SpringFresh provides commercial laundry and linen services to local hospitals, hotels, and restaurants. SpringFresh charges its customers $1.50 per pound laundered, regardless of the items to-be cleaned (e.g., sheet, towel, garment, tablecloth).
SpringFresh budgets to launder 70,000 pounds each month and, for each pound laundered, budgets to spend $0.10 on materials and $0.40 cents on labor. For the most recent month, SpringFresh actually laundered 60,000 pounds and spent $4,000 on materials and $20,000 on labor.
Required:
a. Calculate the materials and labor flexible budget variances for the most recent month.
b. In the absence of any other information, does it appear that SpringFresh’s management has done a good job controlling costs in the most recent month?
c. Assume that in recent months, SpringFresh has received numerous complaints about the quality of their services. Specifically, several customers have complained that their laundry is “not as clean as it used to be” and, even worse, that some of their items have come back stained due to bleeding. Does this information cast the favorable variances and management’s performance in a different light?
SOLUTION
a. The problem provides us with the actual costs for materials and labor; thus, to calculate the flexible budget cost variances, we need only determine the flexible budget amounts for materials and labor. To calculate the flexible budget amounts, we need actual output – for SpringFresh, it is 60,000 pounds laundered. Next, because materials and labor costs are expressed in terms of pounds laundered, we can take the respective budgeted amounts per pound and multiply it by the actual pounds laundered. Thus, we have:
| Flexible Budget | Actual | Variance |
|---|
| Materials | 60,000 $0.10 = $6,000 | $4,000 | $2,000 F |
| Labor | 60,000 $0.40 = $24,000 | $20,000 | $4,000 F |
Notice that because materials and labor costs are directly expressed (budgeted) in terms of pounds laundered and not, for example, in terms of labor hours or detergent usage, we are precluded from calculating the materials and labor price and quantity variances.
b. Absolutely! Without any other information, we would have to conclude that management indeed has done an excellent job controlling materials and labor costs. At a volume of 60,000 pounds SpringFresh would have budgeted to spend a total of $30,000 ($6,000 + $24,000) on materials and labor. However, they only spent $24,000 ($4,000 + $20,000), a savings of $6,000, which is 20% lower than budgeted.
c. Indeed it does! In light of this new information, we would conclude that management is “cutting corners,” using less detergent than quality standards call for, mixing items of different colors and types, and loading the washers with as much as they can hold. Such actions can make employees look good in the short term because they are spending less than budgeted on materials and labor – that is, they are generating favorable cost variances for the company.
However, such actions can lead to quality problems and customer dissatisfaction, as indicated by the customer complaints. Such actions may lead customers to switch laundry service providers – for example, it is possible that SpringFresh only laundered 60,000 pounds in the most recent month, rather than the budgeted 70,000 pounds, because customers are going elsewhere. The lost contribution margin on this volume of business (or sales volume variance) = 10,000 ($1.50 – $0.10 – $0.40) = $10,000, which exceeds the $6,000 “savings” on materials and labor.
A key insight from this problem is that “favorable” variances are not necessarily “good” (and, as a corollary, “unfavorable” variances are not necessarily “bad”). Sometimes, as in the current example, quality and future profitability are being sacrificed to generate favorable variances and short-term profits. Indeed, it is likely that the owners of SpringFresh would look as negatively upon a large favorable cost variance as they would a large unfavorable cost variance because the large favorable variance likely indicates that employees are cutting corners and not adhering to quality standards.