Open Book Publishers (Pty) Ltd (60 marks)

Overview

Open Book Publishers (Pty) Ltd (“OPB”) was established a number of years ago with
the main goal of “making reading more accessible for all”. OPB’s operations are
based in Cape Town and the company focuses solely on the development and
printing (commonly referred to as ‘production’) of two publications, an activity book
and a magazine, which were developed by OPB and for which the company owns the
copyright.

Activity book

The activity book produced by OPB is a book used in Grade 0 teaching and is sold in
large quantities to government schools at a price of R35.00 per book.

The activity book was developed by OPB in 2014 and has not changed since it was
originally developed. It is also not expected to change anytime soon. The paper used
for the activity book is of an appropriate quality such that it cannot easily be
damaged by young children and has only a few words but lots of pictures.

This activity book is produced in four bulk production runs each year and goes
through internal quality assurance checks and external inspections required by
government. OPB estimates that 1 000 000 activity books will be produced and sold
in the company’s financial year ending 28 February 2022 and that it will be subject
to 40 external inspections during the year, in addition to the standard internal
quality assurance check performed on each production run.

Magazine

OPB’s magazine is produced monthly and focuses on health issues. It has 12

production runs per year, each of which produces 10 000 magazines, i.e. there is 1
production run of 10 000 magazines every month. OPB expects to sell all magazines
produced.

The content for each monthly magazine comes from freelance journalists who are
commissioned to submit articles and are paid per word written. Each monthly
publication averages 14 articles, each of 750 words. Each month’s magazine is
compiled by two full time employees, being an editor and a graphic designer, using
computer software. Following this the final copy is sent for printing.
 Open Book Publishers (Pty) Ltd – question pg. 2

The paper used for the magazine is of average quality. A quality assurance check on
magazines produced is conducted with every production run.

The magazine generates revenue through magazine sales as well as through adverts
that are placed in the magazine. The selling price of each magazine is R29.50.

Management concerns

OPB’s management, specifically the board of directors, have expressed concerns

regarding the performance of the company and are debating whether one of the
publications (the activity book or the magazine) should be discontinued. If one was
discontinued, the company could then focus on its most profitable publication.

Due to these concerns, a market research study was recently commissioned by

OPB’s directors. The research indicated that the demand for the magazine would
increase by 50% if there was a 10% reduction in its selling price.

Cost information

OPB currently uses an absorption costing system, allocating all fixed manufacturing
overheads based on units of production, regardless of the type of publication
produced and / or whether the costs are specific to the publication or not.

The following budgeted information relating to the production and sales of the
activity books and magazines has been prepared for the current financial year in
order to aid in addressing management’s concerns:

1. The paper used for an activity book is expected to cost R38.50 per kilogram
(kg), while the magazine’s paper costs R27.40 per kg. The activity book uses
on average 400 grams (g) of paper for each book, on average 2 times as much
weight in paper as each magazine.

2. Printing ink is estimated to cost R62.80 per litre (l). The magazine uses 150
millilitres (ml) of printing ink per publication, while each activity book uses two
thirds of the amount of printing ink used for each magazine.

3. It is estimated that freelance journalists will be paid at a rate of R3.50 per

word.

Source: Milpark 2021 Intake 1 Test 1

 Open Book Publishers (Pty) Ltd – question pg. 3

4. The activity book requires 6 minutes of machine time to produce each book.
The machines used to print the activity book are owned by OPB and incur
variable operating costs of R5.40 per hour. Fixed operating costs associated
with the operation of these machines, which include machine operators’
salaries, are included in the fixed manufacturing overheads (referred to in point
6 below).

5. The magazine requires 10 minutes of machine time to produce each magazine.

Specialised machines are used to produce magazines which are rented by OPB.
The rental paid for the use of the specialised machines include a fixed monthly
base rental and an additional amount that is related to the total hours that the
specialised machines are used during the month. Rental rates are fixed in
terms of the rental agreement and will not increase in the current year. Historic
cost information related to the past six months is given below:

Specialized machines used to produce magazines

Month Hours used Total rental cost

September 1 680 R142 324

October 1 700 R143 810
November 1 660 R142 838
December 1 670 R143 081
January 1 630 R142 109
February 1 660 R142 838

These specialised machines have an operating capacity of 2 000 hours per

month, taking into account normal stoppages such as downtime for routine
maintenance.

6. OPB’s total fixed manufacturing overheads (excluding the machine rental costs
in point 5 above) are expected to be R4 234 000 for the current year. These
overheads are made up as follows and relate to (next page):

Source: Milpark 2021 Intake 1 Test 1

 Open Book Publishers (Pty) Ltd – question pg. 4

Overheads Note R

Property costs 6.1 598 000

Machine costs 6.2 1 882 000
Salary costs 6.3 898 000
Quality control costs 6.4 642 000
Production setup costs 6.5 214 000
4 234 000

6.1. Property costs relate to the rental paid for the production facilities
(factory) as well as associated property maintenance and cleaning. The
publication of the activity book occupies 40% of the production facility
with the remainder utilised to produce magazines.

6.2. Refer to point 4 above. The salaries of machine operators producing

activity books and magazines are included in this figure, which are
R685 000 and R545 000 for the two publications respectively.

6.3. The salary costs relate to the salaries expected to be paid to the editor
and graphic designer responsible for the magazine.

6.4. Quality control costs are made up of costs incurred by internal quality
assurance checks, which account for 65% of these costs, and the costs
incurred by external inspections, which account for the rest. Checks
performed for the internal quality assurance are the same for activity
books and magazines.

6.5. The same production setup cost is incurred regardless of the type of
publication.

7. Variable selling and distribution expenses are estimated at R1.20 for each
activity book and R1.50 for each magazine.

8. Advertising revenue per month from magazines is expected to average

R75 000.

9. Administrative and other non-manufacturing costs, in addition to costs outlined

above, are estimated to total R6 552 000 for the current year. These costs
include an estimate of bonuses to be paid to senior management of
R1 552 000.

End of scenario

Source: Milpark 2021 Intake 1 Test 1

 Open Book Publishers (Pty) Ltd – question pg. 5

Marks
Required
Sub- Total
total

a. For each of OPB’s types of publications (activity books and

magazines), use the existing costing system to calculate
the:
i. Total manufacturing cost per activity book /
magazine and gross profit per activity book /
magazine; and 10
ii. Total operating profit for activity books and
magazines. 3 13

b. For each of OPB’s types of publications (activity books and

magazines), use a more logical and accurate way to allocate
the fixed manufacturing overheads to calculate a:
i. Revised gross profit per activity book / magazine; and 13
ii. Revised total operating profit for activity books and
magazines. 2

Clearly indicate how you have allocated costs. 15

c. Based on your calculations in parts (a) and (b) and the

information provided in the scenario, explain how using
OPB’s existing absorption costing system to allocate fixed
manufacturing overheads could lead to incorrect
management decisions. To support your explanation, include 9
a brief discussion on:
i. Volume- and non-volume-based cost drivers; and
ii. Whether there is potential for OPB to use an activity-
based costing system. 9

d. Based on OPB’s expected sales mix, calculate the number of

activity books and magazines that need to be produced and
sold in the 2022 financial year to break-even. 8 8

Source: Milpark 2021 Intake 1 Test 1

 Open Book Publishers (Pty) Ltd – question pg. 6

e. Discuss six key factors, including strategic considerations,

that should be considered by OPB’s management when
deciding whether to discontinue one of its publications. 6 6

f. Assuming that demand would change in line with market

research around decreasing the selling price of OPB’s
magazine:
i. Perform a financial evaluation of the impact of such a
change; and 5
ii. Outline four key considerations that should be considered
by OPB’s management when deciding whether to
implement this change. 4 9

TOTAL MARKS 60

Source: Milpark 2021 Intake 1 Test 1