Question

Ethics; responsibility for direct materials and direct labor variances ( CMA Adapted)

Taylor Jenkins jumped out of his chair. Harrington Chemicals, a sales lead that Taylor had been working on for six months, had just placed its first order for 8,000 bottles of Omnigar. To get the order, Taylor had had to promise a delivery date of May 20. Though he didn't take the time to check with the production scheduler, he was sure the company wouldn't have any problems filling an order for this important new customer. Harrington's order was more than enough to push Taylor over the April bonus threshold. Since Taylor was retiring at the end of April, it would be a satisfying way to end his 30-year career. If the company missed the delivery date, he would be long gone by the time it happened.

Harrington's order was not met with much enthusiasm when it reached the desk of production scheduler Missy Price. “What was Jenkins thinking when he promised a May 20 delivery date?” she complained. “He knows I have to approve all the delivery dates. We've already scheduled all our available labor for May on the Omnigar line.” Purchasing agent Pat Melton's reaction was similar. “I don't know where I'll get the raw materials for those extra 8,000 bottles. Our supplier is running low and only has enough material for the 12,000 bottles already scheduled for May.”

In response to these concerns, Omnigar's production manager, Charles Elliot, called a meeting to decide how to handle the Harrington order without disrupting the schedule. Pat Melton reported, “Another supplier of raw materials is willing to ship to us, but we have to commit to buy 18,000 pounds at a total cost of $142,200. He promises that the materials are the same quality as those we normally use.” Missy Price reported that she could move Class II labor from another product to help with the extra 8,000 bottles. The standard wage for Class II labor is $16 per direct labor hour.

The standard direct materials and labor costs for one bottle of Omnigar are as follows:

Direct materials:	1.5 pounds at $8 per pound
Direct labor:	1.2 Class III direct labor hours at $14 per direct labor hour

At the end of May, Controller Aiden Brown called Charles to discuss the month's results.

Aiden: Charles, what's up with Omnigar this month? You're usually right on target with standard costs. Just glancing at this performance report makes me think there must be a huge labor variance. Can you give me some insight before I start crunching the numbers? Charles: I'm not surprised. Everything seemed to go wrong in May, but none of it was under my control. We were all set to produce 12,000 bottles of Omnigar based on the orders we had in house. Then Taylor Jenkins decided to do the company one last favor before he retired by accepting a rush order from Harrington Chemical for 8,000 more bottles. He promised a firm delivery date of May 20 without checking with anyone to see if we could meet it. I was able to work with Missy to move some Class II workers over to Omnigar. And as you know, they earn $2 more per hour than the Class III workers who normally work the Omnigar line. If I could have done all the production with Class III workers, I think the labor rate variance would have been negligible. Aiden: I didn't know that Class II workers knew how to make Omnigar. I bet their inexperience affected their productivity as well. Charles: Luckily, the Class II workers got up to speed quickly. The real problem was with the raw materials Pat purchased to do the Harrington order. I know she did the best she could under the circumstances. Our regular supplier couldn't provide any more materials, so Pat found a new supplier with a great price. He promised that the materials were the same quality as those we usually buy, but they were nowhere near the same quality as those of our regular supplier. Spoilage went through the roof! The problem was, we couldn't tell whether the material was good or bad until we had almost finished production. And the error rate didn't seem to be affected by the class of workers we used. Aiden: Well, it certainly sounds as if this was an atypical month for your group. Do you have any information that will help me to analyze the problem? Charles: Yes, I do. And I think all the variances need to be charged to the sales department, not to me. They are the ones who caused all the problems, by accepting the Harrington order and promising delivery on May 20.

To get a better picture of the problem, Aiden drew up the following breakdown of the production costs associated with the two different materials:

Regular Materials

Alternative Materials

Direct materials used (in pounds)

  18,200 - reg

  15,800 - alt

Production (in bottles)

Class III workers

   7,200 - reg

   4,800 - alt

Class II workers

   4,800 - reg

   3,200 - alt

Total production

  12,000 - reg

   8,000 - alt

Actual direct labor hours

Class III workers

   8,600 - reg

   6,600 - alt

Class II workers

   5,900 - reg

   4,400 - alt

Total direct labor hours

  14,500 - reg

  11,000 - alt

Actual direct labor payroll

Class II $163,770 - reg

Class III $216,600 - alt

Required

a.

Was Charles correct in asserting that the alternative material from the new supplier was inferior in quality? Calculate a direct materials quantity variance for both the regular and the alternative materials.

b.

Prepare a labor rate variance analysis by worker class for Aiden.

c.

Was Charles correct in asserting that both classes of labor experienced similar efficiency problems in working with the materials? Compare the direct labor efficiency variances for both classes of workers using (a) regular materials and (b) alternative materials. (Perform four separate variance calculations.)

d.

Which of the variances do you believe should be the sales department's responsibility? Why?

e.

Did Taylor Jenkins act ethically in accepting Harrington's order? Why or why not? Did Pat Melton act ethically in acquiring the alternative materials from the new vendor? Why or why not?

Answer 1

a. Direct material quantity variance

Sr. No.	Particulars	Regular	Alternate
A	Production (units)	12000	8000
B	Standard direct material requirement (pounds per unit)	1.5	1.5
C	Standard direct material requirement (pounds) (A*B)	18000	12000
D	Actual direct material usage (pounds)	18200	15800
E	Variance (pounds) (C-D)	(200)	(3800)
F	Variance to standard material requirement (%) (E/C)	1.11%	31.68%

Yes, the alternative material from the new supplier was inferior in quality as indicated by the large material quantity variance for the alternate product.

b. Labour rate variance analysis

Sr. No.	Particulars	Class III	Class II
A	Actual direct labour hours
1	Regular product	8600	5900
2	Alternate product	6600	4400
3	Total (1+2)	15200	10300
B	Standard hourly rate	14	16
C	Actual labour cost	216600	163770
D	Actual hourly rate (C/A3)	14.25	15.90
E	Variance in hours (B-D)	(0.25)	0.10
G	Variance % (E/B)	(1.79)%	0.62%

The labor rate variance was favorable for Class II workers and unfavorable for class III workers.

c. Direct labor efficiency variance

Sr. No.	Particulars	Class III		Class II
		Regular	Alternate	Regular	Alternate
A	Production	7200	4800	4800	3200
B	Actual labour hours	8600	6600	5900	4400
C	Labour hours per unit (B/A)	1.19	1.38	1.23	1.38
D	Standard labour hours per unit	1.2	1.2	1.2	1.2
E	Variance (D-C)	0.01	(0.18)	(0.03)	(0.18)
F	Variance (%) (E/D)	0.46%	(14.58)%	(2.43)%	(14.58)%

Both classes of workers experienced similar efficiency rates with respect to the alternate materials. However, with respect to the regular materials, the efficiency of class III workers was better compared to class II.

d. The sales department accepted the order without proper scheduling of the same. Hence, the variances that took place as a result of this would be chargeable to the sales department. Variances that could have been reduced or controlled by the manufacturing or purchasing departments by better planning would not be chargeable to the sales department. Hence, the charging should be on the following lines:

1) Direct material variance: Fully chargeable to Sales since an alternate supplier had to be sourced, with quality problems.

2) Labour rate variance: The variance by class of workers would not be charged to sales. However, the variance of Rs. 2 for every hour of class II workers used would be charged to sales, since proper scheduling would have allowed to use Class III workers for production.

3) Labour efficiency variance: Since there was no difference in efficiency of workers from both classes on the alternate product, but Class III workers were more efficient than class II on the regular product, it would have been appropriate to use Class III workers only on the regular product and Class II workers only on the alternate product. So, the variance to the extent of having used the Class II workers for the regular product is chargeable to the manufacturing department as was avoidable by better planning.

e. Taylor Jenkins did not act ethically while accepting the new order because he kept his personal interests above that of the organization while doing so. Pat Melton acted ethically in buying the materials from the new vendor because he did so as a part of his duty to manage delivering the order to the customer which his company had committed to. There was a loss to the company in the process, but there could be a way of recovering the same from the supplier through a penalty for poor quality, though this is not specified in the problem.