Standard Cost Systems Can Have Motivational Effects; Some Are Desirable

question 48

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:

Discount

A reduction in the price of goods, services, or financial instruments, often used as a marketing strategy or to encourage early payment.

International Fisher Effect

A theory stating that differences in nominal interest rates between two countries are directly proportional to changes in the exchange rate over the same period.

Nominal Rates

Interest rates or rates of return that have not been adjusted for inflation.

Note Issuance Facility

A financial arrangement that allows a borrower to issue short-term debt securities as needed, up to a predetermined limit.