Content Slides With Speaker Notes Showing All Calculations

8 10 Content Slides With Speaker Notes Showing All Calculations

You have been approached by a potential customer who could bring considerable business. She says, "I'd like to find an alternative vendor for my future orders of 5,000/yr., but their pricing to me must be competitive." Your CFO has supplied you with the following information. Current product standard costs are as follows:

• $1,400/unit direct material
• $400/unit direct labor
• $200/unit variable overhead
• $200/unit fixed overhead (this figure is the result of budgeted fixed overhead of $2,000,000 and budgeted sales volume of 10,000 units)

The board of directors requests a quick but thorough presentation to determine whether taking on this potential customer is a good idea. Assume that your factory is fully operational and that you will not have any learning curve impacts. Answer the board's following questions based on data from the CFO:

Paper For Above instruction

1. What is meant by budget variance?

Budget variance refers to the difference between budgeted figures and actual figures for a specific financial measure. It indicates whether the company has spent more or less than planned, providing insight into operational efficiency and financial control. For example, if actual costs exceed budgeted costs, it results in an unfavorable variance; conversely, if actual costs are lower, it indicates a favorable variance. Understanding budget variance is essential for managers to analyze deviations from the plan and implement corrective actions.

2. What is an effective way to incorporate variance analysis into the budget process?

An effective method involves integrating regular variance analysis throughout the budgeting cycle. This includes setting detailed, achievable budgets based on historical data and industry trends, then periodically monitoring actual performance against these budgets. Managers should investigate significant variances promptly to determine causes—whether due to operational inefficiencies, price changes, or other factors—and adjust future budgets accordingly. Additionally, linking variance analysis with performance incentives and continuous improvement initiatives fosters accountability and promotes proactive management.

3. What are the differences between labor and material variances?

Labor variances pertain to differences between actual and standard labor costs, influenced by rates paid and hours worked. The primary components are rate variance (difference in pay rates) and efficiency variance (difference in hours used). Material variances relate to the costs incurred versus standard costs, with the main components being price variance (difference in per-unit material cost) and usage or quantity variance (difference in the amount of material used). Both types of variances help identify areas where costs can be controlled or improved.

4. How is a quantity variance different from a rate variance?

A quantity variance measures the difference between the actual quantity of labor or materials used and the standard quantity expected for actual production. It indicates efficiency or wastage issues. A rate variance, on the other hand, measures the difference between the actual hourly wage or material price and the standard rate, reflecting cost control regarding wages or procurement pricing. While quantity variance pertains to usage efficiency, rate variance relates to cost per unit of labor or materials.

5. What are the subcomponents of fixed overhead?

Fixed overhead includes costs that do not vary directly with production volume in the short term. Subcomponents include depreciation, supervisor salaries, rent, insurance, property taxes, and fixed utilities. These costs remain relatively constant regardless of activity level within a relevant range, but can be analyzed further to identify controllable versus uncontrollable components.

6. What are the subcomponents of variable overhead?

Variable overhead encompasses costs that fluctuate with production activity, such as indirect materials, indirect labor, utilities (like electricity) for machinery, and supplies used in the production process. These costs vary proportionally with the number of units produced or machine hours utilized, making accurate management and control essential for cost efficiency.

7. What is the lowest possible price you could offer to this potential customer (You know that we have sufficient capacity, without working overtime and without adding any new equipment, to make this order)? Please show the calculations.

Given the standard costs:

- Direct material: $1,400/unit

- Direct labor: $400/unit

- Variable overhead: $200/unit

Since fixed overhead is fixed regardless of the order, it is not relevant in the short-term pricing decision, assuming no additional fixed costs are incurred. The total variable cost per unit is:

Total variable cost per unit = $1,400 + $400 + $200 = $2,000.

For an order of 5,000 units, total variable costs would be 5,000 * $2,000 = $10,000,000.

To determine the minimum price per unit to break even (cover variable costs), the lowest price should be at least equal to the variable cost per unit: $2,000.

Therefore, the lowest possible price per unit to offer is $2,000, which allows breakeven on variable costs only, assuming no additional fixed costs are affected.

8. In terms of capacity, under what conditions would offering this lowest possible price be a bad decision? Why?

Offering the minimum price of $2,000 per unit can be a bad decision if the entire capacity is already utilized or if accepting the order displaces higher-margin sales. Since fixed costs are already covered at current levels, selling below full cost could lead to marginal or negative contribution margins. Additionally, if the company's capacity is constrained, accepting a low-price large order might strain resources, increase lead times, or reduce flexibility for future profitable sales. It can also erode the perceived value of the product, impacting long-term pricing strategies.

9. How would this change the lowest possible price you could offer to this potential customer and at least still break even, considering the automation investment?

The automation technology costs an additional $100,000 per year, which must be recouped through production savings. The key is that automation reduces labor costs by 50% per unit for the customer's order. The original labor cost is $400/unit; with automation, the new labor cost becomes $200/unit. The savings per unit are thus $200.

Calculations:

Additional annual cost of automation = $100,000.

Number of units = 5,000

> Cost saving per unit = $200

> Total savings = 5,000 * $200 = $1,000,000.

To break even on automation costs, the savings must at least offset the additional expense: $1,000,000 = $100,000 + other costs (if any).

In terms of the price, the new per-unit variable costs are:

- Material: $1,400

- New labor cost: $200

- Variable overhead: $200

Total relevant variable cost per unit after automation = $1,400 + $200 + $200 = $1,800.

Consequently, the lowest price to break even, considering automation costs, is $1,800 per unit.

This price ensures coverage of variable costs and recoupment of the automation investment, assuming production volume remains at 5,000 units.

References

• Drury, C. (2013). Management and Cost Accounting. Cengage Learning.