Question

Your CFO has supplied you with the following information. Current product standard costs are as follows:

• Selling price per unit: $5,000
• $1,400/unit direct material
• $400/unit direct labor
• $200/unit variable overhead
• $200/unit fixed overhead (this figure is the result of the budgeted fixed overhead of $2,000,000 and budgeted sales volume of 10,000 units)
• Income Tax rate = 40%

The board of directors has requested a 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.

In your presentation, answer the following questions from the board using the data from the CFO:

1. What is meant by cost variance?
2. What is an effective way to incorporate variance analysis in the budget process?
3. What are the differences between labor and material variances?
4. How is a quantity variance different from a rate variance?
5. What are the subcomponents of fixed overhead?
6. What are the subcomponents of variable overhead?
7. What is the lowest possible price you could offer to this potential customer (you know that you have sufficient capacity without working overtime and without adding any new equipment to make this order)? Please show your calculations.
8. In terms of capacity, under what conditions would offering this lowest possible price be a bad decision? Why?
9. Create a pro-forma income statement to show a net income/net loss for the year.
10. You have been considering investing in automation to eliminate some factory labor if you get this large order. This technology advancement will cost an added $100,000/yr. to lease (net of taxes), but it will reduce labor cost/unit on the customer's units by 50%. How would this change the lowest possible price you could offer to this potential customer and at least still break even? Please show your calculations.

Answer 1

1. What is meant by cost variance?

Cost variance is the difference between actual amount incurred and the budgeted amount for different types costs.

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

Effective way to incorporate variance analysis is by using flexible budget. While preparing flexible budget the budgeted variable amounts are given as inputs. The amounts in a flexible budget then change according to change in activity levels. These amounts are then compared with the actual amount of expenses. It provides a clear and proper analysis of variances as compared to static budget. In static budget, the amounts are fixed in the beginning of the year for a defined level of activity.

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

Material variances and labor differences are quite similar. They both have differences due to quantity and differences due to rates variances from standard budget. The difference labor and material variances is that labor cannot be stocked so hours paid for cannot be different from hours used for production. Whereas for material, there can be a difference in quantity of stocks purchased and quantity used for production.

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

Quantity variance revolves around the difference in the quantity of material or labor hours used for production. Rate variances is about the difference in the price per unit of the material or labor hours used for production.

Quantity variance can be calculated as follows:

Quantity variance = (Actual quantity used - Standard quantity budgeted) * Standard rate per unit

Rate variance can be calculated as follows:

Rate variance = (Actual rate per unit - Standard rate per unit) * Actual quantity used

Note: As per Chegg policy, in case of multiple sub-questions, only the first four need to be answered.