ANSWERS TO CRITICAL ANALYSIS

16.15 A perfection (or ideal) standard is the cost expected under perfect or ideal operating conditions. A practical (or attainable) standard is the cost expected under normal operating conditions. Many behavioral scientists question the effectiveness of perfection standards. They feel that employees are more likely to perform well when they strive to achieve an attainable standard than when they strive, often unsuccessfully, to achieve a perfection standard.

16.16 Variances represent differences between plans and actual outcomes. Capturing these variances can provide useful information regardless of whether inventories exist. Knowledge about differences between plans and actual outcomes can help managers improve planning or take steps to improve operations.
16.17 The action that management can take in response to price variances is probably quite different than the action that can be taken in response to efficiency variances. The latter is generally more subject to management control. Also, different departments may be responsible for each variance. For example, purchasing may be responsible for the materials price variance and production for the materials efficiency variance. 16.18 The direct-material price variance is based on the quantity purchased (PQ). Deviations between the actual and standard price, which are highlighted by the price variance, relate to the purchasing function in the firm. Timely action to follow up a significant price variance is facilitated by calculating this variance as soon as possible after the material is purchased. The direct-material quantity variance is based on the amount of material used in production (AQ). The quantity variance highlights deviations between the quantity of material actually used (AQ) and the standard quantity allowed (SQ). Therefore, it makes sense to compute this variance at the time the material is used in production. 16.19 The issue of quantity purchased versus quantity used does not arise in the context of direct labor, because direct labor is purchased and used at the same time. Unlike direct material, direct labor cannot be purchased and inventoried for later use.

16.20 Typically, the labor price variances are relatively small since the rates are usually determined in advance through the union negotiation process. However, if a line manager uses workers that are more skilled (and thus higher paid) than the labor that was considered when preparing the budget, an unfavorable price variance would arise that would be the responsibility of the line manager. Presumably, the manager would do this only when the manager expected efficiency improvements at least equal to the unfavorable price variance. If overtime premiums are not accounted for separately, then unbudgeted overtime premiums could be the cause of price variances. 16.21 Several ways in which standard-costing should be adapted in todays advanced manufacturing environment are as follows: y Reduced importance of labor standards and variances: As direct labor occupies a diminished role in todays manufacturing environment, the standards and variances used to control labor costs also decline in importance. y Emphasis on material and overhead costs: As labor diminishes in its importance, material and overhead costs take on greater significance. y Cost drivers: Identification of the factors that drive production costs takes on greater importance in the cost management system. y Shifting cost structure: Advanced manufacturing systems require large outlays for production equipment, which entail a shift in the cost structure from variable costs toward fixed costs. Overhead cost control becomes especially critical. y High quality and no defects: Total quality control programs that typically accompany a JIT approach strive for very high quality levels for both raw materials and finished products. One result should be very low material price and quantity variances and low costs of rework. y Non-value-added costs: A key objective of a cost management system is the elimination of non-value-added costs. As these costs are reduced or eliminated, standards must be revised frequently to provide accurate benchmarks for cost control.

y New measures and standards: In todays advanced manufacturing environment, new measures must be developed to control key aspects of the production process. As new measures are developed, standards should be established as benchmarks for performance. An example is the manufacturing cycle efficiency measure, which is defined as processing time divided by the sum of processing time, inspection time, waiting time, and move time. 16.22 Kaizen costing is most consistent with the saying "slow and steady wins the race." Kaizen costing is the process of cost reduction during the manufacturing phase of a product. The Japanese word kaizen refers to continual and gradual improvement through small betterment activities, rather than large or radical improvements made through innovation or large investments in technology.

ANSWERS TO CRITICAL ANALYSIS

17.17 Preparation of the flexible (ex post) budget allows management to compare actual results with the budget that would have been instituted if certain ex ante unknowns had been known. The most significant of these is, typically, volume of activity. By controlling for the difference between ex ante expectations and the ex post volumes, comparisons between actual results and plans is more meaningful. The controllable factors (i.e., costs per unit, efficiency, and so forth) can be isolated and evaluated. 17.18 Flexible overhead budgets are based on an input activity measure, such as machine hours or direct-labor hours, in order to provide a meaningful measure of production activity. An output measure, such as the number of units produced, could be used effectively only in a single-product enterprise. If multiple, heterogeneous products are produced, it would not be meaningful to base the flexible budget on an output measure aggregated across highly different types of products. 17.19 A flexible budget indicates budgeted revenues, costs and profits for virtually all feasible levels of activity. So, managers can use the flexible budget to determine what costs should be assuming different levels of activity. Since changes in volume of production may not be within a particular managers control, the flexible budget allows supervisory managers to isolate the effect of changes in volume on the overall costs of a department in question. The flexible budget also separates facilitylevel (fixed) from unit-level (variable) costs. Generally, fixed costs are less controllable in the short run than variable costs. 17.20 Computer-integrated manufacturing systems have resulted in a shift from variable toward fixed costs. In addition, as automation increases, more and more firms are

switching to such measures of activity as machine hours or process time for their flexible overhead budgets. Machine hours and process time are linked more closely than direct-labor hours to the robotic technology and computer-integrated manufacturing systems becoming common in today's manufacturing environment. 17.21 Plausible activity bases for a variety of organizations to use in flexible budgeting are as follows: (a) Insurance company: Insurance policies processed or insurance claims processed. (b) Express delivery service: Number of items of express mail or weight of express mail processed. (c) Restaurant: Number of customers served.

(d) State tax-collection agency: Number of tax returns processed. 17.22 Government systems are usually not able to respond to changes in activity levels. For example, an unemployment commission is usually strapped for workers when the unemployment rate rises. By the time the needs are presented to legislators and the needs are met through increased funding, the unemployment rate may well have decreased, leading to over-funding in a subsequent period. In part, this problem is due to the elaborate controls that have been instituted over governmental units. 17.23 An unfavorable variable-overhead spending variance does not imply that the company paid more than the anticipated rate per kilowatt-hour for electricity. An unfavorable spending variance could result from spending more per kilowatt-hour for electricity or from using more electricity than anticipated, or some combination of these two causes. 17.24 A common but misleading interpretation of the fixed-overhead volume variance is that it is a measure of the cost of underutilizing or overutilizing production capacity. For example, when budgeted fixed overhead exceeds applied fixed overhead, the fixed-overhead volume variance is positive. Some people interpret this positive variance to be unfavorable and claim that it is a measure of the cost of not having utilized production capacity to the level that was anticipated. However, this interpretation is misleading, because the real cost of underutilizing capacity lies in the forgone contribution margins from the products that were not produced and sold. 17.25 The fixed-overhead volume variance represents the result of allocating a fixed cost over a different level of activity than was used in computing the allocation rate. Since the cost is fixed, the cash outflows associated with the fixed cost will be unchanged regardless of the amount or direction of the fixed-overhead volume variance. 17.26 The conceptual problem in applying fixed manufacturing overhead as a product cost is that this procedure treats fixed overhead as though it were a variable cost. Fixed overhead is applied as a product cost by multiplying the fixed overhead rate by the standard allowed amount of the cost driver used to apply fixed overhead. For example, fixed overhead might be applied to Work-in-Process Inventory by multiplying the fixed-overhead rate by the standard allowed machine hours. As the number of standard allowed machine hours increases, the amount of fixed overhead applied increases proportionately. This situation is conceptually unappealing, because fixed overhead, although it is a fixed cost, appears variable in the way that it is applied to work in process.

17.27 It is likely that the variance the marketing manager refers to is a revenue variance alone, not a contribution-margin variance. If so, the signal that the marketing manager has received is misleading. Variable costs must be incurred to achieve the higher revenue levels. It would be better to show the budget variance in terms of contribution margins. 17.28 In this situation the company is really selling just one product so a mix variance would not be meaningful. 17.29 In a CPA firm, as in other professional firms, billing rates vary with the level of the professional person performing the services. Hence, a staff accountants time is billed at a lower rate than a partners time. Even though the volume of hours billed may be the same, if the mix of staff to partner time is different, there will be differences in revenue (and, most likely in profit as well).

ANSWERS TO CRITICAL ANALYSIS

18.13 It would be appropriate to change a particular plant from a profit center to an investment center if the manager of the plant is given the authority to make significant investment decisions affecting the plants resources. 18.14 Rarely does a single individual completely control a result in an organization. Most results are caused by the joint efforts of several people and the joint impact of several events. Nevertheless, there is usually a person who is in the best position to explain a result or who is in the best position to influence the result. In this sense, performance reports based on controllability really are based on a manager's ability to influence results. 18.15 Large divisions are, all other things being equal, more likely to rank in the upper half. Hence, a large division manager would tend to receive a bonus with performance that is just barely above the cost of capital whereas a smaller division might need to earn a return far in excess of the cost of capital in order to earn a bonus. The approach used also does not take into account differences in capital charges that might be appropriate for different divisions. 18.16 It is important to make a distinction between an investment center and its manager, because in evaluating the manager's performance, only revenues and costs that the manager can control or significantly influence should be included in the profit measure. The objective of the manager's performance measure is to provide an incentive for that manager to adhere to goal-congruent behavior. In evaluating the investment center as a viable economic investment, all revenues and costs that are

traceable to the investment center should be considered. Controllability is not an issue in this case. 18.17 A division's ROI can be improved by improving the sales margin, by improving the capital turnover, or by some combination of the two. The manager of the automobile division of an insurance company could improve the sales margin by increasing the profit margin on each insurance policy sold. As a result, every sales dollar would generate more income. The capital turnover could be improved by increasing sales of insurance policies while keeping invested capital fixed, or by decreasing the invested assets required to generate the same sales revenue. 18.18 If the division can rent and the rent does not have to be capitalized for inclusion in the investment base, the residual income will increase so long as the income from the asset exceeds the lease payment.

18.19 The chief disadvantage of ROI is that for an investment that earns a rate of return greater than the company's cost of raising capital, the manager in charge of deciding about that investment may have an incentive to reject it if the investment would result in reducing the manager's ROI. The residual-income measure eliminates this disadvantage by including in the residual-income calculation the imputed interest rate, which reflects the firm's cost of capital. Any project that earns a return greater than the imputed interest rate will show a positive residual income. 18.20 (1) Total assets: Includes all divisional assets. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets, including nonproductive assets. (2) Total productive assets: Excludes assets that are not in service, such as construction in progress. This measure is appropriate when a division manager is directed by top management to keep nonproductive assets, such as vacant land or construction in progress. (3) Total assets less current liabilities: All divisional assets minus current liabilities. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. This approach encourages investment-center managers to minimize resources tied up in assets and maximize the use of short-term credit to finance operations. 18.21 Using ROI as the sole performance measurement index will tend to discourage new investment and innovation. Managers will tend to focus on short-run performance. Quality tends to be sacrificed for quantity. Bleak Prospects could improve its situation by adopting a performance system that includes nonfinancial measures of performance such as requiring that a certain level of sales come from new products and that defective goods and rework rates be below a certain level. 18.22 The rise in ROI or residual income across time results from the fact that periodic depreciation charges reduce the book value of the asset, which is generally used in determining the investment base to use in the ROI or residual-income calculation. This phenomenon can have a serious effect on the incentives of investment-center managers. Investment centers with old assets will show higher ROIs than investment centers with relatively new assets. This result can discourage investment-center managers from investing in new equipment. If this behavioral tendency persists for a long time, a division's assets can become obsolete, making the division noncompetitive.