Chapter 10

Chapter 14

The Flexible Budget: Factory OverheadTeaching Notes for Cases

14.1: Budgeting and Performance Evaluation at the Berkshire Toy Company

ABSTRACT: This case provides an opportunity to study budgets, budget variances, and performance evaluation at several levels. As a purely mechanical problem, the case asks for calculations of various price, efficiency, spending, and volume variances from a set of budgets and actual results. The case is also an interpretive exercise. After the variances have been computed, the next step is to develop plausible conjectures about their likely causes. Finally, it is a case about performance evaluation and responsibility accounting. The company has an incentive plan, based on the budget variances, that needs to be analyzed and critiqued.TEACHING NOTES

In a recent survey of U.S. accounting and financial executives, Siegel and Sorensen (1994) identified a preparation gap between the expected and actual level of the employees accounting knowledge, skills, and abilities. Among the top preparation gaps reported, budgeting ranked first and performance evaluation ranked fourth. Subsequent studies in the practice of management accounting confirmed the importance of analytical skills and long-term planning (Siegel and Sorensen 1995, 1999).

This case is designed to help instructors address an important aspect of the preparation gap in budgeting and performance evaluation. Berkshire Toy Company complements and supports topic coverage in a range of popular textbooks and provides an opportunity to integrate concepts from these closely related subjects.An example of a poorly designed reward system is used to help the student identify basic problems created when the system does not support goal congruence between the managers and the owners of the firm. A related issue concerns the coordination of the efforts of the managers within the firm. The case also involves calculating and interpreting variances. It is designed for an upper-division, undergraduate cost accounting course or an M.B.A.-level managerial accounting course.This Teaching Notes section uses an agency framework for analysis of the case questions. Jensen and Meckling (1976, 308) define an agency relationship as one in which a principal delegates decision-making authority to an agent who is expected to act on behalf of the principal in performing assigned tasks. In the modern corporation, the delegation of authority and responsibility flows through a hierarchy of command from the stockholders to the board of directors to top management to lower-level managers and employees. Each link in the chain of command can be viewed as a separate agency contract between a principal and an agent. At Berkshire Toy Company for example, Janet McKinley is both an agent of the Quality Products Corporation stockholders and a principal to lower level managers. However, all Berkshire Toy Company personnel are agents of the stockholders.A general assumption in agency theory is that both principals and agents act in their own self-interest. A manager who has no guarantee of future employment with a given firm has incentives to make short-term decisions. Some decisions may maximize bonuses and compensation for the manager in the short term but reduce the value of owners investment in the long term. Other decisions may maximize leisure, perquisites, or other non-pecuniary benefits for the manager and also decrease the value of the owners investment. Effective performance evaluation plans and incentive systems will produce an agency contract under which managers may profit from decisions that are beneficial to owners.Principals hire agents (managers) to obtain the benefit of the agents knowledge and expertise. Information asymmetry results when managers do not disclose to their principals the full extent of their private information about the operations of the firm.A failure to fully disclose information has implications for budgeting and performance evaluation. The construction of a realistic and accurate operating budget requires managers to reveal their private information about operating costs and revenues. In performing their information task, managers provide the firm with valuable direction in market and production activities. However, the information that would benefit the firms owners may impair the managers prospects for favorable variances, good performance evaluations, and large year-end bonuses (Kaplan and Atkinson, 1998, p. 769). Accordingly, self-interest may perpetuate information asymmetry.Because of Janet McKinleys extensive background and expertise in Berkshire Toy Company operations, the problem of information asymmetry is not critical in preparing a budget or evaluating her subordinate managers. For the majority of companies, however, managements disclosure of information is crucial. In such cases, the firms top management may seek or purchase outside information from consultants and benchmark studies (Horngren et al. 2000, 196). The benchmark information could be shared with internal managers to reduce potential budgetary slack. Compensation plans might also incorporate comparisons between a firm and its benchmark counterparts as a part of a managers overall evaluation.

The teaching notes are organized as follows. Implementation of the case in the classroom is presented first. The next section covers the calculation of the variances and bonuses for Berkshires top management. Following the presentation of the variance calculations, the note provides explanations of the variances in the context of the case facts related to sales volume, materials, labor, and overhead. Relevant textbook approaches to incentive systems and performance evaluations, budgets as a performance measure, responsibility accounting, and the use of a balanced scorecard for performance evaluation are discussed.Implementation of the Case in the Classroom

The Berkshire Toy Company case fits well with a discussion of agency theory as it pertains to budgets, performance evaluation, incentives, and compensation in a corporate environment. In addition, the case is designed to allow students to work with variances at both the mechanical and interpretive levels. To use the case for a classroom discussion, some background reading in performance evaluations is essential to a meaningful dialogue. However, the case is intended to be primarily an outside-the-classroom project.

An earlier version of this case worked well as an individual assignment and as a group project. The calculation of variances fits well into a spreadsheet assignment. One successful strategy has been to assign the variance and bonus calculations to the entire class and then have one group of students lead the discussion of the interpretation of the variances and the evaluation of the incentive plan. This approach has led to some lively classroom discussions.

Generally, students have found the computation of the variances to be fairly straightforward. Graduate students have typically had an easier time than undergraduates. In the interpretation of the variances, most students were quick to spot the effects of raw materials stock-outs and inferior quality materials on production efficiency. They also generally recognized the deleterious effect of high volume on production costs. However, many students were less willing than the authors to assign responsibility for these costs to Marketing Manager Smith. They placed at least an equal burden on Production Manager Wilford for attempting to keep up with Smiths demands without giving due regard to the effect this would have on the productivity of his workers.

Students have tended to save their harshest criticisms for Janet McKinley. As a general rule, the greater the students appreciation for the interactions among departments, the more they criticized McKinleys leadership. According to the prevailing view among these students, it is natural to expect the department managers to focus on their own domains. If interactions cause conflicts among the departments, it is McKinleys job to step in and arbitrate for the greater good of the entire division. These students felt that she failed to perform this crucial role.

Requirement 1a: Calculation of Berkshire Toy Company Variances

The calculation of variances begins with the preparation of the flexible budget shown in Table 6. The flexible budget (Column 3) is based on standard input prices and standard input quantities allowed for the actual level of output achieved. The standard variable selling cost per unit may be derived from the master budget in Table 1 and the budgeted sales units of 280,000. Total fixed costs will be identical in both the flexible and master budgets. The flexible budget revenue (based on the actual sales channel mix) is calculated as the actual number of units sold in each sales channel (174,965; 105,429; and 45,162) multiplied by the appropriate budgeted selling prices of $49, $42, and $32. The flexible budget variable selling cost is calculated as the actual total number of units sold (325,556) multiplied by the unit selling cost of $4.3510. The flexible budget revenue, based on the budgeted sales channel mix (Column 5), is calculated as the actual total number of units sold in all channels (325,556) multiplied by the budgeted mix percentages (85, 0, and 15, respectively), multiplied by planned selling prices. Table 6 also shows also the computations for the sales mix variance and the sales volume variance. The sales volume variance is important to the extent that it captures a portion of the master (static) budget variance that results when actual sales volume is more or less than planned. In the present case, the favorable sales volume variance of $1,145,006 indicates that, holding everything else constant, the increase in sales volume of 45,556 units would have caused operating income to be $1,145,006 above the budgeted amount. The student should know that sales volume equals production volume because inventories are unchanged.

Price and efficiency variance computations are required also to explain the flexible budget variance of $2,101,727 (unfavorable). Table 7 presents the tabular approach to calculate the variances. Actual quantities used of direct materials, direct labor, and variable overhead (based on actual direct labor hours) are multiplied by standard prices for the inputs. The resulting numbers are compared to the actual costs to obtain price variances and to the flexible budget amounts to calculate efficiency variances. The notes to Table 7 provide the supporting calculations. Alternatively, students may prefer to use formulas. Table 7 shows also the variances calculated using the formula approach.

Requirement 1b: Calculation of Bonuses at Berkshire Toy Company

The bonuses for the department heads are presented in Table 8. Bill Wilford will receive no bonus because his bonus base is unfavorable. His bonus base is computed as the sum of the efficiency (usage or quantity) variances for materials, labor, and variable overhead; the labor rate variance; and the variable and fixed overhead spending variances.

Requirement 2a: Discussion of the Berkshire Toy Company Variances

Marketing ManagerThe variances presented in Tables 6 and 7, combined with other information gathered from the conversation with McKinley, provide clues about the causes of the troubles at Berkshire Toy. At a minimum, an investigation of the larger variances should focus on the high volume of sales in fiscal 1998, the quality and availability of production materials and labor, and the adequacy of maintenance performed in the current and prior years.

The total flexible budget variance for fiscal year 1998 was an unfavorable $2,101,727 (Table 6). The unfavorable variances in variable selling expense ($443,100) and fixed selling expense ($560,192) total $1,003,292, or 48 percent of the total flexible budget variance. Through the aggressive marketing efforts of Rita Smith, the companys sales and production volumes were significantly over budget in fiscal 1998. This is reflected in the $2,116,083 favorable sales volume variance for total revenue. However, McKinley reported that Smith achieved the high volume primarily by offering a special Internet sales price discount. The unfavorable sales mix variance of $675,596 is consistent with her report. Although these sales increased, retail and catalog sales decreased overall. Moreover, the Internet sales promoted units that required elaborate costumes and labor-intensive embellishments such as tattoos. It seems doubtful that these cost increases were considered in establishing the discount price of $42.00 per bear. The standard cost sheet (Table 2) shows an historical average for accessories and does not include any additional labor time for appliqus or monograms.

The $443,100 unfavorable flexible budget variance in variable selling expenses and $560,192 unfavorable fixed selling expense variance (Table 6) suggests that Smith also increased her direct selling efforts and advertising expenditures. Information in Table 5 shows an increase in catalogs, brochures, and samples consistent with an expanded advertising campaign. The companys policy on commissions did not change in the current year. However, the decrease in total commissions indicates a shift from retail and wholesale activity to catalog and Internet sales on which commissions were not paid. On a unit basis, shipping and packing increased from $3.74 ($1,015,913 271,971) to $4.85 ($1,580,089 325,556) during the current year. Possible explanations are rate increases by carriers or Berkshires absorption of shipping charges on deliveries that were later than promised. This matter should be investigated further.

Purchasing ManagerApproximately 50 percent of the total unfavorable flexible budget variance can be traced to the activities of the managers of purchasing and production. Table 8 lists the materials price variances for which the purchasing manager, David Hall, was responsible. He obtained favorable price variances for fabric, plastic joints, and fiber filling.

Based on information in the case the decreased prices may have resulted from purchases of inferior materials. Materials of inferior quality could have affected both the quantity of materials used and the number of labor hours used in production.

With respect to the designer box, Table 3 shows that only 315,854 boxes were used, although 325,556 bears were sold during the year. Therefore, for at least 9,702 units, the company must have substituted a different package for the designer box. Some of the units may have been shipped without any box perhaps in a plastic bag and shipping carton, a practice that would likely have long-run consequences for the products image. Product quality and image are policy issues for management. This matter should also be investigated.

Halls bonus basis included also an unfavorable price variance for accessories. The budgeted price was an average of $0.12 per unit. The variance might be explained by unexpected temporary or permanent price increases or the costs of rush orders or special orders of the imported items. The variance may also indicate a shift from the historical mix of accessories to more expensive accessories such as sunglasses, jeans, and specialty outfits that were promoted in the advertising and the Internet sales program. Changing consumer tastes may have also been a factor. It is also possible that the standard costs used in the calculations may have been inaccurate and need to be revised. Finally, the increase in total accessories cost may be correlated to a change in the mix of distribution channels. The case facts do not contain sufficient data to determine whether this is true. The matter should be investigated further.

Production ManagerIt is evident that the high volume of activity in 1998 had consequences outside the marketing department. McKinley stated that production was close to capacity in 1998. Thus, the factory was operating at or beyond the edge of the relevant range for which production standards were determined. Therefore, the assumptions that underlie the formulation of standard costs may no longer be valid. One assumption is that fixed costs remain constant in total, regardless of changes in volume. Another is that total variable costs increase (decrease) proportionally with increases (decreases) in production and sales volume. When a facility operates for an extended time at a volume greater than its long-run optimum, unit costs will increase. The marketing departments high sales volume in 1998 may be a principal cause of the production departments unfavorable efficiency variances in its variable costs. For example, the standard for direct labor is 1.2 hours per bear (Table 2). However, Table 3 indicates that on an average unit basis, the actual direct labor hours per bear increased to 1.4 hours (448,997 hours 325,556 units produced). The case facts suggest that excessive overtime hours were needed to meet demand, which is another indication that production volume was approaching the boundary of the relevant range. In this case, it is also quite possible that the labor cost problems related to high volume were exacerbated by inferior raw materials.

As shown in Table 8, the net of the production variances is an unfavorable $1,171,859. The unfavorable direct labor efficiency variance of $466,638 is a prominent component of the total variance and includes the regular wages paid on overtime hours. Several factors mentioned in the case are important in explaining the variance, including: the reduced morale and efficiency of laborers resulting from high volume and overtime pressure; frequent machine breakdowns and operating inefficiencies; the use of direct labor to manufacture accessories; and poor-quality direct materials. The variable overhead efficiency variance is strictly proportional to the direct labor efficiency variance because variable overhead is applied on the basis of direct labor hours. Therefore, the same factors will explain the unfavorable variable overhead efficiency variance of $181,639. The unfavorable direct materials efficiency variances for the fabric and eyes might also be explained by materials of substandard quality. The unfavorable efficiency variances for the fiber filling might be partially explained by the storm drain overflow in July 1997. However, the variance of $74,188 (Table 7) represents excess usage of 51,164 pounds at a standard cost of $1.45 per pound. It is doubtful that all of this filling could be ruined at one time. At approximately one cubic foot of space for each two pounds of filling, 51,164 pounds would require a volume of 25,582 cubic feet or a space larger than a 40-foot-square room with a 15-foot ceiling. It is more likely that operators of the stuffing machine overstuffed the units over a reasonably long period of time and/or large amounts of stuffing were discarded because of quality problems.

The unfavorable efficiency variance of $43,294 on the plastic joints represents 309,243 joints (16 percent of the total joints used) at a standard cost of $0.14 per joint. Part of this variance may be explained by the box of joints that was accidentally discarded. However, it is also likely that many joints were destroyed in production, possibly because of overworked production workers, possibly because of inferior materials. Further investigation should be performed. The unfavorable direct labor wage rate variance of $76,329 can be explained by the replacement of factory laborers at higher-than-budgeted wage rates. Table 4 provides some clues about the unfavorable variable overhead spending variance of $327,488. The variance is primarily caused by the large increase in overtime premiums paid in fiscal 1998 and the resulting proportional increase in employer taxes and fringe benefits. In addition, maintenance costs rose from $1.00 per unit produced in fiscal 1997 [($256,883 + $15,944) 271,971] to $1.36 per unit produced in fiscal 1998 [($415,224 + $27,373) 325,556]. The higher level of maintenance may have become necessary as a result of pushing the factory to produce beyond its normal capacity. Moreover, maintenance may have been neglected in prior years. Notice that average maintenance costs in fiscal 1994 and 1995 were approximately $1.14 per unit produced, compared with the $1.00 per unit incurred in 1996 and 1997.

Requirement 2b: Discussion of Berkshire Toy Companys Bonus Plan

Many of the troubles at Berkshire Toy Company can be attributed directly to the misaligned incentives created by the incentive compensation plan. This section of the Teaching Notes discusses first the dysfunctional aspects of the bonus plan. Then it suggests several alternative methods of measuring and rewarding performance.

Dysfunctional Aspects of the Compensation PlanThere are two major dysfunctional aspects of the Berkshire Toy Companys incentive compensation plan. First, it treats the departments as self-contained units, failing to take account of interactions among departments. Second, it rewards the marketing manager for all increases in revenues (net of selling expenses) without regard to whether the increased sales volume made a contribution to profit.

At first glance, the incentive compensation plan appears to be a sensible one. Areas of responsibility are divided among the department managers and each manager receives a bonus based on the performance in his or her area of responsibility. The marketing department is evaluated as a revenue center, while the purchasing and production departments are treated as cost centers. The controllability principle (Horngren et al. 2000, 195; Zimmerman 1995, 170) states that each manager should be evaluated and rewarded based on aspects of the companys performance that are under his or her control. However, the compensation plan at Berkshire focuses exclusively on the areas of responsibility under each managers direct control. It ignores entirely the interactions among departments and the ways in which the actions of one department can affect the performance of the others.

The compensation plan ignores the impact of the companys high sales volume on its production costs. Because Berkshires inventories were negligible at the beginning and end of the year, annual production volume must approximate annual sales volume. This means that the factory produced over 325,000 units during the year although its normal capacity was 280,000 units (Table 2). Thus, the factory may have been operating outside of its relevant range in the current year. The predictable result was that production costsespecially direct labor and variable overheaddeparted significantly from standards.

Management has several strategic options in rectifying the problem. It may restrict output to normal capacity, increase prices to decrease demand and/or increase profitability, or make capital expenditures to increase the productive capacity. A capacity expansion may be warranted if management believes that the current years demand is a long-range trend. In the short term, the compensation plan can serve as a control mechanism if it encourages managers to think in terms of overall company profitability instead of discrete areas of managerial responsibility.

Another important interaction ignored by the compensation plan is that between purchasing and production. If the purchasing department is acquiring inferior raw materials, or is acquiring them in insufficient quantities, production will be affected. The result may be excessive waste of materials due to spoilage and extra labor hours required for rework. Coping with raw materials stock-outs can create inefficiencies on the factory floor by stopping production and idling workers. Also, stock-outs can cause managers to reassign workers to produce the missing components, reducing their efficiency. At Berkshire Toys, this occurred when Wilford responded to the shortage of bear outfits by having workers produce them in-house.

The purchasing and marketing departments also have interactions that are not taken into account by the compensation plan. Table 8 shows that David Halls bonus was reduced for a $26,956 unfavorable price variance in accessories. The unfavorable variance might be the result of one or a combination of factors as discussed previously in the Marketing Manager section of Requirement 2a. Although further investigation of the accessories variance is needed, it is apparent that marketing activities could produce an increase in the accessories cost.

Similarly, actions in the purchasing department can have an impact on marketings performance. If the investigation of variances confirms that a large number of units were shipped in standard shipping cartons without the designer box, this could negatively affect the products image and, ultimately, sales. No effect on sales is evident in fiscal 1998, but customer satisfaction may have been diminished.

The case facts do not provide any evidence that McKinley tried to coordinate the efforts of the purchasing, marketing, and production managers or that she provided any feedback on the companys operating results during the year. It seems clear that she received feedback from the individual managers. However, there was minimal sharing of information among managers.

The second dysfunctional aspect of the compensation plan is that the sales manager is rewarded on the basis of revenues (net of selling costs) rather than divisional contribution margin. Thus, Smith is encouraged to consider only sales and the related selling costs. Berkshire Toy Companys marketing plan evolved after the budget was planned for the current year. The plan promoted specialty bears on the Internet with a price discount. Sales volume and total revenues increased over the master (static) budget amount (Table 1). However, the $675,596 (unfavorable) sales mix variance indicates a shift from the retail and catalog channel to Internet and wholesale channels that offered more attractive selling prices. Unfortunately, the variable production costs of materials, labor, and overhead were higher than planned and related, at least in part, to unexpected sales demand. The effect on the bottom line was an operating loss of $843,745. A compensation plan should encourage a sales manager to consider the effects of a marketing plan on both total revenues and costs.

Classical economic theory predicts that a profit-maximizing firm will increase output until marginal revenue (net of distribution and selling costs) equals marginal production costs. By omitting the variable production costs from Smiths bonus formula, the compensation plan is effectively telling her to expand output until net marginal revenue is zero.

Suggestions for Improving the Compensation PlanBudget variances can be used as short-term performance measures to reward Hall, Smith, and Wilford. However, Smiths bonus formula should be based on divisional contribution margin, not on gross revenue. For all department managers, the bonus formula should include a component based on total divisional profit to encourage managers to share information and cooperate in order to maximize overall profit. Janet McKinley has extensive experience, having acquired purchasing, marketing, and production expertise. Accordingly, she should be in a position to approve and implement a budget to plan operations and to measure the performance of her subordinates.

Long-term performance might be enhanced by providing stock options as an element in the managers compensation. In theory, stock options mitigate the effects of separation of ownership and control by giving managers incentives to increase the future market value of the firm. To provide the proper incentive, the option price should be at least as high as the current market price of the stock (Kaplan and Atkinson 1998, 686). These modifications will help to alleviate the most egregious examples of misaligned incentives. However, they will not change the fact that the incentives are based only on financial performance measures.

Requirement 3 (Optional): Discussion of Balanced Scorecard Measures

Kaplan and Norton (1992, 1993, and 1996) proposed a balanced scorecard that augments the traditional financial performance measures with nonfinancial measures and includes both short-term and long-term indicators. The balanced scorecard (BSC) reports on the performance of a business from four interrelated perspectives: the customer perspective, the internal perspective, the innovation and learning perspective, and the financial perspective. The BSC is particularly appropriate for segments and business units as opposed to entire corporations. For example, a BSC can be incorporated into evaluation and compensation plans. However, because information in the BSC is related to a business units competitive advantage, BSC data are not generally included in public disclosures (Kaplan and Norton 1993, 141).

In using a BSC to address the customer perspective, management should articulate the business units goals for customer concerns. These include timeliness of delivery, product or service quality, and cost (Kaplan and Norton 1992, 73).

The BSC necessitates an internal perspective to support the customer perspective. Management should evaluate internal processes related to cycle time, quality, employee skills, and productivity (Kaplan and Norton 1992, 75). This portion of the scorecard will identify the core competencies of the business, and performance measures should be chosen to emphasize them.

The third perspective in a BSC is the innovation and learning perspective, which is concerned with the companys ability to innovate, improve, and create value. Measures of innovation and learning should focus on such factors as new products created, new processes developed, or new markets opened.

The final BSC perspective is the financial perspective, which addresses how the company appears to its shareholders. Common financial measures are operating income, cash flow, and return on investment (ROI).

From the customer perspective, Berkshire will primarily be concerned with product quality and product image. These factors could be measured by the number of defective units returned by customers and the number shipped in nonstandard containers. Web-site surveys could be conducted to measure the products image with the public. Berkshire might monitor the prices of its collectible bears in the secondary market to measure image and quality.

The internal perspective of Berkshires BSC will be concerned with the companys productivity on the factory floor and its consistency in maintaining product quality. Also part of the internal perspective is the companys ability to advertise and market effectively. Productivity can be measured by factory labor hours per unit produced, consistency in quality by the number of units requiring rework, and effectiveness in communication with customers by the number of catalogs mailed and the number of visits to the companys Internet site.

Although the Berkshire Toy Company produces a very traditional product that appeals to old-fashioned values, it must be concerned about innovation. Of particular interest will be the companys ability to develop new marketing channels, measured over the long term by the number of new channels developed, and over the short term by the fraction of sales volume attributable to the newest channels. Important also are the companys ability to create new product generations and product accessories (measured by the time required to develop and implement a new accessory line), and Berkshires ability to improve its production processes (measured by improvements in production costs and/or quality).

Finally, from the financial perspective, the Berkshire Toy Company will be concerned with both its long-term and short-term contribution to the financial health of the Quality Products Corporation. Short-term financial performance can be measured by the annual operating profit (segment margin) of the division. The long-term contribution can be measured by sales growth over a five- to ten-year period.

Berkshire managers should be required to provide a narrative report and summary of the years activities as those activities relate to the BSC. One advantage of the requirement is that it will encourage each manager to examine the consequences of recent decisions on overall company welfare. Second, the requirement will sensitize each manager to areas of concern for future decisions. The narrative reports should be reviewed by McKinley as part of the department managers performance evaluations.

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FlexibleFlexibleSales VolumeMasterBudget PriceQuantityStandard

ActualBudget VarianceBudgetVarianceBudgetor CostAllowedCost

Units:

Retail & Catalog174,965174,965-63,035238,000

Internet105,429105,429105,4290

Wholesale45,16245,1623,16242,000

Total Units325,556325,55645,556280,000

Sales dollar:

Retail & Catalog$8,573,2850$8,573,285-3,088,715$11,662,00049

Internet4,428,01804,428,0184,428,018042

Wholesale1,445,18401,445,184101,1841,344,00032

Total Sales$14,446,4870$14,446,4871,440,487$13,006,000

Variable Production Costs:

Direct materials

Acrylic pile fabric$256,422$256,422$271,286$37,962$233,324$0.83330.023809$35.00

10-mm acrylic eyes125,637125,637123,71117,311106,400$0.38002$0.19

45-mm plastic joints246,002246,002227,88931,889196,000$0.70005$0.14

Polyester fiber filling450,856450,856424,85159,451365,400$1.30500.9$1.45

Woven label16,42216,42216,2782,27814,000$0.05001$0.05

Designer box69,48869,48878,13310,93367,200$0.24001$0.24

Accessories66,01366,01339,0675,46733,600$0.1200

Total direct materials$1,230,840$1,230,840$1,181,215$165,291$1,015,924$3.6283

Direct labor3,668,3053,668,3053,125,338437,3382,688,000$9.60001.2$8.00

Variable overhead1,725,6651,725,6651,216,538170,2341,046,304$3.73681.2$3.11

Total variable production costs$6,624,810$6,624,810$5,523,090$772,862$4,750,228

Variable selling expenses1,859,5941,859,594895,615-322,6651,218,280$0.10

Total variable expenses$8,484,404$8,484,404$6,418,705$450,197$5,968,508

Contribution margin$5,962,083$5,962,083$8,027,782$990,290$7,037,492

Fixed costs:

Manufacturing overhead$658,897$658,897$661,9200$661,920

Selling expenses5,023,1925,023,1924,463,00004,463,000

Administrative expenses1,123,7391,123,7391,124,00001,124,000

Total fixed costs$6,805,828$6,805,828$6,248,9200$6,248,920

Operating income-$843,745-$843,745$1,778,862$990,290$788,572

14.2: The Mesa Corporation

Teaching Strategies for Articles14.1: Kennard T. Wing, Using Enhanced Cost Models in Variance Analysis for Better Control and Decision Making, Management Accounting Quarterly (Winter 2000), pp. 1-9.This article points out that oversimplifications of fixed and variable costs can result in the standard costing system not being used or, if used, can lead to bad decisions. That is, misclassifications of cost behavior patterns make variance analyses paper tigers. For variance reporting to be useful, financial managers need to develop cost models that reflect how costs actually behave.

Discussion Questions:

1.Describe the implications for variance analysis of analyzing a semi-variable cost as either a variable or fixed cost.

Semi-variable costs are fixed below a certain level of volume, and are variable above that level. For this reason, these costs are also referred to as mixed costs.Actual operating level below the budgeted level

Treated as variable costs: Unfavorable (efficiency) variance.

Treated as fixed costs: Favorable (volume) variance.

Actual operating level above the budgeted level

Treated as variable costs: Favorable (efficiency) variance.

Treated as fixed costs: unfavorable (volume) variance.

2.Describe the implications for variance analysis of analyzing a step-fixed cost as either a variable or fixed cost.

Step-fixed costs are fixed up to a certain level of volume, and jump to a higher level of cost that is fixed over a range of volumes until another point is reached at which costs jump again to a higher level, and so on. These costs are sometimes referred to as semi-fixed costs. Actual operating level below the budgeted level

Treated as variable costs: Unfavorable (efficiency) variance.

Treated as fixed costs: No variance.

Actual operating level above the budgeted level

Treated as variable costs: Favorable or unfavorable (efficiency) variance.

Treated as fixed costs: Unfavorable (volume) variance.

3.Describe the implications on operating decisions of analyzing an operation with mixed costs as either a variable or fixed cost.

When volume drops, classifying a mixed cost as a variable cost may lead to decreases in operating resources such as lay-off of employees when the amounts of work needed to sustain the operations do not decrease proportionally. As a result, employee morale of the remaining employees may plummet (as indicated in the case example cited in the article).

When volume increases, treating a mixed cost as a fixed cost may lead to a failure to provide sufficient operating resources to sustain the required operating level. Workers and other resources will likely be overworked. Morale of overworked workers will likely decrease, as will the quality of work performed.

14.2: Jean C. Cooper and James D. Suver, Variance Analysis Refines Overhead Cost Control, Healthcare Financial Management (February 1992).This article illustrates analyses of full costs of selected medical procedures of a healthcare organization. A key feature of the analysis is how the overhead variances are handled, and in particular how to develop an understanding of the volume variance and how it affects profitability. Standard costs are determined for a hypothetical Procedure 101" and there is an illustration of how variances can be obtained and interpreted, given example of actual results for the procedure over a years time. The analysis shows the effect of volume changes on overhead recovery and on contribution to profits.

The common theme in this article and the next (14.3) is that variance analysis can be modified and adapted to the specific situation to provide useful information. In reading 14.2, the context is healthcare, which implies a focus on volume; in the second article, the use of activity analysis is implied.

Discussion Questions:

1. Based on the analysis in this article, what is the key driver of profitability in the discussion example?

Since most of a healthcare organizations costs are fixed relative to the source of revenue, the key driver of profitability is the volume of patient demand, relative to staffing levels and other fixed costs.

2. Explain how the two variances included in Exhibit 3 are developed and interpreted.

The volume variance is a reflection of the gain (or loss) due to an excess (or shortfall) of the actual number of patients relative to the budget, and the cost at the pre-determined fixed overhead rate. This variance also is the amount of over (or under) absorbed fixed overhead. The profit margin variance is the gain (or loss) due to an excess (or shortfall) of the actual number of patients relative to the budget, computed at the contribution margin per patient.

3. Consider the example in Exhibit 4. Why are expenses improperly matched and the reported income overstated?

The effect is due to the volume variance. The volume variance (unbilled overhead, at 150 patients x $20 each) explains why the reported profit of $5,800 is $3,000 greater than the budgeted profit of $2,800.

14.3: Robert E. Malcolm, Overhead Control Implications of Activity Costing, Accounting Horizons (December 1991) pp. 69-78.

This article points out some of the limitations of the traditional treatment of standard cost overhead variances. An example problem from the CMA exam is used as an illustration. The problem is solved both in a traditional format and also using ABC drivers. Regression is used to identify the cost drivers, and a revised solution is derived.

Discussion Questions:

1. What are the limitations of standard cost overhead analysis?

The article points out that overhead variances may have little, if any, useful interpretation, except to provide some information to management regarding the efficiency of labor usage (the typical base for determining the variances). Moreover, a typical variance analysis is done at a far too aggregate level for the information to be useful. The use of labor as the base may be in some cases irrelevant in representing what are the true cost drivers. The assumption that all overhead costs can be represented by a single cost driver (the homogeneity assumption) is rarely true.

2. How does the activity approach improve upon the standard cost analysis of overhead?

By using the activity approach, the different elements of overhead can be identified and tied to the relevant cost drivers. In this way, the interpretation of the variances has real significance for control and performance evaluation. The variances measure the cost drivers that workers have control over, and thus the employees can be motivated to improve the usage of costs, as measured by the variances.

Although the annual production and sales volumes are equal, they are not equal at all times during the year. Inventories of raw materials and finished goods generally increase significantly during the early months of the companys fiscal year, and then decrease during the heaviest selling months from November through May. Because this case focuses on the annual budget and the associated performance evaluations, it ignores the calculation of interim variances (which are computed under an assumption of unequal production and sales volume) and the related issue of month-to-month inventory management.

PAGE Blocher, Stout, Cokins, Chen: Cost Management 4e 14-1 The McGraw-Hill Companies, Inc., 2008