Harvard Business School Teaching Case Polysar Ltd.

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Harvard Business School Teaching CasePolysar
Ltd.
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AGENDAPolysar Ltd.

• Introduction to Polysar
• Flexible Budgeting Standard Costing
• Variance Analysis for Variable Costs
• Fixed Overhead Volume Variance
• Transfer Pricing

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AGENDAPolysar Ltd.

• Introduction to Polysar
• Flexible Budgeting Standard Costing
• Variance Analysis for Variable Costs
• Fixed Overhead Volume Variance
• Transfer Pricing

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POLYSAR

• Canadas largest chemical company.
• The Rubber Group accounts for 46 of Polysars
  sales.
• Primary products for this group are butyl and
  halobutyl.
• Principal customers for these products are tire
  manufacturers.
• Rubber Group has two divisions
• NASA (North America South America)
• EROW (Europe elsewhere)

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POLYSAR

• Butyl is manufactured by NASA at its Sarnia 2
  plant, and by EROW at its Antwerp plant.
• Sarnia 2 is a relatively new facility, dedicated
  entirely to butyl production.
• The Antwerp plant makes both butyl and halobutyl.
• EROWs demand exceeds its manufacturing capacity,
  so EROW buys butyl from NASA.

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POLYSAR
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AGENDAPolysar Ltd.

• Introduction to Polysar
• Flexible Budgeting Standard Costing
• Variance Analysis for Variable Costs
• Fixed Overhead Volume Variance
• Transfer Pricing

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Flexible Budgeting

• Budgets are based on some measure of output such
  as units sold or produced.
• The static budget is based on the original,
  projected level of activity.
• The flexible budget adjusts budgeted costs for
  the actual level of activity.

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Flexible Budgeting

• Building a flexible budget involves the following
  steps
• Obtain the flexible budget for fixed costs
  directly from the static budget.
• Use the static budget to calculate the variable
  cost per unit of activity.
• Multiply the variable cost per unit by the actual
  number of units

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Flexible Budgeting

• Pro forma statements, for hypothetical levels of
  output, also use the same flexible budgeting
  technique.

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The Spring Valley Bicycle Company planned to
produce and sell 6,000 units of its sole product
in 2007. The product is a mountain bike. The
company planned to earn revenues during the year
of 5,160,000. The budget calls for direct
materials of 250 per bike, and direct labor of
114 per bike. Total fixed manufacturing overhead
was budgeted at 1,100,000. Total variable
overhead was budgeted at 402,000. The company
budgeted a sales commission of 70 per unit. In
addition to the sales commission, which is a
variable cost, there are fixed S.G. A.
expenditures budgeted at 85 per unit when 6,000
units are produced and sold. Required Complete
the following table. Be sure to indicate if
variances are favorable or unfavorable.
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The Spring Valley Bicycle Company planned to
produce and sell 6,000 units of its sole product
in 2007. The company planned to earn revenues
during the year of 5,160,000. The budget calls
for direct materials of 250 and direct labor of
114 per bike. Fixed mfg overhead was budgeted at
1,100,000. Total variable overhead was budgeted
at 402,000. The company budgeted a sales
commission of 70 per unit. In addition, there
are fixed S.G. A. expenditures budgeted at 85
per unit when 6,000 units are produced and sold.
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The Spring Valley Bicycle Company planned to
produce and sell 6,000 units of its sole product
in 2007. The company planned to earn revenues
during the year of 5,160,000. The budget calls
for direct materials of 250 and direct labor of
114 per bike. Fixed mfg overhead was budgeted at
1,100,000. Total variable overhead was budgeted
at 402,000. The company budgeted a sales
commission of 70 per unit. In addition, there
are fixed S.G. A. expenditures budgeted at 85
per unit when 6,000 units are produced and sold.
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Two meanings of standard

• A standard is one type of a budgeted number
• Noted for its precision
• Often involves engineering estimates
• Budgeted amounts need not be standard amounts
  (e.g., might be historical data)
• Standard is a type of costing system
• prevalent among manufacturing firms
• other costing systems include actual costing and
  normal costing systems

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What is a Standard?
BUDGET
STANDARD
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Choice of Cost Accounting Systems
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Actual versus Budgeted Amounts

• Actual or budgeted rates for overhead.
• Actual or budgeted prices/rates of direct inputs.
• Actual quantities of direct inputs, or standard
  quantities based on actual production.
• Actual quantity of overhead, or standard quantity
  based on actual production.

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Three Costing Systems
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Three Costing Systems
Standard quantity of the allocation base allowed
for actual outputs budgeted (standard) inputs
per output x actual outputs
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AGENDAPolysar Ltd.

• Introduction to Polysar
• Flexible Budgeting Standard Costing
• Variance Analysis for Variable Costs
• Fixed Overhead Volume Variance
• Transfer Pricing

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The derivation of the price and efficiency
variances
AP actual price per unit of input (e.g., price
per yard). Q
quantity of inputs for total output (e.g., yards).
AP
ACTUAL COST
AQ
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The flexible budget
SP budgeted price per unit of input (e.g.,
price per yard). SQ budgeted quantity of
inputs required for total output achieved (e.g.,
total yards of fabric that should have been
needed for actual production).
SP
FLEXIBLE BUDGET
SQ
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The variable cost flexible budget variance (in
green)
P price per unit of input. Q quantity of
inputs for total output.
Actual Price Standard Price
FLEXIBLE BUDGET
Standard Actual Quantity Quantity
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The price variance
AP actual price per unit of input. SP
budgeted price per unit of input. Q quantity
of inputs for total output.
Actual Price Standard Price
PRICE VARIANCE
FLEXIBLE BUDGET
Standard Actual Quantity Quantity
S.Q. standard quantity for actual outputs
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The efficiency (or quantity) variance
AP actual price per unit of input. SP
budgeted price per unit of input. Q quantity
of inputs for total output.
Actual Price Standard Price
FLEXIBLE BUDGET
QUANTITY VARIANCE
Standard Actual Quantity Quantity
S.Q. standard quantity for actual outputs
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The variable cost flexible budget variance
decomposes into a price variance and an
efficiency variance
AP actual price per unit of input. SP
budgeted price. Q quantity of inputs for total
output.
Actual Price Standard Price
PRICE VARIANCE
FLEXIBLE BUDGET
QUANTITY VARIANCE
Standard Actual Quantity Quantity
S.Q. standard quantity for actual outputs
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The variable cost flexible budget variance
decomposes into a price variance and an
efficiency variance
AP actual price per unit of input. SP
budgeted price. Q quantity of inputs for total
output (e.g., yards).
Actual Price Standard Price
why price?
PRICE VARIANCE
FLEXIBLE BUDGET
QUANTITY VARIANCE
Standard Actual Quantity Quantity
S.Q. standard quantity for actual outputs
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The variable cost flexible budget variance
decomposes into a price variance and an
efficiency variance
Abbreviations Price or Wage Rate or Spending
Variance PV Quantity or Usage or Efficiency
Variance QV Actual quantity of inputs
AQ Standard quantity of inputs
SQ Actual price per input unit
AP Standard price per input unit SP
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The variable cost flexible budget variance
decomposes into a price variance and an
efficiency variance
These variances apply to direct materials, direct
labor, and variable overhead.
Formulas PV AQ x (AP - SP) QV SP x (AQ -
SQ) For direct materials, AQ sometimes refers to
materials purchased, instead of materials used.
In this case, the price variance and the
efficiency variance will not sum to the flexible
budget variance, due to the timing difference.
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The McBean Company makes stars. The budgeted cost
for each star is as follows Materials 2 pounds
of star stuff at 4 per lb. 8 per
star Labor 1.5 hours at 12 per hour 18 per
star In December, 1,200 stars were produced.
2,600 lbs. of star stuff were purchased at
4.25 per lb. Of this amount, 2,300 lbs. were
used in production. Direct labor cost was 20,930
for 1,820 hours. 1. What is the direct material
price variance, assuming that the company
recognizes the price variance at the time
the materials are purchased? 2. What is the
direct material usage (quantity) variance? 3.
What is the direct labor rate (price)
variance? 4. What is the direct labor efficiency
variance?
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Formulas PV AQ x (AP - SP) QV SP x (AQ -
SQ) PV Price Variance QV Quantity
Variance AQ (SQ) Actual (Standard) quantity of
inputs AP (SP) Actual (Standard) price per
input Standards for Direct materials 2 lbs of
star stuff at 4 per lb. 8 per star In
December, 1,200 stars were produced. 2,600 lbs.
of star stuff was purchased at 4.25/lb. Of
this, 2,300 lbs. were used in production. What is
the direct material price variance, assuming that
the company recognizes the price variance at the
time materials are purchased?
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Standards for Direct materials 2 lbs. of star
stuff at 4 per lb. 8 per star In December,
1,200 stars were produced. 2,600 lbs. of star
stuff were purchased at 4.25/lb. Of this, 2,300
lbs. were used in production. What is the direct
material price variance, assuming that the
company recognizes the price variance at the time
materials are purchased? PV AQ x (AP - SP)
2,600 lbs. x (4.25 per lb. - 4.00 per
lb.) 2,600 lb. x 0.25 per lb.
650 Unfavorable
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Formulas PV AQ x (AP - SP) QV SP x (AQ -
SQ) PV Price Variance QV Quantity
Variance AQ (SQ) Actual (Standard) quantity of
inputs AP (SP) Actual (Standard) price per
input Standards for Direct materials 2 lbs.
of star stuff at 4 per lb. 8 per star In
December, 1,200 stars were produced. 2,600 lbs.
of star stuff were purchased at 4.25/lb. Of
this, 2,300 lbs. were used in production. 2.
What is the direct material usage (quantity)
variance?
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Standards for Direct materials 2 lbs. of star
stuff at 4 per lb. 8 per star In December,
1,200 stars were produced. 2,600 lbs. of star
stuff were purchased at 4.25/lb. Of this, 2,300
lbs. were used in production. 2. What is the
direct material usage (quantity) variance? QV
SP x (AQ - SQ) 4 per lb. x (2,300 lbs. -
2,400 lbs.) 4 per lb. x 100 lbs. 400
favorable 2 lbs. per star x 1,200 stars
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Formulas PV AQ x (AP - SP) QV SP x (AQ -
SQ) PV Price Variance QV Quantity
Variance AQ (SQ) Actual (Standard) quantity of
inputs AP (SP) Actual (Standard) price per
input Standards for Direct labor 1.5
hours at 12 per hour 18 per star In
December, 1,200 stars were produced. 2,600 lbs.
of star stuff were purchased at 4.25/lb. Of
this, 2,300 lbs. were used in production. Direct
labor cost was 20,930 for 1,820 hours. 3. What
is the direct labor rate (price) variance?
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Standards for Direct labor 1.5 hours at
12 per hour 18 per star In December, 1,200
stars were produced. 2,600 lbs. of star stuff
were purchased at 4.25/lb. Of this, 2,300 lbs.
were used in production. Direct labor cost was
20,930 for 1,820 hours. 3. What is the direct
labor rate (price) variance? PV AQ x (AP -
SP) 1,820 hr.s x (11.50 per hr - 12 per
hr) 1,820 hr.s x 0.50 per hr 910
favorable 20,930 1,820 hours 11.50 per
hr.
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Formulas PV AQ x (SP - AP) QV SP x (AQ -
SQ) PV Price Variance QV Quantity
Variance AQ (SQ) Actual (Standard) quantity of
inputs AP (SP) Actual (Standard) price per
input Standards for Direct labor 1.5
hours at 12 per hour 18 per star In
December, 1,200 stars were produced. 2,600 lbs.
of star stuff were purchased at 4.25/lb. Of
this, 2,300 lbs. were used in production. Direct
labor cost was 20,930 for 1,820 hours. 4. What
is the direct labor efficiency variance?
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Standards for Direct labor 1.5 hours at 12
per hour 18 per star In December, 1,200 stars
were produced. 2,600 lbs. of star stuff were
purchased at 4.25/lb. Of this, 2,300 lbs. were
used in production. Direct labor cost was 20,930
for 1,820 hours. 4. What is the direct labor
efficiency variance? QV SP x (AQ - SQ)
12 per hour x (1,820 hrs - 1,800 hrs)
12 per hour x 20 hrs. 240 Unfav. 1,200
stars x 1.5 hours per star 1,800 hr.s
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POLYSAR

• 1a) What evidence do we have that Polysar is on
  a standard costing system?
• 1b) Interpret the amount 22,589 on Exhibit 2,
  for variable costs.
• 1c) Interpret the amount 21,450 on Exhibit 2,
  for variable costs.

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POLYSAR

• 1d) Evaluate NASAs performance relative to
  budget for sales price and volume.
• 1e) Evaluate NASAs performance relative to
  budget for plant efficiency, raw materials
  prices, fixed manufacturing expenses, and
  non-manufacturing expenses.

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AGENDAPolysar Ltd.

• Introduction to Polysar
• Flexible Budgeting Standard Costing
• Variance Analysis for Variable Costs
• Fixed Overhead Volume Variance
• Transfer Pricing

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Cost Variances for Fixed and Variable Overhead

• Variances for Variable Overhead
• Variances for Fixed Overhead

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The variable cost flexible budget variance
decomposes into a price variance and an
efficiency variance
Abbreviations Price or Wage Rate or Spending
Variance PV Quantity or Usage or Efficiency
Variance QV Actual quantity of inputs
AQ Standard quantity of inputs
SQ Actual price per input unit
AP Standard price per input unit SP
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The variable cost flexible budget variance
decomposes into a price variance and an
efficiency variance
These variances apply to direct materials, direct
labor, and variable overhead.
Formulas PV AQ x (AP - SP) QV SP x (AQ -
SQ) For Variable Overhead, the Qs are the
quantity of the allocation base. AQ is the actual
quantity of the allocation base used. SQ is the
standard quantity of the allocation base. The Ps
are the Overhead Rate. AP is the Actual Overhead
Rate. SP is the Budgeted Overhead Rate.
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The variable overhead variances
Spending Variance Actual quantity of
allocation base incurred x (Actual O/H rate
Budgeted O/H rate) Efficiency Variance
Budgeted O/H rate x (Actual quantity of
allocation base incurred Standard quantity of
allocation base based on actual output)
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The variable overhead variances
Spending Variance Actual quantity of
allocation base incurred x (Actual O/H rate
Budgeted O/H rate) Efficiency Variance
Budgeted O/H rate x (Actual quantity of
allocation base incurred Standard quantity of
allocation base based on actual output)
Question Given the above definitions, what is
the economic interpretation of each of these
variances?
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Cost Variances for Fixed and Variable Overhead

• Variances for Variable Overhead
• Variances for Fixed Overhead

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Cost Variances for Fixed Overhead
There are important issues related to how the
denominator in the overhead rate is calculated
for the purpose of allocating fixed overhead. Two
choices are 1. Practical Capacity The level of
the allocation base that would be incurred if
fixed assets run full-time, but allowing for
routine maintenance and unavoidable
interruptions. 2. Budgeted Utilization The
level of the allocation base that would be
incurred for budgeted production.
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Cost Variances for Fixed Overhead
Budget variance (a.k.a. spending variance)
actual total FMOH ? budgeted total FMOH Volume
variance budgeted total FMOH ? FMOH allocated
to output using a standard costing system
(budgeted FMOH per unit x actual units
produced) Budgeted FMOH per unit FMOH the
denominator concept, as discussed on the previous
slide. The volume variance is favorable if
actual production exceeds the denominator in the
FMOH rate.
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Coachman Company
The Coachman Company manufactures pencils. The
pencils are sold by the box.
Budget Actual Capacity of boxes
10,000 12,000 20,000 D.L.H.
200 250
5,000 Machine hr.s 500 600
10,000 Fixed O/H 40,000 42,000
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 D.L.H. 200
250 5,000 Machine hr.s 500
600 10,000 Fixed O/H 40,000
42,000 The outputs here are boxes of pencils.
The inputs are direct labor hours and machine
hours.
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 D.L.H. 200
250 5,000 Machine hr.s 500
600 10,000 Fixed O/H 40,000
42,000 Lets calculate a fixed overhead rate
using actual information 42,000 ? 12,000 boxes
3.50 per box
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 D.L.H. 200
250 5,000 Machine hr.s 500
600 10,000 Fixed O/H 40,000
42,000 Lets calculate a fixed overhead rate
using budgeted costs, budgeted production, and
outputs as the allocation base 40,000 ? 10,000
boxes 4.00 per box
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 D.L.H. 200
250 5,000 Machine hr.s 500
600 10,000 Fixed O/H 40,000
42,000 Lets calculate a fixed overhead rate
using budgeted costs in the numerator, production
capacity in the denominator, and outputs as the
allocation base 40,000 ? 20,000 boxes 2.00
per box
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 Fixed O/H 40,000
42,000 40,000 ? 20,000 boxes 2.00 per
box The advantage of using capacity in the
denominator is that this shows how low the fixed
cost per unit can go. Fixed cost per unit goes
down as production goes up. But production
levels cannot generally exceed capacity.
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 D.L.H. 200
250 5,000 Machine hr.s 500
600 10,000 Fixed O/H 40,000
42,000
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
O/H rate x the application base
This is what we actually spent
From either the static or flexible budget
Budget Variance
Volume Variance
Under- or Over- applied Fixed Overhead
These variances are computed for the company as a
whole, not for individual jobs.
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
O/H rate x the application base
42,000
40,000
2,000 Unfavorable
Volume Variance
Under- or Over- applied Fixed Overhead
These variances are computed for the company as a
whole, not for individual jobs.
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First lets allocate based on factory capacity in
the denominator
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 Fixed O/H 40,000
42,000 40,000 ? 20,000 boxes 2.00 per
box The advantage of using capacity in the
denominator is that this shows how low the fixed
cost per unit can go. Fixed cost per unit goes
down as production goes up. But production
levels cannot generally exceed capacity.
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
2.00 per unit x 12,000 units
42,000
40,000
2,000 Unfavorable
Volume Variance
Under- or Over- applied Fixed Overhead
These variances are computed for the company as a
whole, not for individual jobs.
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
24,000
42,000
40,000
2,000 Unfavorable
16,000 Unfavorable
18,000 Fixed Overhead Underapplied.
These variances are computed for the company as a
whole, not for individual jobs.
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
24,000
42,000
40,000
2,000 Unfavorable
16,000 Unfavorable
18,000 Fixed Overhead Underapplied.
The 16,000 Unfavorable Volume Variance can also
be calculated as follows 2 per unit x 8,000
units (capacity less actual production). Hence,
this is the cost of producing below capacity.
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Now lets allocate based on budgeted production
in the denominator
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Coachman Company
Budget Actual
Capacity of boxes 10,000 12,000
20,000 D.L.H. 200
250 5,000 Machine hr.s 500
600 10,000 Fixed O/H 40,000
42,000 Lets calculate a fixed overhead rate
using budgeted costs and production, and outputs
as the allocation base 40,000 ? 10,000 boxes
4.00 per box
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
4.00 per unit x 12,000 units
42,000
40,000
2,000 Unfavorable
Volume Variance
Under- or Over- applied Fixed Overhead
These variances are computed for the company as a
whole, not for individual jobs.
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
48,000
42,000
40,000
2,000 Unfavorable
8,000 Favorable
6,000 Fixed Overhead Overapplied.
These variances are computed for the company as a
whole, not for individual jobs.
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Overhead VariancesFor Fixed Overhead
Actual Fixed Overhead
Budgeted Fixed Overhead
Applied Fixed Overhead
48,000
42,000
40,000
2,000 Unfavorable
8,000 Favorable
6,000 Fixed Overhead Over-applied.
The 8,000 Favorable Volume Variance can also be
calculated as follows 4 per unit x 2,000 units
(actual production less budgeted production).
Hence, this is the cost/benefit of producing
below/above budget.
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POLYSAR

• 2. Calculate NASAs rate for allocating
  manufacturing overhead costs to Butyl.

• 3. Use the rate calculated above to show that
  the following amounts have been calculated
  correctly
• Fixed Costs of Sales on Exhibit 2
• Transfers to Finished Goods Inventory on Exhibit
  1
• Transfers to EROW on Exhibit 1

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POLYSAR

• 4. Does Polysar close out variances to Cost of
  Goods Sold, or allocate variances between Cost
  of Goods Sold and Inventory?

5. Using the information on Exhibit 1, identify
EROWs rate for applying fixed manufacturing
costs to Butyl. What might explain the
difference in the fixed overhead rates of the
two divisions?
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POLYSAR

• 6. What do the budgeted and actual volume
  variances of 6,125 and 11,375 represent?

7. Now assume NASA decided to use budgeted
utilization in the denominator for calculating
the fixed cost rate. What would the rate be
now? What would the actual and budgeted volume
variances now be?
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AGENDAPolysar Ltd.

• Introduction to Polysar
• Flexible Budgeting Standard Costing
• Variance Analysis for Variable Costs
• Fixed Overhead Volume Variance
• Transfer Pricing

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Transfer Pricing

• A transfer price is an internal price what one
  part of the company charges another part of the
  company for intermediate products.
• Applies to companies that
• are decentralized, especially companies that are
  vertically integrated.
• or
• are multinationals

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Transfer Pricing

• The selling division is sometimes called the
  upstream division.
• The buying division is sometimes called the
  downstream division.
• This is because product flows from upstream to
  downstream.

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Shell Oil Company
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Transfer Pricing Options

• Market-Based Transfer Price
• Cost-Based Transfer Price
• Negotiated Transfer Price

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Market-Based Transfer Price

• Advantages
• it is objective.
• in perfectly competitive markets, it will
  generally lead to optimal decisions.
• Disadvantages
• many intermediate products are not traded in
  competitive markets, so no market price exists.
  
• some market prices fluctuate considerably.

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Cost-Based Transfer Price

• Can be variable cost or full cost.
• Whether variable or full, can be actual costs or
  budgeted costs.
• Whether variable or full, can include a mark-up
  to allow profit for the selling division.
• Major disadvantage including fixed costs in the
  transfer price can lead to sub-optimal decisions.

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Negotiated Transfer Price

• Advantage provides greatest autonomy to
  divisions requires least interference by
  headquarters.
• Disadvantages outcome depends on the relative
  bargaining strengths and abilities of the
  Divisional Managers. May not be optimal for the
  company as a whole. May discourage cooperation
  among divisions.

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Dual Transfer Price

• The buying division pays a different amount
  than the selling division receives.
• Since this is a paper transaction, and no cash
  generally changes hands, the use of a dual
  transfer price is possible.
• In theory, dual transfer prices allow transfer
  pricing schemes that are optimal in terms of
  providing managers the appropriate incentives.
• However, dual transfer pricing is seldom used in
  practice.

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Transfer Pricing and Taxes

• Applies to multinational companies
• Tax treaties among nations attempt to tax all
  corporate income once, and only once.
• World-wide income of multinational companies is
  apportioned among tax jurisdictions.
• Companies have incentives to shift income from
  high tax countries to low tax countries.

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• 8a) What type of transfer price does Polysar
  use?
• 8b) What is the transfer price for butyl?
• 8c) What is the effect on NASA when EROW takes
  less butyl than planned, if NASA produces for
  actual demand?
• 8d) What is the effect on NASA when EROW takes
  less butyl than planned, if NASA produces for
  budgeted demand?
• 8e) What is the best butyl sourcing strategy
  for Polysar?
• 8f) What is the best butyl sourcing strategy
  for EROW?