Explain Why the Differences in the Two Operating Incomes Arise for Each Year?

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  • Costs included for inventory valuation
  • Calculation of gross margin

 

 

SKU: Fin833456

Managerial Accounting (ACCT116) Project-Spring 2015

Halfords Pty Ltd is well known as one of the best manufacturers of racing bikes. The company offers a range of racing bike products to customers over the world. Halfords use absorption costing approach for pricing manufactured bikes by which products are priced at 120% of product cost. Recently, Halfords is facing business challenges from (inter)-national competitors of bike makers. Due to this competition, Halfords’ activities have declined by 20% in the sold units and 50% in the produced units in 2014 compared to 2013 as shown in the following table:

Exhibit (1): Sold and produced bikes in 2013, 2014

Description 2013 2014
Sold bikes 2,500 2,000
Produced bikes 3,000 1,500

 

This issue fuelled tension within Halfords between Sara Al-Emadi, the Marketing Manager (MM) and Ahmed Almarri, the Financial Controller (FC). The cause of this tension was due to recorded conversation dated back to 2013:

Ahmed Almarri (FC): Yesterday, I had a look at the quotation you offered at $52,500 for N25-order of 500 bikes, and I must admit I got a bit confused. According to the numbers, you offered them quite a deal, I must say. I thought we were supposed to use the pricing guidelines decided upon by the board and I am not sure this will cover full product costs.

Sara Al-Emadi (MM): Yeah, sure . . . but sometimes they seem unrealistic to me especially after having consultation with Naser Saad, the Management Accountants (MA) who was in favour for this deal under what you called it as accountants variable costing approach.

Ahmed Almarri (FC): well, that might be the case for pricing decision, but it’s also important that all of our customers get a fair deal. What would it look like if different customers were offered different prices from our sales representatives?

Sara Al-Emadi (MM): well, each customer is unique. Besides, this particular customer wouldn’t buy from us if we offered a standard price, since they don’t really need our high quality products. However, N-52 order was very good deal which covers all product costs plus $5 as contribution of each bike.

Ahmed Almarri (FC): Fair enough, but we’re not in the business for charity reasons! After all, the guidelines were developed to ensure that we make enough money after covering product cost on each deal.

Sara Al-Emadi (MM): I know, but what’s the alternative? Even you must admit that, given the market situation, it’s far better to take orders which make a positive contribution margin than to just sit here and wait for better ones? I mean . . . if we do what you propose, it may well be that we make no money at all at the end of the day. Besides, this is not the first time we handle orders this way and there have never been any complaints before!

Ahmed Almarri (FC): I am not sure this deal generates positive contribution and I do not know how did you calculate product cost upon which you offered that quotation?

Sara Al-Emadi (MM): you hit the point…product cost is the key argument. Ahmed Almarri (FC): Shall we escalate this matter to Hamad Al-Dosari the

Chief Financial Officer (CFO) to review the pricing policy guidelines?

Urgently, Hamad Al-Dosari (the CFO of Halfords) have called Naser Saad (MA) to collect data and bring it to board meeting, which will include FC and MM, in order to provide overview on sales and costs of bikes. The following table presents product cost and expenses for 2013, 2014:

Description 2013 2014
Manufacturing costs:
Direct raw material cost per bike $50 $50
Required labour hours per bike 5 hours 5 hours
Wage rate per labour hour $6 per hour $6 per hour
Total manufactured overhead cost* $80,000 $80,000
Selling and administrative expenses:
Total Variable selling and admin expenses $12,500 $12,500
Total fixed selling and admin expenses $10,000 $10,000

 

* Approximately 75% of total manufactured overhead cost is variable whereas the rest is fixed costs.

 

Required:

Assuming the role of Naser Saad (MA), please answer the following questions while using Excel sheet when it is applicable:

1. The CFO (Hamad Al-Dosari) has asked you to compute bike cost and selling price (Selling Price is 120% of product cost) under methods suggested by Ahmed Almarri (FC) (absorption costing) and Sara Al-Emadi (MM) (variable costing) for each year.

 

2. The CFO (Hamad Al-Dosari) is coming from non-accounting background and he is seeking your advice regarding the main assumptions underpin variable and absorption costing methods?

 

3. You have been challenged by the MM (Sara Al-Emadi) to explain how net operating income of Halfords would be affected by bike cost and selling price that calculated in requirement (1). Support your explanation by computation for each method / per year.

 

4. Prepare the numerical reconciliation (for each year) to explain the different operating incomes reported under the two costing methods used in requirement (3). Explain why the differences in the two operating incomes arise for each year? Support you explanation by computation.

 

5. Explain how the offered Quotation of Bike N-52 order for 2013 by Ahmad Al-Marri (see the first paragraph of the conversation for details) may result in profit/lose? Show your calculation.

 

6. The CFO (Hamad Al-Dosari) is seeking your advice for applications of variable and absorption costing methods in relation to (a) pricing decision and (b) reporting profit to stakeholders.

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