Pearl Company (25 points)

Pearl SA manufactures a single product called Omega. The company produces annually 60,000
Omegas, sold at €32 per unit. Costs at this level of activity are as follow:

Direct materials €10/unit

Direct labor (variable) €4.5/unit
Variable manufacturing overhead €2.30/unit
Fixed manufacturing overhead €300,000
Variable selling expenses €1.20/unit
Fixed selling expenses €210,000

1. Calculate the full cost per unit if Pearl produces and sells 60,000 Omega. (3 points)

VC per unit = 10 + 4.5 + 2.3 + 1.2 = €18

Total Fixed Costs = €510 000
Fixed cost per unit for a level of activity of 60 000 Omegas = €8.5
Full cost per unit = 18 + 8.5 = €26.5
*Note: Contribution margin = 32 – 18 = €14

2. Assume that Pearl has enough capacity to produce 90,000 Omegas annually without any
increase in fixed manufacturing overhead costs. The company could increase its sales by 25%
above the present 60,000 units, in increasing its fixed selling expenses by €80,000. What would
be the impact of the increase in these fixed costs on Pearl’s profitability? Would you recommend
this action to the company? Why? (7 points)

25 % of current sales volume = 15 000 Omega the company has enough production capacity to
face an increase of 25 % of sales volume. No additional fixed costs.

Comparison of contribution margins:

Current situation:
Profit/loss = €14 x 60 000 – €510 000 = €330 000
With an increase of fixed selling expenses
Profit/loss = €14 x 60 000 x 1.25 – (€510 000 + €80 000) = €460 000

Increasing the fixed costs of the company increases its profit. However, this option is risky
because it increases the level of fixed costs of the company and, hence, its breakeven point. The
risk of not being able to sell the targeted sales level, in the short or long run, becomes higher.

Nevertheless, we can calculate that to compensate these €80 000 additional fixed costs, the
company should sell at least 5 715 Omegas (80 000/14). We are far from the objective of 15 000
Omegas given in the case, which means there is a large safety margin.
3. Assume that Pearl Company has enough capacity to produce 90,000 Omegas annually without
any increase in fixed manufacturing overhead costs. A foreign customer wants to purchase
20,000 Omegas. Pearl would have to pay taxes and import duties (€1.70 per unit), and a license
to operate in this foreign country (€9,000). In addition to the current variable selling expenses of
€1.20 per unit, there are shipping costs of €3.20 per unit. What would be the minimum price to
bill to the foreign customer to break-even on this order? (4 points)

VC per unit of exported Omega: 18 + 1.7 + 3.2 = €22.9

Total VC of the order = 22.9 x 20 000 Omegas = €458 000
Full cost of the order = 458 000 + 9 000 = €467 000
Minimum selling price/unit = € 467 000/20 000 Omegas = €23.35

4. The company has put aside 1,000 Omegas having some irregularities. These products cannot
be sold at regular price, through the usual distribution channels. The company could sell the raw
materials that have been used to produce the irregular Omegas at €4 per unit. Alternatively, it is
possible to sell the whole batch at once on an e-business site which charges a fixed fee of €100
per transaction. What are the relevant costs to calculate the minimum selling price of these
products? Which is the minimum price at which you would sell the batch of 1,000 Omegas on the
e-business site? (6 points)

All the costs which have been generated by the production of the faulty Omegas (fixed costs,
variable costs) are sunk costs. They are not relevant because, whatever option is taken now, they
are not going to impact the result of the company. The only relevant data in this case are the
amount of the fee paid to the on-line platform and the revenues from selling the raw material.

Option “Selling the raw material” à The Company’s profit will be:
€4 x 1 000 Omegas = €4 000

Option “Selling on line” à The Company’s profit will be:

Selling Price of the batch - €100

For the on-line sale to compensate the sale of raw material, the batch should be sold at a
minimum price of 4 000 + 100 = €4 100.

5. Due to a strike in its supplier's plant, Pearl is unable to purchase more material for the
production of Omega. The strike is expected to last for two months. Pearl has enough material
on hand to operate at 30 % of normal levels for the two-month period. As an alternative, Pearl
could close its plant down entirely for the two months. If the plant closes, fixed manufacturing
overhead costs would continue at 60 % of their normal level during the two-month period and
the fixed selling expenses would be reduced by 20 % (assume that the fixed manufacturing and
selling expenses are equally spread over the year). Which option would minimize the impact of
the strike on Pearl’s results for the two-month period? (5 points)

Plant runs at 30%:

Profit = €60 000 X 30 % x 2/12 x €14 - €510 000 x 2/12 = €43 000

Plant is closed:
Costs = €300 000 x 2/12 x 60 % + €210 000 x 2/12 x 80 % = €58 000
Loss = € (58 000)

It is better to have the plant run at 30 %.

 Play’n’Fun (25 marks)

Play’n’Fun SE manufactures two types of gaming consoles, CP50 and R2D4. Historically and to
the present day, the company has allocated manufacturing overhead costs according to the
direct labour hours consumed; the manufacturing overhead costs for the past year were €80,000.
Selling and distribution costs for the year were € 45 000; these are allocated to the gaming
consoles based on the number of units sold. Additional cost information for the past year is
presented below.

Total Direct Labour Units Sold Direct Costs per Selling Price per
Hours Used Unit Unit

CP50 1950 1300 €10 €90

R2D4 450 1500 €30 €60

Recently, the company lost bids on a contract to sell CP50 to a local wholesaler and was informed
that a competitor offered a much lower price. Play’n’Fun’s controller believes that the cost
reports do not accurately reflect the actual manufacturing costs and product profitability for
these gaming consoles. Given the nature of the electronic gaming market, setting competitive
prices is extremely crucial. The controller has decided to try activity-based costing (ABC) and has
gathered the following breakdown of the Manufacturing Overhead Costs:

Costs of Production Runs: €20 000

Material Input (Component) Costs €50 000

Delivery Costs of Materials €10 000

On further inspection, the Controller has suggested that the following activity data might be
relevant.

Number of Set-ups Number of Components Number of Material

Movements
CP50 3 17 15
R2D4 7 33 35

The number of setups, number of components, and number of material movements have been
identified as activity-cost drivers for overhead.
1. Using Play’n’Fun’s current costing system, what is the net Profit of Play’n’Fun for the Year?
Assume no beginning or ending inventory. (10 points)

Q1 Total DLH Used per Units Sold Direct Costs per Selling Price
unit Unit
CP50 1950 1300 €10.00 €90.00
R2D4 450 1500 €30.00 €60.00

Total DLH 2400

Manufacturing OH € 80000
Overhead Rate per 33.33
Labour Hour €

Selling and 45000

Distribution Costs

Allocated Total OH Allocated OH per Total Manfacturing Total Gross Margin Gross Margin per
Unit Cost per Unit unit
65000 50 60 39000 30
15000 10 40 30000 20

Net Profit 24000

2. Using activity-based costing, calculate the Total Manufacturing Cost per unit of CP50 and R2D4,
and the gross margin for CP50 and for R2D4. Assume no beginning or ending inventory. (10
points)

Q2

Number of Number of Number of Material

Set Ups Components Movements
CP50 3 17 15
R2D4 7 33 35
Total Activity Cost € 20000 50000 10000

Total Number of 10 50 50
Cost Drivers
€Cost per Cost 2000 1000 200
Driver
Total OH € OH per unit Total Manu Cost pu
CP50 € 6,000 € 17,000 € 3,000 € 26,000 € 20 € 30
R2D4 € 14,000 € 33,000 € 7,000 € 54,000 € 36 € 66
 CP50 R2D4
Selling Price 90 60
Direct Cost 10 30
Overheads 20 36
Gross Margin pu 60 -6

3. Identify and explain three advantages and three limitations of activity-based costing. Where
appropriate, relate your answer to the results calculated in Questions 1 and 3 above. (5 points)

Advantages:
• Cost accuracy as it reflects actual resources consumed by recognizing that different
products consume different amounts of activities.
• Visibility on actual profitability of products: allows to make sound strategic choice as to
which product should be pushed forward, or stopped, to improve the overall
profitability of the firm.
• ABC provides better visibility on costs by having a lower granularity of cost pools: as a
result you can actually assess the usefulness of the activities in regards with their actual
cost (it gives ground to Activity Based Management)
• Allows sustainable and competitive pricing when we are in a Cost + pricing model,

Disadvantages:
• ABC systems are complex to set up and maintain => cost of running these costing
systems is higher than with traditional method
• ABC costing systems often provide less visibility on Fixed vs Variable costs
• There is not always one obvious cost driver
 Darmor Ltd. (20 points)

Darmor Ltd. has three products, which require the same production facilities. Information about
the production cost for one unit of its products is as follows:

Product: X Y Z
$ $ $
Labor: Skilled 6 9 3
Unskilled 2 4 10
Materials 12 25 14
Other variable costs 3 7 7
Fixed costs 5 10 10

All labor and materials are variable costs. Skilled labor is paid $12 and hour and unskilled labor is
paid $12 an hour. All references to labor costs above are based on basic rates per day. Skilled
labor is scarce, which means the business could sell more than the maximum that it is able to
make of any of the three products.
Product X is sold in a regulated market and the regulators have set a price of $30 per unit for it.

1. State the price that must be charged for products Y and Z, such that the business would find
it equally profitable to make and sell any of the three products.

Contribution per hour of skilled labour of product X is:

$(30 − 6 − 2 − 12 − 3)
= 14
6
(12)
Given the scarcity of skilled labor, if the management is too indifferent between the products,
the contribution per skilled labor hour must be the same. Thus, for product Y the selling price
must be

($(14 x (9/12)) + 9 + 4 +25 + 7) = $55.50

(that is, the contribution plus the variable costs), and for product Z the selling price must be

($(14 x (3/12)) + 3 + 10 +14 +7) = $37.50

2. State the maximum rate of overtime premium that the business would logically be prepared
to pay its skilled workers to work beyond the basic time.
The business could pay up to $26 an hour ($12 + $14) for additional hours of skilled labour. This
is the potential contribution per hour, before taking account of the labour rate of $12 an hour.