Frankel Ltd., a British merchandising company, is the exclusive distributor of a product that is gaining rapid market acceptance. The company’s revenues and expenses (in British pounds) for the last three months are given below:

Frankel Ltd., a British merchandising company, is the exclusive distributor of a product that is gaining rapid market acceptance. The company’s revenues and expenses (in British pounds) for the last three months are given below:

Frankel Ltd. Comparative Income Statements For the Three Months Ended June 30
		April				May			June
Sales in units		3,000				3,750			4,500
Sales revenue		£ 420, 000				£ 525,000			£ 630,000
Cost of goods sold		168,000				210,000			252,000
Gross margin		252,000				315,000			378,000
Selling and administrative expenses:
Shipping expense		44,000				50,000			56,000
Advertising expense		70,000				70,000			70,000
Salaries and commissions		107,000				125,000			143,000
Insurance expense		9,000				9,000			9,000
Depreciation expense		42,000				42,000			42,000
Total selling and administrative expenses		272,000				296,000			320,000
Net operating income (loss)		£  (20,000)				£  19,000			£  58,000

(Note: Frankel Ltd.’s income statement has been recast in the functional format common in the United States. The British currency is the pound, denoted by £.)

Required:
1.	Identify each of the company’s expenses (including cost of goods sold) as either variable, fixed, or mixed.

Expenses	Classification
Cost of goods sold	Variable
Shipping expense	Mixed
Advertising expense	Fixed
Salaries and commissions	Mixed
Insurance expense	Fixed
Depreciation expense	Fixed

2.	Using the high-low method, separate each mixed expense into variable and fixed elements. State the cost formula for each mixed expense. (Omit the "£" sign in your response.)

     

	Variable Cost		Fixed Cost	Formula
Shipping expense	£	per unit	£	Y = £	+	£  X
Salaries and commissions	£	per unit	£	Y = £	+	£  X

3.	Redo the company’s income statement at the 4,500-unit level of activity using the contribution format. (Input all amounts as positive values except losses which should be indicated by a minus sign. Omit the "£" sign in your response.)

Frankel Ltd. Income Statement For the Month Ended June 30
Sales revenue		£
Variable expenses:
Cost of goods sold	£
Shipping expense
Sales commissions
Contribution margin
Fixed expenses:
Shipping expense
Advertising expense
Sales salaries
Insurance expense
Depreciation expense
Net operating income		£

Explanation: 2. 

Analysis of the mixed expenses:

	Units	Shipping Expense	Salaries and Commissions
High level of activity	4,500	£56,000	£143,000
Low level of activity	3,000	44,000	107,000
Change	1,500	£12,000	£ 36,000

  

Variable cost element:

Variable cost per unit  =	Change in cost
	Change in activity

Shipping expense:	=	£12,000	= £8 per unit
		1,500 units

Salaries and commissions:	£36,000	= £24 per unit
	1,500 units

Fixed cost element:

	Shipping Expense			Salaries and Commissions
Cost at high level of activity	£	56,000		£	143,000
Less variable cost element:
4,500 units × £8 per unit		36,000
4,500 units × £24 per unit					108,000
Fixed cost element	£	20,000		£	35,000

The cost formulas are:

Shipping expense: £20,000 per month plus £8 per unit or

Y = £20,000 + £8X.

Salaries and Commissions: £35,000 per month plus £24 per unit or

Y = £35,000 + £24X.

3.

Cost of goods sold: (4,500 units × £56 per unit) = £252,000

Shipping expense: (4,500 units × £8 per unit) = £36,000

Sales commissions: (4,500 units × £24 per unit) = £108,000

A number of graphs displaying cost behavior patterns are shown below. The vertical axis on each graph represents total cost and the horizontal axis represents the level of activity (volume).

A number of graphs displaying cost behavior patterns are shown below. The vertical axis on each graph represents total cost and the horizontal axis represents the level of activity (volume).

Consider the cost behavior patterns of each of the following situations:
a.	Electricity bill—a flat fixed charge, plus a variable cost after a certain number of kilowatt-hours are used.
b.	City water bill, which is computed as follows:

First 1,000,000 gallons or less	$1,000 flat fee
Next 10,000 gallons	$0.003 per gallon used
Next 10,000 gallons	$0.006 per gallon used
Next 10,000 gallons	$0.009 per gallon used
Etc.	Etc.

c.	Depreciation of equipment, where the amount is computed by the straight-line method. When the depreciation rate was established, it was anticipated that the obsolescence factor would be greater than the wear and tear factor.
d.	Rent on a factory building donated by the city, where the agreement calls for a fixed fee payment unless 200,000 labor-hours or more are worked, in which case no rent need be paid.
e.	Cost of raw materials, where the cost starts at $7.50 per unit and then decreases by 5 cents per unit for each of the first 100 units purchased, after which it remains constant at $2.50 per unit.
f.	Salaries of maintenance workers, where one maintenance worker is needed for every 1,000 hours of machine-hours or less (that is, 0 to 1,000 hours requires one maintenance worker, 1,001 to 2,000 hours requires two maintenance workers, etc.).
g.	Cost of raw material used.
h.	Rent on a factory building donated by the county, where the agreement calls for rent of $100,000 less $1 for each direct labor-hour worked in excess of 200,000 hours, but a minimum rental payment of $20,000 must be paid.
i.	Use of a machine under a lease, where a minimum charge of $1,000 is paid for up to 400 hours of machine time. After 400 hours of machine time, an additional charge of $2 per hour is paid up to a maximum charge of $2,000 per period.

Required:
1.	For each of the above situations, identify the graph that illustrates the cost behavior pattern involved.

Situation	Graph
a.	6
b.	11
c.	1
d.	4
e.	2
f.	10
g.	3
h.	7
i.	9

2.	Would a knowledge of cost behavior patterns such as those above be of help to a manager in analyzing the cost structure of his or her company?
	Yes

Explanation:

2.

Without an understanding of the underlying cost behavior patterns, it would be difficult, if not impossible for a manager to properly analyze the firm's cost structure. The reason is that all costs don't behave in the same way. One cost might move in one direction as a result of a particular action, and another cost might move in an opposite direction. Unless the behavior pattern of each cost is clearly understood, the impact of a firm's activities on its costs will not be known until after the activity has occurred.

The most recent financial statements for Fleury Inc., follow. Interest expense will remain constant; the tax rate and the dividend payout rate will also remain constant. Costs, other expenses, current assets, fixed assets and accounts payable increase spontaneously with sales.

The most recent financial statements for Fleury Inc., follow. Interest expense will remain constant; the tax rate and the dividend payout rate will also remain constant. Costs, other expenses, current assets, fixed assets and accounts payable increase spontaneously with sales.

FLEURY, INC. 2011 Income Statement
Sales				$	755,000
Costs					590,000
Other expenses					11,000
Earnings before interest and taxes				$	154,000
Interest paid					12,000
Taxable income				$	142,000
Taxes (40%)					56,800
Net income				$	85,200
Dividends	$	34,080
Addition to retained earnings		51,120

FLEURY, INC. Balance Sheet as of December 31, 2011
Assets				Liabilities and Owners’ Equity
Current assets				Current liabilities
Cash	$	21,440		Accounts payable	$	55,600
Accounts receivable		33,760		Notes payable		14,800
Inventory		70,720		Total	$	70,400
Total	$	125,920		Long-term debt	$	138,000
				Owners’ equity
Fixed assets				Common stock and paid-in surplus	$	124,000
Net plant and equipment	$	240,000		Retained earnings		33,520
				Total	$	157,520
Total assets	$	365,920		Total liabilities and owners’ equity	$	365,920

  

Complete the pro forma income statements below. (Input all amounts as positive values.)

   

FLEURY INC. Pro Forma Income Statement
	15 % Sales Growth			20 % Sales Growth			25 % Sales Growth
Sales	$			$			$
Costs
Other expenses
EBIT	$			$			$
Interest
Taxable income	$			$			$
Taxes
Net income	$			$			$
Dividends	$			$			$
Add to RE

Calculate the EFN for 15, 20 and 25 percent growth rates. (Negative amount should be indicated by a minus sign.)

	15%	20%	25%
EFN	$	$	$

Explanation:

Taxes 40%
15% Sales Growth	=	$66,040
20% Sales Growth	=	$69,120
25% Sales Growth	=	$72,200

   

We will calculate the EFN for the 15 percent growth rate first. Assuming the payout ratio is constant, the dividends paid will be:

Dividends	=	($34,080 / $85,200)($99,060)
Dividends	=	$39,624

And the addition to retained earnings will be:

Addition to retained earnings	=	$99,060 – 39,624
Addition to retained earnings	=	$59,436

The new retained earnings on the pro forma balance sheet will be:

New retained earnings	=	$33,520 + 59,436
New retained earnings	=	$92,956

The pro forma balance sheet will look like this:

15% Sales Growth:

FLEURY INC. Pro Forma Balance Sheet
Assets				Liabilities and Owners’ Equity
Current assets				Current liabilities
Cash	$	24,656		Accounts payable	$	63,940
Accounts receivable		38,824		Notes payable		14,800
Inventory		81,328		Total	$	78,740
Total	$	144,808		Long-term debt	$	138,000
				Owners’ equity
Fixed assets				Common stock and paid-in surplus	$	124,000
Net plant and equipment		276,000		Retained earnings		92,956
				Total	$	216,956
Total assets	$	420,808		Total liabilities and owners’ equity	$	433,696

So the EFN is:

EFN	=	Total assets – Total liabilities and equity
EFN	=	$420,808 – 433,696
EFN	=	–$-12,888

At a 20 percent growth rate, and assuming the payout ratio is constant, the dividends paid will be:

Dividends	=	($34,080 / $85,200)($103,680)
Dividends	=	$41,472

And the addition to retained earnings will be:

Addition to retained earnings	=	$103,680 – 41,472
Addition to retained earnings	=	$62,208

The new retained earnings on the pro forma balance sheet will be:

New retained earnings	=	$33,520 + 62,208
New retained earnings	=	$95,728

The pro forma balance sheet will look like this:

20% Sales Growth:

FLEURY INC. Pro Forma Balance Sheet
Assets				Liabilities and Owners’ Equity
Current assets				Current liabilities
Cash	$	25,728		Accounts payable	$	66,720
Accounts receivable		40,512		Notes payable		14,800
Inventory		84,864		Total	$	81,520
Total	$	151,104		Long-term debt	$	138,000
				Owners’ equity
Fixed assets				Common stock and paid-in surplus	$	124,000
Net plant and equipment		288,000		Retained earnings		95,728
				Total	$	219,728
Total assets	$	439,104		Total liabilities and owners’ equity	$	439,248

So the EFN is:

EFN	=	Total assets – Total liabilities and equity
EFN	=	$439,104 – 439,248
EFN	=	$-144

At a 25 percent growth rate, and assuming the payout ratio is constant, the dividends paid will be:

Dividends	=	($34,080 / $85,200)($108,300)
Dividends	=	$43,320

And the addition to retained earnings will be:

Addition to retained earnings	=	$108,300 – 43,320
Addition to retained earnings	=	$64,980

The new retained earnings on the pro forma balance sheet will be:

New retained earnings	=	$33,520 + 64,980
New retained earnings	=	$98,500

The pro forma balance sheet will look like this:

25% Sales Growth:

FLEURY INC. Pro Forma Balance Sheet
Assets				Liabilities and Owners’ Equity
Current assets				Current liabilities
Cash	$	26,800		Accounts payable	$	69,500
Accounts receivable		42,200		Notes payable		14,800
Inventory		88,400		Total	$	84,300
Total	$	157,400		Long-term debt	$	138,000
				Owners’ equity
Fixed assets				Common stock and paid-in surplus	$	124,000
Net plant and equipment		300,000		Retained earnings		98,500
				Total	$	222,500
Total assets	$	457,400		Total liabilities and owners’ equity	$	444,800

So the EFN is:

EFN	=	Total assets – Total liabilities and equity
EFN	=	$457,400 – 444,800
EFN	=	$12,600