Problem 1 The following data pertain to the Western Division of Jordan Company:

Division total contribution margin $500,000 Profit margin controllable by the divisional manager 150,000 Average asset investment 600,000

Management bonuses are awarded at the end of each year and based on ROI, and the company uses responsibility accounting concepts when evaluating performance. Western's division manager is contemplating the following three investments. Jordan has a cost of capital of 15% and uses straight line depreciation with no salvage value.

No. 1 No. 2 No. 3 Initial Investment $160,000 $200,000 $300,000 Annual Expected Profit (includes depreciation as an expense)

32,000 24,000 50,000

Years 3 3 3 Salvage Value 0 0 0

Use beginning of period book value for all calculations (no need to average with end of period asset value). In your calculations you might need the following excerpt from the table in the book: Present value of an Annuity of $1 in Arrears; (1- (1+ r)-n)/r

Number of years Rate of return 2 3 4 5 13% 1.668 2.631 2.974 3.517 14% 1.647 2.322 2.914 3.433 15% 1.626 2.283 2.855 3.352 16% 1.605 2.246 2.798 3.274

Problem 1 – Part A. (2 points) which investment(s) (if any) would Jordan’s shareholders want the division manager to make? Why? No. 1 No. 2 No. 3 Initial Investment $160,000 $200,000 $300,000 Years 3 3 3 Annual Expected income 32,000 24,000 50,000 Annual Depreciation (Investment/Years) $53,333 $66,667 $100,000 CF (Income + Depn.) $85,333 $90,667 $150,000 Annuity factor (3 years) 2.283 2.283 2.283 I/CF 1.875 2.2058824 2 NPV $34,816 $6,992 $42,450 Jordan’s shareholders would want the division manager to invest in all three projects.

Problem 1 – Part B. (2 points) Assuming that the Western’s divisional manager expects to leave the company right after receiving the first coming bonus, which investment(s) (if any) would the manager of the Western’s division undertake? Why? Is this choice goal congruent? Why? No. 1 No. 2 No. 3 WD Initial Investment $160,000 $200,000 $300,000 $600,000 Annual Expected income 32,000 24,000 50,000 150,000

ROI (Income/Investment) 20% 12% 17% 25% All three projects have a positive NPV and, therefore, are good for the company, but the manager would not invest in any of them because they have a ROI smaller than the Western Division’s. Therefore, ROI is not goal congruent in this situation.

Problem 1 – Part C. (1 point) Still assuming that the Western’s divisional manager expects to leave the company right after receiving the first coming bonus, if the manager of the Western’s division was evaluated with residual income, which investment(s) (if any) would she undertake? Would her decisions be goal congruent? Why? Show your answer with calculations. No. 1 No. 2 No. 3 Initial Investment $160,000 $200,000 $300,000 Annual Expected income 32,000 24,000 50,000 RI (Income - r * Investment) $8,000.0 ($6,000.0) $5,000.0 Residual income does better than ROI but it is still not goal congruent because the manager would not invest in project 2.

Problem 2 Jerry is the Manager of a division in a manufacturing company that specializes in cell phones for industrial use. Jerry is evaluated on the ROI of his division, and last year he obtained a ROI of 14%. Jerry knows that, if he does not improve the ROI of his division with respect to the previous year, he does not receive a bonus. The engineering department made a proposal for Jerry consisting of two new products, the MaxCell and the SuperCell. In this industry, products have typically a good start, but they become obsolete pretty fast, leading to a fast decline in profits. The controller of the division is uncertain about the products’ profitability. He is worried about the future wellbeing of the division but does not know how to handle the situation. Problem 2. Part A (2 points) The following data allowed the controller to calculate the NPV of each project.

Investment Opportunity MaxCell SuperCell Initial investment $ 6,000,000 $ 10,000,000 Useful life 4 years 4 years Salvage value $ - $ - Expected operating income for year 1 $ 800,000 $ 1,500,000 Operating income annual growth -10% -40% Required rate of return 14% 14%

Calculate the NPV of both projects. Should the company undertake these projects?

Investment $ 6,000,000 Salvage Value $ - MaxCell Year 0 1 2 3 4 NPV Initial Investment 6,000,000

Profit B/T 800,000 720,000 648,000 583,200 Depreciation 1,500,000 1,500,000 1,500,000 1,500,000 Free Cash Flow 2,300,000 2,220,000 2,148,000 2,083,200 Present Value (6,000,000) 2,017,544 1,708,218 1,449,839 1,233,422 $ 409,022

The company should undertake the MaxCell project because it has a positive NPV.

Investment $ 10,000,000 Salvage Value $ -

SuperCell Year 0 1 2 3 4 NPV Initial Investment 10,000,000

Profit B/T 1,500,000 900,000 540,000 324,000 Depreciation 2,500,000 2,500,000 2,500,000 2,500,000 Free Cash Flow 4,000,000 3,400,000 3,040,000 2,824,000 Present Value (10,000,000) 3,508,772 2,616,190 2,051,913 1,672,035 $ (151,090)

The company should not undertake the SuperCell project because it has a negative NPV.

Problem 2. Part B (1.5 points) Jerry knows that he will leave the company at the end of the first year. He wants to look good and jump to a new and higher position in another firm. What projects will he invest in? Is ROI a goal congruent performance measure in this case? Why? ROI of MaxCell = 800,000/6,000,000 = 13.3% ROI of SuperCell = 1,500,000/10,000,000 = 15.0% Since the current ROI is of a 14%, Jerry will invest in the SuperCell project but not on the MaxCell Project. ROI is not goal congruent because the SuperCell project has a negative NPV and, therefore, it is not a good project for the company. That is, Jerry will invest in a negative NPV project. On the contrary, the MaxCell project has a positive NPV and should be undertaken, but Jerry will not invest on this project because that would lower his ROI.

Problem 2. Part C (1.5 points) What would be your answer in part B if Jerry was evaluated with the annual RI? Would your answer change if she planned to stay in the company for 4 years? One year horizon

Residual Income for MaxCell = 800,000 – 0.14 * 6,000,000 = -$40,000 Residual Income for SuperCell = 1,500,000 – 0.14 * 10,000,000 = $100,000

Residual income has the same problem as ROI in this case. MaxCell should be undertaken from the company’s perspective but Jerry will not invest on it because it would yield him a negative residual income. On the contrary, SuperCell should not be undertaken but Jerry will invest because it yields a first year positive RI. Therefore, RI is not goal congruent in this case.

Four years horizon

Thanks to the conservation property of the RI, if Jerry plans to stay in the firm for four years, he will take the decisions that are optimal for the company because he will want to maximize NPV.

Problem 1 Community Coffee Company (CCC) is a processor and distributor of gourmet coffees sold in grocery stores through the Southeastern United States. CCC buys coffee beans from around the world and roasts, blends and packages them for resale. CCC currently produces 15 gourmet blends which it sells in 1 pound bags. Some coffee blends are very popular and sell at a very high volume, while other, newer blends sell at low volumes. CCC sells its coffee at full cost (i.e., direct costs plus overhead costs) plus a 30% mark-up (that is, the price is 1.3 times the full cost). Data for the 2006 budget include manufacturing overhead of $2,600,000, which has been allocated based upon direct labor cost (i.e. labor $). The budgeted direct labor cost for 2006 is $1,000,000. Anticipated unit costs for two of the 15 different blends that CCC produces are as follows: (note 1 pound of coffee = 1 unit): Jamaican Slow Roasted Kona Direct material $2.90 $3.95 Direct labor $0.50 $0.40

Community Coffee recently hired a new controller who is concerned that the traditional costing system may be providing misleading information and is considering implementing activity based costing. She has developed a detailed analysis of the company’s 2006’s budgeted manufacturing overhead costs (shown below): Activity Cost Driver Activity Capacity Budgeted Cost Quality Controls Batches 4,000 $300,000 Material Handling Set-ups 6,000 $600,000 Packaging Packaging Hours 12,000 $500,000 Purchasing Purchase Orders 80,000 $400,000 Roasting and Blending

Machine Hours 180,000 $800,000

Data regarding the total production requirements for both blends of coffee are shown in the following table. Assume there was no raw material inventory for either coffee at the beginning of the year: Jamaican Slow Roast Kona Budgeted Sales 30,000 lbs 9,000 lbs Number of Batches 20 batches 9 batches Setups 20 9 Packaging Time 2,000 hours 700 hours Purchase Orders 800 800 Machine Hours 2,000 hours 8,000 hours

Problem 1 – Part A. (5 points) Using CCC’s current product costing system, determine the full product cost and selling prices for 1 pound of both types of coffee. Total budgeted overhead/cost driver = $2,600,000/$1,000,000 = $2.6 per DL cost Product cost: Selling price: Jamaican Jamaican DM 2.90 4.70 X 1.30 = $6.11 DL .50 OH (2.6) X .5 = 1.30 Total = 4.70 Kona Kona DM 3.95 5.39 X 1.30 = $7.01 DL .40 OH (2.6) X .4 = 1.04 Total = 5.39

Problem 1 – Part B. (20 points) Using activity based costing, determine the new product costs for 1 pound of both types of coffee.

COST ACTIVITY

PRACTICAL CAPACITY

ALLOCATION RATE

QC 300,000 4,000 75 MH 600,000 6,000 100 PACK 500,000 12,000 41.67 PURCH 400,000 80,000 5 R&B 800,000 180,000 4.44 TOTAL 2,600,000 Jamaican Kona Cost

Driver Consumed

Allocated OH Allocated OH / unit

Cost Driver Consumed

Allocated OH

Allocated OH / unit

QC 20 1500 0.05 9 675 0.08 MH 20 2000 0.07 9 900 0.1 PACK 2000 83,340 2.78 700 29169 3.24 PURCH 800 4000 0.13 800 4000 0.44 R&B 2000 8889 0.30 8000 35520 3.95 TOTAL Total

POH 3.33 Total POH 7.81

Product cost: Jamaican Kona DM 2.90 3.95 DL .50 .40 OH 3.33 7.81 Total 6.73 12.16

Problem 1 – Part C. (10 points) Interpret the new information provided by the ABC system. Based on the information provided by the ABC system what would you recommend to CCC as far as product pricing is concerned?

The interpretation of the ABC results: The traditional costing system overcosted the higher volume product (Jamaican) because it requires a bit more direct labor, and undercosted the lower volume more specialty item (Kona). As a result, CCC was selling Kona at a price below cost. This is a frequent distortion that occurs with traditional costing (undercost low volume, overcost high volume). ABC corrects the distortions by taking into account the usage of capacity resources. It allocates the different activity costs according to a cost driver that measures the capacity usage of each product. With ABC the higher consumption of resources required to produce Kona is reflected in the cost. Kona requires more machine hours per unit and more frequent batches. When this is reflected in the cost, one sees that Kona cost almost double than Jamaican. Pricing: CCC should try to increase the price for Kona. At the current price of $7.01, long-term profitability is not possible. If the market does not allow the price increase, CCC should try to replace the product, but always taking into account that from a short-term perspective Kona has a positive contribution margin. Therefore, unless enough capacity resources are avoidable, CCC should not drop Kona immediately, but instead think of a product replacement.

Problem 2 Safety Doors Inc. manufactured three lines of products until 2008: Come-on-in, Who-is-it and Stay-out. In 2008, after working at practical capacity, a report elaborated by the controller showed that Who-is-it had a negative product profit margin. The controller’s following income statement was elaborated allocating Manufacturing Overhead according to direct labor dollars: Income Statement (2008) Come-on-in Stay-out Who-is-it Total Volume (units) 4,000 1,000 9,000 Revenues $1,000,000 $500,000 $1,620,000 $3,120,000 Direct Materials $400,000 $400,000 $900,000 $1,700,000 Direct Labor $320,000 $40,000 $540,000 $900,000 Manufacturing Overhead $160,000 $20,000 $270,000 $450,000 Product Profit Margin $120,000 $40,000 ($90,000) $70,000 Sales and Administration $50,000 Profit before taxes $20,000

Max Gates, CEO of Safety Doors, was convinced that the disappointing result in 2008 was caused by the Who-is-it product line. Consequently, he decided to drop it to redress the situation. Since the practical capacity remained unaltered, Max knew that he would have to deal with idle capacity in the future, but he was still convinced he made the right choice. However, in 2009, the controller’s report did not confirm his conviction: Income Statement (2009) Come-on-in Stay-out Total Volume (units) 4,000 1,000 Revenues $1,000,000 $500,000 $1,500,000 Direct Materials $400,000 $400,000 $800,000 Direct Labor $320,000 $40,000 $360,000 Manufacturing Overhead $400,000 $50,000 $450,000 Product Profit Margin ($120,000) $10,000 ($110,000) Sales and Administration $50,000 Profit before taxes ($160,000)

Problem 2 – Part A (16 points) Max Gates has recently heard about a new costing system called ABC. He wants you to analyze the profitability of the three products with this new system. He provides you with the following additional information: Activities Cost Driver Cost Machining Machine Hours $300,000 Setup Number of Batches $150,000 Total Manufacturing Overhead $450,000

Come-on-in Stay-out Who-is-it Machine hours per unit 2 10 2 Batch Size (units) 100 10 100

Required:

1) Elaborate a new ABC income statement for 2008 containing the product margin for each product and the margin and profit for the whole company.

2) Explain the difference in the margins between the new ABC system and the controller’s calculations (DON’T FORGET THIS PART!!).

First we need to calculate the total capacity for each activity cost driver. Since in 2008 the firm is working at capacity, the total cost driver volume in 2008 is the practical capacity. The number of machine hours consumed by a product line is just the number of product units times the number of machine hours per product unit. The number of batches used in a product line is the number of product units sold for that product line divided by the batch size of that product line.

Activity Cost Driver Come-on-in Stay-out Who-is-it

Total (Practical Capacity)

Machining Machine hours 8,000 10,000 18,000 36,000 Setup Number of Batches 40 100 90 230 Now that we have the practical capacity for both activities, we can calculate the allocation rates: Activity Cost Cost Driver Practical Capacity Driver Rate Machining $300,000 Machine hours 36,000 8.33 Setup $150,000 Batch Number 230 652 With the allocation rates we allocate the cost of each activity to each product line: Come-on-in Stay-out Who-is-it Activity Driver Allocation Driver Allocation Driver Allocation Machining 8,000 $66,667 10,000 $83,333 18,000 $150,000 Setup 40 $26,087 100 $65,217 90 $58,696 With these allocations, we can now write the ABC income statement for 2008: ABC Income Statement (2009) Come-on-in Stay-out Who-is-it Total Revenues 1,000,000 500,000 1,620,000 3,120,000 Direct Materials 400,000 400,000 900,000 1,700,000 Direct Labor 320,000 40,000 540,000 900,000 Manufacturing Overhead: Machining 66,667 83,333 150,000 300,000 Setup 26,087 65,217 58,696 150,000 Product Profit Margin 187,246 -88,551 -28,696 70,000 Sales and Administration 50,000 Unused Capacity 0 Profit before taxes 20,000

We can see that Safety Doors is loosing money not only on the Who-is-it but also on the Stay-out line as well. On the other hand, Come-on-in is even more profitable than initially thought. The Stay-out product line is produced in small batches and therefore consumes a lot of setup resources that were not properly allocated by the controller. In addition, Stay-out consumes a lot more machine hours per unit than the other product lines. These two facts are not properly reflected by the labor dollars cost driver that the controller used to elaborate the report. Instead, Come-on-in and Who-is-it are more labor intensive products than Stay-out and get overcharged with overhead costs in the traditional absorption costing system used by the controller.

Problem 2 – Part B (8 points)

Calculate and write the ABC income statement for 2009. In doing so, assume that the additional information provided in part A is also true for 2009. (Hint: This should be a short exercise given the common data between the 2 years. Many of the calculations do not need to be redone.) Since practical capacity did not change in 2009, and the overhead is the same as in 2008, the allocation rates for both activities are the same as in 2009. Moreover, since the number of units of Come-on-in and Stay-out sold in 2009 is the same as the one sold in 2008, the profit margins for Come-on-in and Stay-out will be unchanged. The overhead that was allocated to Who-is-it will now become the cost of unused capacity. With these changes, the ABC income statement becomes: ABC Income Statement (2009) Come-on-in Stay-out Total Revenues 1,000,000 500,000 1,500,000 Direct Materials 400,000 400,000 800,000 Direct Labor 320,000 40,000 360,000 Manufacturing Overhead Machining 66,667 83,333 150,000 Setup 26,087 65,217 91,304 Product Profit Margin 187,246 -88,551 98,696 Sales and Administration 50,000 Unused Capacity 208,696 Profit before taxes -160,000

Problem 2. Part C (6 points)

Max is determined to do whatever is necessary to save the company. He is now pondering whether to restrict production to the only profitable product left according to his controller’s calculations in 2009, Stay-out. Before taking any drastic action, however, he wants you to let him know what you think is happening.

Required:

1) Explain to Max why his decision making process is wrong.

Max is a victim of the inaccurate information provided to him by the controller. The controller is using a traditional absorption costing system. As a result, he is using total volume of labor as the allocation denominator. When Max decided to drop the Who-is-it product line, no capacity costs were eliminated. In 2009, the traditional costing system reallocated those capacity costs to the remaining product lines making them look even less profitable. Therefore, he is falling into the Death Spiral trap.

In this firm the consumption of capacity resources by the three product lines is very different and the cost of those capacity resources is economically significant. Therefore, the allocation of capacity costs needs to be done carefully. The traditional costing system does not do a good job on that, distorting the product costs and leading Max to take the wrong decisions.

2) Give Max two recommendations that may help him to redress the situation Max could improve the situation by:

1) Not dropping the Come-on-in product line as he seems to be thinking on doing. It is the most profitable!

2) Increasing the prices of Stay-out and Who-is-it. These products are not profitable at the current prices from a long term perspective. If competition does not allow Max to increase prices, he needs to evaluate other solutions. He must either find a way to reduce costs or stat thinking of alternative products to use the available capacity.

3) Reduce the number of batches in the Stay-out line by increasing the batch size. This could be done by standardizing the product line, increasing inventories of finished products, …

4) Perhaps the Come-on-in product line could be expanded. The current profitability of this product might allow the firm to gain market share with a reduction of prices. If demand responds positively because competitors do not retaliate, this would be a good way to increase profits.

Problem 1 P4-43. ($ in millions) a. 2011 NOPAT = $1,118 - ($378 + ($127 × 0.37) = $693 b. 2011 NOA = $7,462 – $1,506 – $846 – $375 – $652 – $495 – $292 = $3,296

2010 NOA = $6,579 - $795 – $726 – $336 – $596 – $469 – $267 = $3,390 c. 2011 RNOA = $693 / [ ($3,296 + $3,390) / 2 ] = 20.73%

2011 NOPM = $693/$9,700 = 7.14% 2011 NOAT = $9700 / [ ($3,296 + $3,390) / 2 ] = 2.90 2011 RNOA = 7.14% × 2.90 = 20.73% (0.0002 rounding error) Nordstrom’s net operating profit margin of 7.14% is significantly above the industry median of 4.46%, which is not surprising given the company’s high-end product. Nordstrom’s net operating asset turnover ratio of 2.90 is just slightly higher than the industry median NOAT of 2.81. It appears that Nordstrom is managing both its income statement and its balance sheet very well.

d. 2011 NNO = $6 +$ 2,775 – $1,506 = $1,275

Confirm: $3,296 = $1,275 + $2,021 2010 NNO = $356 + $2,257 – $795 = $1,818 Confirm: $3,390 = $1,818 + $1,572

e. 2011 ROE = $613 / [ ($2,021 + $1,572) / 2 ] = 34.12% f. 2011 nonoperating return = ROE – RNOA = 34.12% – 20.73% = 13.39% g. ROE>RNOA implies that Nordstrom is able to borrow money to fund operating

assets that yield a return greater than the cost of its debt. The excess accrues to the benefit of Nordstrom’s stockholders.

Problem 1 The following data pertain to the Western Division of Jordan Company:

Division total contribution margin $500,000 Profit margin controllable by the divisional manager 150,000 Average asset investment 600,000

Management bonuses are awarded at the end of each year and based on ROI, and the company uses responsibility accounting concepts when evaluating performance. Western's division manager is contemplating the following three investments. Jordan has a cost of capital of 15% and uses straight line depreciation with no salvage value.

No. 1 No. 2 No. 3 Initial Investment $160,000 $200,000 $300,000 Annual Expected Profit (includes depreciation as an expense)

32,000 24,000 50,000

Years 3 3 3 Salvage Value 0 0 0

Use beginning of period book value for all calculations (no need to average with end of period asset value). In your calculations you might need the following excerpt from the table in the book: Present value of an Annuity of $1 in Arrears; (1- (1+ r)-n)/r

Number of years Rate of return 2 3 4 5 13% 1.668 2.631 2.974 3.517 14% 1.647 2.322 2.914 3.433 15% 1.626 2.283 2.855 3.352 16% 1.605 2.246 2.798 3.274

Problem 1 – Part A. (2 points) which investment(s) (if any) would Jordan’s shareholders want the division manager to make? Why? No. 1 No. 2 No. 3

Initial Investment $160,000 $200,000 $300,000 Years 3 3 3 Annual Expected income 32,000 24,000 50,000 Annual Depreciation (Investment/Years) $53,333 $66,667 $100,000

CF (Income + Depn.) $85,333 $90,667 $150,000

Annuity factor (3 years) 2.283 2.283 2.283 I/CF 1.875 2.2058824 2

NPV $34,816 $6,992 $42,450 Jordan’s shareholders would want the division manager to invest in all three projects.

Problem 1 – Part B. (2 points) Assuming that the Western’s divisional manager expects to leave the company right after receiving the first coming bonus, which investment(s) (if any) would the manager of the Western’s division undertake? Why? Is this choice goal congruent? Why? No. 1 No. 2 No. 3 WD Initial Investment $160,000 $200,000 $300,000 $600,000 Annual Expected income 32,000 24,000 50,000 150,000

ROI (Income/Investment) 20% 12% 17% 25% All three projects have a positive NPV and, therefore, are good for the company, but the manager would not invest in any of them because they have a ROI smaller than the Western Division’s. Therefore, ROI is not goal congruent in this situation.

Problem 1 – Part C. (1 point) Still assuming that the Western’s divisional manager expects to leave the company right after receiving the first coming bonus, if the manager of the Western’s division was evaluated with residual income, which investment(s) (if any) would she undertake? Would her decisions be goal congruent? Why? Show your answer with calculations. No. 1 No. 2 No. 3 Initial Investment $160,000 $200,000 $300,000 Annual Expected income 32,000 24,000 50,000 RI (Income - r * Investment) $8,000.0 ($6,000.0) $5,000.0 Residual income does better than ROI but it is still not goal congruent because the manager would not invest in project 2.

Problem 2 Jerry is the Manager of a division in a manufacturing company that specializes in cell phones for industrial use. Jerry is evaluated on the ROI of his division, and last year he obtained a ROI of 14%. Jerry knows that, if he does not improve the ROI of his division with respect to the previous year, he does not receive a bonus. The engineering department made a proposal for Jerry consisting of two new products, the MaxCell and the SuperCell. In this industry, products have typically a good start, but they become obsolete pretty fast, leading to a fast decline in profits. The controller of the division is uncertain about the products’ profitability. He is worried about the future wellbeing of the division but does not know how to handle the situation. Problem 2. Part A (2 points) The following data allowed the controller to calculate the NPV of each project.

Investment Opportunity MaxCell SuperCell Initial investment $ 6,000,000 $ 10,000,000 Useful life 4 years 4 years Salvage value $ - $ - Expected operating income for year 1 $ 800,000 $ 1,500,000 Operating income annual growth -10% -40% Required rate of return 14% 14%

Calculate the NPV of both projects. Should the company undertake these projects?

Investment $ 6,000,000 Salvage Value $ - MaxCell Year 0 1 2 3 4 NPV Initial Investment 6,000,000

Profit B/T 800,000 720,000 648,000 583,200 Depreciation 1,500,000 1,500,000 1,500,000 1,500,000 Free Cash Flow 2,300,000 2,220,000 2,148,000 2,083,200 Present Value (6,000,000) 2,017,544 1,708,218 1,449,839 1,233,422 $ 409,022

The company should undertake the MaxCell project because it has a positive NPV.

Investment $ 10,000,000 Salvage Value $ -

SuperCell Year 0 1 2 3 4 NPV Initial Investment 10,000,000

Profit B/T 1,500,000 900,000 540,000 324,000 Depreciation 2,500,000 2,500,000 2,500,000 2,500,000 Free Cash Flow 4,000,000 3,400,000 3,040,000 2,824,000 Present Value (10,000,000) 3,508,772 2,616,190 2,051,913 1,672,035 $ (151,090)

The company should not undertake the SuperCell project because it has a negative NPV.

Problem 2. Part B (1.5 points) Jerry knows that he will leave the company at the end of the first year. He wants to look good and jump to a new and higher position in another firm. What projects will he invest in? Is ROI a goal congruent performance measure in this case? Why? ROI of MaxCell = 800,000/6,000,000 = 13.3% ROI of SuperCell = 1,500,000/10,000,000 = 15.0% Since the current ROI is of a 14%, Jerry will invest in the SuperCell project but not on the MaxCell Project. ROI is not goal congruent because the SuperCell project has a negative NPV and, therefore, it is not a good project for the company. That is, Jerry will invest in a negative NPV project. On the contrary, the MaxCell project has a positive NPV and should be undertaken, but Jerry will not invest on this project because that would lower his ROI.

Problem 2. Part C (1.5 points) What would be your answer in part B if Jerry was evaluated with the annual RI? Would your answer change if she planned to stay in the company for 4 years?

One year horizon

Residual Income for MaxCell = 800,000 – 0.14 * 6,000,000 = -$40,000 Residual Income for SuperCell = 1,500,000 – 0.14 * 10,000,000 = $100,000

Residual income has the same problem as ROI in this case. MaxCell should be undertaken from the company’s perspective but Jerry will not invest on it because it would yield him a negative residual income. On the contrary, SuperCell should not be undertaken but Jerry will invest because it yields a first year positive RI. Therefore, RI is not goal congruent in this case.

Four years horizon

Thanks to the conservation property of the RI, if Jerry plans to stay in the firm for four years, he will take the decisions that are optimal for the company because he will want to maximize NPV.

Problem 1

Castaway Products uses a standard costing system to assist in the evaluation of operations. The company has had considerable employee difficulties in recent months. To redress the situation, management has hired a new production supervisor (Joe Simms). Simms has been on the job for six months and has seemingly brought order to an otherwise chaotic situation. The vice-president of manufacturing recently commented that “… Simms has really done the trick. Joe’s team-building/morale-boosting approach has truly brought things under control.” The vice-president’s comments were based on both a plant tour, where he observed a contented work force, and review of a performance report that showed a flexible budget labor variance of $14,000F and a flexible budget direct-material variance of $5,000U. The vice-president is especially impressed by these variances, because they are less than 2% of the company’s budgeted labor and direct-material costs respectively. Additional data (that the VP did NOT see) follow:

• Total completed production amounted to 20,000 units. • Castaway reported a direct-material price variance of $117,000F, approximately 10% of budgeted

material cost. • A review of the firm’s budgeted cost records found that each completed unit requires 2.75 hours of

labor at $14 per hour. • Castaway’s production actually required 42,000 labor hours at a total cost of $756,000.

Problem 1 – Part A. (20 points) Calculate Castaway’s direct-labor price and efficiency variances. Calculate the direct-materials efficiency variance.

Actual Labor Cost “As if” Budget Flexible Budget

Actual Hours x Actual

Rate Actual Hours x Standard

Rate No need to calculate 42,000 x $18.00* 42,000 x $14.00

$756,000 $588,000 $168,000U $182,000F**

Direct-labor rate variance Direct-labor

efficiency variance

Flexible Budget Labor Variance $14,000F

*$756,000 ÷ 42,000 hours ** Flexible Budget Labor Variance = Direct labor rate variance + Direct labor efficiency variance = $14,000

Thus, we just need to calculate: Direct labor efficiency variance = Flexible Budget Labor Variance - Direct labor rate variance

=14,000 – (-168,000) = 182,000 F DL price variance: $168,000 unfavorable DL efficiency variance: $182,000 favorable DM efficiency variance = DM flexible budget variance – DM price variance = = - $5,000 – $117,000 = - $122,000 = $122,000U

Problem 1 – Part B. (20 points) Evaluate Simms based on the direct-labor and direct-material variances. Does the vice-president have a clear picture of what is going on? Given that you have more information than the vice-president, can you give any alternative explanation to the variances? (Make sure you explain a consistent story that fits the variances available and takes into account interactions between variances.) The student could say something about how the variance is larger than the report suggests or that breaking them out gives more information Castaway should be concerned. Although the combined variance of $14,000F is small, a more detailed analysis reveals the presence of sizable, offsetting variances. Both the rate variance and the efficiency variance are in excess of 21% of budgeted amounts ($770,000). A variance investigation should be undertaken if benefits of the investigation exceed the costs. Put simply, things are not going as smoothly as the vice-president believes. A Plain interpretation of variances without interactions The favorable efficiency variance means that the company is producing units by consuming fewer hours than expected. This may be the result of the team-building/morale-boosting exercises, as a contented, well-trained work force tends to be efficient in nature. However, another totally plausible explanation could be that Castaway is paying premium wages (as indicated by the unfavorable rate variance) to hire laborers with above-average skill levels. Indicating something about interdependencies There may be a relationship between the two variances. The favorable labor efficiency variance may partially explain the unfavorable material quantity variance. That is, laborers may be rushing through their jobs and using more material than standard.

Problem 2 Tuscany Statuary manufactures bust statues of famous historical figures. All statues are the same size. Each unit requires the same amount of resources. The following data is from the master budget for 2008: Expected production and sales 5000 units Direct materials 50,000 pounds Direct manufacturing labor 20,000 hours Total fixed costs $1,000,000 Budgeted input quantities, prices and unit costs follow for direct materials and direct labor. Budgeted Input

Quantity (per unit of output)

Budgeted Price Budgeted Unit Cost

Direct materials 10 pounds $10 per pound $100 Direct labor 4 hours $40 per hour $160

During 2008, actual number of units produced and sold was 6,000. Actual cost of direct materials used was $594,000, based on 54,000 pounds purchased at $11 per pound. Direct manufacturing labor-hours actually used were 25,000, at the rate of $38 per hour. This resulted in actual direct manufacturing labor costs of $950,000. Actual fixed costs were $1,005,000. There were no beginning and ending inventories.

Problem 2, Part A. (20 points). Calculate the (variable-cost) sales-volume variance and (variable-cost) flexible-budget variance for direct materials and direct labor. Show and very clearly label your work.

Flexible- Sales- Actual Budget Flexible Volume Static Results Variances Budget Variances Budget

(1) (2) = (1) – (3) (3) (4) = (3) – (5) (5) Units sold 6,000a 0 6,000 1,000 F 5,000a

Direct materials $ 594,000 $ 6,000 F $ 600,000 b $100,000 U $ 500,000c

Direct manufacturing labor 950,000a 10,000 F 960,000d 160,000 U 800,000e Fixed costs 1,005,000a 5,000 U 1,000,000a 0 1,000,000a Total costs $2,549,000 $11,000 F $2,560,000 $260,000 U $2,300,000 $11,000 F $260,000 U Flexible-budget variance Sales-volume variance $249,000 U

Static-budget variance

a Given b $100 × 6,000 = $600,000 c $100 × 5,000 = $500,000 d $160 × 6,000 = $960,000 e $160 × 5,000 = $800,000

Problem 2, Part B. (20 points) Compute price and efficiency variances for direct materials and direct labor. Show and very clearly label your work.

Actual As If Flexible Budget IA*NA*QA IB*NA*QA IB*NB*QA Direct materials $594,000a $540,000b $600,000c

$54,000 U $60,000 F

Price variance Efficiency variance $6,000 F Flexible-budget variance Direct manufacturing labor $950,000a $1,000,000e $960,000f $50,000 F $40,000 U

Price variance Efficiency variance $10,000 F Flexible-budget variance

a 54,000 pounds × $11/pound = $594,000 b 54,000 pounds × $10/pound = $540,000 c 6,000 statues × 10 pounds/statue × $10/pound = 60,000 pounds × $10/pound = $600,000 d 25,000 pounds × $38/pound = $950,000 e 25,000 pounds × $40/pound = $1,000,000 f 6,000 statues × 4 hours/statue × $40/hour = 24,000 hours × $40/hour = $960,000

Problem 2, Part C. (20 points). The company is organized in three departments: purchasing, production and marketing. Recently, the purchasing manager and the production manager have been arguing about quality vs. efficiency issues. Provide the manager of Tuscany Statuary with an idea as to what may have caused and who might be responsible for the following variances as you calculated them in Parts A and B:

i) Sales volume variances ii) Direct material’s price variance iii) Direct labor’s efficiency variance

The following are some of the possible interpretations of the resulting variances:

Direct material’s unfavorable price variance may have been caused by the purchasing department

(1) paying higher price than the standard for the period

(2) changing to a new vendor (3) buying higher-quality materials

Direct material’s favorable efficiency variance may have been caused by the production department

(1) making employee/machinery working more efficiently and having less scrap and waste materials

(2) buying better-quality materials. Notice that, since the direct materials flexible budget variance is favorable, this interpretation would make the increase in quality of direct materials a good decision of the purchasing department.

(3) changing the production process.

Direct labor’s favorable price variance may have been caused by the production department

(1) changing the work force by hiring lower-paid employees

(2) changing the mix of skilled and unskilled workers

(3) not giving pay raises as high as anticipated when the standards were set for the year

(4) having to pay less over-time due to a higher efficiency in the production process

Direct labor’s unfavorable efficiency variance may have been caused by the production department

(1) changing the mix of skilled and unskilled workers. This interpretation is coherent with the favorable labor price variance being caused with lower paid workers. Overall, since the labor flexible variance is favorable, this would have been a good decision of the production department. Nevertheless, one should also consider the effects of these changes on the quality of the final product.

(2) The workforce was increased with unskilled workers to avoid paying overtime. This would be consistent with the favorable labor price variance.

(3) changes of production process (learning something new takes time). This would be consistent with a process change that reduces spoilage or rework and, therefore, produces a favorable direct material’s efficiency variance.

(4) different types of direct materials to work with. This could also be related to a change of materials decided by the purchasing department.

(5) poor working conditions or poor attitudes on behalf of the workers. This might be consistent with giving lower raises to the workforce and thereby obtaining a favorable labor price variance.

Sales volume variances: all sales volume variance are unfavorable because volume increased. This might be because the marketing department has did a better job than expected in promoting sales, or because the marketing department did not forecast sales accurately (or both). In any case, an unexpected high volume of sales may also be related to the unfavorable labor efficiency and direct materials price variances because of rush orders, stock-outs or capacity issues.

Problem 1 The California Instrument Company (CIC) consists of the Semiconductor Division (SD) and the Process-Control Division (PCD), each of which operates as an independent profit center. The SD employs craftsmen to produce two different electronic components: the new high-performance Super-chip and an older product called Okay-chip. These two products have the following cost characteristics: Super-chip Okay-chip Direct materials $2 $1 Direct manufacturing labor (2 hours x $14/hour =)

$28 (.5 hours x $14/hour =)

$7 Annual overhead in SD totals $400,000, all fixed. Due to the high skill level necessary for the craftsmen, the SD’s capacity is set at 50,000 hours per year. The current market price for Super-chips is $60 per chip with a maximum external demand of 15,000 units per year. The maximum external demand for Okay-chip is 50,000 units at $12 per chip. The PCD produces and sells only one product to the external market, a process-control unit, with the following cost structure:

• Direct materials (circuit board, bought to an external supplier): $60 • Direct manufacturing labor (5hours x $10/hour): $50

Fixed overhead of the PCD is $80,000 per year. The current market price for the process-control unit is $132 per unit. A joint research project has just revealed that a single Super-chip could replace the circuit board currently used to make the process-control unit. Using a Super-chip would require one extra labor hour per process-control unit for a new total of 6 hours per-control unit manufactured in the PCD.

Problem 1 - Part A (1 point) If no transfers of Super-chips are made to the PCD, how many Super-chips and Okay-chips should the SD sell to the external market? Show your computations.

Super-chip Okay-chip Selling price $60 $12 Direct material cost per unit 2 1 Direct manufacturing labor cost per unit 28 7 Contribution margin per unit $30 $ 4 Contribution margin per hour ($30 ÷ 2; $4 ÷ 0.5) $15 $ 8

Because the contribution margin per hour is higher for Super-chip than for Okay-chip, CIC should produce and sell as many Super-chips as it can and use the remaining available capacity to produce Okay-chip.

The total demand for Super-chips is 15,000 units, which would take 30,000 hours (15,000 × 2 hours per unit). CIC should use its remaining capacity of 20,000 hours (50,000 – 30,000) to produce 40,000 Okay-chips (20,000 ÷ 0.5).

Problem 1 - Part B (2 points) The PCD expects to sell 5,000 process-control units this year. From the viewpoint of CIC as a whole, should 5,000 Super-chips be transferred from the SD to the PCD to replace circuit boards? Show your computations. Possible Different Calculations: Overall Company Viewpoint Alternative 1: No Transfer of Super-chips:

Sell 15,000 Super-chips at contribution margin per unit of $30 $450,000 Sell 40,000 Okay-chips at contribution margin per unit of $4 160,000 Sell 5,000 Control units at contribution margin per unit of $22 110,000 Total contribution margin $720,000

Alternative 2: Transfer 5,000 Super-chips to Process-Control Division. These Super-chips would require 10,000 hours to manufacture, leaving only 10,000 hours for the manufacture of 20,000 Okay-chips (10,000 ÷ 0.5):

Sell 15,000 Super-chips at contribution margin per unit of $30 $450,000 Sell 20,000 Okay-chips at contribution margin per unit of $4 80,000 Sell 5,000 Control units at contribution margin per unit of $42 210,000 Total contribution margin $740,000

CIC is better off transferring 5,000 Super-chips to the Process-Control Division.

Some students might have shortened the calculations by not considering non-relevant contributions. For instance, the contribution from the sale of 15,000 Super-chips to the market happens in both alternative scenarios with the same contribution margin per unit. Therefore, it can be disregarded. Alternative 1: No Transfer of Super-chips:

Sell 40,000 Okay-chips at contribution margin per unit of $4 160,000 Sell 5,000 Control units at contribution margin per unit of $22 110,000 Total contribution margin $270,000

Alternative 2: Transfer 5,000 Super-chips to Process-Control Division. These Super-chips would require 10,000 hours to manufacture, leaving only 10,000 hours for the manufacture of 20,000 Okay-chips (10,000 ÷ 0.5):

Sell 20,000 Okay-chips at contribution margin per unit of $4 80,000 Sell 5,000 Control units at contribution margin per unit of $42 210,000 Total contribution margin $290,000

The students can even go further in simplifying the calculations and realize that there will be 20,000 Okay-chips difference between alternatives Alternative 1: No Transfer of Super-chips:

Sell 20,000 Okay-chips at contribution margin per unit of $4 80,000 Sell 5,000 Control units at contribution margin per unit of $22 110,000 Total contribution margin $190,000

Alternative 2: Transfer 5,000 Super-chips to Process-Control Division. These Super-chips would require 10,000 hours to manufacture, leaving only 10,000 hours for the manufacture of 20,000 Okay-chips (10,000 ÷ 0.5):

Sell 5,000 Control units at contribution margin per unit of $42 210,000 Total contribution margin $210,000

Another approach is to consider the difference in contribution margins of selling the 5,000 Super-chips in the two alternative scenarios and then take into account the opportunity cost of producing it in the SD as opposed to buying externally. Alternative 2 vs. 1

Sell 5,000 Control units at contribution margin per unit of $42 210,000 - Sell 5,000 Control units at contribution margin per unit of $22 110,000 - Opportunity cost of selling 20,000 Okay-chips at contribution margin per unit of $4 80,000 Total contribution margin $20,000

An even shorter approach is to consider the difference in cost of selling the 5,000 Super-

chips in the two alternative scenarios and then take into account the opportunity cost of producing it in the SD as opposed to buying externally.

Alternative 2 vs. 1

Sell 5,000 Control units at contribution margin per unit of $42 210,000 - Sell 5,000 Control units at contribution margin per unit of $22 110,000 - Opportunity cost of selling 20,000 Okay-chips at contribution margin per unit of $4 80,000 Total contribution margin $20,000

Problem 1 - Part C (2 points) The PCD still expects to sell 5,000 process control units this year. Calculate the minimum transfer price at which the SD would be willing to sell the Super-chip to the PCD, and the maximum transfer price the PCD would be willing to pay for it. For each Super-chip that is transferred, two hours of time (labor capacity) are given up in the Semiconductor Division, and, in those two hours, four Okay-chips could be produced, each contributing $4.

Minimum transfer priceper Super - chip =

transferofpoint theunit toper

cost lIncrementa+ Opportunity cost per unit for

the Semiconductor Division

= $30 + $16 = $46 per unit

If the selling price for the process-control unit were firm at $132, the Process-Control Division would accept any transfer price up to $50 ($60 price of circuit board − $10 incremental labor cost if Super-chip used).

Problem 2.

The Shamrock Company manufactures and sells television sets. Its Assembly Division (AD) buys television screens from the Screen Division (SD) and assembles the TV sets. The SD, which is operating at capacity, incurs an incremental manufacturing cost of $80 per screen. The SD can sell all its output to the outside market at a price of $120 per screen, after incurring a variable marketing and distribution cost of $5 per screen. This variable marketing cost is not incurred if the television screens are sold internally. If the AD purchases screens from outside suppliers at a price of $120 per screen, it will incur a variable purchasing cost of $3 per screen. This cost is not incurred if the supplier is the SD. Shamrock’s division managers can act autonomously to maximize their own division’s operating income. Problem 2 – Part A. (2 points). If the divisions are allowed full discretion to negotiate a transfer price, can an internal transfer take place and at what transfer price? Is this goal congruent?

Division SD

Division SD Status Quo Accept Transfer Revenues 120 TPmin - uvcSD -80 -80 - uvmcSD -5 0 CMA 35 TPmin - 80

Thus, Division A will be indifferent if 35 = TPmin – 80 That is, TPmin = 80 +35 = $115/cs

AD uvcAD = ?

screens PSD=$120/s uvmcSD= $5/s

5000 custom screens

TP

Televisions SD uvcSD= $80

PAD=$120/s uvpcAD= $3/s

screens

PT=$?

Division AD

Division AD Per unit Status Quo Accept Transfer Buy Externally Price 0 PT PT - uvcAD 0 - uvcAD - uvcAD -screen cost 0 - TPmax - 120 -uvpcAD 0 0 -3 ucmAD 0 PT - uvcAD - TPmax PT - uvcAD -123

Thus, Division B will be indifferent between accepting the transfer and buying externally if TPmax = $123/s. A negotiated transfer price can be agreed in the range TP ϵ [115, 123] This is goal congruent because for the company as a whole it is best if the transfer takes place. Since both divisions profit from the transaction, the company as a whole must profit as well. This can also be seen easily because by transferring internally, the company saves the marketing and distribution cost and the purchasing cost.

Problem 2 – Part B. (3 points). Suppose that the SD can sell only 8,000 screens per month externally and has an output capacity of 12,000 screens per month. Capacity cannot be reduced in the short run. The AD can assemble and sell 8,000 TV sets per month. For operational efficiency reasons, order size needs to be a multiple of 4,000 screens. The AD has found a supplier willing to sell screens for $100 per screen.

a. For each possible order size, what is the minimum transfer price at which the SD manager would be willing to sell screens to the AD?

b. If allowed to negotiate, will there be trade between divisions? If yes, at what transfer price and order size?

c. From the point of view of Shamrock’s shareholders how much of the SD output should be transferred to the AD? Is negotiation a goal congruent method to determine the transfer price in this case?

a. The only two possible order sizes are 4,000 and 8,000 screens because AD cannot sell more than that.

Order Size: 4,000 screens

Division SD Status Quo Accept Transfer Revenues 0 4,000*TPmin - uvcSD 0 -4,000*80 - uvmcSD 0 0 ucmSD 0 4,000*(TPmin – 80)

Thus, Division A will be indifferent if 0 = 4,000*(TPmin – 80) That is, TPmin = 80 = $80/s

Order Size: 8,000 screens

Division SD Status Quo Accept Transfer Revenues 4,000*120 8,000*TPmin - uvcSD -4,000*80 -8,000*80 - uvmcSD -4,000*5 0 ucmSD 4,000*35 8,000*(TPmin – 80)

Thus, Division A will be indifferent if 4,000*35 = 8,000*(TPmin – 80) That is, TPmin = 80 +4,000*35 /8,000= $97.5/s

b. Division AD

Order Size: 4,000 screens

Division AD Per unit Status Quo Accept Transfer Buy Externally Price 0 4000*PT 4000*PT - uvcAD 0 -4000* uvcAD -4000* uvcAD -screen cost 0 - 4000*TPmax -4000* 100 -uvpcAD 0 0 -4000*3 ucmAD 0 4,000*(PT - uvcAD - TPmax) 4,000*(PT - uvcAD -103)

Thus, Division B will be indifferent between accepting the transfer and buying externally if TPmax = $103/s.

Order Size: 8,000 screens

Division AD Per unit Status Quo Accept Transfer Buy Externally Price 0 8,000*PT 8,000*PT - uvcAD 0 -8,000* uvcAD -8,000* uvcAD -screen cost 0 - 8,000*TPmax -8,000* 100 -uvpcAD 0 0 -8,000*3 ucmAD 0 8,000*(PT - uvcAD - TPmax) 8,000*(PT - uvcAD -103)

Thus, Division B, at any order size, will be indifferent between accepting the transfer and buying externally if TPmax = $103/s.

There can be trade between divisions at the two order sizes:

At an order size of 4,000 screens the transfer price will be negotiated in TP ϵ [80, 103]

At an order size of 8,000 screens the transfer price will be negotiated in TP ϵ [97.5, 103]

c. From the point of view of the shareholders, the divisions should transfer as many screens as possible internally. For each screen that is transferred internally the company saves the marketing cost the SD and the purchasing cost of the AD. Therefore, 8,000 screens

should be transferred internally. Therefore, it is goal congruent to let them negotiate. They have a range of transfer prices at which they can trade.

Problem 1

Castaway Products uses a standard costing system to assist in the evaluation of operations. The company has had considerable employee difficulties in recent months. To redress the situation, management has hired a new production supervisor (Joe Simms). Simms has been on the job for six months and has seemingly brought order to an otherwise chaotic situation. The vice-president of manufacturing recently commented that “… Simms has really done the trick. Joe’s team-building/morale-boosting approach has truly brought things under control.” The vice-president’s comments were based on both a plant tour, where he observed a contented work force, and review of a performance report that showed a flexible budget labor variance of $14,000F and a flexible budget direct-material variance of $5,000U. The vice-president is especially impressed by these variances, because they are less than 2% of the company’s budgeted labor and direct-material costs respectively. Additional data (that the VP did NOT see) follow:

• Total completed production amounted to 20,000 units. • Castaway reported a direct-material price variance of $117,000F, approximately 10% of budgeted

material cost. • A review of the firm’s budgeted cost records found that each completed unit requires 2.75 hours of

labor at $14 per hour. • Castaway’s production actually required 42,000 labor hours at a total cost of $756,000.

Problem 1 – Part A. (20 points) Calculate Castaway’s direct-labor price and efficiency variances. Calculate the direct-materials efficiency variance.

Actual Labor Cost “As if” Budget Flexible Budget

Actual Hours x Actual

Rate Actual Hours x Standard

Rate No need to calculate 42,000 x $18.00* 42,000 x $14.00

$756,000 $588,000 $168,000U $182,000F**

Direct-labor rate variance Direct-labor

efficiency variance

Flexible Budget Labor Variance $14,000F

*$756,000 ÷ 42,000 hours ** Flexible Budget Labor Variance = Direct labor rate variance + Direct labor efficiency variance = $14,000

Thus, we just need to calculate: Direct labor efficiency variance = Flexible Budget Labor Variance - Direct labor rate variance

=14,000 – (-168,000) = 182,000 F DL price variance: $168,000 unfavorable DL efficiency variance: $182,000 favorable DM efficiency variance = DM flexible budget variance – DM price variance = = - $5,000 – $117,000 = - $122,000 = $122,000U

Problem 1 – Part B. (20 points) Evaluate Simms based on the direct-labor and direct-material variances. Does the vice-president have a clear picture of what is going on? Given that you have more information than the vice-president, can you give any alternative explanation to the variances? (Make sure you explain a consistent story that fits the variances available and takes into account interactions between variances.) The student could say something about how the variance is larger than the report suggests or that breaking them out gives more information Castaway should be concerned. Although the combined variance of $14,000F is small, a more detailed analysis reveals the presence of sizable, offsetting variances. Both the rate variance and the efficiency variance are in excess of 21% of budgeted amounts ($770,000). A variance investigation should be undertaken if benefits of the investigation exceed the costs. Put simply, things are not going as smoothly as the vice-president believes. A Plain interpretation of variances without interactions The favorable efficiency variance means that the company is producing units by consuming fewer hours than expected. This may be the result of the team-building/morale-boosting exercises, as a contented, well-trained work force tends to be efficient in nature. However, another totally plausible explanation could be that Castaway is paying premium wages (as indicated by the unfavorable rate variance) to hire laborers with above-average skill levels. Indicating something about interdependencies There may be a relationship between the two variances. The favorable labor efficiency variance may partially explain the unfavorable material quantity variance. That is, laborers may be rushing through their jobs and using more material than standard.

Problem 2 Tuscany Statuary manufactures bust statues of famous historical figures. All statues are the same size. Each unit requires the same amount of resources. The following data is from the master budget for 2008: Expected production and sales 5000 units Direct materials 50,000 pounds Direct manufacturing labor 20,000 hours Total fixed costs $1,000,000 Budgeted input quantities, prices and unit costs follow for direct materials and direct labor. Budgeted Input

Quantity (per unit of output)

Budgeted Price Budgeted Unit Cost

Direct materials 10 pounds $10 per pound $100 Direct labor 4 hours $40 per hour $160

During 2008, actual number of units produced and sold was 6,000. Actual cost of direct materials used was $594,000, based on 54,000 pounds purchased at $11 per pound. Direct manufacturing labor-hours actually used were 25,000, at the rate of $38 per hour. This resulted in actual direct manufacturing labor costs of $950,000. Actual fixed costs were $1,005,000. There were no beginning and ending inventories.

Problem 2, Part A. (20 points). Calculate the (variable-cost) sales-volume variance and (variable-cost) flexible-budget variance for direct materials and direct labor. Show and very clearly label your work.

Flexible- Sales- Actual Budget Flexible Volume Static Results Variances Budget Variances Budget

(1) (2) = (1) – (3) (3) (4) = (3) – (5) (5) Units sold 6,000a 0 6,000 1,000 F 5,000a

Direct materials $ 594,000 $ 6,000 F $ 600,000 b $100,000 U $ 500,000c

Direct manufacturing labor 950,000a 10,000 F 960,000d 160,000 U 800,000e Fixed costs 1,005,000a 5,000 U 1,000,000a 0 1,000,000a Total costs $2,549,000 $11,000 F $2,560,000 $260,000 U $2,300,000 $11,000 F $260,000 U Flexible-budget variance Sales-volume variance $249,000 U

Static-budget variance

a Given b $100 × 6,000 = $600,000 c $100 × 5,000 = $500,000 d $160 × 6,000 = $960,000 e $160 × 5,000 = $800,000

Problem 2, Part B. (20 points) Compute price and efficiency variances for direct materials and direct labor. Show and very clearly label your work.

Actual As If Flexible Budget IA*NA*QA IB*NA*QA IB*NB*QA Direct materials $594,000a $540,000b $600,000c

$54,000 U $60,000 F

Price variance Efficiency variance $6,000 F Flexible-budget variance Direct manufacturing labor $950,000a $1,000,000e $960,000f $50,000 F $40,000 U

Price variance Efficiency variance $10,000 F Flexible-budget variance

a 54,000 pounds × $11/pound = $594,000 b 54,000 pounds × $10/pound = $540,000 c 6,000 statues × 10 pounds/statue × $10/pound = 60,000 pounds × $10/pound = $600,000 d 25,000 pounds × $38/pound = $950,000 e 25,000 pounds × $40/pound = $1,000,000 f 6,000 statues × 4 hours/statue × $40/hour = 24,000 hours × $40/hour = $960,000

Problem 2, Part C. (20 points). The company is organized in three departments: purchasing, production and marketing. Recently, the purchasing manager and the production manager have been arguing about quality vs. efficiency issues. Provide the manager of Tuscany Statuary with an idea as to what may have caused and who might be responsible for the following variances as you calculated them in Parts A and B:

i) Sales volume variances ii) Direct material’s price variance iii) Direct labor’s efficiency variance

The following are some of the possible interpretations of the resulting variances:

Direct material’s unfavorable price variance may have been caused by the purchasing department

(1) paying higher price than the standard for the period

(2) changing to a new vendor (3) buying higher-quality materials

Direct material’s favorable efficiency variance may have been caused by the production department

(1) making employee/machinery working more efficiently and having less scrap and waste materials

(2) buying better-quality materials. Notice that, since the direct materials flexible budget variance is favorable, this interpretation would make the increase in quality of direct materials a good decision of the purchasing department.

(3) changing the production process.

Direct labor’s favorable price variance may have been caused by the production department

(1) changing the work force by hiring lower-paid employees

(2) changing the mix of skilled and unskilled workers

(3) not giving pay raises as high as anticipated when the standards were set for the year

(4) having to pay less over-time due to a higher efficiency in the production process

Direct labor’s unfavorable efficiency variance may have been caused by the production department

(1) changing the mix of skilled and unskilled workers. This interpretation is coherent with the favorable labor price variance being caused with lower paid workers. Overall, since the labor flexible variance is favorable, this would have been a good decision of the production department. Nevertheless, one should also consider the effects of these changes on the quality of the final product.

(2) The workforce was increased with unskilled workers to avoid paying overtime. This would be consistent with the favorable labor price variance.

(3) changes of production process (learning something new takes time). This would be consistent with a process change that reduces spoilage or rework and, therefore, produces a favorable direct material’s efficiency variance.

(4) different types of direct materials to work with. This could also be related to a change of materials decided by the purchasing department.

(5) poor working conditions or poor attitudes on behalf of the workers. This might be consistent with giving lower raises to the workforce and thereby obtaining a favorable labor price variance.

Sales volume variances: all sales volume variance are unfavorable because volume increased. This might be because the marketing department has did a better job than expected in promoting sales, or because the marketing department did not forecast sales accurately (or both). In any case, an unexpected high volume of sales may also be related to the unfavorable labor efficiency and direct materials price variances because of rush orders, stock-outs or capacity issues.