Efficiency or Capacity Variance (Appendix 2). Argentina Metals Company produces a magnetic instrument at its Buenos Aires plant. A standard cost accounting system is used. When operating at a normal volume of 300,000 machine hours, the plant should produce \(1,200,000\) units of this instrument. In the past few years, the company has been able to sell only 800,000 units of this product line each year. Management is aware of the relatively high fixed overhead costs budgeted at \(4,800,000\) pesos for the year and of the need to operate as closely to normal volume as possible.

The company has two categories of variable overhead: one varies at the rate of 3 pesos per unit of product; the other, which is based on machine hours, varies at 2 pesos per unit of product. Therefore a total of 5 pesos is charged to each product for variable overhead.

Last year the plant operated at 250,000 machine hours and produced 800,000 units of the magnetic instrument. The standard variable overhead cost is 8 pesos per machine hour, and the company incurred 2,050,000 pesos of actual variable overhead. It incurred \(4,800,000\) pesos in fixed overhead.

One of the production supervisors, Ernesto Valdez, has stated that some improvement has been made in operating more closely to normal volume. "By operating at 250,000 machine hours, the plant is up to \(5 / 6\) of normal volume. If the plant had operated at only 200,000 hours, as it did the year before last, we would have absorbed only \(2 / 3\) of the fixed overhead. This year the unfavorable capacity variance is only 800,000 pesos. The year before that, the unfavorable capacity variance woas \(1,600,000\) pesos."

The supervisor of another department, Julio Diaz, disagreed and replied, "You can't eliminate a capacity variance by using more hours. Ernesto, you are confusing the concept of a capacity variance with an efficiency variance."

Valdez answered by saying, "An efficiency variance involves only the variable overhead and has nothing to do with what we are discussing, the absorption of fixed overhead."

\section*{Required:}
1. Calculate both the overhead efficiency variance and the capacity variance for both years.
2. Explain what the efficiency variance measures as compared to what the capacity variance measures.
3. Which of the two supervisors is correct? Explain.