Herrestad Company’s Fixed Costs and Budgeting

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Table of Contents

Fixed Costs
Budgeting
References

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.).Management accounting: Concepts, techniques, and controversial issues. Web.

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

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Herrestad Company’s Fixed Costs and Budgeting

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