Question

Chanaka Associates prepares architectural drawings to conform to local​ structural-safety codes.

Assume administrative and support costs vary with​ professional-labor costs. Consider each requirement independently.

Its income statement for 2017 is as​ follows:

Revenues			$722,400
Salaries of professional staff	(8,000 hours x $50 per hour)		400,000
Travel			19,000
Administrative and support costs			160,000
Total costs			579,000
Operating income			$143,400

The percentage of time spent by professional staff on various activities​ follows:

Making calculations and preparing drawings for clients	78	%
Checking calculations and drawings	3
Correcting errors found in drawings (not billed to clients)	6
Making changes in response to client requests (billed to clients)	5
Correcting own errors regarding building codes (not billed to clients)	8
Total	100	%

1.	How much of the total costs in 2017 are​ value-added, non-value-added, or in the gray area​ between? Explain your answers briefly. What actions can Chanaka take to reduce its​ costs?
2.	What are the consequences of misclassifying a​ non-value-added cost as a​ value-added cost? When in​ doubt, would you classify a cost as a​ value-added or​ non-value-added cost? Explain briefly.
3.	Suppose Chanaka could eliminate all errors so that it did not need to spend any time making corrections​ and, as a​ result, could proportionately reduce​ professional-labor costs. Calculate Chanaka​'s operating income for 2017.
4.	Now suppose Chanaka could take on as much business as it could​ complete, but it could not add more professional staff. Assume Chanaka could eliminate all errors so that it does not need to spend any time correcting errors. Assume Chanaka could use the time saved to increase revenues proportionately. Assume travel costs will remain at $19,000. Calculate Chanaka's operating income for 2017.

Answer 1

Part 1
	Value Added	Grey area	Nonvalue added	Total
Doing calculations and preparing drawings (400000*78%)	$312,000			$312,000
Checking calculations and drawings (400000*3%)		$12,000		$12,000
Correcting errors found in drawings (400000*6%)			$24,000	$24,000
Making changes in response to client requests (400000*5%)	$20,000			$20,000
Correcting errors to meet government building code (400000*8%)			$32,000	$32,000
Total professional labor costs	$332,000	$12,000	$56,000	$400,000
Administrative and support costs at 40% of professional labor costs(160000/400000)	$132,800	$4,800	$22,400	$160,000
Travel	$19,000			$19,000
Total	$483,800	$16,800	$78,400	$579,000
Associate C has to reduce or decrease the cost of non-value-added activities, which is cost by improving the quality of drawings, Error control and providing proper training to its staff.
Part 2
Misclassifying a known value-added cost as the value-added cost will consequently increase supporting costs and it does not provide value to a customer.
When there is doubt in classification, in such cases costs have to be classified as non-value added cost
Part 3
Calculate operating income if errors are eliminated
Current operating income		$143,400
Cost savings in professional labor costs (8000*(6%+8%)*50)	$56,000
Cost savings in variable administrative and support costs (56000*40%)	$22,400
Add: Total cost savings		$78,400
Operating income in 2017 if errors eliminated		$65,000
Part 4
Revenues		$7,224,000
Add: Incremental revenue due to cost-saving		$65,000
Total revenue		$7,289,000
Professional labor costs	$400,000
Travel	$19,000
Administrative and support costs (400000*40%)	$160,000
Total costs		$579,000
Operating income		$6,710,000