1 CH Company Toni Halliday is employed by the Curve Corporation, a publicly traded conglomerate. The corporation manufactures and sells many different kinds of products, including plumbing hardware, food products, sporting goods, children's games and toys, and many other products. Halliday is the President of CH Company, a wholly-owned subsidiary of Curve Corporation. It is July 2000 and Halliday has just received the preliminary income statement for her division for the fiscal year ended June 30, 2000. The master budget and overall variances for the same period are included for comparison purposes. Halliday looks at the bottom line, a loss, then picks up the phone to call you. You are an accountant in the controller's office at the headquarters of Curve Corporation. "I know the bottom line looks pretty bad. But we made great strides this year. Sales are higher than ever. Customers love our product and respect our quality. The variances should provide some insights. Calculate full variance analysis"

BACKGROUND AND EVOLUTION The CH Company was founded by Simon Halliday, Toni's father, in 1982. Halliday was an industrial artist who enjoyed making toys in his spare time. After many years of planning, in 1983, Simon Halliday acquired an old pneumatic pump that had been used to manufacture pillows in the 1950s and 1960s. He modified the machine to mass produce stuffed animals, and the CH Company started to take off. CH has always maintained and prioritized its reputation for quality. And from this quality was borne profits. By 1992, annual sales exceeded $3,000,000. Toni Halliday had learned the business from the bottom up. While a student, she held various positions during the summer and on school breaks. After graduating, she expanded her role in a variety of departments, getting to know the business. Altogether, Toni has held positions in the mail-room, production, sales, and (her favorite) accounting. Based on her performance in theses roles, Toni was named Assistant to the President in 1997 after receiving her M.B.A. In early 1998, at her urging, the company launched an initial public offering of common stock and became publicly traded. After Simon's retirement, Toni became President of CH on January 1, 1999. On March 31, 1999, Halliday was acquired by Curve Corporation. Halliday ensured the acquisition involved protection for existing employees and managers, as well as for herself. 2 The CH Bear The CH Company produces the CH Bear, a teddy bear enjoyed by children and adult toy collectors around the world. The company touts the handcrafted features of the bear. The bears are fully jointed, constructed of washable acrylic pile fabric, and stuffed with a polyester fiber filling. They stand approximately 17 inches high. The toys are dressed in various accessories, such as bow ties, sports jerseys, or character and occupational costumes. Thus, the product can be personalized for numerous occasions. The CH Bear is sold with an unconditional lifetime guarantee. Organizational Structure A majority of CH's employees are organized into three departments: purchasing, production, and marketing. The purchasing department consists of Dean Garcia, the purchasing manager, and a staff of ten individuals. The department is responsible for acquiring and maintaining the supply of production materials. William Reid manages over 160 employees in the production department, where the manufacture and assembly of the product takes place. The marketing department is headed by Harriet Wheeler. She is responsible for all aspects of marketing and supervises approximately 50 individuals that make up CH's marketing department and sales force. The remaining employees include Toni Halliday and a few assistants. BEAR PRODUCTION Production begins with a cutting function that creates the required pieces of acrylic pile fabric. The bolts of fabric are rolled out and layered on the cutting table. The fabric is measured at this time for length and width and inspected for flaws. Flaws, as well as shortages in length or width, increase fabric waste and time inefficiencies, given the rework necessary to fix these problems. CH Bears come in a variety of colors. Fabric dye lots are important for matching colors. Thus, quality control for fabric color is performed as well. Off-color fabric must be scrapped or returned to the supplier. 3 CH obtains the most economical price for specified colors by timing its fabric orders with the production runs of its suppliers. Rush orders almost always substantially increase the price of the required fabric. In the next stage of production, operators of industrial sewing machines construct the various bear parts: arms, legs, head, and torso. Each piece is sewn inside out and then turned right-sideout for assembly. Sewing is the most labor-intensive phase of the production process. Any additional sewing steps (i.e., for specialty bears) require additional production time. In the next step, acrylic eyes are attached to the head with plastic rivets. If the rivet posts are too short, the eyes may fall off later. If the rivet posts are too long, the eyes will stand out from the head, giving a nonstandard appearance. Acrylic eyes are purchased from vendors in "dark brown," but the exact shade may vary from supplier to supplier. Defects are not discovered until the eyes are used in production. At that point, defective eyes are discarded and replaced with ones that meet specifications. After the cut pieces have been sewn together and the eyes have been attached, the company's unique pneumatic stuffing machine is used to blow the polyester fiber filling into the unassembled parts. Except for a few replacement parts and upgraded motors, this is the same machine that Simon Halliday acquired in 1983. Bags of filling are loaded into the machine hopper and mechanically fluffed to the proper loft. An operator places the empty arm, leg, body, or head over a stationary nozzle and uses a foot pedal to control the flow of filling. The machine operator judges whether the part has been filled correctly. Too little filling affects the firmness of the bear; too much filling is unnecessary and expensive. Inferior grade fiber filling is less expensive but can cause clumping and clogging in the hopper. When this happens, production is interrupted and the operator must unclog the vacuum hose and reset the machine. Next, the arms, legs, and head are attached to the torso using hard plastic disc joints. The disc joints allow the head and limbs to rotate and eliminate the need for sewn attachment. The plastic joints are designed to be foolproof in production and dependable for the life of the product. However, the joints cannot be removed without destroying them. Occasionally, after initial joint insertion, the parts do not fit together properly, and they must he removed and replaced. At the end of the construction process, a woven satin label that states "CH Bear" is attached to the back of each bear. More polyester filling is stuffed into the torso and the back-seam is handstitched. Each seam is brushed by hand to give the bear a seamless look. The production process is a continuous source of airborne polyester and acrylic fibers that must be controlled, both to protect the health and safety of the employees and to safeguard the production equipment. The company has taken several steps to control the fibers, including an air filtration system that runs constantly to remove dust and fibers from the factory. Maintenance is important for the sewing machines. Machine oil and static electricity attract pile fabric lint. Lint buildup can cause lines of stitches that are uneven and seams that do not hold. 4 The CH Bear workmanship is guaranteed for life. Burst seams are the biggest cause of rework on bears that have been sent back by customers for repair. All production employees are paid a regular wage for a 40-hour work week. They receive their regular wage plus an overtime premium of one-half the regular wage rate for overtime. Regular wages are charged to direct labor. The cost of fringe benefits and taxes is included in variable overhead costs. PRODUCT MARKETING AND SALES Product Specifics One of the company's taglines is "CH Bears - Friends with Character." Each bear comes with a short backstory of the bear, including a description of its "likes" and "dislikes," favorite kind of stories it likes being read to, and other creative and "customized" dimensions. There are also specialty bears that are used to celebrate holidays and events. Big sellers include graduations, Mother's Day, Valentine's Day, and various religious holidays. Bears are customized with seasonal and celebratory costumes, generally referred to as "accessories." On average the cost of these accessories is relatively small. Given that this cost is small, each bear is assumed to have one accessory (for simplicity). When the company receives an order, an employee takes a bear of the requested color and dresses it according to the customer's order. Then, the bear is packaged with a protective air bag and shipped in a designer box, which contributes to the product's image by creating a feeling of exclusivity, and customization. The box is important, especially to toy collectors who "invest" in bears, hoping they will increase in value, if they remain unopened and in the original box. CH purchases these boxes from another company. When purchased in large volumes, there is a discount that can be secured. Rush orders on designer boxes are significantly more costly. Thus, CH purchases the designer boxes at the beginning of the fiscal year, based on budgeted sales volume for the year. Finally, CH pays sales commissions to sales staff on retail store sales, as well as wholesale sales. Commissions are not paid on sales of other types (as discussed in the next subsection). Sales Channels Marketing and sales of the product takes place via multiple sales channels. CH sells wholesale (i.e., to other distributers, toy stores, and other specialty shops). 5 CH also sells retail (i.e., direct to consumers). The channels used here include mail and phone orders and via its own retail stores. Currently, CH has two of its own stores, one of which is located in the same facility near the manufacturing plant. Mail and phone orders are facilitated via CH's own website, which contains a virtual catalog of available bears, and instructions on ordering. A new channel involves a partnership with Amazon.com, and was implemented in late 1999, somewhat unexpectedly. Fulfilling orders for sales made via the Amazon.com partnership involve many of the same processes used to fulfill "normal" retail sales. (The evolution of this sales channel is describe in the next section.) FOCUS OF ANALYSIS AND INCENTIVE PLAN Continuing your conversation with Toni Halliday, she says to you: "I think I know what some of the problems are, but I would like a detailed analysis that provides confirmation from our accounting data." You ask a basic question about inventory status, and Halliday replies: "Inventory is pretty negligible. We don't have much on hand at the fiscal year end - June 30th, that is. We sell a lot around holidays, and we're pretty good about managing that demand usually. Given our loss this year, it's more the costs that I'm worried about. Revenues, too, I suppose." You jot down a note to ignore changes in raw materials and finished goods inventories and to assume that production volume equals sales volume. Your conversation turns toward the incentive compensation plan, and you learn the following. The new incentive plan was adopted effective July 1, 1999. Under the plan, each of the three department heads is compensated based on the performance of his or her department. Performance is measured against budget. The plan was developed over a long period of time, and involved many meetings, some of which ended in frustration (especially the early conversations). Ultimately, the plan was developed to promote participation, teamwork, and compensate managers fairly for their performance. The final version of the plan was accepted by the managers enthusiastically and implemented. The specifics of the plan are as follows: 6 o Dean Garcia, the purchasing manager, receives a bonus based on the total materials spending variances, across all direct material purchases. That is, the spending variance for each purchased direct material is summed together. If this "total" variance is favorable, Dean receives a bonus equal to 16% of this sum. If the "total" variance is unfavorable, Dean does not receive a bonus. o Harriet Wheeler, the marketing and sales manager, receives a bonus based on the revenue and selling expenses variances (i.e., from the master budget). Net revenues are calculated as gross sales revenue minus all selling expenses. If the total net revenue variance is favorable, Harriet receives a bonus equal to 5% of this sum. If the total net revenue variance is unfavorable, Harriet does not receive a bonus. o William Reid, the production manager, receives a bonus based on several variances: (1) the efficiency variances for all materials, labor, and variable overhead, (2) the labor spending variance, and (3) the variable overhead spending variance, and (4) the fixed overhead spending variance. If the total of all of these variances combined is favorable, William receives 7% of this total. If the total of all of these variances is unfavorable, William does not receive a bonus. CURRENT YEAR PERFORMANCE Marketing and Sales Halliday continues the conversation about some specifics from the past year. "It seems that the incentive plan worked well. Wheeler, in particular, had a terrific year! Unit sales were much higher than budget. Harriet mentioned the success that she had with the new Amazon.com partnership, and all of the planning, marketing, and relationshiplogistics work she did." CH Company had used its own company internet site since 1997, and this proved to be an effective sales channel. In November 1999, CH established a formal relationship with Amazon.com, allowing for special marketing and sales via the growing online retailer. As part of the agreement, Wheeler knew that the selling price collected by CH for sales via Amazon.com was going to be less than the "normal" retail price (i.e., the price displayed on the company's website and in the retail stores). The net sales price of bears sold through Amazon, however, was still greater than the wholesale price. Halliday had approved the pricing. Purchasing Halliday turns toward the purchasing department. 7 "Garcia had a few triumphs of his own. He managed to secure some substantial price discounts on fabric, plastic joints, and filling. Some of these discounts were close to 10% - which really add up, given the volumes that were needed and used. Production Halliday's demeanor changes a bit as the subject of production comes up. "Production is a bit of a different story. William Reid moved from another one of Curve's subsidiaries this year. Our previous production manager left last year. William didn't have the best start. About a week after he joined CH, we had a freak thunderstorm. We hadn't seen rain like that in a long time. The storm-water drain backed up, and it ended up ruining a large amount of filling for the bears. The loss wasn't insured. William and I continued to chat - and still do quite a bit. He complains about substandard materials, deviations from production plans, and increased overtime he has to pay because of the high production volume we need to keep up with demand. I can understand a bit of this. The plant has been operating at near maximum capacity of 350,000 units. His people are tired. Some even quit, and then we needed to hire quickly, which led to higher than normal wages. Other costs increased because William says that extra maintenance was required on machines. This led to inefficiencies, too, as machines weren't running while they were being maintained." She continues. "He is fair and responsible, though. He admitted that he was the person who moved some plastic joints near the trash area, and they got thrown out accidentally by other staff. Hopefully, he can turn things around." 8 INFORMATION AND REQUEST Halliday moves to the information that she has provided and her request. Per a formal communication that follows your meeting, you have the attached exhibits, pertaining to the fiscal year ending June 30, 2000. o Exhibit 1 - Summary of Actuals and Master Budget o Exhibit 2 - Sales by Channel (Actual and Budget) o Exhibit 3 - Standard Cost Information o Exhibit 4 - Actual Costs o Exhibit 5 - Selling Expenses Halliday requests the following items from you: (1) A full revenue variance analysis, which would include the following: a. All revenue variances using gross revenues b. All applicable variances for variable selling costs c. All applicable variances for fixed selling costs (2) A full cost variance analysis, which would include, where applicable, the spending, efficiency, and activity variances for each cost category, including: a. Materials b. Labor c. Variable overhead d. Fixed overhead (3) A calculation of the bonuses for each of the three managers based on the variances calculated and incentive plan details provided earlier. (4) statement regarding opinion of the incentive plan, the outcomes, and potential improvements . . . basically, advice that you might provide Toni regarding the situation, based on your analysis.

\fDirect materials Actrylic pile fabric 288,403 283,873 Acrylic eyes 138,862 123,900 Plastic joints 288,035 221,250 Polyester fiber filling 534,788 427,455 Label 19,707 17,700 Designer box 66,329 76,700 Accessories 62,538 41,300 Total Materials 1,398,662 1,192,178 Direct labor 4,305,881 3,292,200 Variable manufacturing overhead 1,979,441 1,235,460 Fixed manufacutring overhead 767,228 746,940 Variable selling expenses 1,879,779 1,405,500 Fixed selling expenses 5,865,815 5,146,500 Administrative expenses 1,184,801 1,190,000 Operating profit 5 (556,430) S 791,222 Note: The above actual operating income does not include the bonuses paid to management.Exhibit 2 - Sales by Channel Actual Units Unit Price Total Sales ($) Retail 188,898 55.00 10,389,390 Wholesale 49,710 38.00 1,888,980 Amazon 92,792 49.00 4,546,808 331,400 16,825,178 Budget Retail 215,000 56.00 12,040,000 Wholesale 80,000 37.00 2,960,000 295,000 15,000,000Exhibit 4 - Actual Costs Quantity Used Input Price Total Cost Direct materials Quantity Units Dollars Per Input Unit Total Actrylic pile fabric 8,345 bolts 34.5600 bolt 288,403 Acrylic eyes 661,248 eyes 0.2100 eye 138,862 Plastic joints 1,937,023 joints 0.1487 joint 288,035 Polyester fiber filling 354,164 pounds 1.5100 pound 534,788 Label 328,447 labels 0.0600 label 19,707 Designer box 315,854 boxes 0.2100 box 66,329 Accessories 330,190 various 0.1894 each 62,538 Total Materials 1,398,662 Direct labor Hours Units Dollars Per Input Unit Total Sewing 189,211 hours 9.59 hour 1,814,533 Cutting and stuffing 104,117 hours 9.59 hour 998,482 Assembly 121,054 hours 9.59 hour 1,160,908 Dressing and packaging 34,615 hours 9.59 hour 331,958 Total Labor 448,997 hours 9.59 hour 4,305,881 Variable manufacturing overhead 1,979,441 Fixed manufacturing overhead 767,228Exhibit 5 Selling Expenses Units Sold [11! of bears] 'u'arialole Selling Expenses ES] Packing and shipping Commissions Ma rketing materials Total variable selling exp Fixed Selling Expenses [5] Salaries Advertising and promotion Total fixed selling exp 1,5 33,333 125,? 33 134,333 1,333,? :13 3,2?4,3?1 2,533,344 5,335,315 1,333,: 1 4 2 43,3 33 35,35 3 1,435,533 2,335,333 2,443,531 5,1 43,533