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1 LLJ Satellites: Variance Analysis and Budgeting Jack Childs is nervous about his company's future performance. The Childs family own 40% of the shares of LLJ Satellites, and generally has control over the direction of the company. In fact, Jack is currently the CFO and is also a member of the Board of Directors. However, outside shareholders are becoming increasingly anxious due to poor operating results from the past few years. You have been hired by Jack into the controller’s office to provide some fresh perspectives about operations at LLJ Satellites. For your first assignment, Jack asks you to review the financial information from the last fiscal year and to help create a budgeted plan for the next fiscal year. To help you complete this assignment, Jack has provided you with various financial data relating to the previous fiscal year as well as a brief synopsis of the firm’s business model. LLJ Satellites – Company Overview LLJ Satellites makes two types of specialized transistors for satellite communication reception: an advanced and a basic device. At the beginning of each fiscal year, the company creates a projected income statement for planning purposes. Below is the budgeted income statement for the past fiscal year and standard cost information used to create the budget. Currently, the company uses a plant-wide predetermined manufacturing overhead rate to apply manufacturing overhead to its products. Manufacturing overhead includes indirect manufacturing costs such as plant utilities, factory depreciation, plant maintenance, and production supervisor’s salaries. Basically, manufacturing overhead costs include all factory- related costs that are not direct materials or direct labor. These costs are generally estimated using a predetermined manufacturing overhead rate based on a chosen cost driver. Budgeted 2 manufacturing overhead is typically calculated using the following formula: Budgeted MOH = Pre-Determined MOH Rate * Budgeted Cost Driver Amount. LLJ Satellites has chosen Machine Hours for its cost driver to calculate budgeted manufacturing overhead. For example, the $14,250,000 of Budgeted MOH in Table 1 for the Advanced Units = $9.50 per machine hour * 300,000 projected advanced units * 5 projected machine hours per advanced unit (information taken from Tables 1 and 2). Table 1: Budgeted Income Statement for Previous Fiscal Year Revenues – Advanced (Projected Sales = 300,000 units) $52,500,000 COGS - Advanced Direct Materials $17,700,000 Direct Labor $16,800,000 Budgeted MOH $14,250,000 Gross Margin - Advanced $3,750,000 Revenues – Basic (Projected Sales = 350,000 units) $47,250,000 COGS - Basic Direct Materials $11,725,000 Direct Labor $19,600,000 Budgeted MOH $9,975,000 Gross Margin - Basic $5,950,000 Total Gross Margin $9,700,000 Selling Costs Commissions (2 percent of revenues) $1,995,000 Salaries $450,000 Fixed Administrative Costs $1,650,000 Interest $520,000 Pre-Tax Income $5,085,000 3 The company employs a just-in-time inventory system for all of its inventory types (raw materials, work-in-process, and finished goods inventory). Because LLJ Satellites supplies major satellite companies, the company can accurately predict production needs in advance. Thus, the company carries little or no balances in any inventory account. For example, the raw materials manager only buys silicon and plastic when it will be immediately used in production and no real inventory of materials is kept on hand. You can assume all beginning and ending inventory balances are zero for this case. Table 2: Standard Cost Card for Previous Fiscal Year Advanced Device Basic Device Direct Materials Ounces of Plastic per Unit 6.00 9.00 Cost per Ounce of Plastic $2.50 $2.50 Ounces of Silicon per Unit 2.00 0.50 Cost per Ounce of Silicon $22.00 $22.00 Direct Labor DL Hours per Unit (Electrical Components) 1.00 2.00 DL Hours per Unit (Assembly) 3.00 2.00 Total DL Hours per Unit 4.00 4.00 Cost per DL Hour $14.00 $14.00 Manufacturing Overhead (machine hours is the chosen cost driver) Machine Hours per Unit (Electrical Components) 3.00 1.00 Machine Hours per Unit (Assembly) 2.00 2.00 Total Machine Hours per Unit 5.00 3.00 Pre-Determined MOH Rate per Machine Hour $9.50 $9.50 4 As seen in the standard cost card (Table 2), all production units go through two production departments: Electrical Components (where the electrical components in each receiver are produced) and Assembly (where the receivers are assembled). Jack asks that you organize your analyses based on these two departments rather than product line. In other words, you may wish to evaluate the two productions departments separately to better understand what is happening with LLJ’s production processes. Jack is concerned because actual year-end income fell short of projected income for the third straight year (see actual income for the previous fiscal year in Table 3). He notes that the company changed its pricing and selling strategy very early in the fiscal year (after the budget was set) in an attempt to jumpstart sales in the recessionary economy. The company also decided to purchase silicon from a new supplier that offered a lower price. Last year, the company eliminated one sales position, saving on the salary of this salesperson. However, after extended labor negotiations, LLJ Satellites increased the wage rate of the factory employees to $15 per hour at the beginning of the fourth quarter. The firm also eliminated an employee training program that represented a $145,000 savings in administration costs. Unfortunately, the company had an unexpected cash shortage in September. Thus, the firm needed a costly emergency short-term loan that significantly increased the interest costs for LLJ Satellites. Jack wants assistance understanding other reasons why the company fell short of budgeted projections. 5 Table 3: Actual Income Statement for Previous Fiscal Year Revenues – Advanced (Actual Sales = 350,000 units) $59,500,000 COGS - Advanced Direct Materialsa $20,580,000 Direct Laborb $19,950,000 Actual MOHc $18,725,000 Gross Margin - Advanced $245,000 Revenues – Basic (Actual Sales = 200,000 units) $29,000,000 COGS - Basic Direct Materialsa $6,769,000 Direct Laborb $11,685,000 Actual MOHc $6,700,000 Gross Margin - Basic $3,846,000 Total Gross Margin $4,091,000 Selling Costs Commissions (2 percent of revenues) $1,770,000 Salaries $425,000 Fixed Administrative Costs $1,505,000 Interest $630,000 Pre-Tax Income (Loss) ($239,000) a – Direct materials costs consist of 2,100,000 ounces of plastic for the advanced units and 1,820,000 ounces of plastic for the basic; plus 735,000 ounces of silicon for the advanced units and 110,000 for the basic units. The average price paid was $2.45 per ounce for plastic and $21.00 per ounce for silicon. b – Actual direct labors totaled 750,000 hours in the Electrical Components department and 1,470,000 hours in the Assembly department for the fiscal year. c – Actual machine hours totaled 1,350,000 hours in the Electrical Components department and 1,192,500 hours in the Assembly department for the fiscal year. 6 Looking Forward – Planning for the Next Fiscal Year On the advice of outside shareholders, Jack has agreed to change its product pricing strategy. Specifically, the firm is planning on charging $180 for an advanced unit and $140 for a basic unit. Due to a projected improvement in the overall economy, the sales teams believes they can sell 360,000 units of the advanced device and 300,000 units of the basic device at those prices. Sales in this industry are cyclical and the company expects 50 percent of the total sales to occur in the fourth quarter. For simplicity, assume the remaining 50 percent of annuals sales are uniform throughout the first three quarters of the year. Based on the variance analysis, some changes may be needed in the standard costs used for budgeting and planning purposes. However, unless variance results suggest otherwise, all of the standard usages (e.g., ounces of plastic or silicon per unit, machine hours per unit, and direct labor hours per unit) will remain the same as last year for the upcoming fiscal year. The company has no plans that will substantively change the manufacturing process to increase the standard efficiency in using these resources. However, each year LLJ Satellites updates its standard direct materials costs (e.g., cost of silicon/plastic per ounce) to better match current prices. Jack also wants advice if LLJ Satellites should continue to purchase silicon from the new supplier or go back to the old supplier. Also, as a result of the labor negotiations with factory workers, the average hourly pay rate is expected to remain at $15.00 per direct labor hour. A recent accounting hire at LLJ Satellites has analyzed the manufacturing overhead costs at the company. Specifically, she examined past manufacturing overhead costs in each of the two production departments and regressed these costs on various potential cost drivers. Jack is unsure how to best use this data. Results from this analysis are in the table below. 7 Table 4: Regression Analysis of Factory MOH Costs on Potential Cost Drivers Annual Electrical Components Department MOH Costs*** Cost Driver Regression Results (for cost driver) R2 Machine Hours (Electrical Components) Y = 2,800,000 + 13.00(X) 0.83 Direct Labor Hours (Electrical Components) Y = 5,250,000 + 15.00(X) 0.55 Annual Assembly Department MOH Costs*** Cost Driver Regression Results (for cost