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Herrestad Company’s Fixed Costs and Budgeting Essay

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Updated: Apr 29th, 2021

Fixed Costs

In order to prepare a segmented income statement for Herrestad Company, it is necessary to focus not only on variable costs but also on fixed costs. It is possible to allocate all fixed costs for manufactured Product A and Product B with the help of the activity-based costing (ABC) method (Martin, n.d.). It is important to concentrate on cost activities and cost drivers to determine the activity rate (Hermanson, Edwards, & Invacevich, 2011). Thus, the fixed manufacturing overhead for two products equals $200,000, and there are 100 production runs for these products. As a result, the cost of one run is $2,000. Fixed selling and administrative costs equal $100,000, and there are 25 sales representatives. As a result, the cost per one sale representative is $4,000. For Product A, the fixed manufacturing overhead is calculated with reference to 65 runs and $2,000/run. For Product B, the fixed manufacturing overhead is $70,000. Table 1 provides a segmented income statement developed for Herrestad Company.

Table 1. A segmented income statement for Herrestad Company.

Arrested Company
Segmented income statement for the period ending Dec. 31, 2015
A B Total
Sales $960,000 $1,080,000 $2,040,000
Variable costs:
Direct material 560,000 240,000 800,000
Direct labor 120,000 360,000 480,000
Overhead 80,000 120,000 200,000
Selling and administrative costs 26,000 54,000 80,000
Total variable costs 786,000 774,000 1,560,000
Contribution margin 174,000 306,000 480,000
Fixed costs:
Fixed manufacturing overhead 130,000 70,000 200,000
Fixed selling and administrative costs 60,000 40,000 100,000
Total fixed costs 190,000 110,000 300,000
Total costs 976,000 884,000 1,860,000
Profit/loss $(16,000) $196,000 $180,000

It is possible to state that Product B contributes significantly to Herrestad Company’s profitability. Thus, in 2015, the company received high profits associated with manufacturing Product B. On the contrary, costs related to manufacturing Product A were not covered by revenues. Furthermore, the number of runs, as well as costs, for Product B is also lower in comparison to Product A.

Budgeting

In order to conclude about the profitability of Product C, it is necessary to develop the cost structure with the focus on amounts and expenses associated with manufacturing a new product (Walther, 2010). Moreover, it is necessary to calculate the contribution margin per unit and compare it to contribution margins for Product A and Product B. Table 2 provides the cost structure for Product C.

Table 2. The cost structure of Product C.

Product C
Units produced 1,000
Units sold 1,000
Selling price per unit 150
Variable costs per unit
Direct material 28
Direct labor 60
Variable overhead 20
Variable selling and administrative expenses 0
Total variable costs per unit 108
Contribution margin per unit $42

The contribution margin per unit is $42 (the selling price after cost deduction). If 1,000 products are sold, it is possible to expect revenues of $47,000. However, the calculated contribution per unit is lower than it is for Product A ($87) and Product B ($51). Therefore, the expected revenues will be comparably low. If Herrestad Company receives only $140 per unit, the contribution margin will become even lower ($32 per unit) (Table 3).

Table 3. The cost structure of Product C ($140/unit).

Product C
Units produced 1,000
Units sold 1,000
Selling price per unit 140
Variable costs per unit
Direct material 28
Direct labor 60
Variable overhead 20
Variable selling and administrative expenses 0
Total variable costs per unit 108
Contribution margin per unit $32

Therefore, the manager in Herrestad Company should not accept the order because of the potential low profitability. Instead of gaining more revenues, it is possible to expect increases in costs that are associated with training human resources for manufacturing the new product. Furthermore, all production processes can be affected, and the expected revenues will not cover non-financial expenses.

References

Hermanson, R. H., Edwards, J. D., & Invacevich, S. D. (2011). Accounting principles: A business perspective. Web.

Martin, J. R. (n.d.). Web.

Walther, L. M. (2010). Principles of accounting: A complete online text. Web.

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