Question

You have been approached by a potential client who could bring you considerable business. She says, "I'd like to find an alternative vendor for my future orders of 5,000/yr., but their pricing must be competitive." 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: What is meant by cost variance? What is an effective way to incorporate variance analysis in the budget process? What are the differences between labor and material variances? How is a quantity variance different from a rate variance? What are the subcomponents of fixed overhead? What are the subcomponents of variable overhead? 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. In terms of capacity, under what conditions would offering this lowest possible price be a bad decision? Why? Create a pro-forma income statement to show a net income/net loss for the year. 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

Page 1 - Existing cost calculation of the product: New price: sales volume Cunits) 10000 Foco a) sales price 10000 @ 5000 50,000000 5000 @ 5000 28000000 b) variable over head Direct Material 10000 @ 1400 14,000000 8000 @ 1400 7000000 Direct labor 10000 @ 400 400 0000 5000 @ 1400 2000000 Variable overhead 10000 @ 200 2000000 3000 @ 200 6000000 Total - 20000000 10000000 contribution ( sales - Variable cost) 30000000 15000000 fixed overhead - 2000000 1 000 000 Net profit (conto-fo) 28000000 14 000000

NOW , - Page 2 1) cost variance is the cost difference of various cost items between actual performance and the budgeted and planned amount of cost. 2) The effective way to incorporate variance analysis in the budget process is that to raise the budget while taking the updated nooms/ standards of inputs usage and using the presenting prevailing inputs prices. The usage of lates nooms and prices will allow favourable and un favourable Vasiances to be incorporated in the forthcoming Budgets. 3) The differences between labor and material variances are that when the variances are concerned with the labour usage and its dates, it is called Labor variances. But when the variances are concerned with the material norms and its actual usage and the concerned rates, the variances are . called material variances. 4 The quantity variances are the differences between the set standards/ nooms of inputs in budget and actual usage of inputs, where as the rate variances are the differences between the prices/ rates of inputs as set in budget and .. the actual input prices / rates.

page 3 5) the subcomponents of fixed overhead are ; fixed overrhead volume variance, fixed overhead capacity variance and fixed over head efficiency vadiance. The fixed over head includes rent, depreciation, supervision salaries, etc. 6) the subcomponents of variable over head are Indirect Material overhead , Indirect labor over head, factory supplies factory utilities, etc. 7) the lowest possible price we can offer (contribution/ sales) 15000000 15000 = 3000 Per unit. It will be very good decision because it will not impact on fired overhead. If we will consider the new techonology then labor cost will decrease by 50% OM 14000000 + DL 2000000 + 2000000 = 18000000 sales -overhead = 50000000 – 18000000 = 32000000 - 2000000 = 1200000 Less; new technology - 100000 Net profit - 1100000