Question:
A manufacturing company,Man Co,has two divisions:Division L and Division M. Both divisions make a single standardised product. Division L makes component L,which is supplied to both Division M and external customers. Division M makes product M using one unit of component L and other materials. It then sells the completed product M to external customers. To date,Division M has always bought component L from Division L.
Division L charges the same price for component L to both Division M and external customers. However,it does not incur the selling and distribution costs when transferring internally.
Division M has just been approached by a new supplier who has offered to supply it with component L for $37 per unit. Prior to this offer,the cheapest price which Division M could have bought component L for from outside the group was $42 per unit.
It is head office policy to let the divisions operate autonomously without interference at all.
Required：
(a)Calculate the incremental profit/(loss)per component for the group if Division M accepts the new supplier‘s offer and recommend how many components Division L should sell to Division M if group profits are to be maximised.
(b)Using the quantities calculated in (a)and the current transfer price,calculate the total annual profits of each division and the group as a whole.
(c)Discuss the problems which will arise if the transfer price remains unchanged and advise the divisions on a suitable alternative transfer price for component L.
Answer:
(a)Maximising group profit
Division L has enough capacity to supply both Division M and its external customers with component L.
Therefore,incremental cost of Division M buying externally is as follows：
Cost per unit of component L when bought from external supplier:$37
Cost per unit for Division L of making component L:$20.
Therefore incremental cost to group of each unit of component L being bought in by Division M rather than transferred internally:$17 ($37-20).
From the group’s point of view,the most profitable course of action is therefore that all 120，000 units of component L should be transferred internally.(b)Calculating total group profit.
(b)Calculating total group profit
(c)Problems with current transfer price and suggested alternative
The problem is that the current transfer price of $40 per unit is now too high. Whilst this has not been a problem before since external suppliers were charging $42 per unit,it is a problem now that Division M has been offered component L for $37 per unit. If Division M now acts in its own interests rather than the interests of the group as a whole,it will buy.
component L from the external supplier rather than from Division L. This will mean that the profits of the group will fall substantially and Division L will have significant unused capacity. Consequently,Division L needs to reduce its price. The current price does not reflect the fact that there are no selling and distribution costs associated with transferring internally,i.e. the cost of selling internally is $4 less for Division L than selling externally. So,it could reduce the price to $36 and still make the same profit on these sales as on its external sales. This would therefore be the suggested transfer price so that Division M is still saving $1 per unit compared to the external price. A transfer price of $37 would also presumably be acceptable to Division M since this is the same as the external supplier is offering.
Question:
Glove Co makes high quality,hand - made gloves which it sells for an average of $180 per pair. The standard cost of labour for each pair is $42 and the standard labour time for each pair is three hours. In the last quarter,Glove Co had budgeted production of 12,000 pairs,although actual production was 12,600 pairs in order to meet demand. 37,000 hours were used to complete the work and there was no idle time. The total labour cost for the quarter was $531,930.
At the beginning of the last quarter,the design of the gloves was changed slightly. The new design required workers to sew the company‘s logo on to the back of every glove made and the estimated time to do this was 15 minutes for each pair. However,no - one told the accountant responsible for updating standard costs that the standard time per pair of gloves needed to be changed. Similarly,although all workers were given a 2% pay rise at the beginning of the last quarter,the accountant was not told about this either. Consequently,the standard was not updated to reflect these changes.
When overtime is required,workers are paid 25% more than their usual hourly rate.
Required：
(a) Calculate the total labour rate and total labour efficiency variances for the last quarter.
(b) Analyse the above total variances into component parts for planning and operational variances in as much detail as the information allows.
(c) Assess the performance of the production manager for the last quarter.
Answer:
(a) Basic variances
Labour rate variance
Standard cost of labour per hour = $42/3 = $14 per hour.
Labour rate variance = (actual hours paid x actual rate) - (actual hours paid x std rate)
Actual hours paid x actual rate = $531,930.
Actual hours paid x std rate = 37,000 x $14 = $518,000.
Therefore rate variance = $531,930 - $518,000 = $13,930 A
Labour efficiency variance
Labour efficiency variance = (actual production in std hours - actual hours worked) x std rate
[(12,600 x 3) - 37,000] x $14 = $11,200 F
(b) Planning and operational variances
Labour rate planning variance
(Revised rate - std rate) x actual hours paid = [$14·00 – ($14·00 x 1·02)] x 37,000 = $10,360 A.
Labour rate operational variance
Revised rate x actual hours paid =$14·28 x 37,000= $528,360.
Actual cost = $531,930.
Variance = $3,570 A.
Labour efficiency planning variance
(Standard hours for actual production - revised hours for actual production) x std rate
Revised hours for each pair of gloves = 3·25 hours.
[37,800 – (12,600 x 3·25)] x $14 = $44,100 A.
Labour efficiency operational variance
(Revised hours for actual production - actual hours for actual production) x std rate
(40,950 - 37,000) x $14 = $55,300 F.
(c) Analysis of performance
At a first glance,performance looks mixed because the total labour rate variance is adverse and the total labour efficiency variance is favourable. However,the operational and planning variances provide a lot more detail on how these variances have occurred.
The production manager should only be held accountable for variances which he can control. This means that he should only be held accountable for the operational variances. When these operational variances are looked at it can be seen that the labour rate operational variance is $3,570 A. This means that the production manager did have to pay for some overtime in order to meet demand but the majority of the total labour rate variance is driven by the failure to update the standard for the pay rise that was applied at the start of the last quarter. The overtime rate would also have been impacted by that pay increase.
Then,when the labour efficiency operational variance is looked at,it is actually $55,300 F. This shows that the production manager has managed his department well with workers completing production more quickly than would have been expected when the new design change is taken into account. The total operating variances are therefore $51,730 F and so overall performance is good.
The adverse planning variances of $10,360 and $44,100 do not reflect on the performance of the production manager and can therefore be ignored here.
