Question

WX Company produced an oil based chemical product which it sells to paint manufacturers.
Because of the unique nature of the chemical product, price is not driven by the market.
In year 2020 with good market condition, it incurred total cost of $412,000 to produce the
chemical. The invested asset is $1,487,500. The cost per unit to manufacture a gallon of the
chemical is presented as belowDirect Labor $2
Direct Material $5
Apart from this, the variable manufacturing overhead is incurred at a rate of 40% of the cost of
direct labor. Assume that 40% of the variable manufacturing cost is indirect labor, 35% of the
variable manufacturing cost is indirect material and the remaining 25% is utilities. Fixed
manufacturing overhead is also incurred.
WX Company decided to price its product to earn a 16% return on its investment, and it has taken
into account the total cost plus the mark up when pricing its chemical product. The market price
of the chemical is $13.3.
In year 2019, it reported that 40,000 gallons of chemical have been produced by WX Company. It
is the company policy to set the production volume of the current year based on the production
volume of the preceding year and the market condition in the current year. If the market condition
of the current year is good, there will be 25% increase in production volume compared with the
preceding year. If the market condition of the current year is bad, there will be 20% decrease in
production volume compared with the preceding year.
In year 2020, WX Company is considering whether it can manufacture the paint itself. If the
company process the chemical further and manufacture the paint by itself (one gallon of chemical
can be further processed into one gallon of paint), the cost of indirect material will increase by
50%, the cost of indirect labor will rise by $0.09, the cost of utilities will remain the same,
additional cost for direct material per gallon is $1.8 and additional cost for direct labor per gallon
is $0.7. It is the company policy that the selling price of paint is driven by the market. If the
company processes the chemical further and manufactures the paint by itself, the invested assets
will increase by 41% and the fixed cost of production will increase by 50% compared with the
original situation that it produced an oil-based chemical product which it sells to paint
manufactures. The market price of the paint product is $16.5.

Required:
(a) Determine the fixed cost per unit (gallon) for the original situation that it produced an oil
based chemical product which it sells to paint manufactures. Show workings.

(b) Determine the net income per gallon for selling chemical. Reconcile the net income per gallon
with the difference between selling price and total cost per gallon. Show workings.

(c) Determine the incremental per gallon increase in net income and the total increase in net
income if the company manufactures the paint (under the same 2020 production volume).

(d) What is the accounting implication if there is high differentiation between the paint products
produced by WX Company and that produced by other competitors? Explain and provide
supporting calculations.

(e) What is the accounting implication if the invested asset amount has been overstated? Explain.

(f) What is the accounting implication if the company has considered the variable cost only
instead of full cost when pricing its chemical product? Explain.

Answer 1

(a) Fixed cost per unit (gallon) for the original situation:

Calculation of Quantity Produced in 2020
Production volume of the previous year (2019) [In Gallons]	(a)	40,000
If the Market condition of the Current year is Good - 25% increase in volume	(b)	25%
Total Production in Gallons	[a*b]	50,000

Calculation of variable cost per unit
Particulars		Per Unit
Direct Labor		$2.00
Direct Material		$5.00
Variable manufacturing overhead is incurred at a rate of 40% of the cost of direct labor ($2*40%)	$0.80
40% of the variable manufacturing cost is indirect labor [$0.80*40%]		$0.32
35% of the variable manufacturing cost is indirect material [$0.80*35%]		$0.28
the remaining 25% is utilities [$0.80*25%]		$0.20
Total Variable cost Per Unit		$7.80

Total Variable Cost
Unit Produced	(a)	50,000
Total Variable cost Per Unit	(b)	$7.80
Total Variable Cost	[a*b]	$3,90,000
Fixed Cost per unit Calculation
Incurred total cost of to produce the chemical in year 2020	(a)	$4,12,000
Total Variable Cost	(b)	$3,90,000
Total Fixed Cost	(c) = [a-b]	$22,000
Unit Produced	(d)	50,000
Fixed Cost per unit Calculation	(c)/(d)	$0.44

(b)

Determine the net income per gallon for selling chemicals.			Per Unit
The market price of the chemical is	(a)		$13.30
Fixed Cost per unit [Refer calculation above)	(b)	$0.44
Variable Cost per unit [Refer calcualtion above)	(c)	$7.80
Total Cost of Production	(d)	[(b)+(c)]	$8.24
Net income per gallon for selling chemicals.	(e)	[(a)-(d)]	$5.06

(c)

Determination of Cost Per Unit for Manufacturing Paint
	Chemical	Addition	Total for Paint
Direct Labor	$2.00	$0.70	$2.70
Direct Material	$5.00	$1.80	$6.80
Variable manufacturing overhead is incurred at a rate of 40% of the cost of direct labor ($2*40%) = $0.80
40% of the variable manufacturing cost is indirect labor [$0.80*40%]	$0.32	$0.09	$0.41
35% of the variable manufacturing cost is indirect material [$0.80*35%]	$0.28	$0.14	$0.42
the remaining 25% is utilities [$0.80*25%]	$0.20	$0.00	$0.20
Total Variable Cost [Sum of above]	$7.80	$2.73	$10.53
Total Fixed Cost	$0.44	$0.22	$0.66
Total Cost of Production per Unit for Manufacturing Paint [Total variable cost+Total Fixed Cost}			$11.19

Determine the net income per gallon for selling Paint			Per Unit
The market price of the Paint is	(a)		$16.50
Total Cost of Production [Refer above]	(b)		$11.19
Net income per gallon for selling Paint	(c)	[(a)-(b)]	$5.31

Incremental per gallon Increase in the net Income			Per Unit
Net income per gallon for selling Paint [Refer above]	(a)		$5.31
Net income per gallon for selling Chemical [Refer above]	(b)		$5.06
Incremental per gallon Increase in the net Income	(c)	[(a)-(b)]	$0.25

Unit Produced	(a)	50,000
Net income per gallon for selling Paint [Refer above]	(b)	$5.31
Net income per gallon for selling Chemical [Refer above]	(c)	$5.06
Net income for selling Paint	(d)= [(a)*(b)]	$2,65,500.00
Net income for selling Chemical	(e) = [(a)*(c)]	$2,53,000.00
Total Increase in net Income	[(d)-(e) ]	$12,500.00

(d)

Calculation of Return on Investment when manufacturing Paint
For producing Chemical	(a)		$14,87,500.00
41% increase in investment for production paint	(b)	[(a)*41%]	$6,09,875.00
For producing Paint [41% increase]	(c)	[(a)-(b)]	$20,97,375.00
Net Income from Sell Paint [Refer above]	(d)		$2,65,500.00
Return on Investment, when manufacturing paint	(e)	[(d)/(c) ]	12.66%

Company return on investment is 12.66%. If there is high differentiation (More than 12.66%) between company and competitor price than company sales will be impacted and it will lead to impairment of investment. Impairment has to be calculated.

(e) If the investment amount is overstated then impairment analysis has to be done and the company needs to account for impairment. For testing impairment, the future cash flow of the investment has to be calculated. First, need to compare with carrying value of the investment based on an undiscounted basis. IF carrying value is higher than future cash flow on an undiscounted basis than in the second stage future cash to be discount and Present value has to be calculated and the differential amount to be taken as an impairment loss.

(f) In determining the selling prince if fixed cost is not considered than company must have sell products at the lower rate and would have incurred losses.