Small Business Management

Supplemental Questions – Module 4: Cost Behaviour

Question 1

The Music Shop sells musical instruments. An income statement for the guitar department for the past
year is as follows:

Sales revenue $6,400,000

Cost of goods sold 3,200,000
Gross margin 3,200,000
Selling expenses $1,600,000
Administrative expenses 800,000
Total operating expenses 2,400,000
Operating income $800,000

The company sold 4,000 guitars during the year. The department’s variable administrative expenses are
25% variable. The remaining administrative expenses are fixed. The only variable selling expense is a
sales commission of 10%. All other variable costs are fixed.

Required:

1. Prepare an income statement for the year using the contribution margin approach.
2. What was the contribution towards fixed costs and profit from each unit sold during the year?
3. If the Music Shop increases its sales volume by 5% next year, what will be the operating income,
assuming all fixed costs remain at the current level?

Question 2

Rupert Inc. is a wholesaler of furnaces. It has noticed considerable fluctuations in its shipping expense
from month to month. The following information shows the total shipping expense and the number of
shipments, by month, for the past seven months:

Units Total Shipping

Month Shipped Expense
January 8 $4,400
February 14 6,200
March 10 5,200
April 4 3,000
May 6 4,400
June 12 6,000
July 16 7,200

Required:

1. Using the high-low method, estimate the cost formula for shipping expense.
Question 3

Renfrew Inc’s total overhead cost at various levels of activity are as follows:

Direct labour- Total overhead

Month hours costs
September 100,000 $582,000
October 80,000 510,600
November 135,000 728,400
December 140,000 724,800

Assume that the overhead cost above consists of utilities, supervisory costs, depreciation and
maintenance. The breakdown of these cost for the month of October is as follows:

Utilities (variable) $156,000

Supervisory salaries and depreciation (all fixed) 180,000
Maintenance (mixed) 174,600
$510,600

The company wants to break down the maintenance cost into its fixed and variable components.

Required:
1. Estimate how much of the $724,800 of overhead in December was maintenance costs.
2. Using the high-low method, estimate a cost formula for maintenance.
3. Determine the cost formula for overhead.
4. If the activity level is expected to be 90,000 hours in the month of January, what is the
estimated overhead cost?
Question 4

You are a financial analyst at Davie Inc, a manufacturing company. You have been concerned about the
maintenance cost for some time and have assembled the following information:

Quarter Machine-hours Maintenance Costs

1 90,000 $282,000
2 110,000 262,000
3 100,000 264,000
4 120,000 240,000
5 85,000 288,000
6 105,000 204,000
7 95,000 258,000
8 115,000 234,000
9 95,000 282,000
10 115,000 228,000
11 105,000 270,000
12 125,000 216,000
13 90,000 283,500
14 112,000 221,800
15 98,000 267,000
16 122,000 235,000
17 89,000 287,500
18 107,000 207,500
19 92,000 257,800
20 118,000 233,400
21 94,000 284,300
22 113,000 221,000
23 103,000 263,500
24 125,500 224,100
25 87,500 279,500
26 111,500 219,500
Required:

1. Determine the cost formula for maintenance costs, using the high low method.
2. Determine the cost formula for maintenance costs, using regression analysis.
3. You believe that the maintenance work may lag the, by one quarter, the level of machine hours.
In other words, the level of machine hours in one quarter will dictate the maintenance cost in
the next quarter. Test your hypothesis using both the high-low method and the regression
analysis.
Question 5

Dunbar Inc manufactures a children’s bicycle. Dunbar currently manufactures the frame. During the last
fiscal year, the company manufactured 30,000 frames at a total cost of $1,800,000. Crown Inc has offered
to supply as many frames as Dunbar needs for $57.00 per frame. Demand for bicycles is cyclical and has
ranged from a low of 27,000 four years ago to a high of 36,000 two years ago. Dunbar anticipates that the
demand for bicycles will be 33,000 in the current fiscal year.

Required:

1. What was the average cost of manufacturing a bicycle in the last fiscal year? Should Dunbar
accept Crown’s offer?
2. Dunbar’s cost analyst uses regression analysis and has determined that the cost formula is as
follows:
Total cost = $864,000 + $30 (volume of bicycle frames)
Using this equation, estimate how much it would cost Dunbar to manufacture 33,000 frames.
Should Dunbar continue to manufacture the bicycle frame, or should it be outsourced to Crown
Inc.?
Question 6

Main Street Catering serves food and beverages at various social events. The business is seasonal, with
the heaviest demand in the summer months and the holiday season. The usual costs associated with an
event are as follows:

Cost per guest

Food and beverage $20.00
Labour (.5 hours *$15.00 per hour) 7.50
Overhead (.5 hours *$20.50 per hour) 10.25
Total cost per guest $37.75

The standard event lasts three hours and the company hires one worker for every six guests, which is 0.5
hours of labour per guest. The workers are hired as needed.

The normal selling price for an event is $50.00 per guest. The company is confident of the food and
beverage cost and the labour cost but is less certain about the estimated cost of the overhead. The rate
is based on the actual overhead costs and actual direct labour hours from the past year. The monthly
information is provided below.

Labour- Overhead
Month hours expense
January 1,500 $48,400
February 1,560 47,620
March 1,800 52,800
April 2,520 56,320
May 2,700 58,960
June 3,300 62.480
July 3,900 65,120
August 4,500 67,750
September 4.200 66,000
October 2,700 59,840
November 1,860 54,560
December 3,900 64,240

The company has received a request to bid on a 200-person event. This event is a high priority event for
the company as many potential future customers will be in attendance.

Required:

1. Estimate the contribution to profit of a standard 200-person catering event if the company
charges the usual price of $50.00 per guest.
2. The company has heard that a competitor has bid $35.00 per guest for the event. The company
does not think they should meet this price because it does not cover the total cost per guest of
$37.75. Do you agree? Provide support for your response.
3. How low could the company price the event (price per guest) and still not lose money on the
event?