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CHAPTER 11 CONTROL AND EVALUATION OF COST CENTERS 11-1 Outsourcing and Standard Costs The short life cycle of toys suggests that manufacturers would not benefit from using standard costs However, they must bid for business, which indicates that they examine the toy closely before setting a price This analysis is tantamount to developing a standard cost 11-2 Responsibility for Variances The material price variance will be favorable, while the material use, labor efficiency, and VOH efficiency variances will probably be unfavorable Quality could also suffer Before the company changes its standards, we should expect all efficiency variances to be favorable because of the reduced diversity The company might even find material price savings from buying fewer types of materials and components The same things we mentioned in part should happen here Here the company is reducing complexity of products Simplification should result in products that are easier to manufacture The labor rate variance will be favorable, the labor and variable overhead efficiency variances probably unfavorable 11-3 Learning Curves Auto assembly plants experience learning effects during changeovers Assembly lines run slower for a while, then move up to full speed as the workers become more familiar with the operations on the new models Aircraft plants experience learning effects The learning effect was discovered in an aircraft plant in the 1930s The others will not show learning effects because they are machine-driven, processing operations 11-4 Long-Term Contracts The principal reasons for using long-term contracts are to ensure supplies and to obtain firm prices Many companies willingly sacrifice the possibility of paying too much (if prices subsequently fall) to manage the risk of paying too much (if prices rise) or not having an ensured supply For Stanley the ensured supply is not a reason because supplies are available at competitive prices The price risk is therefore Stanley’s principal motivation The principal disadvantage is the possibility of losing lower prices in the future Depending on the terms of the agreement and the commodity or product, companies might also risk having too great a supply If demand for the end product falls and the agreement requires taking a minimum quantity, the company could have unwanted inventory The company might also lose flexibility to substitute other commodities or products if it is required to take a minimum quantity Consider the following statement from Palm’s 2001 Form 10-K “Due to supply constrained inventories experienced during the first three quarters of fiscal year 2001, we built inventory levels for certain components with long lead times and entered into certain longerterm commitments for certain components In the fourth quarter, the sudden and unanticipated significant decrease in demand for our products caused our inventory levels to exceed our forecasted requirements We not currently anticipate that the excess inventory subject to this provision will be used at a future date based on our current 12-month forecast.” 11-5 Productivity Gains Efficiency variances were favorable (or at least some efficiency variances were favorable) and at least some price or rate variances were unfavorable Increases in productivity typically mean increases in efficiency The statement that increased productivity "partially offset increase in our input costs" indicates that the company paid more for inputs, which gives rise to rate or price variances 11-6 Responsibility for Variances Memorandum To: From: Date: Subj: Henry Berger Student Today Identification of rejects Jack Smith has questioned our allocation of rejects that we cannot identify by department on the basis of identifiable rejects The validity of Smith's claim can neither be verified nor refuted, given the available information Obviously, the claim of discrimination would be valid if the proportions, by department, of unidentifiable rejects not equal the proportion of identifiable rejects But, by definition, it is impossible to determine the responsibility for unidentifiable rejects Hence, Smith's claim can be neither proved nor disproved And, from this analysis, it is clear that we are actually charging managers with an arbitrary allocation: they are being charged with costs over which they cannot be shown to have control This violates the principle of controllability in responsibility reporting One possibility is to stop the allocation entirely, charging the managers with only the rejects specifically identifiable as having been caused by their departments If we were to adopt JIT principles, we would perform continual inspection, which would eliminate the problem Another possibility is to develop new evaluation procedures that can better identify the sources of rejects This might require inspecting after each operation rather than after the total assembly operation is complete Even with revised inspection procedures, it might not be possible to assign all rejects Moreover, the cost of the new inspection approach requires justification on the basis that the benefits to be received will be greater than the cost of the procedure 11-7 Significance of Variances Even if total actual costs not exceed total budgeted costs: (1) there can be offsetting total variances for individual elements of cost (materials, labor, individual overhead costs); and (2) a particular cost element can be as budgeted in total, but still have offsetting prices and quantity variances In both cases, investigation may be needed A cheaper material might have been introduced into the production process, creating a favorable material price variance, but also leading to increased labor time requirements, or an increase in scrapped materials These would create, respectively, an unfavorable labor efficiency variance and an unfavorable material use variance The use of lower-paid temporary workers might result in offsetting labor rate and labor efficiency variances Any of these situations is acceptable if the result of properly approved decisions One danger in relying on a comparison of totals is that surprises may be in store in future periods For example, a decline in labor efficiency may have occurred and require action The decline could be masked in one month because of a nonrecurring favorable variance in another cost factor Even if future costs related to some elements can be expected to be lower because of more favorable circumstances, the failure to correct the unfavorable situation with labor efficiency will result in profits being lower than they could have been Failure to investigate variances wastes the potential of a major tool for spotting areas for possible saving areas where control might not be effective Variance analysis does not tell you why costs are lower or higher than budgeted, only that rates and quantities of resources differed from standards 11-8 Basic Material and Labor Variances (10 minutes) This exercise stresses that actual output is the basis for calculating variances The standard quantities, from the budget column, are 0.4 yards of material (36,000/90,000) and 0.2 hours of labor (18,000/90,000) Material use variance (45,000 - [110,000 x 0.4]) x $5 Labor efficiency variance (21,500 - [110,000 x 0.2]) x $15 11-9 Basic Variance Analysis $5,000 U $7,500 F (15 minutes) This exercise is straightforward, but some students will have trouble with materials because the quantity used exceeds the quantity purchased Despite their continual exposure to inventories, students sometimes miss the point that purchases can well be less than use Some students also might have difficulty determining standard labor hours They not have to make the calculation ($24/$12 = standard hours) to complete the assignment We also give the materials variances in a different format You might wish to show students that format is not the critical element Materials variances Price variance: Actual cost of purchases, $5.90 x 3,200 Budgeted cost, 3,200 pounds at $6 Favorable variance $18,880 19,200 $ 320 F Use variance: Standard cost of materials used, 6,200 x $6 Standard cost of standard quantity, 1,200 x x $6 Unfavorable use variance Labor variances $37,200 36,000 $ 1,200 U Actual Cost Budget for 2,250 hours Budget for 1,200 Units $12 x 2,250 1,200 x x $12 or 1,200 x $24 $27,000 $28,800 $225 U $1,800 F Rate variance Efficiency variance $27,225 Variable overhead variances Actual Cost Budget for 2,250 Hours Budget for 1,200 Units $6 x 2,250 1,200 x x $6 or 1,200 x $12 $13,800 $13,500 $14,400 $300 U $900 F Budget variance Efficiency variance This exercise lends itself to using the differences between standard and actual rates to determine price/rate variances Material price variance = ($6.00 - $5.90) x 3,200 Labor rate variance = ($12.00 - $12.10) x 2,250 11-10 Standard Cost Relationships $ $ 320 F 225 U (15-20 minutes) This basic exercise deals with the concept of standards as "should be" quantities and costs It also treats relationships (a) $12 (b) $48 (c) $18 (4 pounds x $3) (3 hours x $16) (3 hours x $6) $420,000 30,000 units (90,000 hours/3 hours per unit) 25,000 units (100,000 pounds/4 pounds per unit) 70,000 x $6 80,000 pounds (60,000 hours/3 hours per unit) = 20,000 units; pounds x 20,000 units = 80,000 pounds $297,000 variable overhead 66,000 lbs/4 lbs per unit = 16,500 units, 16,500 units x hours per unit = 49,500 hours x $6 per hour = $297,000 variable overhead $792,000 labor, 11-11 49,500 hours x $16 per hour = $792,000 labor Basic Learning Curve and Output (10-15 minutes) The schedule below shows results through units Average Time 1,000 850 (1,000 x 85) 722 (850 x 85) 614 (722 x 85) Average x Output = Total Time 1,000 1,700 2,888 4,912 b -.23446 Y = aX , Y = 1,000 x Y = 614 The natural logarithm of 85 is about -.16251, of is 69315, for b = -.23446 11-12 Relationships Standard pounds Units produced (10-15 minutes) 5,000 Pounds used 39,680 Amount paid $227,000 11-13 $40 standard cost/$5 standard price 40,000 standard use/8 standard pounds per unit 40,000 - ($1,600 favorable use variance/$5 standard price per pound) $2,000 U price variance + (45,000 x $5) Ethics and Overhead Assignment (10 minutes) Grayson has a legitimate complaint The controller is certainly not doing the job she should, from a strictly managerial perspective The company is not getting the best information about product costs and managers could be making poor decisions From an ethical viewpoint the situation is less clear However, it is certainly possible to argue that the controller is violating the Standards She is probably violating the objectivity standard by not presenting all of the " relevant information that could reasonably be expected to influence an intended user's understanding " She is probably violating the competence standard to " prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information." 11-14 Fundamentals of Standard Costs and Variances (10-15 minutes) $74 Clay (20 pounds x $3) Direct labor (1/2 hour x $16) Variable overhead (1/2 hour at $12) Total standard variable cost $60 $74 Materials: Actual Cost $71,800 Budgeted Cost $3 x 25,000 $75,000 $3,200 F Price variance Budget for Actual Use $3 x 22,000 Standard Cost $3 x 20 x 1,000 or 1,000 x $60 $66,000 $60,000 $6,000 U Use variance Direct labor: Actual Cost Budget for Actual Hours $16 x 480 Standard Cost $16 x 1/2 x 1,000 $7,350 or 1,000 x $8 $8,000 $7,680 $330 F Rate variance Variable overhead: Actual Cost $320 F Use variance Budget for Actual Hours $12 x 480 $5,400 $5,760 $360 F Budget variance 11-15 Spoilage Variance Standard Cost $12 x 1/2 x 1,000 or 1,000 x $6 $6,000 $240 F Use variance (15-20 minutes) This is a challenging exercise, though the appendix provides the format for solving it Materials: Actual Cost Budgeted Cost $6 x 7,000 $42,000 $41,200 $800 F Price variance Quantity Actual Quantity at Units Standard Price Price Standard Quantity Standard for 2,000 units at for 1,800 Good Standard Price 6,200 x $6 $37,200 2,000 x x $6 $36,000 $1,200 U Use variance at Standard 1,800 x x $6 $32,400 $3,600 U Spoilage variance Direct labor: Standard Quantity Standard Quantity Actual Quantity at for 2,000 units at for 1,800 Good Units Actual Cost Standard Price Standard Price at Standard Price $41,200 3,900 x $10 $39,000 $2,200 U Rate variance 2,000 x $20 1,800 x $20 $40,000 $36,000 $1,000 F $4,000 U Use variance Spoilage variance Variable overhead: Standard Quantity Standard Quantity Actual Quantity at for 2,000 units at for 1,800 Good Units Standard Price Standard Price at Standard Price 3,900 x $4 2,000 x $8 1,800 x $8 $16,500 $15,600 $16,000 $14,400 $900 U $400 F $1,600 U Budget variance Efficiency variance Spoilage variance Actual Cost 11-16 Evaluation in JIT Manufacturing (10 minutes) The company has improved in all ways but one Both processing time and cycle time have dropped since July The drop in cycle time could be especially important for meeting customer demands The inventory data suggest that the company could cut cycle time even more because there is still a 19 day cycle of materials to in-process goods to finished goods (6 + + days) Production rose from July to September, which is good if demand was higher in September We not know whether the rise is good or bad, from production's point of view Defective units fell, as did the percentage of defectives, from 1.2% (90/7,440) to 8% (62/7,720) The company would like defectives to drop to zero and is still short of that goal The decline in days supply of materials is good The drop from days to days supply (50%) is considerable The decline in in-process inventory is also good, but the increase in finished goods supply is not However, the increase in finished goods supply might be the result of market forces or temporary conditions having to with shipping goods to customers 11-17 Revising Standard Costs, Target Costs (15 minutes) Revised Standard Variable Cost Materials ($20 x 1.20 x 95) Direct labor (0.45 hrs x $16.80)* Variable overhead (0.45 hrs x $9) Total standard variable cost $22.80 7.56 4.05 $34.41 * A 5% pay raise brings the direct labor rate to $16.80 per hour and a 10% increase in efficiency reduces the required hours to 0.45 (0.50 hrs x 90%) About 0.3566 hours Target cost Material cost Target direct labor and variable overhead Divided by direct labor/variable overhead rate, $16.80 + $9 Equals target direct labor hours $32.00 22.80 9.20 25.80 3566 The 3356 hour target is 79% of the expected 45 hours, which means the company needs another 21% decline in labor time after the expected 10% Even with this simple assignment, you might wish to point out that increases in efficiency can offset increases in rates, and in some industries, must so offset rate increases for companies to remain competitive 11-18 Learning Curve and (15 minutes) $40,960 and $327,680 (a) Output (b) Average Cost $80,000 64,000 ($80,000 x 80) 51,200 ($64,000 x 80) (a) x (b) Total Cost $ 80,000 128,000 204,800 40,960 ($51,200 x 80) 327,680 b -.3219 Y = aX , Y = $80,000 x Y = $40,960 rounded The natural logarithm of 80 is -.2231, of is 69315, for b = -.3219 11-19 Learning Curve (continuation of 11-18) (20-25 minutes) $80,960 Materials and components Average direct labor and variable overhead (from 11-18) Total variable cost Desired contribution margin Required price $25,000 40,960 $65,960 15,000 $80,960 It is also possible to use the totals Materials and components ($25,000 x 8) Direct labor and variable overhead (from 16-11) Total variable cost Desired contribution margin ($15,000 x 8) Required price $200,000 327,680 $527,680 120,000 $647,680 Dividing $647,680 by gives $80,960 $72,768 All we need to is extend the analysis in assignment 16-11 by one row, from to 16 batches At batches we had an average cost of $40,960, so after 16 batches we have $32,768 ($40,960 x 80) Materials and components Direct labor and variable overhead Total variable cost Desired contribution margin Required price $25,000 32,768 $57,768 15,000 $72,768 $89,130 We must first redo the learning curve using the 85% rate We show the total costs, even though they are not needed for the solution Output Average Cost $80,000 68,000 ($80,000 x 85) 57,800 ($68,000 x 85) 49,130 ($57,800 x 85) $ Total Cost 60,000 136,000 231,200 393,040 Materials and components Direct labor and variable overhead, above Total variable cost Desired contribution margin Required price $25,000 49,130 $74,130 15,000 $89,130 Or, b -.23446 Y = aX , Y = $80,000 x Y = $49,130 Note to the Instructor: You might wish to point out two important items related to the sensitivity of costs to changes in volume One is that changes in the learning rate (80% to 85% here) make a sizable difference in average costs, total costs, and therefore target prices There was an $8,170 decline in average costs ($74,130 - $65,960) and therefore in prices, as learning declined The other is that increasing volume has a significant effect, as the difference in costs and prices as we went from four batches to eight batches shows This might also be a good time to emphasize that the lower the learning rate, the better the results Students should see this when reminded that the learning rate is the percentage to which the average declines as output doubles The lower the rate, the lower each successive average 11-20 Relationships Labor Variances (a) 0.50 produced (20 minutes) standard hours, 2,000 total standard hours/4,000 units $23,110 actual labor cost, 1,900 actual hours x $12 standard rate + $310 unfavorable rate variance $1,200 favorable efficiency variance, 2,000 standard hours - 1,900 actual hours = 100 hours under standard; 100 x $12 = $1,200 (b) $400 favorable rate variance, 8,400 actual hours x $10 = $84,000 budgeted cost less $83,600 actual cost = $400 8,200 standard hours, 8,400 actual hours - ($2,000 unfavorable efficiency variance/$10) standard rate per hour Or, $2,000/$10 = 200 hours over standard, so that 8,400 actual hours are 200 over standard 16,400 units produced, 8,200 standard hours/0.50 standard hours per unit (c) 6,000 standard hours, 3,000 units x hours per unit 5,850 actual hours, efficiency variance of $1,800F/$12 standard rate = 150 hours below standard; 6,000 standard - 150 = 5,850 $71,100 actual labor cost (5,850 actual hours x $12 = $70,200 budget for 5,850 hours, plus $900 unfavorable rate variance = $71,100) (d) 2,000 units produced, 6,000 standard hours/3 hours per unit $4 standard rate, $24,500 actual cost + $300 favorable rate variance - $800 unfavorable efficiency variance = $24,000 standard cost for 6,000 standard hours $24,000/6,000 = $4 6,200 actual hours, 6,000 standard hours + ($800 unfavorable efficiency variance/$4 standard rate) Or, 200 hours over standard, from $800/$4 11-21 Variance Analysis (15-20 minutes) Materials: Actual Cost Budget for Actual Quantity 1,800,000 x $1.10 $2,108,000 $1,980,000 $128,000 U Price variance Budget for Actual Use 1,588,000 x $1.10 $1,746,800 Standard Cost for 200,000 200,000 x x $1.10 $1,760,000 $13,200 F Use variance Labor: Budgeted Cost for Actual Quantity Actual Cost 200,000 32,200 x $20 $644,000 $645,750 $1,750 U Rate variance Standard Cost for Production of 200,000 x 1/6 x $20 $666,667 $22,667 F Efficiency variance Overhead: Actual Cost $1,288,500 Budgeted Cost for Production of 200,000 $840,000 + ($11 x 200,000/6) $1,206,667 $81,833 U Total variance Note to the Instructor: You might wish to point out that the company can find the variable overhead efficiency variance and the combined fixed and variable overhead budget variances The efficiency variance is $12,467 F, which is the 1,133 favorable direct labor hours (33,333 standard minus 32,200 actual) times the $11 variable overhead rate Then there is a $80,700 unfavorable total budget variance This assignment relies on the discussion of separating actual overhead into its fixed and variable components 11-22 Performance Reporting (15 minutes) Because the report uses static budget allowances based on budgeted output, not actual output, we cannot tell from it whether performance was above or below standard A revised, more informative report follows Budget Production, in units Costs:* Direct labor, $2 Supplies, $0.10 Repairs, $0.25 Power, $0.20 Total Actual 4,800 4,800 $ 9,600 480 1,200 960 $12,240 $ 9,300 580 1,120 880 $11,880 Variance $ $ 300F 100U 80F 80F 360F * All listed costs are variable, so we can compute per-unit budgeted costs by dividing the original budgeted amounts by budgeted production of 4,000 units Alternatively, we could simply multiply the budgeted costs at 4,000 units by 120%, to give budgeted amounts for 4,800 units Lab Test-related Overhead Actual Cost Budget for 47 Tests Standard for 10 Batches 47 x $60 10 x $300 $2,870 $2,820 $3,000 $50 U $180 F budget variance efficiency variance $130 F total variance The interpretation of the ABC variances is the same as for those driven by labor or machine time The budget variance reflects spending to perform the activity as many times as required, and the efficiency variance reflects efficient or inefficient use of the driver labor, setups, and lab tests The company spent more time doing setups and did fewer lab tests than standard 11-33 Standards and Variances, Two Products (25-30 minutes) It is best to start by determining the standard quantities Harcombe Exeter Total Standard quantities: Feet of materials, 2,000 x 6; 1,000 x 12,000 20,000 Direct labor, 2,000 x 1; 1,000 x 4,000 8,000 2,000 2,000 Variances: Material price variance, 22,000 x $0.10 Material use variance, (19,900 - 20,000) x $5 $2,200 F $ 500 F Direct labor rate variance, 4,200 x $0.20 Direct labor efficiency variance, (4,200 - 4,000) x $14 $ 840 U $2,800 U Variable overhead budget variance, $31,500 - (4,200 x $8) Variable overhead efficiency, (4,200 - 4,000) x $8 $2,100 F $1,600 U In previous editions the problem stated that the company could not calculate variances by product Even lacking that statement, it is clear that the company needs information about the quantities of inputs used for each product to calculate variances by product The principal reason to compute variances by product is that offsetting favorable and unfavorable variances might exist Managers need to know whether such is the case because product standards might not reflect currently attainable costs Short-term decisions such as special orders, make or buy, and pricing, require currently attainable standard variable cost data 11-34 Overhead Rates, ABC, and Pricing Materials Direct labor at $12/hour Variable overhead: Labor-related at $4/DLH Machine setups at $9 Number of parts at $0.50 Total variable overhead (25 minutes) Major Product $35 36 $12 Minor Product $65 36 $12 72 26 93 Total standard variable cost $97 $194 To: From: Date: Subj: Memorandum Laura Hurlbut Student Today Activity-based overhead costs The standard costs I developed using activity-based rates are more informative than those we have been using Our current overhead costs are based only on direct labor, so high-volume products are allocated the most overhead cost High-volume products therefore subsidize lowvolume products The difficulty is that low-volume products generate many costs that are not associated with direct labor In our case, setups and numbers of parts are significant cost drivers and the laborbased rate does not recognize this Low-volume products increase our costs in various ways because they make our operations more complex Obviously, we could lower costs if we made only one or two high-volume products ABC rates overcome the bias that labor-based rates have: that lowvolume products will appear more profitable and high-volume products less profitable The low-volume products bear more overhead costs, as they should The specific cases illustrate the point The cost of the minor product increases 25% ($155 to $194) and that of the major product declines 22% ($125 to $97) The margin we earn on the major product is very high and we can afford to cut its price to meet the competition We should raise the price on the minor product This requirement is covered in requirement give students a hint about requirement 11-35 Input Standards versus Output Standards We included it to (25-30 minutes) Note to the Instructor: Many students will find this problem quite difficult because they will fail to see that the key is to express the budget based on 51,000 gallons, or 10,200 standard hours, instead of on the input value of 10,000 hours, because 10,200 is 102% of 10,000 It is also possible to relate gallons and hours Thus, with 51,000 gallons for 10,200 hours, gallons per hour = (51,000/10,200) or each gallon requires 1/5th of an hour (The calculation could also be made using 50,000 budgeted gallons and 10,000 budgeted hours.) Using the budgeted costs for 10,000 hours gives the bases for calculating the standards Material use variance There is no material price variance, or, more correctly, the production manager is not responsible for it because the report shows materials used at standard prices Actual material cost at standard prices (given) Standard material cost at standard prices $24,000 x 102% Material use variance Direct labor variances Actual labor cost Budgeted cost for 10,000 hours $26,700 24,480 $ 2,220 U $69,200 68,000 Rate variance $ 1,200 U Standard cost for 51,000 gallons ($68,000 x 102%) Budgeted cost for 10,000 actual hours Efficiency variance $69,360 68,000 $ 1,360 F Indirect labor variances Actual cost Budgeted cost for 10,000 hours Budget variance $28,100 26,500 $ 1,600 U Budgeted cost for 10,000 hours, as above Standard cost for 51,000 gallons ($26,500 x 102%) Efficiency variance $26,500 27,030 $ 530 F Other variable overhead variances Actual cost Budgeted cost for 10,000 hours Budget variance $26,100 27,300 $ 1,200 F Budgeted cost for 10,000 hours, as above Standard cost for 51,000 gallons ($27,300 x 102%) Efficiency variance $27,300 27,846 $ 546 F Note to the Instructor: This problem can be used to discuss the interpretation of budgets when the basis for comparison is not units of product This company is not getting as much information as it could because it is using an input factor to determine budgeted costs It is not calculating efficiency variances It is relatively easy to determine the standards for a unit of product and use those in calculating variances Materials ($24,000/50,000) Direct labor ($68,000/50,000) Indirect labor ($26,500/50,000) Other variable overhead ($27,300/50,000) Total standard cost 11-36 Standards and Idle Time $0.48 1.36 0.53 0.546 $2.916 (15-20 minutes) Note to the Instructor: This assignment shows that the usual calculation of the labor efficiency variance assumes that workers are producing goods all of the time, that there is no idle time The chapter introduces the problem of idle time While this assignment extends the chapter material, it is stated clearly enough that most students will see the problem, and many will make the points covered in requirement below Cost accounting courses pay more attention to this point $35,000 U Actual hours Standard hours allowed (1,200,000/100 x 2) Unfavorable labor time Times $7 standard rate = unfavorable efficiency variance 29,000 24,000 5,000 $35,000 No The enforced idle time results from company policy, not from labor inefficiency Using the company's estimate of idle time it is possible to separate the $35,000 variance in requirement into two parts There is a $38,500 unfavorable variance (5,500 x $7) resulting from the company's policy During the time that they actually had work to do, the workers were efficient, spending 23,500 hours (29,000 total - 5,500 idle) accomplishing 24,000 standard hours worth of work This yields a $3,500 favorable variance 11-37 Evaluation in JIT Manufacturing (15-20 minutes) Memorandum To: Sharon Fennell From: Student Date: Today Subj: Performance evaluation The measures that we will use as we convert to JIT differ from those we used before We are now more concerned about overall operations, about quality, and about progress than we were before are also less concerned about the performance of individual cost centers We I have summarized the major features of each item below Unit production: This measure serves several purposes It allows us to calculate percentages of some items to total production (such as defectives) It also tells us how we are using our capacity how much work we are doing Number of defectives: This measure is important because quality is a primary concern We will track both the number of defectives and their percentage to total output Percentage of orders shipped on time: This tells us how well we are meeting our customers' demands It should be used in conjunction with measures of cycle time The quicker we can manufacture products, the quicker we can ship them Faster deliveries give us an advantage over the competition Manufacturing interval (cycle time): This tells us how long we spend from the time we receive an order until we ship it The closer this time comes to actual manufacturing time (value-adding time), the less non-value-adding time The lower the interval, the less time we waste Supply of inventories: Inventories hide defects and generate many costs The lower the supply we keep, the more efficiently we are manufacturing This is a basic measure of JIT efficiency Cost of scrap: This is a financial measure of quality We track defective units, and should also be concerned about the cost of those units Scrap as percentage of output: This is a percentage measure of physical quality, as opposed to a dollar quality This is the number of defectives divided by total output Number of line disruptions: This is a measure of how efficiently we are operating People can shut down lines for various reasons, including defectives Time spent dealing with disruptions is not value-adding time Percentage of people cross-trained: As we move toward manufacturing cells, our people must be able to several jobs to ensure better flow of products Moreover, people who can several jobs are usually better motivated and more productive Note to the Instructor: Not all of these are mentioned in the chapter Some require a return to the description of JIT in Chapter 11-38 Analyzing Results Sales and Cost Variances (35-40 minutes) Note to the Instructor: This is a very difficult problem Although students analyzed contribution margin variances in Chapter 4, they did so without the complication of changes in variable costs Another difficulty is that students fail to adjust the original budget for variable costs, and so show a variance of $4.0 M ($44.0 - $40.0) Preliminary calculations Budgeted selling price Actual selling price Budgeted contribution margin $12 ($120.0/10.0) $11.306 ($122.1/10.8) $ 8.00 ($12 - $4) Contribution margin variances CM at Actual Volume and Actual Price with Standard Unit Variable Cost CM for Actual Volume at Budgeted Price Budgeted CM 10.8 x ($11.306 - $4) 10.8 x $8 10.0 x $8 $78.9 $86.4 $80.0 $7.5 U $6.4 F sales price variance sales volume variance $1.1 U total contribution margin variances Variable cost variances: Cost Factor Budgeted Variable Costs at 10.8 M units * Materials Direct labor Variable overhead Totals * $21.6 16.2 5.4 $43.2 Actual Variable Costs Variance ( U ) $21.8 17.0 5.2 $44.0 ($0.20) ( 0.80) 0.20 ($0.80) Original budget divided by 10.0 M and multiplied by 10.8 M Fixed cost variances: Manufacturing ($50.8 - $50.0) Selling and administrative ($19.9 - $20.0) Total A summary is: Budgeted profit Contribution margin variances Variable cost variances Fixed cost variances Total variances Actual profit 11-39 $0.80 U 0.10 F $0.70 U $10.00 $ 1.10 U 0.80 U 0.70 U Actual to Actual Comparisons JIT 2.60 U $ 7.40 (30 minutes) Memorandum To: From: Date: Subj: Controller Student Today Manufacturing performance Our unit cost increased slightly, but much of the increase is attributable to price differences over which we have little control have analyzed costs into price and efficiency variances below The price variances simply reflect the difference between May and June prices multiplied by June use of the input factor I The efficiency variances are based on using May input quantities as the "standard." I adjust May costs to reflect the higher output in June (10,300 units to 11,000 units) I calculate June input use at May prices, and the difference is attributable to using more or less of the input factor in June For variable overhead I made only one calculation Labor time per unit decreased slightly from about 1.9612 hours (20,200/10,300) to 1.9545 (21,500/11,000), which is an improvement gained $512 from increased efficiency, using May as the base and holding the $7.00 wage rate constant Cost for June Output Actual Cost at May Rate at May Rate 21,500 x $7.00 $150,500 We 20,200/10,300 x 11,000 x $7.00 $151,010 $510 favorable efficiency variance The wage rate increased by $0.20, which gave us a $4,300 (21,500 DLH x $0.20 increase) unfavorable rate variance Material prices declined by $0.02 per pound, giving a $900 ($0.02 x 45,000) favorable price variance We used more material per unit of product, from 3.98 (41,000/10,300) to 4.091 (45,000/11,000) gallons, costing $1,189 June Cost with May Actual Cost at May Price Price and Quantity 45,000 x $0.98 $44,100 41,000/10,300 x 11,000 x $0.98 $42,911 $1,189 unfavorable use variance Variable overhead increased in total, but declined per unit Actual Overhead $85,800 June Cost Adjusted from May Base $83,400/10,300 x 11,000 $89,068 $3,268 F In summary, the following factors contributed to the cost difference Labor efficiency Labor rate Material price Material use $ 510 4,300 900 1,189 F U F U Variable overhead Total 3,268 F 811 U $ Note to the Instructor: You might wish to use the following analysis to show the difference of $811 June costs: Materials, 45,000 x $0.96 Direct labor, 21,500 x $7.20 Variable overhead Total $283,800 $ 43,200 154,800 85,800 Cost for 11,000 units at May prices and quantities: Materials, (41,000/10,300) x 11,000 x $0.98 $ 42,911 Direct labor, (20,200/10,300) x 11,000 x $7.00 151,010 Variable overhead, ($83,400/10,300) x 11,000 89,068 Total 282,989 Difference 811 11-40 Variance Analysis Changed Conditions $ (35 minutes) Material use variance Budget for Standard Cost Actual Quantity Used for 3,700 units (12,300 x $4) (3,700 x $12) $49,200 $44,400 $4,800 U Unfavorable use variance Direct labor variances Actual Cost $66,100 $700 F Favorable rate variance Budget for Standard Cost for Actual Quantity Used Production of 3,700 (8,350 x $8) (3,700 x $16) $66,800 $59,200 $7,600 U Unfavorable efficiency variance Variable overhead variances Budget for Standard Cost for Actual Quantity Used Production of 3,700 (8,350 x $4) (3,700 x $8) $34,200 $33,400 $29,600 $800 U $3,800 U Unfavorable Unfavorable budget variance efficiency variance Summary of Variances Favorable Unfavorable Material use $4,800 Direct labor rate $700 Direct labor efficiency 7,600 Variable overhead spending 800 Variance overhead efficiency 3,800 Total $700 $17,000 Actual Cost Because the problem states that the standards are currently attainable and that variances have been small, we can conclude that the September variances resulted from using the new material The equal quality of the finished product does not preclude differences in working with the material There is a question whether the workers will soon adjust to the new material, reducing the variances as they become more familiar with it If not, the variances will likely continue The material price variance will average about $6,000 favorable using the new material (average purchases of 4,000 units x pounds x $0.50 saved = $6,000) The saving is considerably less than the $17,000 unfavorable variances that seem attributable to using the new material (We might, however, calculate the material use variance using the $3.50 figure instead of the $4 We that below.) Those variances were for 3,700 units; at 4,000 units they will probably be higher We can almost certainly ignore the favorable labor rate variance, unless we could determine that it was caused by using unskilled workers who would therefore have been less efficient than usual One thing we could is compute a new standard cost assuming that the September experience becomes the currently attainable standard The result is $2.74 higher than the currently attainable standard Materials (3.32 pounds x $3.50) Direct labor (2.26 hours x $8) Variable overhead, $4 per DLH Total standard variable cost $11.62 18.08 9.04 $38.74 Materials: 12,300/3,700 = 3.32 pounds (rounded) Direct labor: 8,350/3,700 = 2.26 hours 11-41 Economic Cost of Labor Inefficiency (30 minutes) General Note to the Instructor: This problem makes two important points First, it emphasizes the cost of labor inefficiency is not limited to labor cost, but also includes the variable overhead cost associated with labor Second, and more subtle, is that if the company is operating at capacity, labor inefficiency is best measured by the opportunity cost of lost sales And of course, the opposite holds true when labor performance is better than standard Actual labor hours 280,000 Standard hours, 12,500 x 14 and 19,200 x 14 268,800 Excess hours 11,200 Times standard rate of $10 equals DLEV $112,000 Excess hours times $8 rate VOH equals VOHEV 89,600 Total variances related to labor inefficiency $201,600 January 179,400 June 175,000 4,400 $44,000 35,200 $79,200 The January variances reflect the economic cost, but not the June variances In June the company could have produced 20,000 units at normal labor efficiency (280,000/14), but only produced 19,200 Lost sales Contribution margin: Selling price Material cost Labor and VOH, 14 x $18 Lost contribution margin Variances above Total cost of inefficiency 800 units $620 ( 82) (252) $286 $228,800 201,600 $430,400 Some students might believe that the variances involve double counting The following alternative format shows the actual results compared with those the company would have achieved at normal efficiency Potential Revenue at $620 x 20,000, 19,200 Standard cost at $334 Contribution margin at standard Less variances Contribution margin $12,400,000 6,680,000 5,720,000 $ 5,720,000 Actual $11,904,000 6,412,800 5,491,200 201,600 $ 5,289,600 The difference is $430,400 11-42 Unit Costs and Total Costs (20 minutes) Matthews is not correct The reason that unit cost was less than budgeted is that production was greater than budgeted, spreading the fixed manufacturing overhead over 100,000 units instead of 90,000 The variances that we can identify appear below The approach is to compute the total variances for materials, labor, and overhead, and then back out the variances for which Matthews is not responsible Material use variance: Total material cost Standard for 100,000 units [($288,000/90,000) x 100,000] Total materials variances Less material price variance (from text) Material use variance $341,800 320,000 21,800 16,000 $ 5,800 U Labor efficiency variance: Total labor cost Standard for 100,000 units [($679,500/90,000) x 100,000] Total labor variances Less labor rate variance (from text) Labor efficiency variance $773,800 755,000 18,800 15,100 $ 3,700 U Variable overhead variances: Total variable overhead cost Standard for 100,000 units [($339,750/90,000) x 100,000] Total variable overhead variances* $391,300 377,500 $ 13,800 U Fixed overhead budget variance, $860,700 - $850,000 $ 10,700 U Total variances under Matthews' control $34,000 U * We could determine the variable overhead efficiency variance and spending variance if we assume that variable overhead is related to direct labor Because those variances will be in the same direction and in the ratio of standard labor cost to standard variable overhead cost, we could calculate the variable overhead efficiency variance as $1,850 unfavorable (half of the unfavorable labor efficiency variance because variable overhead of $339,750 is half of direct labor of $679,500), leaving an unfavorable spending variance of $11,950 Again, these calculations are justified only if variable overhead is related to direct labor We reconcile the numbers as follows Budgeted variable costs for 90,000 units are $1,307,250 ($288,000 + $679,500 + $339,750), so the flexible budget allowance for 100,000 units is $1,452,500 ($1,307,250/90,000 x 100,000) Flexible budget for 100,000 units $1,452,500 Add budgeted fixed costs 850,000 Total budget for 100,000 units 2,302,500 Plus price/rate variances from text ($16,000 + $15,100) 31,100 Total allowable cost 2,333,600 Actual total cost 2,367,600 Controllable unfavorable variances, as above $ 34,000 Note to the Instructor: Students are likely to find this problem quite difficult because they are not likely to see, at first, that they can compute the total standard cost for variable costs They will also spend some time determining that the rate variances are computed correctly They are likely to notice immediately, however, the manager's error in including fixed costs in his calculation of the "adjusted budgeted costs." 11-43 Design Change Variances (25-30 minutes) Note to the Instructor: This assignment is not simple, although the principle is straightforward The idea is to show students various ways to calculate and interpret variances The suggestion that variances be split makes good sense, and companies often calculate design change variances if they not revise standards Material use variance Budget for Actual Use Original Standard Cost 13,700 x $3.00 2,000 x $18 $41,100 $36,000 $5,100 U Use variance Direct labor efficiency variance Budget for Actual Hours 1,180 x $10 $11,800 Original Standard Cost 2,000 x $6 $12,000 $200 F Use variance Variable overhead efficiency variance Budget for Actual Hours 1,180 x $7 $8,260 Original Standard Cost 2,000 x $4.20 $8,400 $140 F Use variance We first calculate the variances using the standard for the redesigned tool Material use variance Budget for Actual Use same as above $41,100 $900 F Use variance Standard Cost 2,000 x $21 $42,000 Direct labor efficiency variance Budget for Actual Hours Standard Cost same as above 2,000 x $5.50 $11,800 $11,000 $800 U Efficiency variance Variable overhead efficiency variance Budget for Actual Hours Standard Cost same as above 2,000 x $3.85 $8,260 $7,700 $560 U Efficiency variance The summary of variances resulting from design changes is the difference between the variances computed above and those computed in requirement Efficiency Variances Based on Old Standard New Standard From Design Change Material use variance DLH efficiency variance VOH efficiency variance Totals $5,100 200 140 $4,760 U F F U $900 800 560 $460 F U U U $6,000 1,000 700 $4,300 U F F U It appears that the manager's performance was worse with respect to direct labor and variable overhead using the new standard and better with respect to materials Note, however, that the variances identified as "from design change" are really a mixture of results from operating with two designs, not necessarily the result of the design change 11-44 Analysis of Income Statement (40-50 minutes) This is a difficult problem and you might wish to give out some hints prior to assigning it Telling students that they must determine total standard direct labor hours will help them get on the track $8,800 unfavorable Actual direct labor cost Total variance Standard direct labor cost $144,800 4,000 U 140,800 Divided by 22,000 units = standard cost per unit Divided by 0.80 standard hours per unit = standard rate Total standard hours (22,000 x 80) Total actual hours (22,000 x 85) Variance in hours, unfavorable Multiplied by $8 standard rate = $8,800U $6.40 $8.00 17,600 18,700 1,100 $4,800 favorable, $8,800 efficiency variance minus $4,000 total variance $4 Total standard unit cost ($240,000/20,000) Direct labor Variable overhead ($2 x 0.80) Standard material cost $12.00 $6.40 1.60 $38,200 Standard variable cost (22,000 x $1.60) Variances Actual variable overhead cost 8.00 $ 4.00 $35,200 3,000 U $38,200 $2,200 unfavorable 1,100 unfavorable labor hours x $2 per hour $800 unfavorable $3,000 total variance - $2,200 unfavorable efficiency variance $77,000 $75,000 budgeted plus $2,000 unfavorable budget variance pounds $4 standard cost/2 pounds per unit 41,000 pounds, the $6,000 favorable materials variance is all use since materials were bought at the standard price Standard use (22,000 x 2) 44,000 Variance in pounds ($6,000/2) 3,000 Actual use 41,000 11-45 Forecasting Income (30-40 minutes) $7.21 Materials, 0.45 x $4.20 Direct labor, 0.35 x $10 Variable overhead, 0.35 x $5.20 Total standard variable cost $1.89 3.50 1.82 $7.21 Sales (115,000 x $20) Standard cost of sales (115,000 x $7.21) Standard gross margin (115,000 x $12.79) Variances (see below) Material use Direct labor efficiency Variable overhead efficiency Actual gross margin Fixed costs: Manufacturing ($560,000 x 1.05) S&A ($470,000 x 1.05) $2,300,000 829,150 1,470,850 $ 4,536 U 25,200 U 13,104 U $588,000 493,500 42,840 U 1,428,010 1,081,500 Profit $ Variances: Material use: standard = 120,000 x 45 = 54,000 Excess use at 2% Standard price Material use variance 346,510 1,080 $4.20 $4,536 Direct labor efficiency: standard = 120,000 x 35 = 42,000 Excess use at 6% 2,520 Standard rate $ 10 Labor efficiency variance $25,200 Variable overhead efficiency 11-46 2,520 x $5.20 = $13,104 Selecting a Vendor (15 minutes) The point of this assignment, of course, is to show that various factors besides price are important in selecting a vendor Spartan is clearly superior on all dimensions except price, so the question is whether the division is better off saving roughly $377,000 Note the divisions at the ends of the calculations to incorporate the defect rates Spartan, 1,000,000 x $4.40 x 99%/99% Capital, 1,000,000 x $3.90 x 98%/95% Difference favoring Capital $4,400,000 4,023,158 $ 376,842 The answer is not automatically to select Spartan If the division is not a JIT operation and can manage with less service, it might well buy from Capital For instance, technical support might be a trivial matter, the division might be sufficiently flexible to live with erratic deliveries, and defectives might appear quickly and not be made into product before being discovered Under these circumstances, it might pay to deal with Capital Spartan nonetheless does better on every dimension save price, and could be the lower-total-cost vendor 11-47 Analyzing Results (a) and (b) Actual Results* $3.99 x 450,000 $1,795,500 (35 minutes) Budgeted contribution margin is $4.09, $8.00 - $3.91 Actual Volume at Budgeted Margin $4.09 x 450,000 $1,840,500 $45,000 U sales price variance Budgeted Results $4.09 x 400,000 $1,636,000 $204,500 F sales volume variance $159,500 F total marketing variances * Actual selling price of $7.90 ($3,555,000/450,000) minus $3.91 standard variable cost (c) Material price variance, only milk chocolate has a variance Purchases equal use Ounces Bought (Standard Price - Actual Price*) Variance Cookie mix 4,650,000 x ($.02 - $.02) $ Milk chocolate 133,000U Almonds Total 2,660,000 x ($.15 - 480,000 x ($.50 $.20) - $.50) $133,000U *Actual total cost/actual total quantity, $93,000/4,650,000 = $0.02, $532,000/2,660,000 = $0.20, $240,000/480,000 = $0.50 (d) Material quantity variance Standard Price Standard Use - Actual Use Variance Cookie mix 02 x 10 x 450,000 - 4,650,000 $ 3,000U Milk chocolate 15 x x 450,000 - 2,660,000 61,500U Almonds 50 x x 450,000 480,000 15,000U Total variance $79,500U (e) Labor efficiency variance Standard Rate per Minute* Mixing, $0.24 Baking, $0.30 Total variance x x Standard Minutes - Actual Minutes minute x 450,000 - 450,000 minutes x 450,000 - 800,000 Variance $ 30,000F $ 30,000F * $14.40/60 = $0.24, $18.00/60 = $0.30 (f) and (g) Variable overhead variances Actual Variable Overhead Budgeted Variable Overhead Standard Variable for 1,250,000 minutes Overhead 1,250,000 x $0.54* 450,000 x $1.62 $750,000 $675,000 $729,000 $75,000 U $54,000 F budget variance efficiency variance $21,000 U total variance * $32.40 hourly rate divided by 60 Summary of Variances (a) (b) (c) (d) (e) (f) (g) Sales price variance Sales volume variance Material price variance Material quantity variance Labor efficiency variance Variable overhead efficiency variance Variable overhead spending variance Total variances $ 45,000U 204,500F 133,000U 79,500U 30,000F 54,000F 75,000U $ 44,000U A problem might be that direct labor hours is not an appropriate base for Aunt Molly's Old Fashioned Cookies because it might not be the activity that drives variable overhead A possible indication of this disconnect is shown in the variance analysis The labor efficiency variance is favorable, while the variable overhead spending variance is unfavorable Another problem is that baking requires considerably more electricity than mixing, which could distort product costs Activity-based costing might alleviate the problems described in part above and, therefore, is an alternative that Aunt Molly's should consider Since direct labor does not seem to have a direct cause-andeffect relationship with variable overhead, the company should try to identify the activity or activities that drive variable overhead If the same proportion of these activities is used in all of Aunt Molly's products, then ABC will probably not be beneficial; however, if the products require a different mix of these activities, then ABC could well be beneficial ... Actual cost of purchases, $5.90 x 3,200 Budgeted cost, 3,200 pounds at $6 Favorable variance $18,880 19,200 $ 320 F Use variance: Standard cost of materials used, 6,200 x $6 Standard cost of standard... sources of differences between actual costs and standard costs Standard costs should be related to flexible budgets that change with the quantity of output We have been comparing actual costs with... standard to " prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information." 11-14 Fundamentals of Standard Costs and Variances (10-15 minutes)
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