Although Richard Haney did not implement either of the suggestions Oliver Douglas made in Rainier Fastener (A & B), he did agree with Oliver's comment that it is important to find ways to improve profitability. From the basic CVP model, Haney understood that there are three fundamental ways to improve profitability - increase selling price, decrease cost, or increase volume. Rainier operates in a highly competitive market where market share is determined primarily by selling prices. It is difficult to increase selling prices without losing market share because customers shift quickly to lower cost providers. At the same time, it is difficult to increase market share by lowering price because competitors quickly match lowered prices. Therefore, to improve profitability, Haney decided to concentrate on lowering costs.

Exhibit 4 shows profit or loss by product line for 2017, where direct costs were traced to product lines and indirect costs were allocated as described in Rainier Fastener (B). Overall profit for 2017 is $95,000, an improvement from the $418,000 loss reported in 2016.

Exhibit 5 presents a flexible budget for 2017 developed by the accounting department. This budget was constructed by multiplying the actual volume of feus sold in 2017 for each of Rainier's three product lines by the cost per feu from 2016, based on the assumption that costs per feu in 2017 should be the same as the costs per feu in 2016 (as shown in Exhibit 3). The next-to-last column of Exhibit 5 shows the actual total costs for 2017 (as also shown in Exhibit 4), and the last column shows variances for each cost, where favorable variances are labelled with F and unfavorable variances with U.

Oliver Douglas and Richard Haney reviewed the actual and budgeted results in Exhibits 4 and 5. Oliver found several reasons for optimism: "First, we seem to be doing a really good job of running our operations. For many of the categories where our costs are large, such as rent, property taxes, selling expense, general administrative expense, and depreciation, our actual costs were much lower than budgeted costs, resulting in large favorable variances. Second, it looks like we have turned the corner on profitability. In 2016, we lost $418,000 but in 2017 we made $95,000 so profitability was $513,000 higher in 2017 than in 2016. Third, not only did we improve relative to last year's loss, we also did substantially better than the budget. Our actual profit of $95,000 is $576,000 better than the projected loss of $481,000 in Exhibit 5."

Richard Haney found less reason for optimism in the 2017 results. "Now that I have seen the budget and results, I realize that we made a fundamental error in the way we constructed the budget in Exhibit 5. As a result, those favorable variances do not mean what you think they mean. Second, while it is true that our profit in 2017 increased relative to 2016, we also had a substantial shift in product mix, selling more units of our more expensive alloy grade fasteners that sell for $22.93 per feu, and fewer units of common fasteners that sell for only $15.80 per feu. The way we constructed our budget suggests that with the changed product mix, we should have expected a loss of $481,000 (as shown in Exhibit 5). However, because of our fundamental error in constructing the budget, this was not a reasonable expectation. If we corrected the error in our budget construction, we would see that we should have made far more than our actual profit of $95,000."

Questions:

1. For Direct Labor (a variable cost), how was the $14,381 budgeted amount computed? Explain the $672 unfavorable variance relative to the $14,381 budgeted amount for Direct Labor?
2. For Rent (a fixed cost), how was the $7,335 budgeted amount computed? Explain the $235 favorable variance relative to the $7,335 budgeted amount for Rent?
3. Exhibit 5, are the favorable variances that Oliver pointed out usually associated with fixed costs or with variable costs? Are the unfavorable variances usually associated with fixed costs or with variable costs? Do you agree with Oliver's statement that the favorable variances mean that Rainier is "... doing a really good job of running our operations."? Explain.
4. Provide a flexible budget for 2017 that corrects the fundamental budgeting error identified by Haney. Following the description in Exhibit 2, assume each cost is either fixed or variable with respect to volume. Compensation Insurance represents a combination of a fixed cost and a variable cost because it is 5% of Direct Labor, a variable cost, plus 5% of Indirect Labor, a fixed cost. In 2017, the amounts for each cost are expected to be the same as in 2016. That is, for each fixed cost, the expected total cost in 2017 is the same as the actual total fixed cost in 2016 and for each variable cost, the expected variable cost per unit produced is the same as the actual cost per unit in 2016.
5. To simplify the calculations and presentation, compute budget using the following summary format:

For each product line, sum together all the variable costs per unit shown in Exhibit 5 and then multiply the sum of the variable costs per unit by the number of units (fastener equivalent units, or feus) produced to get total variable cost for the product line. For example, combine all the variable costs per unit for common (CN) grade fasteners into a total variable cost per unit for CN and then multiply by the number of common grade feus produced to get total variable cost for CN, denoted below as VCost(CN).

The top three lines will reflect the familiar formula: Revenue-Variable Cost = Contribution Margin. Total fixed costs (totaled across all three product lines) are subtracted from CM(Total) to find net income:

Common(CN)Alloy(AG)Stainless(SS)Total

RevenueRev(CN)Rev(AG)Rev(SS)Rev(Total)

Less: Variable CostsVCost(CN)VCost(AG)VCost(SS)VCost(Total)

Contribution MarginCM(CN)CM(AG)CM(SS)CM(Total)

Less: Fixed CostsTotal Fixed

Net IncomeNet Income

a)show a flexible budget for 2017 using the assumptions and format above.

b)Compute variances that compare the actual totals for 2017 in Exhibits 4 or 5 to your budgeted total revenue, total variable cost, and total fixed cost. Use these variances to evaluate Oliver's conclusion "...we seem to be doing a really good job of running our operations." What do the variances relative to your corrected flexible budget imply about whether Rainier Fastener is achieving Haney's goal of lowering costs?

c)Explain Haney's conclusion that "... we should have made far more than our actual profit of $95,000."

Exhibit 1

Rainier Fastener Company

Income Statement for Year Ending December 31, 2016

Dollars in thousands

Sales81,143

Cost of sales49,893

Gross profit31,250

Less:Selling expense14,116

General administration7,120

Depreciation10,432

Total expenses31,668

Profit (loss)(418)

Exhibit 2

Accounting Department's Comments on Cost Behavior

Rent:Fixed.The term of the lease runs for 15 more years. Allocated based on direct labor dollars.

Property taxes:Fixed.Assessed valuation has been constant, the tax rate has risen slowly over time.Allocated based on direct labor dollars.

Direct Labor: Varies directly with production volume. Labor is continually adjusted to match production volume by hiring temporary workers.

Direct labor dollars is used as the measure of volume to allocate the costs of rent, property taxes, indirect labor, light and heat, and depreciation.

Indirect Labor: Fixed. Allocated based on direct labor dollars.

Compensation insurance: Five percent of direct labor and five percent of indirect labor.

Power: Varies directly with production volume.Rates are not expected to change.

Light and heat: Light and heat are fixed, regardless of level of production.Allocated based on direct labor dollars.

Materials:Varies directly with production volume.Exhibit 3 figures include allowances for waste and rework.

Repairs:Varies directly with production volume within normal operating range.

General administrative, selling expense:Fixed.Allocated based on dollars of sales.

Depreciation: Fixed.Allocated based on direct labor dollars.

Exhibit 3

Rainier Fastener Company

Profit and Loss by Product for Year Ending December 31, 2016

Common (CN)Alloy Grade (AG)Stainless Steel (SS)Total

$ thousands $ per feu$ thousands $ per feu$ thousands $ per feu $ thousands

Rent2,6821.27532,0822.04122,3362.36687,100

Property taxes9750.46387570.74238500.86072,582

Direct labor5,2582.50024,0824.00204,5804.640313,920

Indirect labor2,9391.39742,2812.23672,5602.59357,780

Compensation insurance4100.19493180.31193570.36171,085

Power1720.08181920.18822320.2351596

Light and heat2760.13152150.21042410.2440732

Materials6,4703.07663,6183.54713,7243.773013,812

Repairs1,0380.49366300.61766180.62612,286

Subtotal20,2209.615014,17613.897615,49715.701449,893

Selling expense5,7802.74864,0693.98904,2674.323014,116

General administrative2,9161.38642,0522.01202,1522.18057,120

Depreciation3,9401.87373,0592.99923,4323.477610,432

Total expense32,85715.623723,35622.897825,34925.682481,561

Sales33,22715.800023,38922.930024,52724.850081,143

Profit (loss)3710.1763330.0322(822)-0.8324(418)

Unit sales (thousands of feu)2,103 1,020 987

Exhibit 4

Rainier Fastener Company

Profit and Loss by Product for Year Ending December 31, 2016

Common (CN)Alloy Grade (AG) Stainless Steel (SS) Total

$ thousands $ per feu $ thousands $ per feu $ thousands $ per feu $ thousands

Rent2,6821.2753 2,0822.0412 2,3362.36687,100

Property taxes9750.46387570.7423 8500.86072,582

Direct labor5,2582.5002 4,0824.0020 4,5804.640313,920

Indirect labor2,9391.3974 2,2812.2367 2,5602.59357,780

Compensation insurance4100.19493180.3119357 0.3617 1,085

Power1720.08181920.1882 2320.2351596

Light and heat2760.13152150.2104 2410.2440732

Materials6,4703.07663,6183.5471 3,7243.773013,812

Repairs1,0380.49366300.6176 6180.62612,286

Subtotal20,2209.615014,17613.8976 15,49715.701449,893

Selling expense5,7802.74864,0693.9890 4,2674.323014,116

General administrative2,9161.38642,0522.0120 2,1522.18057,120

Depreciation3,9401.87373,0592.9992 3,4323.477610,432

Total expense32,85715.623723,35622.8978 25,34925.682481,561

Sales33,22715.800023,38922.9300 24,52724.850081,143

Profit (loss)3710.1763330.0322 (822)-0.8324(418)

Unit sales (thousands of feu)2,103 1,020 987