Colin Drury, Cost & Management Accounting: An Introduction Lynch Printers

Lynch Printers Peter Clarke, University College Dublin

Dermot Lynch is the owner and managing director of a small printing business which carries his name. The company undertakes each printing job according to special instructions received from the customer. The type of printing orders include cards, invitations, small books and even occasional trade magazines. The nature of the printing business virtually ensures that there is no closing stock of finished goods on hand at the end of any accounting period. Work is done according to customer orders received or not at all. Sales and purchase invoices were paid on delivery so that the working capital investment in the company was virtually negligible. According to the financial results for 20x1, the accounting year just ended, Lynch Printers had returned a net loss for the first time in its history. The loss was not of alarming proportions but Lynch wondered what had gone wrong and what he could do about it. Logic suggested that his problems were due to either low prices or excessive costs but this puzzled Lynch since each job was priced to include all costs to which a satisfactory profit margin was added. Moreover costs did not appear to have increased compared with previous years. Lynch Printers has developed over the years a good reputation in the trade for quality work and reliability of delivery. Lynch passionately believed that these two factors were crucial in determining the success of his business. Quotation price was very much of secondary importance. Over the years his customers had continually insisted on good quality work and adherence to agreed delivery dates. For guarantees on these two issues the customer was willing to pay any price within reasonable bounds. Lynch Printers use a system recommended by his trade association to quote a price for each printing job. When the customer specifies the type of work required, Lynch establishes an estimated cost for the job which includes direct and indirect expenses. A fixed percentage (10%) is added to total cost for profit and the final figure is given to the customer as a quotation. The quotation price as far as Lynch is concerned, is not negotiable. Thus there are no special prices for any jobs. Its a take it or leave it situation as far as Lynch is concerned. If accepted by the customer it becomes a fixed price so that any cost overruns are absorbed by the printers and are not passed on to customers. This quotation system has been in operation for several years and Lynch prided himself on his estimating ability. Moreover it was a rare occurrence for a customer not to accept the quoted price. Admittedly, the absence of other printing firms in the locality meant that potential customers were placed at a slight disadvantage when dealing with Lynch. The production process in Lynch Printers was relatively simple. Initially Lynch consulted his production manager about the feasibility of the order including the size and styles of type to be used. Once agreement was reached and the order confirmed by the customer Lynch issued a production order, which included printing instructions, and the material was sent to the composing room, where it was set in type. A galley proof was printed and sent to the copy editor who checked it against the original material. Any errors were marked on the proof which was then sent to the customer for approval. When returned by the customer the appropriate corrections were made and the order was then sent to the pressroom for production. Copies were then printed, bound and packaged for delivery to the customer. The direct expenses of the business consisted of the cost of paper used and actual labour hours worked on each printing job. All other expenses were classified as overhead. Lynch Printers currently employ six individuals in the production process. They work a maximum of 35 hours per week, 48 weeks per year with four weeks holiday entitlements. The annual average cost of

Colin Drury, Cost & Management Accounting: An Introduction Lynch Printers

this typesetting and printing labour is [Euro]18,200 inclusive of employers pension and social welfare contributions. Because of space limitations no more than six typesetters may be employed at any one time. The company has recently introduced the practice of flexitime which has improved work practices enormously and has eliminated the necessity for overtime. For example if an employee takes Monday morning off he will work late some other evening, at no additional cost, to make up lost time. For quotation purposes the total number of labour hours required in typesetting and printing for each job is estimated by Lynch and is priced at actual cost of labour work to be performed. To this computed labour cost a predetermined percentage is added to cover production overhead costs, including non-chargeable labour hours and also administration and delivery costs. EXHIBIT 1 Profit and Loss Account for year ended 31 December, 201 B Sales Direct costs: Cost of paper consumed Wages (directly charged out) Overheads: Consumables (not directly chargeable) Wages (not directly chargeable) General production overheads, administration and delivery Net Profit B 226 900 22 000 90 720 4 400 18 480 72 240

207 840 19 060

The other direct cost is that of paper. It is fairly easy to estimate the amount of paper required for each job since the customer specifies the size of the paper required, e.g. A4 size. In addition the quality of paper to be used is agreed in advance with the customer. Lynch personally discusses such requirements with each customer and offers advice. They normally accept his recommendation and are ultimately more than pleased with the completed product. To the estimated cost of paper used is added a predetermined percentage to cover consumables such as ink and other minor costs incidental to the production process. The predetermined percentages to recover both production overhead and consumables are always set equivalent to the actual percentage relationships between corresponding costs incurred during the previous financial year. In effect last years actual cost performance becomes the budget for the following year. While this basis may compound any inefficiencies within the production process it has the advantage of considerably simplifying the accounting calculations. A summary of the actual results for 20x1 which formed the basis for 20x2 estimates is provided in Exhibit 1. Comparing the 20x1 profit performance with the loss incurred in 20x2, Lynch was even more puzzled especially since there were no cost increases over the two years. He knew, however, that in 20x2 business had fallen measured in terms of chargeable labour hours. In 20x1, 90% of the labour hours worked were charged to specific jobs. However, in 20x2 only 75% of hours worked represented chargeable hours. Even though the volume of trade had dropped no one had been laid off since good typesetters and printers were difficult to recruit and volume might improve in following years.

Colin Drury, Cost & Management Accounting: An Introduction Lynch Printers

The actual general production overheads including administration and delivery costs amounted to B72240 in 20x2. Lynch was not surprised that they were the same as the previous year since they were predominantly fixed in nature. The cost of paper consumed during 20x2 amounted to B19 000. At least it was less than last year, Lynch consoled himself, as was the B3500 incurred on consumables. As always it was necessary to obtain reliable data on what had actually happened during the year in order to analyse the situation, Lynch thought to himself. Once obtained, he could begin to draw conclusions and implications. Even at this preliminary stage Lynch anticipated that this whole basis of pricing policy might be in need of revision for 20x3. Requirement (1) What were the recovery rates used in 20x2 for both consumables and production overhead? Use these rates and other actual data to calculate actual sales for 20x2. (2) What was the amount of the loss for 20x2? Explain how the loss has arisen. Comment critically on Lynchs pricing system. (3) Prepare a statement comparing actual performance in 20x2 from budget. What information content do these variances have? Justify your choice of budget figures.