1. Harvard Business School Teaching Case Polysar Ltd.

2. AGENDA Polysar Ltd. Introduction to Polysar Standard Costing Variance Analysis for Variable Costs Fixed Overhead Volume Variance Transfer Pricing

3. AGENDA Polysar Ltd. Introduction to Polysar Standard Costing Variance Analysis for Variable Costs Fixed Overhead Volume Variance Transfer Pricing

4. POLYSAR Canada’s largest chemical company. The Rubber Group accounts for 46% of Polysar’s 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)

5. 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. EROW’s demand exceeds its manufacturing capacity, so EROW “buys” butyl from NASA.

6. POLYSAR

7. AGENDA Polysar Ltd. Introduction to Polysar Standard Costing Variance Analysis for Variable Costs Fixed Overhead Volume Variance Transfer Pricing

8. 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.

9. POLYSAR 1d) Evaluate NASA’s performance relative to budget for sales price and volume. 1e) Evaluate NASA’s performance relative to budget for plant efficiency, raw materials prices, fixed manufacturing expenses, and non-manufacturing expenses.

10. POLYSAR 1a) What evidence do we have that Polysar is on a standard costing system?

11. Product Costing and Transfer Prices – Butyl rubbers were costed using standard rates for variable and fixed costs. Variable costs included feedstocks, chemicals, and energy. Standard variable cost per ton of butyl was calculated by multiplying the standard utilization factor (i.e., the standard quantity of inputs used) by a standard price established for each unit of input. Since feedstock prices varied with worldwide market conditions and represented the largest component of costs, it was impossible to establish standard input prices that remained valid for extended periods. Therefore, the company reset standard costs each month to a price that reflected market prices. Chemical and energy standard costs were established annually.

12. POLYSAR 1b) Interpret the amount $22,589 on Exhibit 2, for variable costs.

15. The $22,589 is in the “actual” column, and is the variable cost at standard. Therefore, it is based on the actual volume of output (i.e., sales), but uses the budgeted cost of the inputs (feedstocks, chemicals, and energy) per ton of output. The standard cost per ton for raw materials, averaged over the 9 months,was $631 per ton ($22,589/35.8). The $22,589 is equivalent to a flexible budget amount. It is the answer to the question: What should our input costs have been for our actual level of output (sales)?

16. POLYSAR 1c) Interpret the amount $21,450 on Exhibit 2, for variable costs.

18. This is the static budget number for variable costs (feedstocks, chemicals, energy). Since it is the static budget, it is based on the original, projected level of sales. From Exhibit 1, the projected level of sales was 33,000 tons. Hence, the standard cost per ton for variable costs, as of the beginning of the year, was $650 per ton ($21,450/33).

19. How can the standard cost per ton for variable costs differ from the beginning of the year to the end of the year? I.e.: $650 per ton vs. $631 per ton. POLYSAR

20. Product Costing and transfer Prices – Butyl rubbers were costed using standard rates for variable and fixed costs. Variable costs included feedstocks, chemicals, and energy. Standard variable cost per ton of butyl was calculated by multiplying the standard utilization factor (i.e., the standard quantity of inputs used) by a standard price established for each unit of input. Since feedstock prices varied with worldwide market conditions and represented the largest component of costs, it was impossible to establish standard input prices that remained valid for extended periods. Therefore, the company reset standard costs each month to a price that reflected market prices. Chemical and energy standard costs were established annually.

21. AGENDA Polysar Ltd. Introduction to Polysar Standard Costing Variance Analysis for Variable Costs Fixed Overhead Volume Variance Transfer Pricing

22. POLYSAR 1d) Evaluate NASA’s performance relative to budget for sales price and volume.

25. Evaluate NASA’s performance relative to budget for sales price and volume. Sales Volume: Budgeted: 33,000 tons Actual: 35,800 tons Sales Price per Tonne: Budgeted: $1,850 ($61,050/33) Actual: $1,840 ($65,872/35.8)

26. POLYSAR 1e) Evaluate NASA’s performance relative to budget for plant efficiency, raw materials prices, fixed manufacturing expenses, and non-manufacturing expenses.

29. Price and Efficiency Variances for Feedstocks, Chemicals and Energy S.P. A.P. A.Q.* S.Q.* $22,294K ACTUAL COST $241K FAV. $54K FAVORABLE “COST ADJUSTMENT” EFFICIENCY VARIANCE *For actual output The outer box represents the flexible budget amount of $22,589.

32. POLYSAR Sales price per ton is slightly below budget. Sales volume is almost 10% above budget. The efficiency variance for variable costs is very small. The price variance for variable costs is very small, due in part to the fact that standards are revised monthly. Fixed manufacturing expenses are within 2% of budget. Non-manufacturing expenses are within 1% of budget.

33. POLYSAR Why do 80% of manufacturing companies use Standard Costing Systems? Survey data shows that the most important reason is to help control costs. How does a standard costing system help Polysar control costs? In a standard costing system, all variances flow through the accounting system, and appear on the monthly income statements.

35. AGENDA Polysar Ltd. Introduction to Polysar Standard Costing Variance Analysis for Variable Costs Fixed Overhead Volume Variance Transfer Pricing

36. POLYSAR 2.Calculate NASA’s rate for allocating manufacturing overhead costs to Butyl.

37. POLYSAR Fixed Manufacturing Overhead Demonstrated Capacity = $44,625K. 85,000 tons per year x 9/12 = $700 per ton

38. POLYSAR 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

39. POLYSAR Fixed Costs of Sales on Exhibit 2 Actual: $700/tonne x 35.8K tonnes = $25,060K Budgeted: $700/tonne x 33.0K tonnes = $23,100K

40. POLYSAR Transfers to Finished Goods Inventory on Exhibit 1 Actual: $700 x (47.5 + 2.1 - 35.8 - 12.2) = $700 x 1.6K tonnes = $1,120K Budgeted: $700 x (55 + 1 - 33 - 19.5) = $700 x 3.5K = $2,450K

41. POLYSAR Transfers to EROW on Exhibit 1 Actual: $700/tonne x 12.2K tonnes = $8,540K Budget: $700/tonne x 19.5K tonnes = $13,650K

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

43. POLYSAR In the previous question, we were able to recalculate the fixed cost component of butyl added to ending inventory, and butyl transferred to EROW, using the budgeted $700 per ton rate. Therefore, no variances are included in these amounts, and all variances closed out to the income statement (Exhibit 2). These variances appear on the line items for “Cost Adjustments,” “Spending Variance,” and “Volume Variance.”

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

45. POLYSAR From the Budgeted column on Exhibit 1, we know that NASA planned to take 1K tonnes of butyl from EROW, at a cost (i.e., fixed cost component) of $620K, or $620 per ton. EROW’s fixed cost rate of $620 is lower than NASA’s rate of $700, probably because EROW’s facility is older. Note that the difference in rates cannot be due to differences in capacity utilization.

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

47. POLYSAR Budget Capacity for 9 mo.s of 63,750 tons Budgeted production of 55,000 (63,750 - 55,000) x $700 = $6,125K Actual Capacity for 9 months of 63,750 tons Actual production of 47,500 (63,750 - 47,500) x $700 = 16,250 x $700 = $11,375K

48. POLYSAR 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.

49. POLYSAR Fixed Manufacturing Overhead Budgeted Production = $44,625K. 55,000 tons = $811 per ton

50. POLYSAR Using this $811 per ton rate: There would be no budgeted volume variance, since $811/ton x 55K tons = $44,625K Actual volume variance would be $811 x (55,000 - 47,500) = $6,085

51. AGENDA Polysar Ltd. Introduction to Polysar Standard Costing Variance Analysis for Variable Costs Fixed Overhead Volume Variance Transfer Pricing

52. POLYSAR 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?

53. POLYSAR 8a.What type of transfer price does Polysar use?

54. Transfer Pricing Options Market-Based Transfer Price Cost-Based Transfer Price Negotiated Transfer Price Dual Transfer Price

55. Product Costing and Transfer Prices – … Product transfers between divisions for performance accounting purposes were made at standard full cost, representing, for each ton, the sum of standard variable cost and standard fixed cost.

56. POLYSAR Polysar uses a cost-based transfer price.

57. 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.

58. POLYSAR Interview with Pierre Choquette (Vice President of NASA Rubber Division) – “Our transfers to EROW are still a problem. Since the transfers are at standard cost and are not recorded as revenue, these transfers do nothing for our profit. Also, if they cut back on orders, our profit is hurt through the volume variance. Few of our senior managers truly understand the volume variance.

59. POLYSAR Polysar uses a cost-based transfer price. It is a full cost transfer price (i.e., it includes both variable and fixed costs). It is based on budgeted (i.e., standard costs). It does not include a mark-up.

60. POLYSAR 8b. What is the transfer price for butyl?

61. Product Costing and Transfer Prices – … Fixed costs were allocated to production based on a plant’s “demonstrated capacity” using the following formula, standard fixed cost per ton = estimated annual total fixed cost ÷ annual demonstrated plant capacity To apply the formula, product estimates were established each fall for the upcoming year.

63. CALCULATION OF TRANSFER PRICE FOR BUTYL Total Fixed Costs were budgeted at $44,625K (from Exhibit 1). Denominator is “demonstrated capacity.” This is 85,000 tons per year, or 63,750 tonnes for 9 months. $44,625K/63,750 = $700 per ton

64. POLYSAR 8c.What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for actual demand?

65. POLYSAR Each ton of butyl transferred to EROW has $700 in fixed costs attached to it. EROW covers $700 of NASA’s fixed costs with each ton “purchased” from NASA. When EROW takes less butyl than planned, and NASA cuts back on production accordingly, NASA’s volume variance increases, and its net contribution (i.e., income) decreases, relative to plan.

66. POLYSAR 8d.What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for budgeted demand?

67. POLYSAR If NASA produces at budgeted demand, and EROW purchases less butyl than planned, NASA will increase its ending inventory. In this case, the fact that EROW takes less butyl than planned will have no effect on NASA’s net contribution. The $700 per ton in fixed costs that NASA thought would be covered by EROW, will now be capitalized in ending inventory.

68. POLYSAR 8c.What is the best butyl sourcing strategy for Polysar?

69. POLYSAR Polysar should allocate production of butyl and halobutyl to EROW and NASA to minimize total production and shipping costs, while still meeting customer demand. In making this determination, fixed costs are irrelevant, since they are either sunk costs, or are unavoidable unless the plant is closed down. Polysar should manufacture butyl as long as the sales price is more than the variable costs of production and distribution.

70. Product Costing and Transfer Prices – … Fixed costs comprised three categories of cost. Direct costs included direct labor, maintenance, chemicals required to keep the plant bubbling, and fixed utilities. Allocated cash costs included plant management, purchasing department costs, engineering, planning, and accounting. Allocated non-cash costs represented primarily depreciation.

72. POLYSAR EROW’s variable cost per ton is approximately $595. NASA’s variable cost per ton is approximately $623.

73. POLYSAR 8f.What is the best butyl sourcing strategy for EROW, given the current accounting treatment, and the bonus scheme?

74. POLYSAR From EROW’s point of view, the $700 per tonne allocation of fixed costs is a variable cost. If EROW can manufacture an extra ton of butyl in Antwerp, instead of buying the butyl from NASA, EROW saves $700. EROW should manufacture as much butyl in Antwerp as possible, before buying butyl from NASA.

75. POLYSAR If EROW can sell one more ton of butyl, at a price equal to NASA’s variable costs, plus shipping, plus $699, will they want to? In the above situation, will the company want EROW to make the sale?

76. POLYSAR Compensation Management – For managers, the percent of remuneration received through annual bonuses was greater than 12% and increased with responsibility levels. The bonuses of top Division management in 1985 were calculated by a formula that awarded 50% of bonus potential to meeting or exceeding Divisional profit targets and 50% to meeting or exceeding corporate profit targets.

77. POLYSAR Product Scheduling Although NASA served customers in North and South America and EROW served customers in Europe and the rest of the world, regular butyl could be shipped from either the Sarnia 2 or Antwerp plant. NASA shipped approximately 1/3 of its regular butyl output to EROW. Also, customers located in distant locations could receive shipments from either plant due to certain cost or logistical advantages. For example, Antwerp sometimes shipped to Brazil and Sarnia sometimes shipped to the Far East. …

78. POLYSAR Product Scheduling … In September and October of each year, NASA and EROW divisions prepared production estimates for the upcoming year. These estimates were based on estimated sales volumes and plant loadings (i.e., capacity utilization). Since the Antwerp plant operated at capacity, the planning exercise was largely for the benefit of the managers of the Sarnia 2 plant, who needed to know how much regular butyl Antwerp would need from the Sarnia 2 plant.

79. POLYSAR What are EROW’s incentives in the budgeting process? What happens if EROW estimates greater demand for butyl than EROW actually needs?

80. POLYSAR Interview with Pierre Choquette (Vice President of NASA Rubber Division) – “Our transfers to EROW are still a problem. Since the transfers are at standard cost and are not recorded as revenue, these transfers do nothing for our profit. Also, if they cut back on orders, our profit is hurt through the volume variance. Few of our senior managers truly understand the volume variance …”