Question

Tom Brady is the relatively new controller of the Body and Bath Division of New Scotland Drugs (NSD). He completed his CPA designation three years earlier (at a major auditing firm in Moncton) and has worked at the Body and Bath Division for the past six months). The move to Halifax was a major decision for Tom, but he is getting used to the climate and the new firm.

The Body and Bath Division (BPD) is located in Halifax, which is also the headquarters of NSD. This location gives NSD excellent access to distribution networks across North America while enjoying very low operating costs. (Wages and occupancy costs in Halifax are 40–60% lower than metropolitan centres like Vancouver or Toronto.)

At the request of the division’s long-time president, Belinda Belichick, Brady developed a proposal for a new product to be called Vital Hair. This product is a cream to be rubbed on the scalp to restore hair growth. The fixed costs associated with the development, production, and marketing of Vital Hair are $25,000,000. The majority of these costs are associated with the human trials needed to get federal health approval for this type of product. Due to the nature of the product, it has to be monitored by a doctor. Each customer will pay a doctor $98 per monthly treatment, of which $68 is paid to NSD. Brady estimates NSD’s variable costs per treatment to be $28.50. Included in this is $9.25 for potential product litigation costs. Brady did some research on this type of product, and while most of the data came from the United States, he noticed that there is an increasing trend in Canada for consumers to take companies to court for the slightest issue with a product.

Belinda Belichick and Brady are scheduled to make a presentation to the NSD executive committee on the expected profitability of Vital Hair. After reading Brady’s report, Belichick called him to her office. Belichick was livid at Brady for including the $9.25 estimate. She argued that it is imperative to get the R&D funds approved (and quickly) and that any number that increases the breakeven point reduces the likelihood of the Vital Hair project being approved. She notes that NSD has had few successful lawsuits against it, in contrast to some recent “horrendous” experiences of competitors with breast implant products. Moreover, she was furious that Brady put the $9.25 amount in writing. “How do we know there will be any litigation problem?” She suggested that Brady redo the report excluding the $9.25 litigation risk cost estimate. “Put it on the whiteboard in the executive committee room, if you insist, but don’t put it in the report sent to the committee before the meeting. You can personally raise the issue at the executive committee meeting and have a full and frank discussion.”

Brady took Belichick’s “advice.” He changed the report’s variable cost to $19.25 per treatment. Although he felt uneasy about the changes, he was comforted by the fact that he would flag the $9.25 amount to the executive committee in his forthcoming oral presentation.

One month later, Belichick walks into Brady’s office. She is in a buoyant mood and announces she has just come back from an executive committee meeting that approved the Vital Hair proposal. Brady asks why he was not invited to the meeting. Belichick says the meeting was held in Toronto, and she decided to save the division money by going alone. She then says to Brady, “It is now time to get behind the new venture and help make it the success the committee and the team members believe it will be.”

Required

1.            What is the breakeven point (in units of monthly treatments) when NSD’s variable costs (a) include the $9.25 estimate and (b) exclude the $9.25 estimate for potential product litigation costs?

2.            Should Brady have excluded the $9.25 estimate in his report to the executive committee of NSD? Explain your answer.

3.            What should Brady do in response to Belichick’s decision to make the presentation on her own? What options does he have? As a CPA what are his responsibilities?

Answer 1

A. 1. The break-even point in economics, business and specifically cost accounting is the point at which total cost and total revenue are equal, i.e. even. There is no net loss or gain, and one has "broken even", though opportunity costs have been paid and capital has received the risk-adjusted, expected return. In short, all costs that must be paid are paid, and there is neither profit nor loss.

Therefore, Total Revenue = Total Costs

Price per unit * No. of units = Total variable cost + Total fixed costs.

Part (a) Let the number of monthly treatments be "X" and assume that the fixed cost of $ 25,000,000 is annual cost and can be spread evenly accross 12 months.

so we have, X * $68 = X * 28.50 + ($25,000,000/12)

X * ($68 - $ 28.50) = $ 2083333.33

X * ($ 39.50) = $ 2083333.33

X = 52,743 (Rounded off)

Therefore NSD has to take 52,743 cases to cover their costs.

(b)

Let the number of monthly treatments be "X" and assume that the fixed cost of $ 25,000,000 is annual cost and can be spread evenly accross 12 months.

so we have, X * $68 = X * 19.25 + ($25,000,000/12)

X * ($68 - $ 19.25) = $ 2083333.33

X * ($ 48.75) = $ 2083333.33

X = 42,735 (Rounded off)

Therefore NSD has to take 42,735 cases to cover their costs.

2. While considering the potential litigation costs in costing of this product we must understand the fact there is a strong possibility that this cost would arise at some point of the life cycle of the product and there are high chances for this as the product's target audience is Canada which easily allows people to drag companies to the court. Also, if consider the concept of life cycle costing, it is evident that we must include all the costs that are bound to incurr during the life cycle of the product. To understand this we must first learn what life cycle costing is:

When seeking to make a profit on a product it is essential that the total revenue arising from the product exceeds total costs, whether these costs are incurred before, during or after the product is produced. This is the concept of life cycle costing, and it is important to realise that target costs can be driven down by attacking any of the costs that relate to any part of a product’s life.

There are four principal lessons to be learned from lifecycle costing:

• All costs should be taken into account when working out the cost of a unit and its profitability.
• Attention to all costs will help to reduce the cost per unit and will help an organisation achieve its target cost.
• Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty costs. More attention to training can machine maintenance costs. More attention to waste disposal during manufacturing can reduce end-of life costs.
• Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in the future because of decisions that have already been made. Costs are incurred only when a resource is used.

Conventional costing records costs only as they are incurred, but recording those costs is different to controlling those costs and performance management depends on cost control, not cost measurement. Hence, we must include the potential litigation costs while costing the product.