Artisans Shirtcraft Annual and Monthly Financial Statements

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Cases 6-1: Artisans Shirtcraft
Background
Artisans Shirtcraft manufactures and sells hand-painted shirts of original design. Three sisters founded the company in 1992: Cathy, Linda, and Valerie Montgomery. Shirtcraft started out: as a -means of financing a hobby; profits from shirt sales were used to pay the cost of supplies. However, word of the sisters' appealing products spread quickly, eventually creating strong and wide spread demand for Shirtcraft shirts. By 1996, the year of Shirtcraft's incorporation, the company no longer relied on selling at the occasional crafts fair. It now earned almost all of its revenue through sales to upscale boutiques and department stores. Shirtcraft had grown into a legit business, but the hobby mentality remained. The company retained a simple approach that had served it well: Buy quality materials when available at a bargain price and produce their Shirts. At this time, the sisters had a ready market for whatever they could produce.
In 1997, the sisters loosely organized Shirtcraft into three functional areas, each based around a talent at which one of them excelled. Cathy would hunt high and low for the best prices, Linda would oversee the painting of the original designs, and Valerie would sell the shirts and deal with the general annoyances of business administration. No separate departmental financial records were kept.
Demand for Shirtcraft shirts continued to grow. To finance additional production, the company had become increasingly dependent upon debt. By the beginning of the 2000s, bankers had become an integral part of life at Shirtcraft. The sisters were devoting themselves primarily to executive administration, leaving most day-to-day operations to hired managers.
By the end of 2002, more than 75 employees were on the payroll. However, some of Shirtcraft creditors began to get cold feet. Given the sluggish economy, some felt that continued investment in a company such as Shirtcraft would be foolish. In light of the scrutiny under which their industry presently operated, the bankers wondered about the prudence of increased and continued commitment to a company that was virtually devoid of financial controls. The bankers were particularly concerned by Shirtcraft's continuing reliance on the bargain purchase strategy. They thought the company was inevitably vacillate between periods of incurring excessive inventory holding costs for over purchases materials and periods of lost sales due to under purchasing. If Shirtcraft wanted the banks to con long term to a rapidly growing credit line, the sisters would have to demonstrate their willingness to establish organizational structures and controls such as those found in larger companies.
Plan
In April 2003, a plan was established. Three functional areas were organized: purchasing, product and sales and administration. Purchasing and production would be cost centers, each monitored! comparisons of actual costs to budgeted costs. Compensation for key personnel of the cost ceflj would be tied to the results of this comparison. The sisters would officially be employees of the a and administrative department, which would hold final responsibility for all executive and corpc* decisions. Key empl oyees of sales and administration would be judged and compensated based) overall firm profitability.to be
For the 12 months beginning in September 2003, the sisters expected to sell 192,000 shirts at: anj average price of $23 per shirt. Expenses for the sales and administrative department are estimation $750,000 for the year. Interest expenses for the period are estimated at $550,000. Incentive pay to various departments is expected to amount to $75,000 per functional area. Under the plan, all expenses are charged to the individual department that incurs them, except for interest expenses. I and incentive pay. These are treated as corporate profit and loss items. Taxes are expected to be 40 percent of corporate pretax income.
After considerable negotiations between the sisters and the purchasing manager, direct materials costs should average about $7 per shirt if purchases are made based on prai tion department demand aat. Although this approach results in higher direct materials costs than a 1 gain purchase strategy, the demand-based purchase strategy is cheaper when opportunity cost as inventory holding costs and contribution margin forgone due to lost sales are considered. Salaries and other overhead for the purchasing department are expected to amount to $150,000 for the year.
Discussions with the production manager led to estimates that production will use fixed over¬head costing $240,000. Production's variable overhead consists wholly of direct labor. An average of 1 /2 hour of direct labor, at a cost of $6 per hour, is needed for each shirt.
Previously, financial records were kept only on a corporate level. Under the new plan, cost records, both budgeted and actual, will be kept for each department. Of Shirtcraft's sales, 40 percent are expected to occur during September, October, November, and December. Sales are divided equally between months within each group of months. All costs that do not vary with shirt production are di¬vided equally throughout the year. All monthly purchasing and production are based on that month's orders and are assumed to be completely sold during that month. Only negligible inventory is held.
Required:
a. Considering only costs, prepare budgeted annual and monthly financial statements for
purchasing and production. (Assume that production is not responsible for any costs
already Assigned to purchasing.) Prepare an annual budgeted income statement for Artisans
Shirtcraft for the period September 2003 through August 2004. Annual costs for income
statement purposes consist of the following:
Cost of goods sold Administrative expenses Interest Taxes
All salaries and overhead for purchasing and production are treated as product costs and assigned to individual units. Therefore, these costs should be included in Shirtcraft's annual income statement under cost of goods sold.
b. In general terms, consider the changes in Shirtcraft due to growth. How is the company
different from an organizational standpoint? What role do budgeting and cost centers have
in attempting to meet the challenges presented by this growth?
SOURCE: G Hurst.

5-27: University Medical Lab
The University has a medical school that operates a large teaching hospital. Other smaller hosp in the region are independent of University Hospital in the sense that they are owned and operate unaffiliated not-for-profit corporations. University Hospital has a Medical Laboratory Department (MLD) that provides a wide range of medical tests including hematology, biopsies, electron microscopy, immunology, toxicology, virology. Few of the other independent hospitals in the region have the scale to provide the : comprehensive range of tests that MLD provides. Consequently, other hospitals rely on MLD some of their lab For quality assurance and billing purposes, MLD tracks how much time laboratory technician spend on each test performed. Based on these time sheets and the salaries of the technicians. "70 per cent of MLD's lab technician salary expense (direct labor cost) is incurred performing lab technician -patients at University Hospital. The remaining 30 percent of MLD's lab technician direct labor; is incurred performing tests for patients at the other nonaffiliated hospitals. Direct labor cost c of the salaries and benefits of the lab technicians while they are performing test procedures.26
MLD charges other departments at University Hospital the variable cost of performing the test where variable cost is actual direct labor cost of the lab technician (salary and benefits) plus direct materials. Direct materials (laboratory materials, supplies, chemicals, and other consumables) are 40 percent of direct labor. So if the direct labor if a lab technician for a particular test is $120, the University Hospital department requesting the test is charged $168 ($120 + 40% x $120). The reason for charging University Hospital departments requesting lab work only the variable (direct) cost of the tests is to keep the cost of lab work down. The vast majority of patients at University Hospital have HMO or other third-party insurance providers that pay University Hospital providing care to their clients. Before University Hospital can get reimbursed from these third-party providers, the insurance provider must pre approve the treatment plan (including lab tests). If the Hospital does not get permission, the insurance provider might deny the charge. Since insurance providers base their approval decisions to some extent on the estimated cost of the treatment (including lab work), the Hospital wants to reduce the cost of lab tests to encourage the performance of adequate test procedures.
Outside, unaffiliated hospitals are charged 200 percent of the direct cost of performing a test. Therefore, if an outside (unaffiliated) hospital sends a specimen to MLD and requests a test that has a direct labor cost of $120, it is charged $336 ([$120 4- 40% X $120] X 2).
The following table lists the expenses incurred by MLD in the most recent fiscal year.

MEDICAL LABORATORY DEPARTMENT
University Hospital
Expenses
(Most Recent Fiscal Year)
Direct labor $1 ,400,000
Direct materials & supplies 560,000
Fixed overhead cost 900,000

Fixed overhead cost of 5900,000 consists of supervision and administrative costs, occupancy costs, depreciation and leases of equipment, training, and so forth.
Required:
a. Based on the existing pricing arrangements for inside and outside users, prepare an income
statement for MLD for the most recent fiscal year.
b. Given the income statement you prepared in part (a), discuss the financial condition of
MLD and the reasons for MLD's financial condition for the last fiscal year.
c. The manager of MLD believes that University Hospital departments sending specimens to
his department for testing are not paying their fair share of the costs of his department
under the current pricing arrangement. The MLD manager is proposing that inside users of
MLD be charged the full cost that his department incurs to provide testing services (direct
labor plus direct material plus fixed overhead). The manager proposes that since MLD's
fixed costs are $900,000 and the direct labor costs are SI ,400,000, then for every $1 of
direct labor cost in each lab test, that lab test (for inside University Hospital departments)
should be charged S0.6429 ($900,000/51,400,000) of fixed overhead (in addition to the
direct material charge of $0.40 and the direct labor charge of S1). The pricing of lab tests
for outside users will not change. Prepare an income statement for MLD for the most
recent fiscal year assuming the MLD manager's proposal is accepted.
d. Explain briefly why the net income figures computed in parts (a) and (c) differ.
e. Describe the likely consequences for MLD if its manager's suggestion described in
part (c) is implemented.