Harvard Business School Teaching Case Polysar Ltd.

Harvard Business School Teaching Case Polysar Ltd.

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

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)

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.

POLYSAR

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.

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

Flexible Budgeting Pro forma statements, for hypothetical levels of output, also use the same “flexible budgeting” technique.

The Spring Valley Bicycle Company planned to produce and sell 6,000 units of its sole product in 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.

Static budget variance Actual results Flexible budget variance
The Spring Valley Bicycle Company planned to produce and sell 6,000 units of its sole product in 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. Static budget Static budget variance Actual results Flexible budget variance Flexible budget Units made Units sold Revenue COGS Gross Margin Fixed SG&A Sales comm. Income 8,000 7,000 $6,181K 4,238K 1,943K 485K 525K $ 933K

Static budget variance Actual results Flexible budget variance
The Spring Valley Bicycle Company planned to produce and sell 6,000 units of its sole product in 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. Static budget Static budget variance Actual results Flexible budget variance Flexible budget Units made Units sold Revenue COGS Gross Margin Fixed SG&A Sales comm. Income 6,000 $5,160K 3,686K 1,474K 510K 420K $544K 1,021K F 552K U 469K F 25K F 105K U 389K F 8,000 7,000 $6,181K 4,238K 1,943K 485K 525K $ 933K 161K F 258.5K U 97.5K U 35K U 107.5K U $6,020 3,979.5K 2,040.5K 490K $1,040.5

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

What is a Standard? BUDGET STANDARD

Choice of Cost Accounting Systems

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.

Three Costing Systems Actual Normal Standard Direct Costs
actual prices x actual inputs per output actual outputs budgeted prices x budgeted inputs per output Over-head actual overhead rate actual quantity of the allocation base incurred budgeted overhead rate standard quantity of the allocation base allowed for actual outputs

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

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

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

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

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

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

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

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

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

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.

The McBean Company makes stars
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?

PV = AQ x (AP - SP) QV = SP x (AQ - SQ)
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?

PV = AQ x (AP - SP) = 2,600 lb. x $0.25 per lb.
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

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?

= $4 per lb. x 100 lbs. = $400 favorable
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

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?

= 1,820 hr.s x (11.50 per hr* - $12 per hr)
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.

PV = AQ x (SP - AP) QV = SP x (AQ - SQ)
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?

= $12 per hour x 20 hrs. = $240 Unfav.
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

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.

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.

Cost Variances for Fixed and Variable Overhead
Variances for Variable Overhead Variances for Fixed Overhead

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

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 Q’s 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 P’s are the Overhead Rate. AP is the Actual Overhead Rate. SP is the Budgeted Overhead Rate.

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)

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?

Cost Variances for Fixed and Variable Overhead
Variances for Variable Overhead Variances for Fixed Overhead

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.

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.

Coachman Company The Coachman Company manufactures pencils. The pencils are sold by the box. Budget Actual Capacity # of boxes , , ,000 D.L.H ,000 Machine hr.s ,000 Fixed O/H $40, $42,000

Coachman Company # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000
Budget Actual Capacity # of boxes , , ,000 D.L.H ,000 Machine hr.s ,000 Fixed O/H $40, $42,000 The outputs here are boxes of pencils. The inputs are direct labor hours and machine hours.

Budget Actual Capacity # of boxes , , ,000 D.L.H ,000 Machine hr.s ,000 Fixed O/H $40, $42,000 Let’s calculate a fixed overhead rate using actual information: $42,000  12,000 boxes = $3.50 per box

Budget Actual Capacity # of boxes , , ,000 D.L.H ,000 Machine hr.s ,000 Fixed O/H $40, $42,000 Let’s 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

Budget Actual Capacity # of boxes , , ,000 D.L.H ,000 Machine hr.s ,000 Fixed O/H $40, $42,000 Let’s 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

Coachman Company # of boxes 10,000 12,000 20,000
Budget Actual Capacity # of boxes , , ,000 Fixed O/H $40, $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.

Budget Actual Capacity # of boxes , , ,000 D.L.H ,000 Machine hr.s ,000 Fixed O/H $40, $42,000

Overhead Variances For Fixed Overhead
Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead This is what we actually spent From either the static or flexible budget O/H rate x the application base Budget Variance Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 O/H rate x the application base $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.

First let’s allocate based on factory capacity in the denominator

Coachman Company # of boxes 10,000 12,000 20,000
Budget Actual Capacity # of boxes , , ,000 Fixed O/H $40, $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.

Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $2.00 per unit x 12,000 units $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.

Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $24,000 $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.

Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $24,000 $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.

Now let’s allocate based on budgeted production in the denominator

Budget Actual Capacity # of boxes , , ,000 D.L.H ,000 Machine hr.s ,000 Fixed O/H $40, $42,000 Let’s 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

Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $4.00 per unit x 12,000 units $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.

Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $48,000 $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.

Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $48,000 $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.

POLYSAR 2. Calculate NASA’s 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

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 EROW’s rate for applying fixed manufacturing costs to Butyl. What might explain the difference in the fixed overhead rates of the two divisions?

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?

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

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.

Shell Oil Company

Transfer Pricing Options
Market-Based Transfer Price Cost-Based Transfer Price Negotiated Transfer Price

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.

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.

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.

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.

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.

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?

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