Chapter 14

The Flexible Budget: Factory Overhead

Teaching 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.

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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

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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 Manager

The 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

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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.

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 Purchasing Manager

Approximately 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 Manager

It 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

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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 Plan

There 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.1 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.

1
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.

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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 Plan

Budget 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.

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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

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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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 Flexible Flexible Sales Volume Master Budget Price Quantity Standard
Actual Budget Variance Budget Variance Budget or Cost Allowed Cost
Units:
Retail & Catalog 174,965 174,965 -63,035 238,000
Internet 105,429 105,429 105,429 0
Wholesale 45,162 45,162 3,162 42,000
Total Units 325,556 325,556 45,556 280,000
Sales dollar:
Retail & Catalog $8,573,285 0 $8,573,285 -3,088,715 $11,662,000 49
Internet 4,428,018 0 4,428,018 4,428,018 0 42
Wholesale 1,445,184 0 1,445,184 101,184 1,344,000 32
Total Sales $14,446,487 0 $14,446,487 1,440,487 $13,006,000

Variable Production Costs:

Direct materials
Acrylic pile fabric $256,422 $256,422 $271,286 $37,962 $233,324 $0.8333 0.023809 $35.00
10-mm acrylic eyes 125,637 125,637 123,711 17,311 106,400 $0.3800 2 $0.19
45-mm plastic joints 246,002 246,002 227,889 31,889 196,000 $0.7000 5 $0.14
Polyester fiber filling 450,856 450,856 424,851 59,451 365,400 $1.3050 0.9 $1.45
Woven label 16,422 16,422 16,278 2,278 14,000 $0.0500 1 $0.05
Designer box 69,488 69,488 78,133 10,933 67,200 $0.2400 1 $0.24
Accessories 66,013 66,013 39,067 5,467 33,600 $0.1200
Total direct materials $1,230,840 $1,230,840 $1,181,215 $165,291 $1,015,924 $3.6283
Direct labor 3,668,305 3,668,305 3,125,338 437,338 2,688,000 $9.6000 1.2 $8.00
Variable overhead 1,725,665 1,725,665 1,216,538 170,234 1,046,304 $3.7368 1.2 $3.11
Total variable production costs $6,624,810 $6,624,810 $5,523,090 $772,862 $4,750,228
Variable selling expenses 1,859,594 1,859,594 895,615 -322,665 1,218,280 $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 $661,920 0 $661,920
Selling expenses 5,023,192 5,023,192 4,463,000 0 4,463,000
Administrative expenses 1,123,739 1,123,739 1,124,000 0 1,124,000
Total fixed costs $6,805,828 $6,805,828 $6,248,920 0 $6,248,920
Operating income -$843,745 -$843,745 $1,778,862 $990,290 $788,572

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

Blocher, Stout, Cokins, Chen: Cost Management 4e 14-1 The McGraw-Hill Companies, Inc., 2008
Blocher, Stout, Cokins, Chen: Cost Management 4e 14-2 The McGraw-Hill Companies, Inc., 2008
Blocher, Stout, Cokins, Chen: Cost Management 4e 14-3 The McGraw-Hill Companies, Inc., 2008
Blocher, Stout, Cokins, Chen: Cost Management 4e 14-4 The McGraw-Hill Companies, Inc., 2008
Teaching Strategies for Articles
14.1: 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.

Blocher, Stout, Cokins, Chen: Cost Management 4e 14-5 The McGraw-Hill Companies, Inc., 2008
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.

Blocher, Stout, Cokins, Chen: Cost Management 4e 14-6 The McGraw-Hill Companies, Inc., 2008
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.

Blocher, Stout, Cokins, Chen: Cost Management 4e 14-7 The McGraw-Hill Companies, Inc., 2008