UVA-C-2198

Rev. Jun. 15, 2009

BLACKHEATH MANUFACTURING COMPANY—REVISITED

Part 1

Mr. Blackheath had promoted Lee High to vice president of finance. Lee had practically
been running the firm for several years, during which time sales and profit had been declining.
On November 15, Mr. Blackheath announced that his son, Trafalgar Blackheath, would take over
as owner and president on January 1. Trafalgar was a graduate of an MBA program, and for
several years had been working for a large consulting firm as a marketing specialist. In their
private discussions, Mr. Blackheath told his son that the problems in the family firm were
marketing rather than financial, so the situation was ready-made for Trafalgar. Mr. Blackheath, it
seems, had been completely taken by Lee High.

When Trafalgar arrived on December 1 and began to read various internal reports, he
realized Blackheath Manufacturing did not have a cash budget, and there didn’t seem to be much
in the way of financial planning. Trafalgar asked Lee about this. Lee’s response was that
Blackheath Manufacturing ran on the basis of several well-developed decision rules, and budgets
weren’t necessary because if the firm ever ran out of funds, Mr. Blackheath simply deposited
$10,000 or $20,000 in the bank. Trafalgar’s response was clear: “My father is a millionaire, but I
am not!’ Lee indicated he didn’t know much about budgeting, but he would get an assistant to
work up some “stuff.”

Trafalgar decided to call his old friend Crofton Brockley. Brockley was in charge of
several large budgeting projects for a consulting firm, and Trafalgar knew Crofton to be a
recognized expert on budgeting for small companies. Fortunately for Trafalgar, Brockley wasn’t
busy that week and was able to fly down the next day.

Crofton spent two days going over the accounting records, interoffice memos, and
everything else he could find. On Friday morning, Trafalgar found the following note on
his desk:

This case was prepared by Professor Francis J. Spreng of McKendree College. It was written as a basis for class
discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 2004
by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies,
send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a
retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical,
photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 6/09. ◊
 -2- UVA-C-2198

Dear Trafalgar:
Had to leave last night for Pittsburgh. During the two days I spent in the
office, I discovered:
1. You have no budget or control system at all.
2. Lee High’s decision rules are all wrong.
3. High doesn’t know the first thing about finance, budgeting, or manufacturing.
Will be back on Monday morning to talk to you. By the way, if you can find
Adelaide Ladywell, I would like to speak to her.
Your friend,
Crofton

Trafalgar was perplexed by the note but decided he had better find out who this Ladywell
was. Lee told Trafalgar that Adelaide was a file clerk who had been fired a couple of years ago
because she refused to follow company policy. Trafalgar asked Lee if he could find Adelaide.
Lee said that he heard she was working for some firm in town and would find out where.

Eventually, Trafalgar found Adelaide working as a bookkeeper for Maze Woolwich.

During a phone conversation Adelaide explained about her being fired by Mr. Blackheath. She
went on to explain that after she got fired, she went to see Mr. Woolwich. Apparently, Woolwich
realized that Adelaide was right, and that Lee High and Mr. Blackheath were wrong. Adelaide
went on to say that Mr. Woolwich felt bad about her getting fired. Woolwich had intended to
retire but decided to hire Ms. Ladywell as a bookkeeper. Adelaide had been working for
Woolwich ever since.

Shortly after Trafalgar finished talking to Adelaide, Crofton entered the office. With his
usual efficiency, he made the following points:

• “We had better get a budgeting system immediately and try to see where we are. (Any
complex cost accounting would have to wait.)”
• “Lee has got to go.”
• “We must decide on how to get a budgeting system put together quickly because
Blackheath’s might be broken.”

Crofton concluded by asking, “Did you find Adelaide Ladywell? She is the only person
around here in the last three years who did anything right, and she got fired.”

Trafalgar indicated that Ms. Ladywell was going to stop by after work and talk to them.
Crofton then suggested Trafalgar fire Lee High and try to rehire Adelaide as the
bookkeeper/analyst. That afternoon, Lee was fired, given two months pay, and asked to leave the
office by 3:00 p.m.. The same evening, Adelaide agreed to work for Trafalgar on the condition
 -3- UVA-C-2198

she would not have to deal with either the older Mr. Blackheath or Lee High. Trafalgar explained
that Lee was already gone, and his father had left for Florida several days previously.

Adelaide agreed to be at work the following Monday morning. She indicated that Mr.
Woolwich was all but out of business and no longer needed her services.

Part 2

After Lee High had left the office, Crofton Brockley went through all the available
records and files and, as a result, was able to establish the following information as a basis to
begin the budgeting process.

Items about which Lee High seemed to be correct

Variable Direct Costs

Direct materials cost per unit $0 .75
Direct labor cost per unit l.25
Total $2.00

Variable Overhead
Indirect labor cost per unit $ 0.20
Electricity cost per unit 0.10
Other overhead per unit produced 0.50
Total $ .80

Fixed Costs
Indirect labor per week $100
Indirect materials per week 300
Electricity per week 75
Factory insurance per week 125
Other overhead per week 110
Total $710

The office expenses are very close to $781 per week. Of this amount, the breakdown
seemed to be

Salaries (including fringe benefits and payroll tax) $400

Rent on office 200
Depreciation on office equipment 81
Utilities 100
Total $781
 -4- UVA-C-2198

Direct labor was paid on a piece-rate (or “piecework”) basis. Workers were paid $1.25
per unit produced.

Average rate of accounts receivable collection was as follows:

During the month in which sale is made 30%

1st month after sale 40%
2nd month after sale 20%
3rd month after sale 10%
100%

Several other notations made by Crofton Brockley

(a) Trafalgar expected to draw $1,400 per month for personal use.
(b) Consulting fees will be billed at about $225 per week or $900 per month.
(c) A reasonable estimation of the value of factory and equipment is $70,000. Depreciation
should be monthly on the basis of an average useful life of five years. This equipment
will have a salvage value of $2,500.
(d) The production process to produce the Great Heath is fairly simple. Raw materials consist
of a single item, which is usually entered into the process in the morning. Various
machining operations take place during the day. At the end of each day, all the finished
units are moved into the storeroom. Because started units are always finished before the
workers go home, there is never a work-in-process inventory overnight.
(e) Assume that this coming year’s net income will be relatively low and, therefore, compute
income tax on the basis of 25% of net income. Taxes will be paid quarterly at the end of
the last day of the quarter.
(f) The inventory of raw materials at the beginning of the coming year will be 800 units, and
there will be 750 units of finished product.

General guidelines set by Crofton Brockley

These guidelines should be followed through the year, at which time they are to be
reviewed and revised.

(a) The estimates of variable costs of production are almost certainly correct.
(b) Fixed costs of production are almost certainly correct at $710 per week, except that there
is no estimation or allowance for depreciation. Take fixed cost of production to equal
$710 plus depreciation.
(c) Charge fixed factory overhead on a monthly basis. Since the $710 per week amount
seems reasonable, charge a monthly amount of $710 times 4.5. The over- or underapplied
 -5- UVA-C-2198

overhead existing at the end of a month will be charged as part of that month’s cost of
goods sold.
(d) Establish cost accounting records on the basis of full cost, assuming that normal output is
500 units per week, or 2,250 units per month. Thus, budgeted full cost is $4.72 per unit.
(e) Selling commission should be 10% on all sales, and the price on regular sales should be
set at $7.00 per unit for at least the first quarter of the year.
(f) All depreciation should be on a straight-line basis.

Following is an estimation of the balance sheet as it will appear on January 1, when

Trafalgar Blackheath takes complete control of the business:

Cash $10,000 Accounts payable $ 1,275

Receivables 14,700 Notes payable 30,000
Raw material inventory 600 Capital: Trafalgar Blackheath 85,687
Finished goods inventory
($4.72/unit) 3,540 $116,962
Office equipment 13,122
Factory equipment 70,000
Land 5,000

$116,962

Required

1. Production Budget

Adelaide’s first important step in budgeting was to develop a production budget and a
raw materials schedule for the first quarter of the coming year. Actual sales for the prior October
and November were available, and reasonable estimates of sales for December and the first four
months of the coming year were made.

Actual sales (units) Expected sales (units)

October 1,500 December 1,800
November 2,300 January (of the coming year) 2,000
February (of the coming year) 2,200
March (of the coming year) 1,900
April (of the coming year) 2,100

Since there was no established policy on production scheduling, inventory planning, or

raw materials inventory, it was necessary to establish one. Crofton, Trafalgar, and Adelaide
agreed that a policy based on experience would have to wait until some data were collected over
 -6- UVA-C-2198

the next six to eight months. In an effort to “get things going,” they settled on a two-part
operational statement of policy:

(a) Production in any month should be scheduled so that an ending inventory of Great
Heaths will equal one-half of the next month’s expected sales.
(b) Purchase of raw material should be made so that on average there is enough raw
material on hand to produce 700 Great Heaths. Thus, no end-of-month inventory
should have fewer than 700 units of raw material.

Prepare a production schedule, schedule of raw material use, and a schedule of raw
material purchases for January, February, and March.

2. Cost of Production and Flexible Budget

Adelaide’s next task was to prepare a flexible budget that could later be used to prepare a
budgeted income statement and would also help Trafalgar tell whether actual expenditures were
as they should be. She decided to use the format shown in the variable budget table below. On
the left she would write in the cost formula, which would show how much should be spent on
each item for any given production volume. Then she would fill in the amounts for the volume of
production she had projected for the first three months of the coming year.

Projected number of units produced January February March

Cost Formula Cost Item

Materials used
Direct labor
Indirect labor
Electricity
Indirect materials
Factory insurance
Other overhead
Depreciation
Total cost
Cost per unit

3. Income Statements

Having developed the data in assignments 1 and 2, Adelaide decided to project

income statements for January, February, and March.
 -7- UVA-C-2198

4. Cash Budgets

After developing the income statements, Adelaide decided to see what would happen to
the cash position of Blackheath during the quarter. When Mr. Blackheath actually turns
the business over to Trafalgar, Mr. Blackheath will withdraw all cash. All receivables
will be due to Trafalgar, and all payables will be his responsibility. Trafalgar expects to
pay $30,000 for the business, which will be a liability of the business, and he intends to
deposit $10,000 in the firm’s checking account to establish a working balance.

• Raw materials are always purchased on a 30-day-due basis. Consequently, payments

are always made in the month following the purchase of materials.
• It is expected that 1,700 units of materials will be purchased during the December
prior to the coming year.
• Direct labor, all overhead, commissions, salaries, rent, and utilities are paid in the
month incurred.

5. Balance Sheet

As a final step in the general budget process Adelaide decided to project a balance sheet
as of the coming year’s April 1.

6. Evaluation of the Budget

Armed with the material developed in Items 1 through 5, Adelaide, Crofton, and
Trafalgar had a meeting to discuss problems that were likely to arise. What points would
be likely to dominate such a meeting? Why?

7. January Activity

In early February, the following information was available on January’s activity. Prepare
an analysis of the results:

Sales: 2,250 units @ $7.00 per unit

Actual production: 2,250 units
Expenses actually paid:
Direct materials bought $1,660.00
Direct labor 2,812.50
Indirect labor 895.00
Electricity 325.00
Indirect materials 1,570.00
Factory insurance 562.50
Other overhead 1,600.00
Office expense 2,260.00
Commissions 1,400.00
 -8- UVA-C-2198

Ending raw materials were 600 units

Neither Crofton nor Trafalgar had been paid anything yet.

8. Variable Costing

At a meeting in early February, Crofton suggested that Adelaide rework the data under an
assumption of variable costing. He argued that seeing the data assuming variable costing
would be useful. Furthermore, he suggested that after the variable costing data were
developed for actual and projected sales at $7.00 per unit, it would be interesting to see
what would happen to profit, cash, and retained earnings if 500 additional units could be
sold at an average of $6.00 per unit each month. These additional units, he stressed,
would be special offers and should not in any way affect regular sales or selling price.
Furthermore, no credit would be given on such sales.