Question

Portsmouth Company makes fine colonial reproduction furniture. Upholstered furniture is one of its major product lines and the bottleneck on this production line is time in the upholstery shop. Upholstering is a craft that takes years of experience to master and the demand for upholstered furniture far exceeds the company�s capacity in the upholstering shop. Information concerning three of the company�s upholstered chairs appears below:

Recliner Sofa Love Seat   

Selling Price per unit: $1,400 $1,800 $1,500

Variable Cost Per Unit $800 $1,200 $1,000

Upholstery shop time required 8 hours 10 hours 5 hours

Required:
1. More time could be made available in the upholstery shop by asking the employees who work in this shop to work overtime. Assuming that this extra time would be used to produce sofas, up to how much should the company be willing to pay per hour to keep the upholstery shop open after normal working hours?
2. A small nearby upholstering company has offered to upholster furniture for Portsmouth at a fixed charge of $ 45 per hour. The management of Portsmouth is confident that this upholstering company�s work is high quality and their craftsmen should be able to work about as quickly as Portsmouth�s own craftsmen on the simpler upholstering jobs such as the love seat. Should management accept this offer? Explain.

Answer 1

Concepts and reason

Cost: The concept of cost in management accounting refers to the amount paid or amount sacrificed to obtain something. The value of all the costs will have to be determined in monetary values. There are various types of costs in cost accounting. Therefore, identification of the costs is a significant task in management decision making.

Cost-Volume Profit Analysis: Cost-volume profit analysis is a technique which is used to determine the effect that changes in cost and volume of sales have on the operating income and the net income of the company. This managerial accounting technique is based on certain assumptions, which are:

• All the costs involved can be categorized into two categories, that is fixed cost and variable cost.

• Selling price per unit, variable cost per unit and fixed cost remain constant

• All that is produced is sold.

Fundamentals

Variable expenses: The variable expenses are directly linked to the production process. The variable cost per unit remains constant. The total variable cost variates with the production level or activity level. These are considered direct costs which are relevant for the decision-making process. Direct material per unit, labor cost per unit etc. is the examples of variable expenses.

Fixed expenses: Fixed expenses are one-time expenses. Fixed expenses do not variant with the level of production activity. Fixed expenses incur even when there is no production. Fixed expenses remain constant throughout the production process, irrespective of the level of production activity. Fixed cost per unit variates with production level but total fixed cost remains constant. Depreciation, rent etc. are the examples of fixed expenses.

Contribution Margin: Contribution margin is sales revenue minus the variable expenses. Contribution margin per unit of sales is selling price per unit minus variable expenses per unit. Contribution margin is the amount of money with a company for covering its fixed costs. It is the contribution of company’s revenue towards fixed expenses and net income of the company.

Contribution Margin Ratio: Contribution margin ratio is the ration of contribution margin to net sales revenue. It reflects change in contribution margin with change in revenue from sales.

Net operating income: Net operating income is the net income from sales after covering all variable and fixed expenses.

The amount that the company would be willing to pay per hour to keep the upholstery shop open after normal working hours is calculated below:

Thus, the amount that the company would be willing to pay per hour to keep the upholstery shop open after normal working hours is $60 per hour.

The various calculations required for the purpose of analysis are as follows:

Thus, the offer to upholster chairs for $45 per hour should be accepted.

Ans: Part 1

The amount that the company would be willing to pay per hour to keep the upholstery shop open after normal working hours is $60 per hour.