Chapter 5.A, Problem 7P

Problem 5A-7 Cost Behavior; High-Low Method; Contribution Format Income Statement LO5-10

Morrissey & Brown, Ltd., of Sydney is a merchandising company that is the sole distributor of a product that is increasing in popularity among Australian consumers. The company's income statements for the three most recent months follow:

Morrissey& Brown, Ltd.

Income Statements
For the Three Months Ended September 30

		July	August	September
Sales in units.		4,000	4,500	5,000
Sales		$400,000	$450,000	$500,000
Cost of goods sold		240,000	180,000	200,000
Selling and administrative expenses:
Advertising expenses		21,000	21,000	21,000
Shipping expense		34,000	36,000	38,000
Salaries and commissions		78,000	84,000	90,000
Insurance expense		6,000	6,000	6,000
Depreciation expense		15,000	15,000	1 5,000
Total selling and administrative expenses		154,000	162,000	170,000
Net operating income		$6,000	$18,000	$30,000

Required;

By analyzing the data from the company's income statements, classify each of its expenses (including cost of goods sold) as either variable, fixed, or mixed.

Using the high-low method, separate each mixed expense into variable and fixed elements. Express the variable and fixed portions of each mixed expense in the form Y= a+bX.

Redo the company's income statement at the 5,000-unit level of activity using the contribution format

To determine

High−Low Method: It is one of the methods distribution of cost used to split the mixed cost into fixed cost and variable cost.

1. The classification of expenses into variable, fixed, or mixed from the data given in the income statement.

2. The variable and fixed elements from the mixed expenses using the high-low method.

3. The contribution format income statement at the 5,000 unit level of activity.

Answer to Problem 7P

Solution:

1.

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

2. The total cost equation for shipping expenses is $Y=\text{ \$18,000 }+\text{ \$4*X}$.

The total cost equation for Salaries and Commissions is $Y=\text{ \$30,000 }+\text{ \$12*X}$.

3.

Morrisey & Brown, Ltd Contribution Format Income Statement
Sales		$500,000
Variable expenses:
Cost of goods sold	$300,000
Shipping expenses	$20,000
Salaries and commissions	$60,000
Total variable expenses		$380,000
Contribution margin		$120,000
Fixed expenses:
Advertising expenses	$21,000
Shipping expenses	$18,000
Salaries and commissions	$30,000
Insurance expenses	$6,000
Depreciation expenses	$15,000
Total fixed expenses		$90,000
Net operating income		$30,000

Explanation of Solution

1. If the total amount of any expenses does not changes at different level of sales, it is a fixed expenses and if the total amount of any expenses changes at different level of sales, it is a variable expenses or mixed expenses. The combination of fixed and variable expenses is called a mixed expense.

2.

Applying High-low method to Shipping expenses (Mixed expenses)

	Units	Shipping Expenses
High Activity level	5,000	$38,000
Low Activity level	4,000	$34,000
Change	1,000	$4,000

  $\begin{array}{l}Variableexpensesperunit=\frac{Changeofcost}{Changeinactivity}\hfill \\ =\frac{\$4,000}{1,000units}\hfill \\ =\$4perunit\hfill \end{array}$

  $$

Computation of Fixed cost at highest level of activity

  $\begin{array}{l}\begin{array}{l}Fixedcost=Totalcost–\left(VariablecostperunitXhighestlevelofactivity\right)\\ FixedCost=\$\text{ 38,000 }–\left(\$\text{ 4 X 5,000}\text{units}\right)\end{array}\hfill \\ =\$\text{ 38,000 }–\text{ \$20,000}\hfill \\ =\$18,000\hfill \end{array}$

Applying High-low method to Salaries and commissions expenses (Mixed expenses)

	Units	Shipping Expenses
High Activity level	5,000	$90,000
Lowest Activity level	4,000	$78,000
Change	1,000	$12,000

  $\begin{array}{l}Variableexpensesperunit=\frac{Changeofcost}{Changeinactivity}\hfill \\ =\frac{\$12,000}{1,000units}\hfill \\ =\$12perunit\hfill \end{array}$

Computation of fixed cost at highest level of activity

  $\begin{array}{l}\begin{array}{l}Fixed\text{ C}ost=Totalcost–\left(VariablecostperunitXhighestlevelofactivity\right)\\ FixedCost=\$\text{ 90,000 }–\left(\$\text{12 X 5,000}\text{units}\right)\end{array}\hfill \\ =\$\text{ 90,000 }–\text{ \$60,000}\hfill \\ =\$30,000\hfill \end{array}$

3. The mixed expenses are distributed according to the variable and fixed elements based upon the figures computed by High-low Method. The variable expenses are $4 for shipping expenses and $12 for salaries and commissions. The fixed expenses are $18,000 for shipping expenses and $30,000 for salaries and commissions. The fixed expenses and variable expenses per unit will always remain the same for any level of sale.

Given:

Morrisey & Brown, Ltd. Income Statements For the Three Ended September 30
Sales units	4,000	4,500	5,000
Sales	$400,000	$450,000	$500,000
Cost of goods sold	$240,000	$270,000	$300,000
Gross margin	$160,000	$180,000	$200,000
Selling and administrative expenses:
Advertising expenses	$21,000	$21,000	$21,000
Shipping expenses	$34,000	$36,000	$38,000
Salaries and commissions	$78,000	$84,000	$90,000
Insurance expenses	$6,000	$6,000	$6,000
Depreciation expenses	$15,000	$15,000	$15,000
Total selling and administrative expenses	$154,000	$162,000	$170,000
Net operating income	$6,000	$18,000	$30,000

Conclusion

It is concluded that the Morrisey & Brown, have two mixed expenses which are shipping expenses and salaries expenses. A mixed expense can be identified by finding the change in percentage of the expense. Usually a variable expenses changes according to the change in the sales. So it means that the percentage change in sales will always be equal to percentage change in variable expenses. Hence if the percentage change in an expense is not equal to percentage change in sales, it is known as a mixed expenses.