Profit Analysis of Management Accounting - MyAssignmenthelp.com

Question: Discuss about the Profit Analysis of Management Accounting. Answer: Profit Analysis With regards to revenue, it is apparent that for 20X6, there has been an increase of about 12% on a y-o-y basis. Also, the actual revenue for 20X6 is about 5% higher than the budgeted amount for the same year. This clearly augers well for the company and implies that the revenue performance of the business has exceeded expectations in 20X6. The concerning aspect for the company is with regards to direct expenses in 20X6. Even though on a y-o-y basis, there has been an increase of 12% in the sales, but the increase in wages, transportation costs, cleaning supplies have increased by more than 25% due to which there has been a significant decline in the gross margin. As a result, absolute gross margin in 20X6 is lower than the corresponding figure in 20X5 even though the revenue in 20X6 is higher. Also, all the items under the direct expenses are exhibiting unfavourable variance over their budgeted cost in 20X6 which highlights the higher direct expenses seen in 20X6 are unexpected by the company also. With regards to indirect expenses as well, it is apparent that each of the item has an unfavourable variance which reflects that the actual expenses have exceeded the budgeted expenses. A noticeable unfavourable deviation is with regards to training and administration costs which are higher by more than 10% from the budget estimates. Also, as compared to last year, there has been a 33% increase in the promotional expense which may have been responsible for the rising revenues. Thus, it is apparent that based on exhibit 1, the business should be worried about the unfavourable deviation in expenses (especially in direct expenses) which has led to erosion of profit margins. Costing Analysis It is apparent that the overhead costs comprise of costs related to cleaning supplies, operation manager salaries along with transportation costs. The actual costs for the above items for 20X6 are listed below. Cleaning Supplies (20X6) = $88,541 Transportation Costs (20X6) = $30,281 Salaries of operations managers (20X6) = $120,000 Total overhead costs (20X6) = 88541 + 30281 + 120000 = $238,822 Total direct costs (20X6) = $292,184 Number of hours of direct labour = 292184/13.2 = 22,135.15 Actual overhead rate = 238822/22135.15 = $ 10.79 per direct labour hour However, the overhead rate considered is $ 10 per labour hour. Hence, under the current practice of applying $ 10 per direct labour hour as the overhead rate, the overhead rate is underapplied as the actual overhead rate exceeds the currently applied rate. Based on the regression results summary highlighted in Exhibit 3, it is apparent that there is weak linear relationship between transportation costs and direct labour hours. This is apparent from the R2 value of 0.13697 which implies that changes in direct labour hours are capable of offering explanation to only about 13.7% of the changes in transportation costs. Also, the slope of the regression line does not seem significant as is apparent from the t value of the slope which would lead to a p value in excess of 0.05 (assumed significance level). Thus, it is apparent that direct labour hour is not a reliable estimator of transportation costs. With regards to regression result between cleaning supply costs and labour hours, it is apparent that the linear relationship is strong. This is reflected from the R2 value of 0.6963 which implies that changes in direct labour hours are capable of offering explanation to about 69.63% of the changes cleaning supply costs. Further, this is also supported by the corresponding t stat of the slope which would lead to a p value of lower than 0.05 (assumed significance level). Hence, it would be appropriate to conclude that direct labour hour is a reliable estimator of cleaning supply costs. On the basis of the above, it may be appropriate to conclude that transportation costs should not be linked to direct labour hours which would enable better prediction of the overhead rate. The requisite regression equation for cleaning supplies is as highlighted below. Cleaning supplies cost = 5922. 62 + 0.78922*Direct labour hours Clearly from the above equation, the fixed cleaning supplies cost would be $5,922.62 while the variable supplies cost would amount to $ 0.78922 per direct labour hours. Direct labour hours (20X6) = 22,135.15 (as computed in part a) Hence, cleaning supplies cost = 5922.62 + 0.78922*22135.15 = $23,392. 12 Thus, total overhead costs (20X6) = 23392.12 + 30281 + 120000 = $173,673.1 Thus, revised overhead application rate = 173,673.1/22135.15 = $7.85 per labour hour Therefore, the computation above reflects that the current application rate of $ 10 per direct labour hour is higher than the computed rate above. Hence, there is over-application of the overhead rate based on the above calculations. The derivation of the respective costs based on ABC costing is highlighted below. The breakup of revenue from residential and commercial is in the ratio of 40:60 and the wages and benefits also have to be divided in the same ratio. Based on this understanding a partial operating profit computation and profit margin is as highlighted below. The reasons for difference between the traditional and ABC costing are highlighted below. The ABC costing tends to derive costs based on the respective activities unlike traditional costing whereby overheads costs are linked to direct costs. Since ABC tends to break the overhead cost into various cost drivers, hence it facilitates better allocation of cost. In case of traditional costing, no such basis is available and hence direct cost linkage is the only plausible choice. ABC also allows more appropriate cost allocation across the various divisions or department which is not possible under traditional costing which tends to apply overhead rates at a uniform rate which is clearly incorrect as exhibited above. It is apparent from the above analysis that currently there is an under application of the overhead rate as the actual overhead rate is higher than $ 10 per direct hour that is being applied. Also, the regression analysis has indicated that the direct labour hour is a good indicator for cleaning supplies cost but the same cannot be said for transportation costs. If the cleaning supplies cost are determined using regression, then the current overhead rate would be over applied as the computed rate works out to be lesser than $ 10 per direct labour hour. Also, ABC costing is imperative for determining the actual profit margins of the various segments by ensuring better allocation of overhead costs. Based on this, it is apparent that the residential customer segment seems to be operationally loss making while the commercial customer segment is operationally highly profitable. The revised allocation of direct costs based on ABC is shown below. The revenue is assumed to be divided between commercial and residential in the ratio 60:40 and the wages and benefits for 20X7 would be divided in the same ratio. However, it is noticeable that the wages and benefits for 20X7 would be higher than 20X6 due to increase in rate per hour to $13.46 from $ 13.20. The operating budget for the two customer segments is as highlighted below. It is apparent based on the above computation that for the year 20X7, it is expected that the business would make a loss both from the residential and commercial customers. Owing to increase in various costs and limited increase in revenues, there is continuous decrease in the margins as is apparent from the above computation. As a result, it is imperative that the business should primarily focus on commercial customers and need to also improve the pricing or cut down the costs so as to ensure that the business can produce operational profits. The operating budget for 20X7 in the contribution form is highlighted below. b) The contribution margin based on the above computations arrive at 48.78% and 54.58% for commercial and residential customer segment respectively. Further, the overall fixed costs estimated from operating budget for 20X7 is $498,680. Considering the present sales mix, overall contribution margin = 0.6*48.78 + 0.4*54.58 = 51.10% Let the break even dollar revenues be X 51.10% of X = Fixed cost or $498,680 Hence, X = 498680/0.5110 = $975,890 c) Now a profit margin of 25% is desired It is noteworthy that contribution minus fixed costs is equal to profit. Let the requisite dollar revenues be Y (51.10% of X) - $498,680 = 25% of X Hence, X = 498680/(0.5110-0.25) = $1,910,651 d) From the above it is apparent that the company needs to significantly increase the revenue for the desired profit margin of 25%. Even for breaking even at the operational level, the expected revenues for 20X7 currently estimated would not suffice. As a result, there is no margin of safety for the business. However, the above analysis has been conducted assuming that the company would continue to focus on both the customer segments especially when it is apparent that the residential customer segment is incurring huge losses. Further, there are indirect expenses which can be avoided by focusing exclusively on the commercial clients. Also, it is assumed that there is no incremental efforts on the part of the company to reduce the costs further especially indirect costs. In order to arrive at the price to be charged, it is imperative to estimate the variable costs that would be incurred in serving the given clients. Commercial Client Total area = 1950 m2 A cleaning agent in one hour is able to clean an average area of 50 m2 Hence, direct labour hours required = 1950/50 = 39 hours Benefit and wage per hour (20X7) = $ 13.46 Thus, benefit and wage cost = 13.46*39 = $524.94 Cleaning supplies per m2 (20X7) = 82613/710538 = $ 0.11627 Cleaning supplies cost = 1950*0.11627 = $226.72 Transportation cost per km (20X7) = 33006/54339 = $0.6067 Total annual distance to be covered for serving the client = 50*20 = 1000km Transportation cost = 1000*0.6067 = $606.7 Total variable cost = 524.94 +226.72+606.7 = $1,358.36 Applying a mark-up of 60%, price of a commercial contract = $1,358.36 *1.6 = $2,173 Residential Client Total area = 232 m2 A cleaning agent in one hour is able to clean an average area of 50 m2 Hence, direct labour hours required = 232/50 = 4.64 hours Benefit and wage per hour (20X7) = $ 13.46 Thus, benefit and wage cost = 13.46*4.64= $62.45 Cleaning supplies per m2 (20X7) = 18948/473692 = $ 0.039999 Cleaning supplies cost = 232*0.039999 = $9.28 Transportation cost per km (20X7) = 33006/54339 = $0.6067 Total distance to be covered for serving the client = 25 km Transportation cost = 25*0.6067 = $15.17 Total variable cost = 62.45 +9.28+15.17 = $86.9 Applying a mark-up of 60%, price of a residential contract = $86.9*1.6 = $139