Question

"I just don't understand these financial statements at all!” exclaimed Mr. Elmo Knapp. Mr. Knapp explained that he had turned over management of Racketeer, Inc., a division of American Recreation Equipment, Inc., to his son, Otto, the previous month. Racketeer, Inc., manufactures tennis rackets. "I was really proud of Otto,” he beamed. “He was showing us all the tricks he learned in business school, and if I do say so myself, I think he was doing a rather good job for us. For example, he put together this budget for Racketeer, which makes it very easy to see how much profit we'll make at any sales volume ( Exhibit 17.8 ). As best as I can figure it, in March we expected to have a volume of 8,000 units and a profit of $14,500 on our rackets. But we did much better than that! We sold 10,000 rackets, so we should have made almost $21,000 on them." “Another one of Otto's innovations is this standard cost system,” said Mr. Knapp proudly. “He sat down with our production people and came up with a standard production cost per unit (see Exhibit 17.9). He tells me this will let us know how well our production people are performing. Also, he claims it will cut down on our clerical work.” Mr. Knapp continued, “But one thing puzzles me. My calculations show that we should have earned profit of nearly $21,000 in March. However, our accountants came up with less than $19,000 in the monthly income statement ( Exhibit 17.10 ). This bothers me a great deal. Now, I'm sure our accountants are doing their job properly. But still, it appears to me that they're about $2,200 short.” “As you can probably guess," Mr. Knapp concluded, “we are one big happy family around here. I just wish I knew what those accountants were up to... coming in with a low net income like that.” Requried: Prepare a report for Mr. Elmo Knapp and Mr. Otto Knapp that reconciles the profit graph with the actual results for March (see Exhibit 17.11 ). Show the source of each variance from the original plan (8,000 rackets) in as much detail as you can and evaluate Racketeer's performance in March. (Do not round intermediate calculations. Indicate the effect of each variance by selecting "F" for favorable, or "U" for unfavorable. If there is no effect, do not select either option.)

Answer 1

ANSWER

As per the given Question

The following solution is based on a report by Tom Terpstra. Elmo's problem is that he thinks that the graph and the income statement measure the same thing. Otto should have told him that they do not. The income statement presents actual costs in a full-absorption costing format, while the profit graph is based on standard costs in a variable costing format. These differences account for the difference in the profit measurement. Because the profit graph is based on standard costs, the profit it shows will be the actual profit only in those very rare cases when the variances net out to zero. Racketeer has some significant variances listed on the income statement, so Elmo should expect that the actual profit would differ from the profit on the graph. These variances are:

Material Labor Overhead cccc Selling and administrative Total

The overhead amount differs from the figure on the income statement, because the income statement overhead variance includes a production volume variance of $470(= $.47 x 1,000). But that variance does not reflect a difference between actual and budget or standard costs when fixed manufacturing costs are not unitized. The other part of the difference between the two profit figures is explained by the difference in accounting methods. Variable costing expenses fixed costs when they are incurred. With full- absorption, the fixed costs are assigned to the units produced, and then expensed in the period in which the units are sold. Racketeer treats each racket as having a fixed cost of $.47. For the 10,000 rackets sold, the fixed cost expense is $4,700 under full-absorption costing. Additionally, the production volume variance of $470 is also expensed during this period. Thus, $5,170 in fixed costs aside from price variances) was deducted from income on the income statement. Under variable costing, the only fixed cost to be expensed is the standard cost for the period of $3,760 (also aside from price variances). So, the use of different accounting methods results in a profit difference of $1,410. (Before Elmo starts to complain about the accountants' use of full-absorption, one should remind him that, in those months when production exceeds sales, the full-absorption method would expense less fixed costs than variable costing, so it evens out in the long run.) Now the two results can be reconciled:

Profit per chart $20,940 Less: Cost variances 772 Additional fixed costs in full-absorption 1,410 Profit per Income Statement $18,758 Besides failing to explain the profit graph, Otto also failed to set up a format to take advantage of the standards he developed. The company should set up a chart showing the actual results, the flexible budget, and the master budget. This would provide information concerning the profit changes in relation to the change in sales volume. Additionally, the manufacturing variances could be analyzed in greater detail, as shown in Exhibits A and B on the following pages

Actual Manufacturing Variance Selling and Administrative Variance Sales Price Variance Flexible Budget Sales 500.000 500,000 Less Variable Costs Materials 37.990 S 490 | | 37,500 Labor 19,392392 10,000 Overhead 1,440|140 1,300 Contribution Margin $31,178|$1,022 | | -- o $32,200 Less Fixed Costs: 3.810 500 Manufacturing 3.760 Selling and Administrative 7.200 $300 7.500 Operating Profit S20168||$1,072 || 5300 $20,940

Activity Variance Master Budget $18,000 72,000 7.500 30,000 3.800 15,200 200 1,040 $8.440 FS25,780 3.780 7.500 $ 6.440 F $14.500

Activity Variance Master Budget $18,000 72,000 7.500 30,000 3.800 15,200 200 1,040 $8.440 FS25,780 3.780 7.500 $ 6.440 F $14.500

$ Sales at $9 70,000 60,000 Profit - $ 14,500 50,000 40,000 Total costs S&A costs - $ 7,500 costs Manufacturing costs 30,000 20,000 10,000 2,000 4,000 6,000 8,000 Number of Rackets

Price Variance Production Volume Variance Actual Costs Fixed Overhead Budget $.47 x 8,000 = $3,760 Applied ($.47 x 7,00 = $3.290 $3,810 $50 U 470 U

The variance breakdown in Exhibits A and B highlights the areas that Elmo and Otto should research. One area involves the strings. Is the combination of a favorable price variance and unfavorable efficiency variance an indicator that low quality string was purchased? Another point for investigation is the apparent waste of 100 racket frames. Is there something in the production process that causes frames to break? Or are the standards unrealistic? A third area is the labor efficiency variances. Why are the skilled workers spending more time than budgeted, while the unskilled are spending less? Finally, the relationship between labor efficiency and materials efficiency variances is worth investigating, because use of substandard materials might result in an unfavorable labor efficiency variance. These are the types of questions that should be raised as a result of this variance analysis

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