Professional stage Knowledge Level: Management Information

Chapter 1 Fundamentals of costing

Problems and solutions

Problem 1 (High –Low method):

A company has recorded the following costs over the last six months
Month Total cost Units produced
£
1 74,000 3,000
2 72,750 1,750
3 73,250 2,000
4 75,000 2,500
5 69,500 1,500
6 72,750 2,000
Using the high-low method, which of the following represents the total cost equation?
A. Total cost = 61,250 + (1.25 x quantity)
B. Total cost = 65,000 + (3 x quantity)
C. Total cost = 65,000 + (1.25 x quantity)
D. Total cost = 61,250 + (3 x quantity)

Answer: B

Total cost = 65,000 + (3 x quantity) £

Highest production 3,000 units 74,000
Lowest production 1,500 units 69,500
1,500 4,500

Variable cost per unit = £4,500/1,500 = £3 per unit

Total cost = fixed cost + (£3 x quantity)
£74,000 = fixed cost + (£3 x 3,000)
Fixed cost = £74,000 - £9,000
= £65,000

Problem 2 (High-low method):

The high-low method of cost estimation is useful for:

A. Calculating the budgeted cost for the actual activity

B. Calculating the highest and lowest costs in the budget period
C. Measuring the actual cost for the budgeted activity
D. Predicting the range of costs expected in the budget period
Answer: A

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Professional stage Knowledge Level: Management Information
Chapter 1 Fundamentals of costing

The high-low method of cost estimation is a method of linear extrapolation or interpolation between
two actual data points. It is a method for flexing a budget by calculating the budgeted cost for the actual
activity.
The high-low method uses the highest and lowest costs in the budget period for the extrapolation process
itself. The measurement of actual cost for the budgeted activity is irrelevant. The high-low method
estimates a single cost at a certain level of activity and not a range of costs.

Problem 3 (Cost estimation)

A company's telephone bill consists of two parts:

1. A charge of £40 per month for line rental
2. A charge of £0.01 per minute of call time.

Which of the following equations describes the total annual telephone cost, C if the company
uses T minutes of call time in a year?
A. C = 480 + 0.01T
B. C = 40 + 0.01T
C. C = 480 + 0.12T
D. C = 40 + 0.01T/12
Answer: A

Problem 4: Estimating a cost function. (High and Low method)

Laurie Daley is examining customer-service costs in the southern region of Capitol Products.
Capitol Products has more than 200 separate electrical products that are sold with a six-month
guarantee of full repair or replacement with a new product. When a product is returned by a
customer, a service report is prepared. This service report includes details of the problem and
the time and cost of resolving the problem. Weekly data for the most recent 8-week period are
as follows:

1. What is the relationship between customer-service costs and number of service reports. Is the
relationship economically plausible?
2. Use the high-low method to compute the cost function, relating customer-service costs to the number
of service reports.
3. What variables, in addition to number of service reports, might be cost drivers of weekly customer
service costs of Capitol Products?

Answer:
Estimating a cost function, high-low method.
1. There is a positive relationship between the number of service reports (a cost driver) and the
customer-service department costs. This relationship is economically plausible.

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Professional stage Knowledge Level: Management Information
Chapter 1 Fundamentals of costing

2.
Calculation of fixed cost:
Customer-
Number of Service
Particulars
Service Reports Department
Costs
Highest observation of cost driver
455 21,900
Lowest observation of cost driver 115 13,000
Difference 340 8,900

8,900
Variable cost per number of service reports: = $26.18
340

Calculation of fixed cost:

Customer-
Number of Service
Particulars
Service Reports Department
Costs
Total cost 455 21,900
Variable cost 455 11,910
Fixed cost 9,990

Cost function:
Customer-service department costs = C + b(number of service reports)

= 9990 + $26.18 * number of service reports

3. Other possible cost drivers of customer-service department costs are:
a. Number of products replaced with a new product (and the dollar value of the new products
charged to the customer-service department).
b. Number of products repaired and the time and cost of repairs.
Problem 5

Opportunity cost
Luzon Fabricators, Inc. estimates that 60,000 special components will be used in the
manufacture of a specialty steel window for the whole next year. Its supplier quoted a price of
P60 per component. Luzon prefers to purchase 5,000 units per month, but its supplier could
not guarantee this delivery schedule. In order to ensure availability of these components, Luzon
is considering the purchase of all the 60,000 units at the beginning of the year.

Assuming Luzon can invest cash at 8%, the company’s opportunity cost of purchasing all the
60,000 units at the beginning of the year is

A. P132,000 B. P150,000 C. P144,000 D. P264,000

Answer: A

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Professional stage Knowledge Level: Management Information
Chapter 1 Fundamentals of costing

Problem 6

Opportunity costs are -

A. Costs that increase due to a higher volume of activity or the performance of an
additional
B. activity
C. Costs that a company must incur to perform an activity at a given level, but will not
be
D. incurred if a company reduces or discontinues the activity
E. The profits that a company forgoes by following a particular course of action
F. Costs that were incurred prior to making a decision
Answer: E
Problem 7
In a make-or-buy decision, which of the following is true?
A. Variable costs are the only relevant costs.
B. Allocated fixed costs are relevant.
C. Alternative uses of space and machinery are relevant.
D. Making the product is the correct decision when there is idle capacity.

Answer: C

Problem 8
The opportunity cost of making a component part in a factory with excess capacity for which
there is no alternative use is
A. the total manufacturing cost of the component.
B. the total variable cost of the component.
C. the fixed manufacturing cost of the component.
D. zero.

Answer: D
Problem 9
The cost of not receiving rent from a space because you decide to make the part rather than
buying it from an outside supplier is considered a(an)
A. sunk cost C. opportunity cost
B. future cost D. fixed cost

Answer: C

Problem 10
An opportunity cost commonly associated with a special order is
A. the contribution margin on lost sales
B. the variable costs of the order
C. additional fixed cost that is related to the increased output
D. any of the above

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Professional stage Knowledge Level: Management Information
Chapter 1 Fundamentals of costing

Answer: A

Problem 11
Operating at or near full capacity will require a firm considering a special order to recognize
the:
A. opportunity cost arising from lost sales
B. value of full employment
C. time value of money
D. need for good management

Answer: A

Problem 12:
Baxter Corporation is working at full production capacity producing 10,000 units of a unique product,
JKL. Manufacturing costs per unit for JKL follow:

Direct material $2
Direct manufacturing labor 3
Manufacturing overhead 5
$10

The unit manufacturing overhead cost is based on a variable cost per unit of $2 and fixed costs of
$30,000 (at full capacity of 10,000 units). The non-manufacturing costs, all variable, are $4 per unit,
and the selling price is $20 per unit. A customer, Jacksonville Company, has asked Baxter to produce
2,000 units of a modification of JKL to be called RST. RST would require the same manufacturing
processes as JKL. Jacksonville Company has offered to share equally the non-manufacturing costs with
Baxter. RST will sell at $15 per unit.
Required:
a. What is the opportunity cost to Baxter of producing the 2,000 units of RST (assume that no
overtime is worked)?
b. The Graves Company has offered to produce 2,000 units of JKL for Brown, so
Brown can accept the Jacksonville offer. Graves Company would charge Baxter $14
per unit for the JKL. Should Baxter accept the Graves Company offer?
c. Suppose Baxter had been working at less than full capacity producing 8,000 units of JKL at the
time the RST offer was made. What is the minimum price Baxter should accept for RST under
these conditions (ignoring the $15 price mentioned previously)?
Answer:
a. JKL
Particulars
Sales price $20
Variable cost ($2 + $3 + $2 + $4) -11

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Professional stage Knowledge Level: Management Information
Chapter 1 Fundamentals of costing

Contribution margin $9

For 2,000 units $18,000

RST
Particulars
Sales price $15
Variable cost ($2 + $3 + $2 + $2) (9)
Contribution margin $6

For 2,000 units $12,000

Opportunity cost $6,000

b. Make ($15 - $2,000 without giving up any current production = DO IT.

c. The variable cost to make and sell = $11 ($2 + $3 + $2 + $4) would be the minimum.
Any price over $11 would increase the contribution margin.

Problem 13
The master budget for Serse Ltd, a single-product firm, for the current year is as follows:
£
Sales 480,000
Variable materials (20,000 tonnes at £10 per tonne) 200,000
Variable labour 96,000
Variable overhead 48,000
Fixed overhead 72,000
Total cost (416,000)
Budgeted net profit 64,000

Serse Ltd has substantial excess production capacity. A sales enquiry has been received, late in the year,
which will increase sales and production for the year by 25% over budget.

The extra requirement for 5,000 tonnes of material will enable the firm to purchase 7,000 tonnes at a
discount of 5% on its normal buying price. The additional 2,000 tonnes will be used to complete the
year’s budgeted production.

What price should Serse Ltd charge for the special order in order to earn the same budgeted net profit
for the year of £64,000?

A. £83,500
B. £100,500
C. £82,500
D. £101,500

Answer: C
The total sales will use 25,000 tonnes of material, at a cost of:
(18,000 × £10) + (7,000 × £10 × 95%)

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Professional stage Knowledge Level: Management Information
Chapter 1 Fundamentals of costing

= (£180,000) + (£70,000 × 95%)

= £246,500

The variable labour and overhead cost for this level of production would increase to:
(£96,000 + £48,000) × 125% = £144,000 × 125% = £180,000

The fixed costs remain at £72,000

Total costs are therefore (£246,500 + £180,000 + £72,000) = £498,500

The requirement is to earn the same budget profit of £64,000. This means the total required sales income
will be (£498,500 + £64,000) = £562,500.

The sales revenue without the extra order is £480,000 and therefore the revenue to be generated from
the extra order is (£562,500 – £480,000) = £82,500.

Problem 14

Within decentralised organisations there may be cost centres, investment centres and profit
centres. Which of the following statements is true?

A. Cost centres have a higher degree of autonomy than profit centres

B. Investment centres have the highest degree of autonomy and cost centres have the lowest
C. Investment centres have the lowest degree of autonomy
D. Profit centres have the highest degree of autonomy and cost centres have the lowest

Answer: B
Cost centres have the lowest degree of autonomy with managers only able to control costs. Profit centres
have a higher degree of autonomy as managers can not only control costs but can also control sales
prices and revenue. Investment centres have the highest degree of autonomy as managers can not only
control costs and revenues but can also make investment decisions not open to managers in either of
the other two centres.

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