books and magazines. 6.5. The same production setup cost is incurred regardless of the type of publication. expenses are estimated at R1.20 for each 7. Variable selling and distribution activity book and R1.50 for each magazine. revenue per month from magazines is expected to average 8. Advertising R75 000. 9. Administrative and other non-manufacturing costs, in addition to costs outlined above, are estimated to total R6 552 000 for the current year. These costs include an estimate of bonuses to be paid to senior management of R1 552 000. QUESTIONS 1. For each of OPB's types of books and publications (activity costing system magazines), use the existing to calculate the: 1.1. Total cost per activity book / manufacturing and gross magazine profit per activity book / magazine; 1.2. Total operating profit for activity books and magazines. 2. For each of OPB's types of publications (activity books and magazines), use a more logical and accurate way to allocate the fixed manufacturing overheads to calculate a: 2.1. Revised gross profit per activity book / magazine; 2.2.Revised total operating profit for activity books and magazines. Clearly indicate how you have allocated costs 3. Based on your calculations in parts (a) and (b) and the information provided in the scenario, explain how using OPB's existing absorption costing system to allocate fixed manufacturing overheads could lead to incorrect management decisions. To support your explanation, include a brief discussion on: 3.1. Volume- and non-volume-based cost drivers 3.2. Whether there is potential for OPB to use an activity- based costing system. 4. Based on OPB's the number of expected sales mix, calculate magazines that need to activity books and be produced and sold in the 2022 financial year to break-even. 5. Discuss six key factors, including strategic considerations, that should be considered by OPB's management when deciding whether to discontinue one of its publications. 6. Assuming that demand would line with market change in the selling research around decreasing price of OPB's magazine: 6.1. Perform a financial evaluation of the impact of such a change 6.2. Outline four key considerations that should be considered when deciding whether to by OPB's management implement this change. Overview Open Book Publishers (Pty) Ltd ("OPB") was established a number of years ago with the main goal of "making reading more accessible for all. OPB's operations are based in Cape Town and the company focuses solely on the development and printing (commonly referred to as 'production') of two publications, an activity book and a magazine, which were developed by OPB and for which the company owns the copyright Activity book The activity book produced by OPB is a book used in Grade 0 teaching and is sold in large quantities to government schools at a price of R35.00 per book. The activity book was developed by OPB in 2014 and has not changed since it was originally developed. It is also not expected to change anytime soon. The paper used for the activity book is of an appropriate quality such that it cannot easily be damaged by young children and has only a few words but lots of pictures. This activity book is produced in four bulk production runs each year and goes through internal quality checks and external inspections required by government. OPB estimates that 1 000 000 activity books will be produced and sold in the company's financial year ending 28 February 2022 and that it will be subject 40 external inspections during the year, in addition to the standard internal quality assurance check performed on each production run. assurance to Magazine OPB's magazine is produced monthly and focuses on health issues. It has 12 production runs per year, each of which produces 10 000 magazines, i.e. there is 1 production run of 10 000 magazines every month. OPB expects to sell all magazines produced. The content for each monthly magazine comes from freelance journalists who are commissioned to submit articles and are paid per word written. Each monthly publication averages 14 articles, each of 750 words. Each month's magazine is compiled by two full time employees, being an editor and a graphic designer, using computer software. Following this the final copy is sent for printing. The paper used for the magazine is of average quality. A quality assurance check magazines produced is conducted with every production run. The magazine generates revenue on as adverts through magazine sales las well through that are placed in the magazine. The selling price of each magazine is R29.50. Management concerns Management concerns OPB's management, specifically the board of directors, have expressed concerns regarding the performance of the company and are debating whether one of the publications (the activity book or the magazine) should be discontinued. If one was discontinued, the company could then focus on its most profitable publication. Due to these concerns, market research study was recently commissioned by OPB's directors. The research indicated that the demand for the magazine would increase by 50% if there was a 10% reduction in its selling price. Cost information OPB currently uses an absorption costing system, allocating all fixed manufacturing overheads based on units of production, regardless of the type of publication produced and / or whether the costs are specific to the publication or not. The following budgeted information relating to the production and sales of the activity books and magazines has been prepared for the current financial year in order to aid in addressing management's concerns: 1. The paper used for an activity book is expected to cost R38.50 per kilogram (kg), while the magazine's paper costs R27.40 per kg. The activity book uses on average 400 grams (g) of paper for each book, on average 2 times as much weight in paper as each magazine. 2. Printing ink is estimated to cost R62.80 per litre (). The magazine uses 150 millilitres (ml) of printing ink per publication, while each activity book two thirds of the amount of printing ink used for each magazine. uses 3. It is estimated that freelance journalists will be paid at a rate of R3.50 per word. 4. The activity book requires 6 minutes of machine time to produce each book. The machines used to print the activity book owned by OPB and incur are associated operators' variable operating costs of R5.40 per hour. Fixed operating costs with the operation of these machines, which include machine salaries, are included in the fixed manufacturing overheads (referred to 6 below). in point are are 5. The magazine requires 10 minutes of machine time to produce each magazine. Specialised machines used to produce magazines which rented by OPB. The rental paid for the of the specialised machines include fixed monthly base rental and an additional amount that is related to the total hours that the use a are specialised machines used during the month. Rental rates are fixed in terms of the rental agreement and will not increase in the current year. Historic cost information related to the past six months is given below: Specialized machines used to produce magazines Month Hours used Total rental cos September 1 680 R142 324 October 1 700 R143 810 November 1 660 R142 838 December 1 670 R143 081 January 1 630 R142 109 February 1 660 R142 838 These specialised machines have an operating capacity of 2 000 hours per month, taking into account normal stoppages such as downtime for routine maintenance. costs 6. OPB's total fixed manufacturing overheads (excluding the machine rental in point 5 above) are expected to be R4 234 000 for the current year. overheads are made up as follows and relate to (next page): These Overheads Note R Property costs 6.1 598 000 Machine costs 6.2 1 882 000 Salary costs 6.3 898 000 Quality control costs 6.4 642 000 Production setup costs 6.5 214 000 4 234 000 6.1. Property costs relate to the rental paid for the production facilities (factory) as well as associated property maintenance and cleaning. The 40% of the production facility publication of the activity book occupies with the remainder utilised to produce magazines. 6.2. Refer to point 4 above. The salaries of machine operators producing activity books and magazines are included in this figure, which are R685 000 and R545 000 for the two publications respectively. 6.3. The salary costs relate to the salaries expected to be paid to the editor and graphic designer responsible for the magazine. 6.4. Quality control costs are made up of costs incurred by internal quality assurance checks, which account for 65% of these costs, and the costs incurred by external inspections, which account for the rest. Checks internal quality assurance are the same for activity performed for the books and magazines. 6.5. The same production setup cost is incurred regardless of the type of publication. expenses are estimated at R1.20 for each 7. Variable selling and distribution activity book and R1.50 for each magazine. revenue per month from magazines is expected to average 8. Advertising R75 000. 9. Administrative and other non-manufacturing costs, in addition to costs outlined above, are estimated to total R6 552 000 for the current year. These costs include an estimate of bonuses to be paid to senior management of R1 552 000. QUESTIONS 1. For each of OPB's types of books and publications (activity costing system magazines), use the existing to calculate the: 1.1. Total cost per activity book / manufacturing and gross magazine profit per activity book / magazine; 1.2. Total operating profit for activity books and magazines. 2. For each of OPB's types of publications (activity books and magazines), use a more logical and accurate way to allocate the fixed manufacturing overheads to calculate a: 2.1. Revised gross profit per activity book / magazine; 2.2.Revised total operating profit for activity books and magazines. Clearly indicate how you have allocated costs 3. Based on your calculations in parts (a) and (b) and the information provided in the scenario, explain how using OPB's existing absorption costing system to allocate fixed manufacturing overheads could lead to incorrect management decisions. To support your explanation, include a brief discussion on: 3.1. Volume- and non-volume-based cost drivers 3.2. Whether there is potential for OPB to use an activity- based costing system. 4. Based on OPB's the number of expected sales mix, calculate magazines that need to activity books and be produced and sold in the 2022 financial year to break-even. 5. Discuss six key factors, including strategic considerations, that should be considered by OPB's management when deciding whether to discontinue one of its publications. 6. Assuming that demand would line with market change in the selling research around decreasing price of OPB's magazine: 6.1. Perform a financial evaluation of the impact of such a change 6.2. Outline four key considerations that should be considered when deciding whether to by OPB's management implement this change