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Managerial Accounting Decision - Cost Analysis

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You have been approached by a potential customer who could bring considerable business. She says, "I'd like to find an alternative vendor for my future orders of 5,000/yr, but their pricing to me must be competitive."

Your CFO has supplied you with the following information. Current product standard costs are as follows:

$1,400/unit direct material
$400/unit direct labor
$200/unit variable overhead
$200/unit fixed overhead (this figure is the result of budgeted fixed overhead of $2,000,000 and budgeted sales volume of 10,000 units)
The board of directors requests a quick but 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. Answer the board's following questions based on data from the CFO:

What is meant by budget variance?
What is an effective way to incorporate variance analysis into 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 we have sufficient capacity, without working overtime and without adding any new equipment, to make this order)? Please show the calculations.
In terms of capacity, under what conditions would offering this lowest possible price be a bad decision? Why?
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 the calculations.

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Solution Summary

Your tutorial is 581 words plus three analyses in Excel (see attached, click in cells to see computations). This gives you the strategy for analyzing special orders and the discussion takes you through the classic reasons.

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What is meant by budget variance?

Budget variance is the difference between budget and actual.

What is an effective way to incorporate variance analysis into the budget process?

The best way is to adopt a flexible budget practice where the analysis is separated into (1) the changes do solely to activity differences from the beginning of the year budget (static budget) and the end of the year (flexible budget) and (2) the changes due to spending or price differences between expectations and actual. This isolates differences expected (no need for follow up) and differences that are no expected (need to ask about these if material).

What are the differences between labor and material variances?

Material variances are very similar to labor differences because you can have differences due to quantity and differences due to price variances from standard. The key differences is that labor cannot be "inventoried" so quantity purchased cannot be different from quantity used. For material, you can have a difference in quantity purchased and quantity used.

How is a quantity variance different from a rate variance?

Quantity is about how much of the material or labor was used, such as five pounds or three hours. Rate variances are about the price such as $4.00 per foot or ...

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Carol Sargent, PhD
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  • MSc, University of Virginia
  • PhD, Georgia State University
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