Analysis of Polysar

Harvard Business School Teaching Case

Polysar Ltd.

AGENDA Polysar Ltd.Introduction to PolysarStandard CostingVariance Analysis for Variable CostsFixed Overhead Volume VarianceTransfer Pricing

POLYSARCanadas largest chemical company.The Rubber Group accounts for 46% of Polysars sales.Primary products for this group are butyl and halobutyl.Principal customers for these products are tire manufacturers.Rubber Group has two divisionsNASA (North America & South America)EROW (Europe & elsewhere)

POLYSARButyl is manufactured by NASA at its Sarnia 2 plant, and by EROW at its Antwerp plant.Sarnia 2 is a relatively new facility, dedicated entirely to butyl production.The Antwerp plant makes both butyl and halobutyl.EROWs demand exceeds its manufacturing capacity, so EROW buys butyl from NASA.

POLYSAR

POLYSAR1a) What evidence do we have that Polysar is on a standard costing system?

1b) Interpret the amount $22,589 on Exhibit 2, for variable costs.

1c) Interpret the amount $21,450 on Exhibit 2, for variable costs.

POLYSAR1d) Evaluate NASAs performance relative to budget for sales price and volume.

1e) Evaluate NASAs performance relative to budget for plant efficiency, raw materials prices, fixed manufacturing expenses, and non-manufacturing expenses.

POLYSAR1a) What evidence do we have that Polysar is on a standard costing system?

Product Costing and Transfer Prices Butyl rubbers were costed using standard rates for variable and fixed costs.Variable costs included feedstocks, chemicals, and energy. Standard variable cost per ton of butyl was calculated by multiplying the standard utilization factor (i.e., the standard quantity of inputs used) by a standard price established for each unit of input. Since feedstock prices varied with worldwide market conditions and represented the largest component of costs, it was impossible to establish standard input prices that remained valid for extended periods. Therefore, the company reset standard costs each month to a price that reflected market prices. Chemical and energy standard costs were established annually.

POLYSAR1b) Interpret the amount $22,589 on Exhibit 2, for variable costs.

1b) Interpret the amount $22,589 on Exhibit 2, for variable costs.

The $22,589 is in the actual column, and is the variable cost at standard. Therefore, it is based on the actual volume of output (i.e., sales), but uses the budgeted cost of the inputs (feedstocks, chemicals, and energy) per ton of output.The standard cost per ton for raw materials, averaged over the 9 months,was $631 per ton ($22,589/35.8).The $22,589 is equivalent to a flexible budget amount. It is the answer to the question: What should our input costs have been for our actual level of output (sales)?

POLYSAR1c) Interpret the amount $21,450 on Exhibit 2, for variable costs.

1c) Interpret the amount $21,450 on Exhibit 2, for variable costs.

This is the static budget number for variable costs (feedstocks, chemicals, energy). Since it is the static budget, it is based on the original, projected level of sales. From Exhibit 1, the projected level of sales was 33,000 tons.

Hence, the standard cost per ton for variable costs, as of the beginning of the year, was $650 per ton ($21,450/33).

How can the standard cost per ton for variable costs differ from the beginning of the year to the end of the year?

I.e.: $650 per ton vs. $631 per ton.

POLYSAR

POLYSAR

Product Costing and transfer Prices Butyl rubbers were costed using standard rates for variable and fixed costs. Variable costs included feedstocks, chemicals, and energy. Standard variable cost per ton of butyl was calculated by multiplying the standard utilization factor (i.e., the standard quantity of inputs used) by a standard price established for each unit of input. Since feedstock prices varied with worldwide market conditions and represented the largest component of costs, it was impossible to establish standard input prices that remained valid for extended periods. Therefore, the company reset standard costs each month to a price that reflected market prices. Chemical and energy standard costs were established annually.

POLYSAR1d) Evaluate NASAs performance relative to budget for sales price and volume.

Evaluate NASAs performance relative to budget for sales price and volume.Sales Volume: Budgeted: 33,000 tons Actual: 35,800 tons

Sales Price per Tonne: Budgeted: $1,850 ($61,050/33) Actual: $1,840 ($65,872/35.8)

POLYSAR1e) Evaluate NASAs performance relative to budget for plant efficiency, raw materials prices, fixed manufacturing expenses, and non-manufacturing expenses.

Price and Efficiency Variances for Feedstocks, Chemicals and EnergyS.P.

A.P.

A.Q.* S.Q.*$22,294KACTUAL COST$241KFAV.$54K FAVORABLECOST ADJUSTMENTEFFICIENCY VARIANCE*For actual outputThe outer box represents the flexible budget amount of $22,589.

POLYSARSales price per ton is slightly below budget.Sales volume is almost 10% above budget.The efficiency variance for variable costs is very small.The price variance for variable costs is very small, due in part to the fact that standards are revised monthly.Fixed manufacturing expenses are within 2% of budget.Non-manufacturing expenses are within 1% of budget.

POLYSARWhy do 80% of manufacturing companies use Standard Costing Systems?Survey data shows that the most important reason is to help control costs.How does a standard costing system help Polysar control costs?In a standard costing system, all variances flow through the accounting system, and appear on the monthly income statements.

POLYSAR2.Calculate NASAs rate for allocating manufacturing overhead costs to Butyl.

POLYSARFixed Manufacturing Overhead Demonstrated Capacity= $44,625K .85,000 tons per year x 9/12=$700 per ton

POLYSAR3.Use the rate calculated above to show that the following amounts have been calculated correctly:

Fixed Costs of Sales on Exhibit 2

Transfers to Finished Goods Inventory on Exhibit 1

Transfers to EROW on Exhibit 1

POLYSARFixed Costs of Sales on Exhibit 2

Actual:$700/tonne x 35.8K tonnes = $25,060K

Budgeted:$700/tonne x 33.0K tonnes = $23,100K

POLYSAR

Transfers to Finished Goods Inventory on Exhibit 1

Actual:$700 x (47.5 + 2.1 - 35.8 - 12.2) = $700 x 1.6K tonnes = $1,120K

Budgeted:$700 x (55 + 1 - 33 - 19.5) = $700 x 3.5K = $2,450K

POLYSARTransfers to EROW on Exhibit 1

Actual:$700/tonne x 12.2K tonnes = $8,540K

Budget:$700/tonne x 19.5K tonnes = $13,650K

POLYSAR4.Does Polysar close out variances to Cost of Goods Sold, or allocate variances between Cost of Goods Sold and Inventory?

POLYSARIn the previous question, we were able to recalculate the fixed cost component of butyl added to ending inventory, and butyl transferred to EROW, using the budgeted $700 per ton rate. Therefore, no variances are included in these amounts, and all variances closed out to the income statement (Exhibit 2). These variances appear on the line items for Cost Adjustments, Spending Variance, and Volume Variance.

POLYSAR5.Using the information on Exhibit 1, identify EROWs rate for applying fixed manufacturing costs to Butyl. What might explain the difference in the fixed overhead rates of the two divisions?

POLYSARFrom the Budgeted column on Exhibit 1, we know that NASA planned to take 1K tonnes of butyl from EROW, at a cost (i.e., fixed cost component) of $620K, or $620 per ton.EROWs fixed cost rate of $620 is lower than NASAs rate of $700, probably because EROWs facility is older. Note that the difference in rates cannot be due to differences in capacity utilization.

POLYSAR6.What do the budgeted and actual volume variances of $6,125 and $11,375 represent?

POLYSARBudgetCapacity for 9 mo.s of 63,750 tonsBudgeted production of 55,000 (63,750 - 55,000) x $700 = $6,125KActualCapacity for 9 months of 63,750 tonsActual production of 47,500 (63,750 - 47,500) x $700 = 16,250 x $700 = $11,375K

POLYSAR7.Now assume NASA decided to use budgeted utilization in the denominator for calculating the fixed cost rate. What would the rate be now? What would the actual and budgeted volume variances now be.

POLYSARFixed Manufacturing Overhead Budgeted Production=$44,625K .55,000 tons

= $811 per ton

POLYSARUsing this $811 per ton rate:There would be no budgeted volume variance, since$811/ton x 55K tons = $44,625K

Actual volume variance would be$811 x (55,000 - 47,500) = $6,085

POLYSAR8a) What type of transfer price does Polysar use?8b) What is the transfer price for butyl?8c) What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for actual demand?8d) What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for budgeted demand?8e) What is the best butyl sourcing strategy for Polysar?8f) What is the best butyl sourcing strategy for EROW?

POLYSAR8a.What type of transfer price does Polysar use?

Transfer Pricing OptionsMarket-Based Transfer PriceCost-Based Transfer PriceNegotiated Transfer PriceDual Transfer Price

Product Costing and Transfer Prices Product transfers between divisions for performance accounting purposes were made at standard full cost, representing, for each ton, the sum of standard variable cost and standard fixed cost.

POLYSARPolysar uses a cost-based transfer price.

COST-BASED TRANSFER PRICECan be variable cost or full cost.Whether variable or full, can be actual costs or budgeted costs.Whether variable or full, can include a mark-up to allow profit for the selling division.

POLYSAR

Interview with Pierre Choquette (Vice President of NASA Rubber Division) Our transfers to EROW are still a problem. Since the transfers are at standard cost and are not recorded as revenue, these transfers do nothing for our profit. Also, if they cut back on orders, our profit is hurt through the volume variance. Few of our senior managers truly understand the volume variance.

POLYSARPolysar uses a cost-based transfer price.It is a full cost transfer price (i.e., it includes both variable and fixed costs).It is based on budgeted (i.e., standard costs).It does not include a mark-up.

POLYSAR8b. What is the transfer price for butyl?

Product Costing and Transfer Prices Fixed costs were allocated to production based on a plants demonstrated capacity using the following formula,standard fixed cost per ton = estimated annual total fixed cost annual demonstrated plant capacity

To apply the formula, product estimates were established each fall for the upcoming year.

CALCULATION OF TRANSFER PRICE FOR BUTYLTotal Fixed Costs were budgeted at $44,625K (from Exhibit 1).Denominator is demonstrated capacity. This is 85,000 tons per year, or 63,750 tonnes for 9 months.$44,625K/63,750 = $700 per ton

POLYSAR8c.What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for actual demand?

POLYSAR Each ton of butyl transferred to EROW has $700 in fixed costs attached to it. EROW covers $700 of NASAs fixed costs with each ton purchased from NASA.

When EROW takes less butyl than planned, and NASA cuts back on production accordingly, NASAs volume variance increases, and its net contribution (i.e., income) decreases, relative to plan.

POLYSAR

8d.What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for budgeted demand?

POLYSAR If NASA produces at budgeted demand, and EROW purchases less butyl than planned, NASA will increase its ending inventory. In this case, the fact that EROW takes less butyl than planned will have no effect on NASAs net contribution. The $700 per ton in fixed costs that NASA thought would be covered by EROW, will now be capitalized in ending inventory.

POLYSAR8c.What is the best butyl sourcing strategy for Polysar?

POLYSARPolysar should allocate production of butyl and halobutyl to EROW and NASA to minimize total production and shipping costs, while still meeting customer demand.In making this determination, fixed costs are irrelevant, since they are either sunk costs, or are unavoidable unless the plant is closed down.Polysar should manufacture butyl as long as the sales price is more than the variable costs of production and distribution.

Product Costing and Transfer Prices Fixed costs comprised three categories of cost. Direct costs included direct labor, maintenance, chemicals required to keep the plant bubbling, and fixed utilities. Allocated cash costs included plant management, purchasing department costs, engineering, planning, and accounting. Allocated non-cash costs represented primarily depreciation.

POLYSAREROWs variable cost per ton is approximately $595.

NASAs variable cost per ton is approximately $623.

POLYSAR8f.What is the best butyl sourcing strategy for EROW, given the current accounting treatment, and the bonus scheme?

POLYSAR From EROWs point of view, the $700 per tonne allocation of fixed costs is a variable cost. If EROW can manufacture an extra ton of butyl in Antwerp, instead of buying the butyl from NASA, EROW saves $700.EROW should manufacture as much butyl in Antwerp as possible, before buying butyl from NASA.

POLYSAR If EROW can sell one more ton of butyl, at a price equal to NASAs variable costs, plus shipping, plus $699, will they want to?In the above situation, will the company want EROW to make the sale?

POLYSARCompensationManagement For managers, the percent of remuneration received through annual bonuses was greater than 12% and increased with responsibility levels.The bonuses of top Division management in 1985 were calculated by a formula that awarded 50% of bonus potential to meeting or exceeding Divisional profit targets and 50% to meeting or exceeding corporate profit targets.

POLYSARProduct SchedulingAlthough NASA served customers in North and South America and EROW served customers in Europe and the rest of the world, regular butyl could be shipped from either the Sarnia 2 or Antwerp plant. NASA shipped approximately 1/3 of its regular butyl output to EROW. Also, customers located in distant locations could receive shipments from either plant due to certain cost or logistical advantages. For example, Antwerp sometimes shipped to Brazil and Sarnia sometimes shipped to the Far East.

POLYSARProduct Scheduling In September and October of each year, NASA and EROW divisions prepared production estimates for the upcoming year. These estimates were based on estimated sales volumes and plant loadings (i.e., capacity utilization). Since the Antwerp plant operated at capacity, the planning exercise was largely for the benefit of the managers of the Sarnia 2 plant, who needed to know how much regular butyl Antwerp would need from the Sarnia 2 plant.

POLYSAR What are EROWs incentives in the budgeting process?

What happens if EROW estimates greater demand for butyl than EROW actually needs?

POLYSAR

Interview with Pierre Choquette (Vice President of NASA Rubber Division) Our transfers to EROW are still a problem. Since the transfers are at standard cost and are not recorded as revenue, these transfers do nothing for our profit. Also, if they cut back on orders, our profit is hurt through the volume variance. Few of our senior managers truly understand the volume variance

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Analysis of Polysar