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 controllers 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 create a preliminary budgeting 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 firms 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 supervisors salaries. Basically, manufacturing overhead costs include all factoryrelated 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 = Predetermined MOH Rate * Budgeted Cost Driver Amount. LLJ Satellites has chosen Machine Hours for its cost driver to calculate budgeted manufacturing overhead. For example, the $12,845,625 of Budgeted MOH in Table 1 for the Advanced Units = $9.75 per machine hour * 310,000 projected advanced units * 4.25 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 = 310,000 units) $53,940,000 COGS - Advanced Direct Materials $18,104,000 Direct Labor $17,670,000 Budgeted MOH $12,845,625 Gross Margin - Advanced $5,320,375 Revenues Basic (Projected Sales = 360,000 units) $48,240,000 COGS - Basic Direct Materials $12,132,000 Direct Labor $20,520,000 Budgeted MOH $8,775,000 Gross Margin - Basic $6,813,000 Total Gross Margin $12,133,375 Selling Costs Commissions (2 percent of revenues) $2,043,600 Salaries $460,000 Fixed Administrative Costs $1,800,000 Interest $550,000 Pre-Tax Income $7,279,775 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 aluminum and plastic when it will be immediately used in production and no 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 $2.40 $2.40 Ounces of Aluminum per Unit 2.00 0.55 Cost per Ounce of Aluminum $22.00 $22.00 Direct Labor DL Hours per Unit (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 $14.25 $14.25 Manufacturing Overhead (machine hours is the chosen cost driver) Machine Hours per Unit (Components) 2.50 0.75 Machine Hours per Unit (Assembly) 1.75 1.75 Total Machine Hours per Unit 4.25 2.50 Pre-Determined MOH Rate per Machine Hour $9.75 $9.75 4 inventory of materials is kept on hand. You can assume all beginning and ending inventory balances are zero for this case. LLJ Satellites creates an annual standard cost card to set expectations for factory workers and supervisors (see Table 2 for the cost card from the previous fiscal year). The company has tried to set attainable and realistic standard costs and usages in developing these standards. As seen in the standard cost card for last year (Table 2), all production units go through two production departments: Components (where the various components in each receiver are produced) and Assembly (where the receivers are assembled). Details regarding all expected perunit manufacturing costs for the two product types are found on the standard cost card. This cost card is typically updated each year to reflect changes in prices and production usages of resources. 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). While reviewing these results with factory managers, the factory managers were unsurprised by the lower-thanexpected margins for both types of units. They described difficulties in working with new suppliers of aluminum and plastic. The company chose switch to new suppliers near the beginning of the last fiscal year due to market pressures in these supplies. As such, Jack suggests you focus on evaluating each of these material types separately in your analyses. Factory managers were also concerned that the current manufacturing standards may not reflect difficulties between the two manufacturing departments. Jack tells you of some minor complaints from factory workers during this past year. In efforts to approve morale and after extended negotiations, the company increased the wage rate of all factory employees to $15 per hour (from $14.25 per hour) at the beginning of the fourth quarter. 5 Table 3: Actual Income Statement for Previous Fiscal Year Revenues Advanced (Actual Sales = 360,000 units) $60,840,000 COGS - Advanced Direct Materialsa $21,978,000 Direct Laborb $20,880,000 Actual MOHc $17,100,000 Gross Margin - Advanced $882,000 Revenues Basic (Actual Sales = 210,000 units) $30,240,000 COGS - Basic Direct Materialsa $7,654,500 Direct Laborb $12,240,900 Actual MOHc $6,300,000 Gross Margin - Basic $4,044,600 Total Gross Margin $4,926,600 Selling Costs Commissions (2 percent of revenues) $1,821,600 Salesperson Salaries $430,000 Fixed Administrative Costs $1,655,000 Interest $650,000 Pre-Tax Income (Loss) $370,000 a Direct materials costs consist of 2,160,000 ounces of plastic for the advanced units and 1,890,000 ounces of plastic for the basic; plus 810,000 ounces of aluminum for the advanced units and 157,500 for the basic units. The average price paid was $2.30 per ounce for plastic and $21.00 per ounce for aluminum. b Actual direct labors totaled 780,000 hours in the Electrical Components department and 1,504,200 hours in the Assembly department for the fiscal year. c Actual machine hours totaled 1,057,500 hours in the Electrical Components department and 1,282,500 hours in the Assembly department for the fiscal year. 6 Production managers also expressed skepticism about the current model to assign manufacturing overhead between the two departments. Currently, LLJ Satellites uses a single, plant-wide manufacturing overhead rate to estimate overhead costs based on machine hours. This estimate is calculated as the actual machine hours used in production multiplied by the predetermined manufacturing overhead rate described earlier. Estimates are commonly used in businesses until actual manufacturing overhead costs are known at the end of the fiscal period. At the end of the year, these estimates are trued-up or adjusted to match actual known costs. Managers seemed especially skeptical of the overhead costs assigned to the Assembly department. They also questioned if these estimates will be accurate if production increases or decreases significantly. Jack also describes other strategic decisions made during the past year in attempts to improve profitability. Most importantly, he notes that the company changed its pricing and selling strategies very early in the fiscal year (after the budget was set) in an attempt to jumpstart sales in the recessionary economy. The company also eliminated one sales position, saving on the salary of this salesperson, and eliminated a management 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 also wants your assistance to understand any additional reasons why the company fell short of budgeted projections. 7 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 $169 for an advanced unit and $139 for a basic unit. Due to a projected improvement in the overall economy, the sales teams believes they can sell 390,000 units of the advanced device and 330,000 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 annual 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 your variance or other analyses suggest otherwise, all of the standard usages (e.g., ounces of plastic or aluminum 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 in the upcoming year. An exception is that LLJ Satellites updates its standard direct materials costs (e.g., cost of aluminum/plastic per ounce) each year to better match current prices. Jack also wants advice if LLJ Satellites should continue to purchase materials from the new suppliers or go back to the old suppliers and your standard material costs should reflect your recommendations. Each supplier (new and old) is quoting similar prices to those used last year. The company can mix and match between suppliers if needed for the two materials. Finally, as a result of the labor negotiations with factory workers last year, the average hourly pay rate will be $15 per direct labor hour for the upcoming fiscal year. Due to the skepticism of production managers regarding how manufacturing overhead is calculated, a recent accounting hire at LLJ Satellites has analyzed the manufacturing overhead 8 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. 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 = 4,250,000 + 13.60(X) 0.86 Direct Labor Hours (Electrical Components) Y = 3,275,000 + 14.50(X) 0.32 Annual Assembly Department MOH Costs*** Cost Driver Regression Results (for cost driver) R2 Machine Hours (Assembly) Y = 1,500,000 + 2.20(X) 0.19 Direct Labor Hours (Assembly) Y = 1,750,000 + 2.00(X) 0.93 *** These regressions are based on annual data. The MOH costs include $1,300,000 of factory depreciation from the Electrical Components Department and $450,000 of factory depreciation from the Assembly Department. All other costs are paid in cash when incurred. Predicting the non-manufacturing costs for the upcoming fiscal year is relatively simple. Jack doesnt expect any changes in the sales persons salaries from last years actual amount of $430,000. The commission rate will also remain at two percent. The fixed administrative costs are also expected to remain at $1,655,000 and include $245,000 of depreciation expense on administrative equipment. Jack has also given you some information regarding cash receipts and payments. On average, 30 percent of quarterly sales are paid in cash and the remaining are credit sales. The company collects 60 percent of credit sales in the same quarter as the sale, and 40 percent during the quarter following the sale. At the end of the last fiscal year, LLJ Satellites had $14,000,000 in 9 its accounts receivable balance. All material purchases are made on account. The company generally pays 80 percent of its payables during the quarter of the purchase and the remainder one quarter after the purchase. At the end the last fiscal year, the accounts payable balance is $3,130,000. All other cash expenses are paid when incurred. As noted earlier, last year LLJ Satellites had a cash shortage that resulted in unexpected interest costs. Due to these problems, the board of directors wants to reduce debt as much as possible during the next fiscal year as quickly as allowable. The loan arrangement calls for a simple, non-compounding interest rate of three percent per quarter. The company will not have any penalties from paying any loans back early. Also note that any additional loans must be taken at the beginning of a quarter and all interest and principal payments are made on the last day of each quarter. At the end the previous fiscal year, the company had an outstanding loan balance of $6,200,000 and a cash balance of $115,000. Ideally to run operations, the company needs a minimum of $150,000 of cash on hand at the end of every quarter. 10 Required Write a memo directed to Jack Childs providing your insights for the LLJ Satellites. Your memo should include the following: (1) A variance analysis for the past fiscal year comparing the actual income statement results with the budgeted income statement. In your report, include a flexible budget that is commonly used to assist in variance analysis. Clearly describe what decisions and choices may have led to the variances you find. Give suggestions for improvement where applicable. (2) Schedules of applicable budgets for the next fiscal year. Please provide an updated standard cost card used in your budgets and describe your reasoning for any changes. Further, the budgets you create and report should include a sales budget, a cash collections budget, a production budget including schedules for direct materials, direct labor, and manufacturing overhead, a cash budget, and a projected income statement in the contribution margin format. Please clearly describe the assumptions and choices you make in creating these budgets.