Budgeting and Performance Evaluation at the Berkshire Toy Company

Executive SummaryIn 1974, Berkshire Toy Company (BTC) was founded by Franklin Berkshire, Janet McKinley’s farther. Janet was soon became the CEO of the company when her father retires on 1993. After two years, BTC was acquired by Quality Products Corporation, a manufacturer of different products, for a common stock of $23.2 million.

The preliminary statement of divisional operating income for the year ended June 30, 1998 presented the actual values generated together with the master (static) budget and master budget variances for the period.

The company obtained higher Total Revenue than their budget but it turned out to an Operating Loss near a million dollars. This paper aims to study the budgets from actual results, and to compute the budget variances and to analyze its causes. After that, the company performance will be evaluated to recommend alternative solutions for improvement.

IntroductionAs a division of Quality Products Corporation, Berkshire Toy Company produces the Berkshire Bear, a fifteen-inch teddy bear which are fully jointed, washable, and dressed in various accessories.

Statement of the ProblemObtaining a loss approaching a million dollars despite the increase in sales. Substantial unfavourable variances resulting from production department Effects of the incentive compensation plan to the performance of each departments

Discussion

ActualMasterBudgetVarianceUnits sold325,556.00280,000.0045,556.00Total revenue14,446,487.0013,006,000.001,440,487.00 (U)Total variable expenses8,484,4045,968,5082515,896 (U)Contribution margin5,962,0837,037,4921,075,409 (U)Total fixed costs6,805,8286,248,920556,908 (U)Operating income-843,745788,5721632,317 (U)Table 1. Preliminary Statement of Divisional Operating Income for the Year Ended June 30, 1998

The following can be derived from the table:Revenue were 11% higher than the master budgetVariable expenses were $2,515,896 higher than the master budget Fixed costs were $556,908 higher than the master budget

Actual(1)Master (Static) Budget(2)Flexible Master Budget(3)Sales Mix variance(1-3)Sales quantity variance(3-2)Units sold325,556.00280,000325,556.00045,556.00 (F)Retail & catalog8,573,285.0011, 662,000.0013, 559,407.404,986,122.40 (U)1,897,407.40 (F)Internet4,428,018.00004,428,018.00 (F)0Wholesale1,445,184.001,344,000.001,562,668.80117,484.80 (U)218,668.80 (F)Total revenue14,446,487.0013,006,000.0015,122,076.20675,589.20 (U)2,116, 067.20 (F)Table 2. Sales Analysis Schedule

Sales volume quantity variance indicates an increase in profit by $2,116,067.20 if the budgeted sales mix is maintained for the actual sales volume of 325,556. However, there is an unfavourable variance of $675,589.20 because the actual sales mix was not in accordance with the budgeted sales mix.

If we would check the sales volume variance, sales volume quantity variance plus sales mix variance is equal to favourable $1,440,487.00, which is the variance in table 1.

Production costsActualMaster Static BudgetFlexible BudgetMaster Budget VarianceFlexible varianceTotal Direct Materials1,230,840.001,015,924.001,181,214.83214,916.00 (U)49,625.17 (U)Direct Labour3,668,305.002,688,000.003,125,337.60980,305.00 (U)542,967.40 (U)Variable Production overhead1,725,665.001,046,304.001,216,537.66679,361.00 (U)509,127.34 (U)Fixed Manufacturing overhead658,897661,920769,614.383023 (F)-110,717.38 (F)Table 3. Schedule of Production Variances

Direct Material varianceThe budgeted price is higher than the actual resulting to a favourable material price variance. This is due to the price discounts of 7 to 10 percent of the three main inputs of the product namely acrylic pile fabric, plastic joints, and polyester fiber filling which contributed to some savings.

However, the actual quantity used in production is greater than the standard quantity allowed per unit that results to unfavourable material usage variance. This maybe because of substandard quality of materials used that more materials are needed to produce one unit of product. In addition, there was an incident of thunderstorm that ruined the uninsured materials wherein the company doesn’t able to recover large amount of fiber filling.

Another factor that would affect the direct material usage variance is the lifetime guarantee that the company offers which include the bear hospital since repairs or replacements of teddy bear are free. Also, defects may be a factor for the material variances which are only traced after the production process.

Direct Labour varianceThe actual number of hours used and the actual wage rate of BTC are higher than the standard rate allowed for the actual production. Since most part of the production of bear is labor-intensive, the company may have set a low standard for the number of hours required to produce a unit. Additional sewing steps and inspection of the fabric color may have contributed to the actual labor hours used.

Moreover, shortages of length in the cutting stage may require additional cutting set-ups which increase production time. Considering the production of the company, they have operated near to maximum capacity that the people are tired and some of them quit and had to be replaced at higher-than-standard wage rates that may lead to higher cost when unskilled workers are employed.

Variable OverheadDue to the effect of the increased in labor requirements, the company also incurred increased payroll taxes and fringes. Employees need to have overtime to meet the actual demanded product volume which is higher than the budgeted that consequently increase the overtime premiums paid by BTC.

Since the company has been using the same machine since it was established, frequent breakdowns occurred that maintenance work have contributed to the increase in the variable expenses. This includes the maintenance labor andsupplies needed.

Fixed OverheadThe increase in utilities expense was related to the overtime of employees in the production as the demand of teddy bear boost.

Incentive Plan

David Hall

With the favourable net materials price variance of $295,144.00, David Hall the Purchasing Manager will have a bonus of $59,028.72.

Rita Smith, Marketing Manager

Since the Actual Net Revenue is a loss, the marketing manager will not have bonus even if she manage to increase the company sales.

Bill Wilford, Production Manager

Direct Labour

Variable Overhead

Fixed Overhead

Direct Material Efficiency Variance$ 122,790 (U)Direct Labor Efficiency Variance466,638.40 (U)Direct Labor rate Variance76,329.00 (U)Variable Overhead spending variance327,488.34 (U)Variable Overhead Efficiency Variance181,639.00 (U)Fixed Overhead spending variance(3,023.00) (F)Total Variance1,171,862 (U)BonusZero

Advantages and Disadvantages of Incentive Compensation Plan

AdvantagesDisadvantagesThe incentive plan will motivate department headsMarketing Department focuses on less profitable distribution mix. Increase the morale of employees as their efforts will be rewarded Production Department:uses low quality materialsforced to work overtimePerformance of the company will attract positive resultsPurchasing Department bought discounted materials which may sacrifice the quality of production.

Conclusion

Though the company may have increased their number of sales for the current period, they still have incurred losses due to the unfavourable variances that have resulted from their production.  Substantial increase in the number of bears sold is noted for the year’s performance. It can be assumed of a good performance of the marketing department. However, loss still occurred.

The figures of sales may post a good performance conversely the current sales might give the lowest possible sales due to wrong sales mix. The marketing department has focused too much on the Internet Sales whereas it gives a lower contribution than the Retail Sales.

Variances in the production of the product are due to the wrong focused of the department head because of the new incentive compensation program. Favourable direct material price variance occurred due to lower prices and discounts on the materials purchased. However, unfavourable material usage variance have occurred probably due to substandard materials were used to the production.

Direct labour on the hand, have resulted to unfavourable variances on both efficiency and rate. Focused of the manager may be on the efficiency of labour due to the incentive program which gives the need to hire more skilled workers. This resulted to unfavourable labour rate variance. However, due to substandard materials were used the workers may have needed additional time to work on the teddy bears which still resulted to unfavourable variance.

The incentive program may have good intentions but this lead the department heads on the wrong direction and have resulted to unfavourable variances. Other factors that may have affected the variances are the spoilage due to the thunderstorms that have occurred. Machine maintenance is another factor especially in the overhead variances where frequent breakdowns happened.

Alternative solutions obtainFirst solution that we recommend is the revision of the incentive compensation plan. The objective of the plan is good and should be maintained however some computation for the said bonus should be changed. Computation of Bonus for the Marketing Manager could be retained as net revenue is a good measure not only in the performance of the marketing department but as well as the performance of the company.

Computation for the Purchasing Manager should have also considered the Material Usage Variance as quality of the materials purchased in also a key factor in their production. Bonus for the production manager may have been a good computation as it may have covered different factors to assess the performance of the department.

On the other hand, some overhead expenses should be observed by the company as it continuously increase overtime. They may need to consider purchasing new machine as maintenance cost has been a big part of their cost. A new machine may also address the issue of frequent overtime of employees and the increasing maintenance supplies expenses.