ACCT 311 Week 3 Group Discussion Board Forum 2 Example

Group Discussion Board Forum 2: Process Costing and Cost-Volume-Profit Relationships

ACCT 311 Corporate Accounting, Group Discussion Board Forum 2

Thread by [Student Name]

The brewery, its figures and the classmate are composites; the textbook, Scripture and the peer-reviewed sources cited are real.

A composite craft brewery in Asheville sells about 4,500 barrels of beer a year to bars and grocery stores at an average of $300 a barrel. Today it pays a contract brewer to produce its recipes, which keeps its own fixed costs low. The owners are considering building their own brewhouse, which would cut the cost of each barrel but add substantial fixed costs for equipment, a building lease and two full-time brewers. Chapter 5 gives exactly the tools to compare the two options.

Garrison et al. (2018) define the contribution margin as sales minus variable expenses, the amount available to cover fixed expenses and then to provide profit. Under contract brewing, the variable cost is $210 a barrel, leaving a contribution margin of $90, and fixed costs for the taproom staff and sales team are $180,000, so the break-even point is $180,000 / $90 = 2,000 barrels. With its own brewhouse, the variable cost falls to $120 a barrel and the contribution margin rises to $180, but fixed costs rise to $540,000, so break-even is $540,000 / $180 = 3,000 barrels. Setting the two profit formulas equal, $90 per barrel less $180,000 against $180 per barrel less $540,000, gives an indifference point of 4,000 barrels. Above 4,000 barrels the brewhouse earns more; below it, contract brewing does.

At expected sales of 4,500 barrels, contract brewing earns $225,000 and the brewhouse $270,000. The brewhouse looks better, but the operating multiplier, contribution margin divided by net operating income, tells a different part of the story: $405,000 / $225,000 = 1.8 for contract brewing and $810,000 / $270,000 = 3.0 for the brewhouse. If sales fall 20 percent to 3,600 barrels, contract brewing's profit falls 36 percent to $144,000, while the brewhouse's falls 60 percent to $108,000. The brewhouse is the better bet only if the owners are confident sales will stay comfortably above 4,000 barrels; it is a bet on volume as much as on cost. Its margin of safety at 4,500 barrels is also thinner: 1,500 barrels, or 33 percent, against 2,500 barrels, or 56 percent, for contract brewing.

The finance research agrees that this risk is real. Lev (1974) showed analytically and empirically that, other things equal, firms with higher fixed-cost intensity, meaning lower unit variable costs and higher fixed costs, have higher overall and systematic stock risk, and he suggested that capital budgeting for investments that raise fixed-cost intensity should use a higher cutoff rate. Yet firms often choose the fixed structure anyway. Banker et al. (2014) found that manufacturers facing more uncertain demand chose more rigid cost structures with higher fixed and lower variable costs, because uncertain demand makes very high sales more likely and extra capacity avoids the congestion costs of being unable to meet them. For our brewery, the question is which risk is worse: losing profit in a slow year or losing sales because the contract brewer cannot fit in extra batches during a busy summer.

Proverbs advises preparing work outside and getting the fields ready first, and only then building a house (English Standard Version Bible, 2001/2016, Proverbs 24:27). For the brewery, preparing the field means proving demand before committing to fixed costs. Growing contract volume steadily past 4,000 barrels, and building a margin of safety, would show that the market can carry the brewhouse before the owners take on its fixed costs.

Reply to Rachel

Rachel, your post walked through the weighted-average method for a bottling department, and your equivalent-units calculation made the steps very clear: finished units added to the partly finished work still in the tanks, weighted by its stage of completion, with materials and conversion counted separately because they are added at different points. I think your post and mine actually meet in the brewery. If the owners build their own brewhouse, they will need process costing to find the cost of each barrel, since beer moves continuously through brewing, fermenting and packaging departments.

That matters for my numbers. I assumed a variable cost of $120 a barrel for the brewhouse, but Garrison et al. (2018) note that process costing assigns both direct materials and conversion costs, which include manufacturing overhead, to equivalent units. Some of that overhead, such as the brewers' salaries and depreciation, is fixed, so the unit cost a process costing report shows would be higher than the variable cost CVP needs. If the owners used the full process cost per barrel in a break-even analysis, they would double count fixed costs and understate the brewhouse's contribution margin. Suppose the process costing report shows $165 a barrel because it spreads $45 of fixed brewing overhead over each barrel. Using $165 would shrink the contribution margin from $180 to $135 and push the apparent break-even point up toward 4,000 barrels, which could talk the owners out of a choice that the correct numbers support.

One way to avoid that mistake would be to separate the conversion costs in your equivalent-units schedule into variable and fixed portions, so the same report can serve both product costing and decision making. Do you think the weighted-average method would be accurate enough for that, or would a brewery with large batches in fermentation tanks at month-end need the FIFO method to keep each month's cost per barrel from being blended with the last?

References

Banker, R. D., Byzalov, D., & Plehn-Dujowich, J. M. (2014). Demand uncertainty and cost behavior. The Accounting Review, 89(3), 839-865. https://doi.org/10.2308/accr-50661

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial accounting (16th ed.). McGraw-Hill Education.

Lev, B. (1974). On the association between operating leverage and risk. Journal of Financial and Quantitative Analysis, 9(4), 627-641. https://doi.org/10.2307/2329764