Part A: Absorption and Marginal Costing

Golden Star Company manufactures and sells a unique product that has been quickly accepted by the consumers. The results of last month s operations are shown below (absorption costing basis):

Sales (10,000 units @ $20)

$200,000

Less: cost of goods sold (10,000 units @ $14)

140,000

Gross margin

60,000

Less: selling and administrative expenses

45,000

Net income

$ 15,000

Variable selling and administrative expenses are $2 per unit. Variable manufacturing costs total $10 per unit, and fixed manufacturing overhead costs total $48,000 per month. There was no beginning inventory. The company produced 12,000 units during the month.

Required:

1- Restate Golden Star s income statement in contribution margin format, using variable costing.

2- Reconcile the variable costing and absorption costing net income figures.

3- State which costing approach is used in published financial statements, and briefly explain the usefulness of the other approach.

4- The easiest way to distinguish between relevant and irrelevant costs is by cost behavior; variable costs are relevant costs and fixed costs are irrelevant costs. Explain why you do or do not agree with this statement and support your answer with suitable example(s).

[Marks (Words): 15(150) + 10(150) + 10(200) + 10(200) = 45(700)]

Part B:Capital Investment Decisions

The management of a New Hotel Group is deciding whether to scrap an old but still serviceable machine bought five years ago to produce fruit pies, and replace it with a newer type of machine. It is expected that the demand for the fruit pies will last for further five years only and will be as follows:

Year

Number of pies

produced and sold

1

70,000

2

50,000

3

40,000

4

30,000

5

25,000

Each machine is capable of meeting these requirements. Data for two machines are as follows:

Existing

Machine

($)

New

Machine

($)

Capital cost

400,000

180,000

Operating cost per unit:

Direct labor

0.70

0.50

Materials

0.70

0.70

Variable overheads

0.40

0.30

Fixed overheads per unit:

Depreciation

0.90

1.10

Allocated costs (75% direct labor)

0.525

0.375

3.225

2.975

The fruit pies are currently sold for $4 per pie. Unit operating costs, fixed overhead costs and selling price are expected to remain constant throughout the five year period.

Required:

a- Using data relating only to the new machine:

1- Calculate the net present value of the new machine. The New Hotel Group expects that its cost of capital will be 8% throughout the period.

2- Calculate the payback period of the new machine.

b- Using present value calculations, determine whether the existing machine should bereplaced by the new machine. Assume that the existing machinery could be sold for$150,000 immediately, if it were replaced.

c- Discuss the nonfinancial factors would you recommend that Hotel Group executives take into consideration regarding this proposal.

d- If the Hotel Group s management is uncertain about the accuracy of the cost savings that have been estimated for this proposal. Explain the actions that they can take to ensure that the estimates of: costs, revenues, and cash flows are not overly optimistic or pessimistic.