Standard Cost Systems Can Have Motivational Effects; Some Are Desirable

question 75

Essay

Standard cost systems can have motivational effects; some are desirable, some are not. Consider the following situation:
The materials purchasing manager is paid a salary plus a bonus based on the net favorable materials price variance. Generally, this bonus amounts to 30 - 40% of the manager's total compensation. Due to the bankruptcy of a company in a related field, there is an opportunity to buy a key raw material. The standards for this material call for grade 2A, usually purchased for $56 per ton. Because of the bankruptcy, the company can obtain a higher grade, 4A, for $62 per ton. While the quality of the final product will be the same regardless of the grade of material used, there will be substantial savings in material yield and labor productivity if 4A is used. These savings are expected to be two-to-three times the additional cost of $6 per ton.
Required:
A. How would an unfavorable price variance on a particular purchase affect the overall price variance for the year and the manager's bonus?
B. Would the use of the materials price variance as a basis for the manager's bonus lead to a desirable or undesirable behavioral outcome? Explain being sure to note whether the manager would likely pursue acquisition of the grade 4A material.

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Definitions:

Compounded Semi-annually

Interest on a loan or investment calculated twice a year, added to the principal sum, and earning interest thereafter.

Mortgage Loan

A loan secured by real property through the use of a mortgage note, typically used to purchase property.

Compounded Annually

Compounded annually refers to the process of earning interest on both the initial principal and the accumulated interest from previous periods once a year.

Rate of Return

The increase or decrease in the value of an investment during a set timeframe, represented as a proportion of the investment's starting price.