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Harvard Business School Teaching Case Polysar Ltd. AGENDA Polysar Ltd. Introduction to Polysar Standard Costing Variance Analysis for Variable Costs Fixed Overhead Volume Variance Transfer Pricing . AGENDA Polysar Ltd. Introduction to Polysar Standard Costing

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slide2

AGENDAPolysar Ltd.

  • Introduction to Polysar
  • Standard Costing
  • Variance Analysis for Variable Costs
  • Fixed Overhead Volume Variance
  • Transfer Pricing
slide3

AGENDAPolysar Ltd.

  • Introduction to Polysar
  • Standard Costing
  • Variance Analysis for Variable Costs
  • Fixed Overhead Volume Variance
  • Transfer Pricing
polysar
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)
polysar5
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.
slide7

AGENDAPolysar Ltd.

  • Introduction to Polysar
  • Standard Costing
  • Variance Analysis for Variable Costs
  • Fixed Overhead Volume Variance
  • Transfer Pricing
polysar8
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.

polysar9
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.

polysar10
POLYSAR

1a) What evidence do we have that Polysar is on a standard costing system?

slide11

Product Costing and Transfer Prices –

Butyl rubbers were costed using standard rates for variable and fixed costs.

Variable costs included feedstocks, chemicals, and energy. Standard variable cost per ton of butyl was calculated by multiplying the standard utilization factor (i.e., the standard quantity of inputs used) by a standard price established for each unit of input. Since feedstock prices varied with worldwide market conditions and represented the largest component of costs, it was impossible to establish standard input prices that remained valid for extended periods. Therefore, the company reset standard costs each month to a price that reflected market prices. Chemical and energy standard costs were established annually.

polysar12
POLYSAR

1b) Interpret the amount $22,589 on Exhibit 2, for variable costs.

1b interpret the amount 22 589 on exhibit 2 for variable costs
1b) Interpret the amount $22,589 on Exhibit 2, for variable costs.

The $22,589 is in the “actual” column, and is the variable cost at standard. Therefore, it is based on the actual volume of output (i.e., sales), but uses the budgeted cost of the inputs (feedstocks, chemicals, and energy) per ton of output.

The standard cost per ton for raw materials, averaged over the 9 months,was $631 per ton ($22,589/35.8).

The $22,589 is equivalent to a flexible budget amount. It is the answer to the question: What should our input costs have been for our actual level of output (sales)?

polysar16
POLYSAR

1c) Interpret the amount $21,450 on Exhibit 2, for variable costs.

1c interpret the amount 21 450 on exhibit 2 for variable costs
1c) Interpret the amount $21,450 on Exhibit 2, for variable costs.

This is the static budget number for variable costs (feedstocks, chemicals, energy). Since it is the static budget, it is based on the original, projected level of sales. From Exhibit 1, the projected level of sales was 33,000 tons.

Hence, the standard cost per ton for variable costs, as of the beginning of the year, was $650 per ton ($21,450/33).

slide19

POLYSAR

How can the standard cost per ton for variable costs differ from the beginning of the year to the end of the year? I.e.: $650 per ton vs. $631 per ton.

slide20

POLYSAR

Product Costing and transfer Prices –

Butyl rubbers were costed using standard rates for variable and fixed costs.

Variable costs included feedstocks, chemicals, and energy. Standard variable cost per ton of butyl was calculated by multiplying the standard utilization factor (i.e., the standard quantity of inputs used) by a standard price established for each unit of input. Since feedstock prices varied with worldwide market conditions and represented the largest component of costs, it was impossible to establish standard input prices that remained valid for extended periods. Therefore, the company reset standard costs each month to a price that reflected market prices. Chemical and energy standard costs were established annually.

slide21

AGENDAPolysar Ltd.

  • Introduction to Polysar
  • Standard Costing
  • Variance Analysis for Variable Costs
  • Fixed Overhead Volume Variance
  • Transfer Pricing
polysar22
POLYSAR

1d) Evaluate NASA’s performance relative to budget for sales price and volume.

evaluate nasa s performance relative to budget for sales price and volume
Evaluate NASA’s performance relative to budget for sales price and volume.

Sales Volume:

Budgeted: 33,000 tons

Actual: 35,800 tons

Sales Price per Tonne:

Budgeted: $1,850 ($61,050/33)

Actual: $1,840 ($65,872/35.8)

polysar26
POLYSAR

1e) Evaluate NASA’s performance relative to budget for plant efficiency, raw materials prices, fixed manufacturing expenses, and non-manufacturing expenses.

price and efficiency variances for feedstocks chemicals and energy

Price and Efficiency Variances for Feedstocks, Chemicals and Energy

The outer box represents the flexible budget amount of $22,589.

S.P.

A.P.

$54K FAVORABLE

“COST ADJUSTMENT”

EFFICIENCY

VARIANCE

$241K

FAV.

$22,294K

ACTUAL COST

A.Q.* S.Q.*

*For actual output

polysar32
POLYSAR
  • Sales price per ton is slightly below budget.
  • Sales volume is almost 10% above budget.
  • The efficiency variance for variable costs is very small.
  • The price variance for variable costs is very small, due in part to the fact that standards are revised monthly.
  • Fixed manufacturing expenses are within 2% of budget.
  • Non-manufacturing expenses are within 1% of budget.
polysar33
POLYSAR
  • Why do 80% of manufacturing companies use Standard Costing Systems?
  • Survey data shows that the most important reason is to help control costs.
  • How does a standard costing system help Polysar control costs?
  • In a standard costing system, all variances flow through the accounting system, and appear on the monthly income statements.
slide35

AGENDAPolysar Ltd.

  • Introduction to Polysar
  • Standard Costing
  • Variance Analysis for Variable Costs
  • Fixed Overhead Volume Variance
  • Transfer Pricing
polysar36
POLYSAR

2. Calculate NASA’s rate for allocating manufacturing overhead costs to Butyl.

polysar37
POLYSAR

Fixed Manufacturing Overhead

Demonstrated Capacity

=

$44,625K .

85,000 tons per year x 9/12

=

$700 per ton

polysar38
POLYSAR

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
polysar39
POLYSAR
  • Fixed Costs of Sales on Exhibit 2
  • Actual:
  • $700/tonne x 35.8K tonnes = $25,060K
  • Budgeted:
  • $700/tonne x 33.0K tonnes = $23,100K
polysar40
POLYSAR
  • Transfers to Finished Goods Inventory on Exhibit 1
  • Actual:
  • $700 x (47.5 + 2.1 - 35.8 - 12.2) =
  • $700 x 1.6K tonnes = $1,120K
  • Budgeted:
  • $700 x (55 + 1 - 33 - 19.5) =
  • $700 x 3.5K = $2,450K
polysar41
POLYSAR
  • Transfers to EROW on Exhibit 1
  • Actual:
  • $700/tonne x 12.2K tonnes = $8,540K
  • Budget:
  • $700/tonne x 19.5K tonnes = $13,650K
polysar42
POLYSAR

4. Does Polysar close out variances to Cost of Goods Sold, or allocate variances between Cost of Goods Sold and Inventory?

polysar43
POLYSAR

In the previous question, we were able to recalculate the fixed cost component of butyl added to ending inventory, and butyl transferred to EROW, using the budgeted $700 per ton rate.

Therefore, no variances are included in these amounts, and all variances closed out to the income statement (Exhibit 2). These variances appear on the line items for “Cost Adjustments,” “Spending Variance,” and “Volume Variance.”

polysar44
POLYSAR

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?

polysar45
POLYSAR

From the Budgeted column on Exhibit 1, we know that NASA planned to take 1K tonnes of butyl from EROW, at a cost (i.e., fixed cost component) of $620K, or $620 per ton.

EROW’s fixed cost rate of $620 is lower than NASA’s rate of $700, probably because EROW’s facility is older. Note that the difference in rates cannot be due to differences in capacity utilization.

polysar46
POLYSAR

6. What do the budgeted and actual volume variances of $6,125 and $11,375 represent?

polysar47
POLYSAR

Budget

Capacity for 9 mo.s of 63,750 tons

Budgeted production of 55,000

(63,750 - 55,000) x $700 = $6,125K

Actual

Capacity for 9 months of 63,750 tons

Actual production of 47,500

(63,750 - 47,500) x $700

= 16,250 x $700 = $11,375K

polysar48
POLYSAR

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.

polysar49
POLYSAR

Fixed Manufacturing Overhead

Budgeted Production

=

$44,625K .

55,000 tons

= $811 per ton

polysar50
POLYSAR

Using this $811 per ton rate:

There would be no budgeted volume variance, since

$811/ton x 55K tons = $44,625K

Actual volume variance would be

$811 x (55,000 - 47,500) = $6,085

slide51

AGENDAPolysar Ltd.

  • Introduction to Polysar
  • Standard Costing
  • Variance Analysis for Variable Costs
  • Fixed Overhead Volume Variance
  • Transfer Pricing
polysar52
POLYSAR

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?

polysar53
POLYSAR

8a. What type of transfer price does Polysar use?

transfer pricing options
Transfer Pricing Options
  • Market-Based Transfer Price
  • Cost-Based Transfer Price
  • Negotiated Transfer Price
  • Dual Transfer Price
slide55

Product Costing and Transfer Prices –

… Product transfers between divisions for performance accounting purposes were made at standard full cost, representing, for each ton, the sum of standard variable cost and standard fixed cost.

polysar56
POLYSAR
  • Polysar uses a cost-based transfer price.
cost based transfer price
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.
slide58

POLYSAR

Interview with Pierre Choquette (Vice President of NASA Rubber Division) –

“Our transfers to EROW are still a problem. Since the transfers are at standard cost and are not recorded as revenue, these transfers do nothing for our profit. Also, if they cut back on orders, our profit is hurt through the volume variance. Few of our senior managers truly understand the volume variance.

polysar59
POLYSAR
  • Polysar uses a cost-based transfer price.
  • It is a full cost transfer price (i.e., it includes both variable and fixed costs).
  • It is based on budgeted (i.e., standard costs).
  • It does not include a mark-up.
polysar60
POLYSAR

8b. What is the transfer price for butyl?

slide61

Product Costing and Transfer Prices –

… Fixed costs were allocated to production based on a plant’s “demonstrated capacity” using the following formula,

standard fixed cost per ton =

estimated annual total fixed cost ÷

annual demonstrated plant capacity

To apply the formula, product estimates were established each fall for the upcoming year.

calculation of transfer price for butyl
CALCULATION OF TRANSFER PRICE FOR BUTYL

Total Fixed Costs were budgeted at $44,625K (from Exhibit 1).

Denominator is “demonstrated capacity.” This is 85,000 tons per year, or 63,750 tonnes for 9 months.

$44,625K/63,750 = $700 per ton

polysar64
POLYSAR

8c. What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for actual demand?

polysar65
POLYSAR

Each ton of butyl transferred to EROW has $700 in fixed costs attached to it. EROW covers $700 of NASA’s fixed costs with each ton “purchased” from NASA.

When EROW takes less butyl than planned, and NASA cuts back on production accordingly, NASA’s volume variance increases, and its net contribution (i.e., income) decreases, relative to plan.

polysar66
POLYSAR

8d. What is the effect on NASA when EROW takes less butyl than planned, if NASA produces for budgeted demand?

polysar67
POLYSAR

If NASA produces at budgeted demand, and EROW purchases less butyl than planned, NASA will increase its ending inventory.

In this case, the fact that EROW takes less butyl than planned will have no effect on NASA’s net contribution. The $700 per ton in fixed costs that NASA thought would be covered by EROW, will now be capitalized in ending inventory.

polysar68
POLYSAR

8c. What is the best butyl sourcing strategy for Polysar?

polysar69
POLYSAR

Polysar should allocate production of butyl and halobutyl to EROW and NASA to minimize total production and shipping costs, while still meeting customer demand.

In making this determination, fixed costs are irrelevant, since they are either sunk costs, or are unavoidable unless the plant is closed down.

Polysar should manufacture butyl as long as the sales price is more than the variable costs of production and distribution.

slide70

Product Costing and Transfer Prices –

… Fixed costs comprised three categories of cost. Direct costs included direct labor, maintenance, chemicals required to keep the plant bubbling, and fixed utilities. Allocated cash costs included plant management, purchasing department costs, engineering, planning, and accounting. Allocated non-cash costs represented primarily depreciation.

polysar72
POLYSAR

EROW’s variable cost per ton is approximately $595.

NASA’s variable cost per ton is approximately $623.

polysar73
POLYSAR

8f. What is the best butyl sourcing strategy for EROW, given the current accounting treatment, and the bonus scheme?

polysar74
POLYSAR

From EROW’s point of view, the $700 per tonne allocation of fixed costs is a variable cost. If EROW can manufacture an extra ton of butyl in Antwerp, instead of buying the butyl from NASA, EROW saves $700.

EROW should manufacture as much butyl in Antwerp as possible, before buying butyl from NASA.

polysar75
POLYSAR

If EROW can sell one more ton of butyl, at a price equal to NASA’s variable costs, plus shipping, plus $699, will they want to?

In the above situation, will the company want EROW to make the sale?

slide76

POLYSAR

Compensation

Management –

For managers, the percent of remuneration received through annual bonuses was greater than 12% and increased with responsibility levels.

The bonuses of top Division management in 1985 were calculated by a formula that awarded 50% of bonus potential to meeting or exceeding Divisional profit targets and 50% to meeting or exceeding corporate profit targets.

slide77

POLYSAR

Product Scheduling

Although NASA served customers in North and South America and EROW served customers in Europe and the rest of the world, regular butyl could be shipped from either the Sarnia 2 or Antwerp plant. NASA shipped approximately 1/3 of its regular butyl output to EROW. Also, customers located in distant locations could receive shipments from either plant due to certain cost or logistical advantages. For example, Antwerp sometimes shipped to Brazil and Sarnia sometimes shipped to the Far East. …

slide78

POLYSAR

Product Scheduling

… In September and October of each year, NASA and EROW divisions prepared production estimates for the upcoming year. These estimates were based on estimated sales volumes and plant loadings (i.e., capacity utilization). Since the Antwerp plant operated at capacity, the planning exercise was largely for the benefit of the managers of the Sarnia 2 plant, who needed to know how much regular butyl Antwerp would need from the Sarnia 2 plant.

polysar79
POLYSAR

What are EROW’s incentives in the budgeting process?

What happens if EROW estimates greater demand for butyl than EROW actually needs?

slide80

POLYSAR

Interview with Pierre Choquette (Vice President of NASA Rubber Division) –

“Our transfers to EROW are still a problem. Since the transfers are at standard cost and are not recorded as revenue, these transfers do nothing for our profit. Also, if they cut back on orders, our profit is hurt through the volume variance. Few of our senior managers truly understand the volume variance …”

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