Advanced: Investigation of variances

(a) The Secure Locke Company operates a system of standard costing, which it uses amongst other things as the basis for calculat¬ ing certain management bonuses.

In September the Company’s production of 100000 keys was in accordance with budget. The standard quantity of material used in each key is one unit; the standard price is £0.05 per unit. In September 105 000 units of material were used, at an actual purchase price of £45 per thousand units (which was also the replacement cost).

The materials buyer is given a bonus of 10% of any favourable materials price variance. The production manager is given a bonus of 10% of any favourable materials quantity variance.

You are required:

(i) to calculate the materials cost variances for September; (4 marks)

(ii) to record all relevant bookkeeping entries in journal form; (2 marks)

(iii) to evaluate the bonus system from the view-points of the buyer, the production manager, and the company. (6 marks)

(b) In October there was an adverse materials quantity variance of £500. A decision has to be made as to whether to investigate the key¬ making process to determine whether it is out of control.

On the basis of past experience the cost of an investigation is estimated at £50. The cost of correcting the process if it is found to be out of control is estimated at £100. The probability that the process is out of control is estimated at .50.

You are required:

(i) to calculate the minimum present value of the expected savings that would have to be made in future months in order to justify making an investigation;

(6 marks)

(ii) to suggest why the monthly cost savings arising from a systematic investigation are unlikely to be as great as the adverse materials variance of £500 which was experienced in the month of October;

(3 marks)

(iii) to calculate, if the expected present value of cost savings were first £600 and second £250, the respective levels of probability that the process was out of control, at which the management would be indifferent about whether to conduct an investigation. (4 marks)

ICAEW Management Accounting