Chapter 25, Problem 6CP

a.

To determine

Prepare a production budget for the coming year for Plant B of Corporation U.

Explanation of Solution

Budget: Budget is an effective tool to achieve the financial and operational goals of the business. Budget is the key element of the financial planning and it assists managers to control the business costs. Management should set the budgeted amount at reasonable and achievable levels.

Production budget: Production budget is the estimation or projection of number of units the company needs to produce to equate the planned sales or budgeted sales and inventory.

Prepare a production budget.

Production Budget
Particulars	Units
Budgeted unit	20,000
Add: Desired ending inventory of finished goods $\left(10\%\times 20,000\text{ units}\right)$	2,000
Units budgeted to be available for sale	22,000
Less: Beginning inventory units	0
Planned Production of Finished Goods	22,000

Table (1)

Hence, the planned production of finished goods is 22,000 units.

b.

To determine

Prepare a budgeted responsibility income statement for the coming year for Plant B of Corporation U.

Explanation of Solution

Budget: Budget is an effective tool to achieve the financial and operational goals of the business. Budget is the key element of the financial planning and it assists managers to control the business costs. Management should set the budgeted amount at reasonable and achievable levels.

Prepare a budgeted income statement.

Plant B
Budgeted Income Statement
For the year ended December 31,
Particulars	Amount	Amount
Sales Revenue $\left(20,000\text{ units}\times \$425\text{ per unit}\right)$		$8,500,000
Less: Cost of Goods Sold $\left(20,000\text{ units}\times \$250\text{ per unit}\right)$		($5,000,000)
Gross Profit		$3,500,000
Less: Operating Expenses:
Variable Selling and Administrative Expense  $\left(20,000\text{ units}\times \$5\text{ per unit}\right)$	$100,000
Fixed Selling and Administrative Expense	$1,800,000
Total Operating Expenses		($1,900,000)
Budgeted Operating Income		$1,600,000

Table (2)

Hence, the budgeted operating income for Plant B of Corporation U is $1,600,000.

c.

To determine

Compute the direct labor variances and indicate whether direct labor variances are favorable or unfavorable and explain reason for such considerations.

Explanation of Solution

Labor efficiency variance: Labor efficiency is a part of a total labor variance which is caused due to the difference in the standard and actual number of labor hours required to complete a task. The labor rate variance can be calculated by using the formula:

$\text{Labor efficiency variance = Standard hourly rate ×}\left(\text{Standard hours}-\text{Actual Hours}\right)$

Compute labor efficiency variance.

$\begin{array}{c}\begin{array}{l}\text{Labor efficiency}\\ \text{ variance}\end{array}\}\text{ = Standard hourly rate ×}\left[\left(\begin{array}{l}\text{Actual units}\\ \text{ produced}\end{array}\right)\times \left(\begin{array}{l}\text{Standard }\\ \text{hours per unit}\end{array}\right)-\text{Actual Hours}\right]\\ =\$90\text{ per hour}\times \left[\left(23,000\text{ units}\times 1.5\text{ hours per unit}\right)-34,000\text{ hours}\right]\\ =\$90\text{ per hour}\times \left[34,500\text{ hours}-34,000\text{ hours}\right]\\ =\$45,000\text{ favorable}\end{array}$

The labor efficiency variance is favorable because workers of Plant B took 500 less hours $\left[34,500\text{ hours}-34,000\text{ hours}\right]$ to produce 23,000 units than the standard hours.

Labor rate variance: Labor rate variance usually indicates the extents to which the hourly wages rate that are contributed to deviations from standard costs. Labor rate variance is a part of a total labor variance which is caused due to the difference in the standard hourly rate and the actual. The labor rate variance can be calculated by using the formula:

$\text{Labor rate variance = Actual labour cost }-\left(\text{Standard hourly rate}\times \text{Actual hours worked}\right)$

Compute labor rate variance.

$\begin{array}{c}\text{Labor rate variance = }\left(\text{Standard hourly rate}\times \text{Actual hours worked}\right)-\text{Actual labour cost}\\ =\left(\text{\$90 per hour}\times \text{34,000 hours}\right)-\text{\$3,094,000}\\ \text{=\$3,060,000}-\text{\$3,094,000}\\ =(\$34,000)\text{ Unfavorable}\end{array}$

The labor rate variance is unfavorable because actual wage costs of $3,094,000 for 34,000 hours are higher than the standard wage costs of $3,060,000 for 34,000 hours.

d.

To determine

Determine the direct materials variances (materials price variance and quantity variance).

Explanation of Solution

Materials price variance: Materials price variance is a part of a total materials variance which is caused due to the difference in the payment price of materials than the estimated standard cost. The material rate variance can be calculated by using the formula:

$\text{Material price variance = Actual direct material costs }-\left(\text{Standard price}\times \text{Actual quantity used}\right)$

Compute the materials price variance:

$\begin{array}{c}\text{Material price variance = Actual direct material costs }-\left(\text{Standard price}\times \text{Actual quantity used}\right)\\ =\$1,000,000-\left(\$20\text{ per pound}\times \text{50,000 pounds}\right)\\ =\$1,000,000-\$1,000,000\\ \text{=\$0 No variance}\end{array}$

There is no variance in the material price because the actual price paid was equivalent to the standard price.

Materials quantity variance: Materials quantity variance is a part of a total material variance which arises due to the more or less material used in the production process than the standard quantity. The material rate variance can be calculated by using the formula:

$\begin{array}{l}\text{Materials quantity}\\ \text{ variance}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Standard price}\\ \text{ per unit}\end{array}\right)\text{ ×}\left[\left(\begin{array}{l}\text{Actual }\\ \text{units}\\ \text{ produced}\end{array}\right)\times \left(\begin{array}{l}\text{Standard }\\ \text{price }\\ \text{per unit}\end{array}\right)-\left(\begin{array}{l}\text{Actual quantity of }\\ \text{materials purchased}\end{array}\right)\right]$

Compute the materials quantity variance:

$\begin{array}{c}\begin{array}{l}\text{Materials quantity}\\ \text{ variance}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Standard price}\\ \text{ per unit}\end{array}\right)\text{ ×}\left[\left(\begin{array}{l}\text{Actual }\\ \text{units}\\ \text{ produced}\end{array}\right)\times \left(\begin{array}{l}\text{Standard }\\ \text{price }\\ \text{per unit}\end{array}\right)-\left(\begin{array}{l}\text{Actual quantity of }\\ \text{materials purchased}\end{array}\right)\right]\\ =\$20\text{ per pound}\times \left[\left(23,000\text{ units}\times 2\text{pounds per unit}\right)-50,000\text{ pounds}\right]\\ =\$20\text{ per pound}\times \left[46,000\text{ pounds}-50,000\text{ pounds}\right]\\ =\left(\$80,000\right)\text{ Unfavorable}\end{array}$

The materials quantity variance is unfavorable by ($80,000) because 4,000 pounds were used to produce 23,000 units than the standard units that were expected to use.

e.

To determine

Determine the total over- or under applied (both fixed and variable) overheads and indicate whether the cost of goods sold be a larger or smaller expense item after the adjustments made for for over- or under applied overhead.

Explanation of Solution

Determine the total over- or under applied (both fixed and variable) overheads.

Particulars	Amount
Overhead applied:
Fixed $\left(23,000\text{ units}\times \$45\text{ per unit}\right)$	$1,035,000
Variable $\left(23,000\text{ units}\times \$30\text{ per unit}\right)$	$690,000
Total overhead applied (A)	$1,725,000
Actual overhead costs:
Fixed	$1,080,000
Variable	$620,000
Total actual overhead (B)	$1,700,000
Over application of overhead $\left(\text{A}\right)-\left(\text{B}\right)$	$25,000

Table (3)

Thus, the over-applied of fixed and variable overhead is $25,000. After the adjustment for the over-application of overhead, the Cost of goods sold would be a smaller expense item.

f.

To determine

Determine the actual plant operating profit for the year.

Explanation of Solution

Operating profit: Income statement reports revenues and expenses from business operations, and the result of those operations before taxes, other revenues and expenses, is referred as operating profit.

Determine the actual plant operating profit for the year.

Plant B
Actual plant operating profit for the year
Particulars	Amount
Sales Revenue $\left(21,500\text{ units}\times \$420\text{ per unit}\right)$	$9,030,000
Less: Cost of Goods Sold (Refer Table (5))	($5,419,000)
Gross Profit	$3,611,000
Less: Selling and Administrative Expense	($2,000,000)
Operating profit	$1,611,000

Table (4)

Therefore, the actual plant operating profit for the year is $1,611,000.

Working Note:

Determine the cost of goods sold.

Plant B
Computation of cost of goods sold
Particulars	Amount
Standard cost of units sold $\left(21,500\text{ units}\times \$250\text{ per unit}\right)$	$5,375,000
Adjustment for variances:
Less:  Direct labor efficiency variance	($45,000)
Less:  Over application of overhead	($25,000)
Add:  Direct labor rate variance	$34,000
Add:  Direct  material quantity variance	$80,000
Add:  Direct  material price variance	$0
Total cost of goods sold	$5,419,000

Table (5)

g.

To determine

Explain the difference between the budgeted operating profit and the actual operating profit for the Plant B for its first year of operations using flexible budget and identify the part of the variance that would be the plant manager’s responsibility.

Explanation of Solution

Budget: Budget is an effective tool to achieve the financial and operational goals of the business. Budget is the key element of the financial planning and it assists managers to control the business costs. Management should set the budgeted amount at reasonable and achievable levels.

Determine the difference amount between the budgeted operating profit and the actual operating profit.

Particulars	Amount
Flexible budget operating profit $\left[\left\{\left(\$425-255\right)\times 21,500\text{ units}\right\}-\$1,800,000\right]$	$1,855,000
Less: Actual operating profit (Refer Table (4))	($1,611,000)
Flexible budget variance	$244,000
Budgeted operating profit (Refer Table (2))	$1,600,000
Less: Actual operating profit (Refer Table (4))	($1,611,000)
Master budget	($11,000)

Table (6)

As per Table (6), the flexible budget operating profits were $244,000 which is higher than actual profits primarily because actual selling and general administrative costs were $200,000,000 over the budgeted selling and general administrative cost and the net operating variances were $44,000$\left(\$80,000+\$34,000-\$45,000-\$25,000\right)$. Moreover, the actual operating profit was $11,000 more than the budgeted operating profit. This difference was driven by higher sales than budgeted. The plant manager should bear the responsibility of the flexible budget variance. Since, the unit is a profit center, the plant manager should be held responsible for the inefficient management of selling and general administrative cost.

h.

To determine

Determine the return on investment for the first year of operations and compute the return on sale (ROS) and capital turnover (CT) for the plant using the DuPont method of evaluation.

Explanation of Solution

Return on sales ratio evaluates the operating income that can be expected from one dollar of sales. This ratio is calculated using the formula:

$\text{Return on sales }=\frac{\text{Operating earnings}}{\text{Net sales}}$

Determine the return on sales.

$\begin{array}{c}\text{Return on sales }=\frac{\text{Operating earnings}}{\text{Net sales}}\\ =\frac{\$1,611,000}{\$9,030,000}\\ =17.84\%\end{array}$

Capital turnover is a ratio that measures the amount of sales generated from each dollar of capital investment. Thus, it shows the relationship between the net sales and the average capital invested. This ratio is calculated using the formula

$\text{Capital turnover }=\frac{\text{Net sales}}{\text{Average total assets}}$

Determine the capital turnover.

$\begin{array}{c}\text{Capital turnover }=\frac{\text{Net sales}}{\text{Average total assets}}\\ =\frac{\$9,030,000}{\$8,050,000}\\ =112.17\%\end{array}$

DuPont model: It is a model which allows the analyst to analyse a company’s performance using ratios. This model uses the ratios that indicate the company performance. DuPont model equation is as follows:

$\begin{array}{c}\begin{array}{l}\text{Return on }\\ \text{Investment (ROI)}\end{array}\}=\text{Capital turnover}\times \text{Return on sales}\\ \frac{\text{Operating income}}{\text{Average total assets}}\text{=}\frac{\text{Net sales}}{\text{Average total assets}}\times \frac{\text{Operating earnings}}{\text{Net sales}}\end{array}$

Determine the return on investment.

$\begin{array}{c}\begin{array}{l}\text{Return on }\\ \text{Investment (ROI)}\end{array}\}=\text{Capital turnover}\times \text{Return on sales}\\ =112.17\%\times 17.84\%\\ =20.00\%\end{array}$

i.

To determine

Identify and explain whether the manager would undertake the project or not, and identify other evaluation tools that could be used by Corporation U to make the performance of the plant better.

Explanation of Solution

Return on investment (ROI): This financial ratio evaluates how efficiently the assets are used in earning income from operations. So, ROI is a tool used to measure and compare the performance of a units or divisions or a companies. The formula for ROI is as follows:

$\text{Return on investment}\left(\text{ROI}\right)\text{ = }\frac{\text{Operating income }}{\text{Average total investment}}$

Determine the ROI of the new equipment.

$\begin{array}{c}\text{Return on investment}\left(\text{ROI}\right)=\frac{\text{Operating income}}{\text{Average total investment}}\\ =\frac{\$108,000}{\$600,000}\\ =18\% \end{array}$

The ROI of the new equipment is 18% and the existing ROI is 20% which reflects that the manager of the plant would not undertake this investment because the existing ROI (20%) is higher than the ROI (18%) of new equipment.

The manager of Corporation U could use residual income or economic value addition measures of plant performance to encourage investment above the required rate of return.

j.

To determine

Explain whether the annual bonus of Plant B’ manger should depend upon the ROI of the plant after deducting the corporate wide administrative fee or not.

Explanation of Solution

The bonus of the plant manager should be based on the ROI that would be earned after subtracting the corporate-wide administrative expenses. Assessment of the plant as an investment center implies that the unit is being considered as a stand-alone business. Generally, the stand alone businesses would incur similar administrative expenses.

Therefore, the manager of Plant B should be charged for corporate-wide administrative expenses and the manger should be rewarded based upon the ROI including such expenses.