1．Explains the method used to cost the ‘Belma’ overcoat and the purpose of variance analysis. (20% of Element 2)
The method Merinos Ltd used to calculate the cost of the ‘Belma’ overcoat is absorption costing. Basically, absorption costing is a costing system that accumulates all manufacturing costs with the production process, including direct materials, direct labour, and both fixed and variable overhead 3. It provides the basis for variance analysis and further cost-control actions. Variance analysis, which compares the budgeted and actual results, is crucial for management simply because variances do not end in themselves but facilitate subsequent investigation and action. Primarily, variance analysis serves as a cost management technique. Its purpose is to identify any exceptions from budget, thus keep management informed of the areas planned results are different from the actual. This information is of great importance since it is not only used to correct undesirable problems through control action, but also draws management attention on the fairness of the standards and stimulates further reasonable adjustments 4. In addition, variance analysis could also be used for responsibility accounting. It makes it easy and clear for each department to be responsible for any deviation from budget activity. There are also many organizations exploring variance analysis as a tool to assess the performance of managers and divisions. It can be seen that variance analysis is essential in both cost-control and decision making process.
Discusses the key findings of the variance analysis undertaken for October to December 2011. This should include possible reasons for and implications of the variances identified. (50% of Element 2)
Direct material variance:
All the three material suffer from material price increase to different extent. In particular, the price of leather increases 62.28% [= (£47.06 – £29.00)/ £29], contributing to the largest adverse results. This may due to three reasons. Firstly, it maybe caused by uncontrollable market factors2. Secondly, it may indict the poor contract negotiations by the purchasing officer, or poor discount rate from suppliers through the changes of purchasing volume once at a time 7. Thirdly, it is also reasonable that the company alter to buy higher quality of materials, especially for leather, thus they can make higher quality products and charge more from customers.
However, the price increase on materials is not necessary a bad news to Barry, because the higher quality materials will help to reduce waste in production process.
The results of material usage among leather, cloth and buttons are unfavourable, which indicts usage is greater than budgeted. Possible reasons include lower quality inputs or the substitutes of material leading to workers temporarily unskilled. Moreover, the untrained workers hired result in higher materials usage.
Direct labour variance
In terms of labour rate variance of skilled labour and semi-skilled labour (i.e. £-10499.67 for skilled labour and – £3013.00 for semi-skilled labour), the negative variance implies a payment premiums, which means the actual amounts paid to employees may include extra payments for shift differentials or overtime.
Barry should be more concerned because the efficient performance and payment system is crucial in internal control 4.
An interesting finding here is that the labour efficiency of skilled labours and semi-skilled labours show a different pattern. To be specific, the labour efficiency variance for skilled labours is positive £5226.67 at the meantime the result of semi-skilled labour shows negative £3130. It is also proved that the skilled labour are more productive than semi-skilled labours, because they are better trained to use equipment proficiently and deal with different situations than semi-skilled labours. Moreover, the skilled labours produce more quickly than expected due to self- motivation or salary leading motivation. Meanwhile, the semi-skilled labour lost time in operation process may caused by lack of training or less motivated. Therefore, the suggestion given to Barry is to provide more training to semi-skilled labours and hopefully could increase working efficiency.
A special point mentioned here is Celebrity Fee, which is the only item that the company did not include in its budget. Actually, asking Ben to join in promotion is worthwhile. Although the payment to Ben increase price piece by piece, the increase of sales volume is to some extent counted on his reputation. The detailed explanation on the sales volume variance is discussed in section “Sales variance”.
The key point in this issue for Barry to pay more attention is whether Ben contributes more than he gets paid. Barry should further compare the promotion work done by other channels, such as TV advertisement or sales discounts 5.
Fixed overhead variance
In terms of fixed overhead expenditure variance, rent, managers and utilities shows the same pattern that is an adverse result, which indicts a marginal overspend on fixed costs for the period. To compare, the fixed overhead volume variance are all positive. Recall that the fixed manufacturing overhead must be assigned to each product6, therefore the exceed production (=6400) than budgeted (=5500) leads to a positive variance.
Recommendations to Barry are to make operation plan by periodically, and adjust the depreciation of long-term fixed asset appropriately 3.
The prominent favourable sales variance contributes the largest profit (=£455275.91) to net profit comparing to other variables. To start with, the positive £71275.91 sales margin volume variance reveals the exceed sales than budget. In other words, an increase in the actual number of units sold contributes to the favourable results. In addition, sales price variance takes large proportion of 84% [=£384000.00/ (£384000.00 + £71275.91)] of the total sales variances, which indicts the company is able to pass most of the increase in costs onto their customers.
As mentioned above, with price increases 31.58% [= (£250 – £190)/ £190] and sales volume improves 16.36% [=(6400-5500)/5500] simultaneously, it suggested that Barry can further increase the overcoat price to make more profit. The possible reasons include taking advantages of Ben’s promotion or the competitive advantages (i.e. the better design and lower price) comparing to the competitors, such as Armani.
Advises Barry how to respond to the recent publicity. This should include a review of the profit margin of the ‘Belma’overcoat in light of sector information and relevant ethical issues. (25% of Element 2)
The recent publicity mainly criticizes the ‘Belma’ overcoat from two aspects. The first one is the “100% mark-up”, which simply means the publicity regards the selling price of ‘Belma’ overcoat is too high. Actually, Barry could argue that although the company has relatively high profit margin, it does not mean the selling price is high, simply because not only price but also cost determine the value of profit margin. The high margin here is a result of effective cost control actions the company has done in the production process. More persuasively, Barry could point out that the gross profit margin for the clothing manufacturing sector ranges from approximately 25 to 70 percent 1. The competitors, for instance, H&M had a gross profit margin of 62.9% and Zara’s was 59.3% in 2010 (ibid). Therefore, the Merinos Ltd’s overcoat is not expensive and its 54% [= (£250-£1036606.80/6400) / (£1036606.80/6400)] profit margin is perfectly normal. The second criticism concern with the company’s marketing strategy. The publicity claims the celebrity endorsement encourages young people to buy the product on credit, which seems unethical. Barry could firstly emphasis that the product is not expensive. Thus, young people would not go so far as to borrow to buy it. Additionally, Merinos’ promotion does not involve a lack of honesty or a conflict of interests, which is not unethical. Finally, Barry could indicate that the company will always keep taking into account all ethical consideration when it prices and promote products.
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Recommendations to Barry:
As the funder and top manager of the manufacturing company, it is essential to understand the concepts and applications of management accounting and cost accounting, which helps to enhance internal control and generate the profits.