Blackheath Manufacturing Company Case

I. CASE SUMMARY

Blackheath Manufacturing Company produces a single product named the Great Heath. The company recently hired a new cost accountant, Lee High, who intends to conduct a new cost analysis over a period of three production weeks. He wanted to better identify the fixed, variable, and semi-variable costs associated with the production of Great Heath. Once these costs were categorized, he determined the cost per unit to break-even. The case shows the assumptions that Lee High made with respect to variable versus fixed costs in determining the cost of goods sold per unit. He was able to develop decision rules for use by the company's owner, Charlton Blackheath, for management decision-making purposes. Based upon Lee High's data, Mr. Blackheath sent a memo that sales could not be less than a $7.00 per unit order and additional sales decision rules for sales representatives on the road with commission and for direct sales with no commission. The case then introduced a series of sales prospects that were accepted or declined based on these decision rules. However, a young file clerk decided to take an under-bid proposal at $5.50 for an order of 100 units of Great Heath based upon her own assumption that such a volume order would be profitable. A subsequent sales cost report was developed by Lee High showing cost per unit based upon his predetermined analysis of costs and including profit per unit. Data showed the file clerk's order generated a subsequent loss because the sales price per unit was too low. Based upon this data, Mr. Blackheath fired the clerk for her error and set a new commission structure based on a re-adjusted unit price of $8.00 aiming to generate a higher profit.

II. POINT OF VIEW

In analyzing the case, the group will be using the point of view of an external cost consultant who will examine the correctness of Mr. Lee High's calculations and decision rules.

III. STATEMENT OF THE PROBLEM

The problem is to check the correctness of Mr. Lee High's cost analysis and the corresponding decision rules and advise if the new commission structure set by the owner, Mr. Charlton Blackheath, is beneficial for the profit of the company.

IV. FRAMEWORK OF ANALYSIS

In determining if Lee High's cost calculations are correct or not, we will gather first the assumptions he made and check if they are proper or not. Then, we will show how Lee High could have calculated the figures he presented and what were the errors in his calculations. Then, we will present the correct cost calculation by first determining how much is the variable cost and how much is the fixed cost. This will allow us to get the contribution margin for each unit sold based on a given sales price and in turn calculate the break-even point. Once we have these figures, we can analyze if the company gained or loss profit from the sales decisions made and determine if the new commission structure set by Mr. Blackheath will help increase profit or not.

V. ANALYSIS

Lee High's calculations were based on several assumptions. First, he assumed that fixed administrative expenses were $781 just because the president told him so. Second, he based the unit cost computation on an assumption of 500 units per week sales. Third, he split the cost of producing the units into average variable and fixed cost to get the unit cost but used only the lump sum of cost of goods sold.

The cost of goods sold on a per unit basis decreases as the no. of units actually sold increase and this is shown in Table 1 in the Appendix. Lee High was not able to understand why this is so because he did not consider the variable and fixed components of the cost of goods sold. Variable cost per unit and total fixed cost remains constant for a given level of production efficiency. If fixed cost is expressed on a per actual unit basis, as the no. of actual units sold increase, the fixed cost per unit decreases. Since cost of goods sold is the sum of the variable cost per unit and fixed cost per unit, if variable cost per unit is constant and fixed cost per unit decreases as the no. of actual units sold increase, then the cost of goods sold per unit should also decrease correspondingly. Thus, as long as the volume of units sold increase accordingly, it appears that Blackheath can sell at a lower price and still have a good profit margin because of the decrease in cost of goods sold per unit.

Lee High used 500 units sold as the standard and got the cost per unit as shown in Figure 1 in the Appendix. He did not take into account the cost fluctuation when the no. of units sold deviate from this standard.

To calculate the variable cost and fixed cost per unit for the cost of goods sold, the production costs should be categorized first. Table 2 in the Appendix shows this.

For mixed costs such as Indirect Labor, Electricity, Other Overhead and Other Expenses, several techniques can be used to split them into variable and fixed components. One way is to use the High-Low technique . Another way is to use graphical method and simple linear regression analysis. We will use both methods to double-check our computation. Lee High could have used any of these methods.

Using the High-Low technique, the variable and fixed components of the Indirect Labor is calculated as follows using data for Week 1 (lowest activity) and Week 3 (highest activity):

Variable Cost per unit of Indirect Labor = ($220 - $180) / (600 - 400) = $0.20 per unit

Fixed Cost of Indirect Labor = $180 - (400 units x $0.20 per unit) = $100

Using graphical method and linear regression analysis, the graph in Figure 2 shows that for Indirect Labor, the variable component is also $0.20 as given by the slope of the trend line and the y-intercept equal to $100 is the fixed component of Indirect Labor. The R-squared is a perfect 1.0, so this linear regression analysis is accurate. The values are exactly the same as what we arrived using the High-Low method so we can conclude that our cost structure and method of computation is accurate.

Table 3 shows the total variable cost and total fixed cost of Indirect Labor for each week. The fixed component of Indirect Labor ($100) is the same for all 3 weeks while the variable component per unit is the same whichever week we choose in our computation. This further proves that production efficiency is at the same level in all three weeks.

Using the same calculation technique used to breakdown the fixed and variable components of Indirect Labor, we can determine